Options clearing corporation",

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What Is Options Clearing Corporation?

The Options Clearing Corporation (OCC) is a vital financial institution that functions as the world's largest equity derivatives clearing organization. As a key component of financial market infrastructure, the OCC serves as a central counterparty for listed options and futures contracts traded in the United States, effectively guaranteeing the performance of contracts between buyers and sellers²⁶, ²⁷. Its role is critical in mitigating counterparty risk and ensuring the stability and integrity of the markets it serves²⁵. The Options Clearing Corporation operates under the regulatory oversight of the U.S. SEC and the Commodity Futures Trading Commission (CFTC).

History and Origin

The Options Clearing Corporation was established in 1973 as a clearing house for five listed markets for equity options ²⁴. Its formation was significantly encouraged by the SEC, as the Chicago Board Options Exchange had previously managed its own clearing entity. The OCC was founded to centralize the clearing process, a critical step as the volume of equity options trading began to increase dramatically²³. By becoming the issuer and guarantor of options contracts, the Options Clearing Corporation aimed to bring stability and efficiency to the burgeoning options market²². In March 2011, the organization officially revised its name and brand identity from "The Options Clearing Corporation" to "OCC" to better reflect its broader suite of clearing solutions beyond just options²¹. The organization's commitment to market stability was highlighted by its designation as a Systemically Important Financial Market Utility (SIFMU) in 2012 under the Dodd-Frank Act, subjecting it to enhanced regulatory scrutiny over its risk management systems²⁰.

Key Takeaways

The Options Clearing Corporation (OCC) acts as the central counterparty for listed options and futures contracts in the U.S., guaranteeing the fulfillment of contractual obligations.¹⁹
It operates under the regulatory jurisdiction of both the SEC and the CFTC, providing clearing and settlement services for a wide range of equity derivatives.
The OCC minimizes counterparty risk by stepping between buyers and sellers, effectively becoming the buyer to every seller and the seller to every buyer.¹⁶, ¹⁷, ¹⁸
Through robust risk management practices, including the collection of margin, the OCC helps maintain the financial integrity and liquidity of the markets.¹⁵
The organization also provides investor education and research services to support the growth and understanding of the derivatives markets.

Interpreting the Options Clearing Corporation

The Options Clearing Corporation's role is primarily infrastructural, ensuring that the complex machinery of the derivatives markets operates smoothly. For market participants, the existence of the OCC means that the creditworthiness of their trading counterparty is replaced by the OCC's own robust financial backing and risk management framework¹³, ¹⁴. This interposition eliminates the need for individual market participants to assess the credit risk of their direct trading partner, fostering greater confidence and encouraging participation in the options markets. The OCC’s operations enhance market liquidity by facilitating quick and reliable settlement of trades, as participants can confidently close out positions without concern for the other side of the trade defaulting.

¹²## Hypothetical Example

Imagine an investor, Alice, wants to buy a call option on XYZ stock, and another investor, Bob, wants to sell that same call option. When Alice places her order through her broker-dealer, and Bob places his, their orders meet on an exchange. Once the trade is executed, the Options Clearing Corporation steps in.

The OCC becomes the seller to Alice and the buyer to Bob. This means Alice now holds an option contract issued and guaranteed by the OCC, and Bob has an obligation to the OCC. If Alice decides to exercise her option, the OCC ensures that the underlying shares are delivered, even if Bob were to default on his obligation. Conversely, if Bob's option is assigned, the OCC guarantees his payment or delivery to Alice. This intermediary role simplifies the trading process and removes bilateral counterparty risk from the individual investors.

Practical Applications

The Options Clearing Corporation underpins the functionality of the U.S. listed options markets. Its core service involves providing central counterparty clearing and settlement services across 16 different exchanges. ¹¹This includes options on common stock, stock indexes, foreign currencies, and interest rate composites, as well as futures contracts and options on futures.

Beyond its central role in clearing, the OCC also offers services for securities lending transactions, further cementing its position as a critical piece of market infrastructure. The benefits of central clearing, as exemplified by the Options Clearing Corporation, include the reduction of risks through standardized risk management practices like margin collection, and improved market resilience, especially during periods of stress. ⁹, ¹⁰As noted by the Federal Reserve Bank of New York, central clearing allows for multilateral netting, significantly reducing settlement obligations and the balance sheet usage for broker-dealers. ⁸Such mechanisms enhance market liquidity and stability, which are crucial for the broader financial system.

Limitations and Criticisms

Despite its crucial role in market stability, the Options Clearing Corporation has faced scrutiny and criticism, primarily concerning its risk management and compliance procedures. As a Systemically Important Financial Market Utility (SIFMU), the OCC is subject to heightened regulatory expectations. In September 2019, the SEC and CFTC jointly announced that the OCC would pay $20 million in penalties for failing to establish and enforce policies and procedures related to financial risk management, operational requirements, and information-systems security. The SEC further noted that the OCC had changed core risk management policies without obtaining required SEC approval.
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More recently, in February 2023, the Options Clearing Corporation agreed to pay $22 million in additional penalties to the SEC and CFTC, addressing charges that it failed to comply with internal rules for managing risks. ⁶Specifically, the OCC did not properly implement and enforce written policies and procedures for operational risks, and its clearing fund was underfunded by hundreds of millions of dollars at various times between October 2019 and May 2021. ⁴, ⁵These instances underscore the challenges even major clearing organizations face in maintaining impeccable compliance and risk management standards in complex financial environments, despite holding significant collateral from members to cover potential defaults.

Options Clearing Corporation vs. Clearing House

While the terms are related, the Options Clearing Corporation (OCC) is a specific type of clearing house. A clearing house is a general term for a financial institution that facilitates the exchange of payments, securities, or derivatives, acting as an intermediary to reconcile orders between transacting parties. It ensures the efficient settlement of financial transactions and reduces various risks, including counterparty risk.

The Options Clearing Corporation, on the other hand, is the designated clearing house for virtually all U.S. listed options and certain futures contracts. Its specialization lies in equity derivatives and related instruments. Therefore, while all OCC functions are characteristic of a clearing house, not all clearing houses are the Options Clearing Corporation. Other clearing houses might specialize in different asset classes, such as bonds or commodities.

FAQs

What does the Options Clearing Corporation do?

The Options Clearing Corporation (OCC) acts as a central intermediary for listed options and futures contracts in the U.S. It guarantees that the obligations of these contracts are fulfilled, effectively becoming the buyer to every seller and the seller to every buyer. This helps eliminate counterparty risk for market participants and ensures smooth settlement.

², ³### Is the Options Clearing Corporation a regulator?
While the Options Clearing Corporation works closely with regulators like the SEC and CFTC, and operates under their jurisdiction, it is primarily a clearing house and central counterparty. It sets and enforces its own rules for its clearing members, but its overarching authority comes from federal financial regulators.

How does the Options Clearing Corporation manage risk?

The Options Clearing Corporation employs various risk management strategies. A primary method is requiring its clearing members to post margin (collateral) to cover potential losses from defaulting positions. This collateral acts as a buffer to protect the OCC and the broader market from financial instability. The OCC also utilizes sophisticated systems like STANS (System for Theoretical Analysis and Numerical Simulations) for calculating margin requirements.¹