On December 12, 2006, the Securities and Exchange
Commission (“SEC”) approved1 additional amendments to
NYSE Rule 431 (“Margin Requirements”) that permit the application of
portfolio margin to an expanded universe of eligible products. In
addition, amendments to NYSE Rule 726 (“Delivery of Options
Disclosure Document and Prospectus”) eliminate the sample portfolio
margining risk disclosure statement from the Rule. However, the Rule
will continue to require member organizations to provide customers
with a written disclosure statement in a form prescribed by the
Exchange, as well as to receive from customers a signed
acknowledgement, in a form to be published at a later date. The
amendments are effective April 2, 2007.
Background
On July 14, 2005, the SEC approved,2 on a
pilot basis expiring July 31, 2007,3 amendments to Rule
431 to permit the application of a prescribed risk-based margin
requirement (“Portfolio Margin”) to certain eligible products
(including listed broad based securities index options, warrants,
futures, futures options and related exchange traded funds) as an
alternative to strategy-based margin requirements.4
Amendments to Rule 726 were also approved requiring disclosure to,
and written acknowledgment from, customers in connection with the
use of portfolio margin. These amendments are referred to herein as
the Initial Pilot Program.
On July 11, 2006, the SEC approved additional
amendments5 to Rule 431 that:
1) Expanded the scope of products eligible for
portfolio margining and cross-margining; and
2) Conformed customer disclosure requirements under
Rule 726 to comply with this expansion; and
3) Modified certain net capital requirements in
connection with the maintenance of portfolio margin
accounts.
Collectively these
amendments are referred to herein as the Expanded Pilot. The
Expanded Pilot expanded the scope of products eligible for portfolio
margining and cross-margining to include listed security futures and
listed single stock options. Further, the Expanded Pilot permitted
pilot program participants to effect transactions solely in security
futures and listed single stock options without maintaining the $5
million equity requirement applicable to effecting transactions in
all other eligible products.
Recent
Amendments
Expansion of Eligible Products / Equity Requirement for
Pilot Participants
As
amended, the scope of products eligible for portfolio margining has
been expanded to include all margin equity securities6
and all equity-based listed options, unlisted derivatives and
security futures products.
In
addition, the number of eligible pilot program participants has been
increased by eliminating the $5 million dollar minimum equity
requirement, except for those participants that establish and
maintain positions in unlisted
derivatives.
Elimination
of the Cross-Margin Account
The provision pertaining to the use of a cross-margin
account for margining eligible securities products with eligible
commodity products has been eliminated. A single portfolio margin
account is now permitted for margining all eligible
products.
Eligible Products not Part of a Hedge
Strategy
Under the Initial
and Expanded Pilots, any position in an eligible product or related
instrument that is not part of a hedge strategy must be transferred
to the appropriate security or commodity account within ten business
days, unless the position becomes part of a hedge strategy again. As
amended, any position in an eligible product or related instrument
that is not part of a hedge strategy may be carried in a portfolio
margin account.
Method of Margin Calculation
The Initial Pilot
established a methodology for calculating a customer's margin
requirement by "shocking" a portfolio at ten equidistant intervals
along a valuation point range representing a potential increase and
decrease for an assumed market movement in the current market value
of the underlying instrument. The range for non-high capitalization
indexes is between an assumed market increase of 10% and decrease of
10%, and the range for high capitalization indexes is an increase of
6% and a decrease of 8%. Gains and losses for each instrument in the
portfolio are netted at each calculation point to derive a potential
portfolio wide net gain or loss.7 The Expanded Pilot
expanded the eligible products and their attendant valuation point
range to an assumed market value increase of 15% and a decrease of
15% for listed security futures and listed single stock options. The
most recent amendments increase the valuation point range to an
assumed market increase of 15% and a decrease of 15% for any other
eligible product that is, or is based on, an equity security or a
narrow-based index.
Positions not Eligible for Portfolio
Margin Treatment
Positions
not eligible for portfolio margin treatment (except for ineligible
related instruments) may now be carried in a portfolio margin
account, provided the member organization has the ability to apply
the applicable strategy-based margin requirements promulgated under
Rule 431.
Day Trading in a Portfolio Margin
Account
The day trading
requirements under Rule 431 shall not apply to portfolio margin
accounts that establish and maintain at least $5 million dollars in
equity, provided the member organization has the ability to monitor
the intra-day risk associated with day trading. Portfolio margin
accounts that do not establish and maintain at least $5 million
dollars in equity will be subject to the day trading restrictions
under the Rule, provided the member organization has the ability to
apply the applicable day trading requirements to a portfolio margin
account. However, if the position or positions that are day traded
are part of a hedge strategy, the day trading restrictions will not
apply.
Meeting a Margin
Deficiency by Liquidation
The amendment provides that member organizations should
not permit an eligible participant to make a practice of meeting a
portfolio margin deficiency by liquidation. However, liquidating to
eliminate a margin deficiency that is caused solely by adverse price
movements may be disregarded.
Approval to Participate in Portfolio
Margin
As with the
Expanded Pilot, member organizations, for which the Exchange is the
Designated Examining Authority (“DEA”), seeking to participate in
portfolio margin must provide written notification and receive
approval from the Exchange prior to establishing a portfolio margin
methodology.8 In this regard, member organizations are
expected to establish written procedures for monitoring the risk
associated with portfolio margin accounts; such procedures must
incorporate a methodology for assessing any potential risk to the
member organization’s capital. As previously discussed in
Information Memo 06-57, the procedures must be fully documented and
should address, at minimum, the following:
· Opening of portfolio margin
accounts.
· The profile of customers who will be eligible for
portfolio margining, including the initial approval process to be
applied.
· A
description of minimum equity requirements for each
customer.
· The determination, review and approval of credit limits
for each customer and across all customers.
· A description of any
internal model used to determine risk in individual customer
accounts, including the documentation for this
model.
· A
description of correlation assumptions included in any internal
models used for assessing the adequacy of margin in a customer’s
account.
· A
description of the stress testing scenarios that are performed on
the accounts, and provide the frequency of such testing and the
results of the most recent stress test.
· Monitoring of accounts to
ensure that the account contains a portfolio of hedged
instruments.
· Identification of security concentrations within an
account.
· Identification of concentrations in individual
securities across customer accounts.
·
Intraday monitoring of exposure in
customer accounts.
· Detection, prevention and circumvention of day trading
requirements.
· Monitoring of limitation on credit extended on
portfolio margining to 1,000 percent of the member organization’s
net capital.
· A description of the process for obtaining the TIMS
theoretical valuation points and the process used to compute margin
requirements in individual customer accounts.
· A description of house
margin requirements if they differ from the TIMS
requirement.
· A description of exception reports that will be
utilized to monitor margin exposure.
·
A description of the escalation procedures
to alert senior management of unusual risks.
· The regular review and
testing of the risk analysis procedures by an independent unit such
as internal audit or other comparable group.
· If an organization would
like to provide portfolio margining to customers in unlisted
derivatives, the application should include a description of the
products as well as a detailed description of the credit analysis
and collateral management process that will be utilized to monitor
any exposure that may result to the broker-dealer. This information
may be submitted at a later date if unlisted derivatives are not
being offered to customers on the implementation date.
Member organizations seeking
approval to participate in portfolio margining must submit all
relevant supporting documentation to their finance coordinator. Such
documentation must be accompanied by an organization chart
identifying those persons primarily responsible for portfolio margin
risk management and the person or persons to whom they
report.
In order for member organizations to be
approved by the effective date of April 2, 2007, written
notifications must be submitted no later than February 15, 2007.
The approved rule text can be viewed on the
Exchange’s website at: http://www.nyse.com/. Select
NYSE Regulation/Rules & Interpretations/Rule Filings/NYSE Rule
Filings.
Any questions regarding this Information Memo
can be directed to Rudolph Verra at 212-656-2924, Steve Yannolo at
212-656-2274, or your finance
coordinator.
