Options Clearing Corp. #AA+# Rating Placed On CreditWatch Negative Following Review Of Its Financial Safeguards

Stocks and Financial Services Press Releases Wednesday May 18, 2016 09:26
NEW YORK--18 May--S&P Global Ratings
NEW YORK (S&P Global Ratings) May 17, 2016--S&P Global Ratings said today that it placed its 'AA+' long-term issuer credit rating on OCC on CreditWatch with negative implications.
The CreditWatch placement follows our review of the OCC's clearing and settlement risk compared with that of other U.S. clearinghouses and global peers.

From a loss-absorbing perspective, OCC sizes its financial resources using a "cover 1" basis, which is supplemented by various add-ons including a "prudential margin of safety," currently set at $1.8 billion. This means that in a stress scenario and under extreme-but-plausible conditions, OCC would have enough resources to absorb clearing losses if the largest clearing member were to default; however, it could exhibit a shortfall if the largest two clearing members were to default at the same time. Although OCC's practice is consistent with U.S. regulatory requirements, we view it as weaker than the "cover 2" that other U.S. central counterparties (CCPs) and most EU peers now meet.

In the U.S., the Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE) operate at a "cover 2" level based on the Commodity Futures Trading Commission's interpretation that the products they clear are "complex." In theory, National Securities Clearing Corp. and Fixed Income Clearing Corp.--the primary regulator of which is the SEC (like OCC)--operate on a "cover 1" basis from a loss-absorbing standpoint, consistent with regulatory requirements. However, margins at these entities are akin to clearing fund contributions and are available to absorb losses arising from the default of other clearing members, and so these entities operate at least on a "cover 2" basis in practice. Clearinghouses in the EU are required to meet at least a "cover 2" (from a loss-absorbing standpoint) under EU regulation. Overall, we view the "cover 1" for OCC (from a loss-absorbing standpoint) as the main weakness to the rating, even though it's consistent

with the U.S. regulations applicable to it.

OCC is party to "one-pot" cross-margining agreements with the CME and ICE. We do not view these cross-margining arrangements as a major weakness for now, as they only apply to some specific clearing members and products and represent less than 10% of total margins in practice. However, this could become a negative rating factor if the scope of cross-margining were to expand significantly, considering that it would introduce potentially significant operational risk in a clearing member default scenario (with multiple clearinghouses having to perfectly synchronize their default management frameworks).

On the other hand, OCC's financial safeguards exhibit some strengths compared with some peers, starting with the use of a two-day margin period, consistent with the liquidity of equity options in the U.S., and the inclusion of a $1.8 billion "prudential margin of safety" in the clearing fund beyond the "cover 1" level. We also view positively the possibility of calling for additional individual intra-day clearing fund contributions of up to $1 billion and the re-sizing of the clearing fund intra-month if required by changing market conditions. However, these strengths only partially offset the "cover 1," in

our view.
It's our understanding that OCC has plans to enhance its clearing fund methodology.

We will gather additional information on OCC's clearing fund plans. In addition, we will re-assess the resilience of the clearinghouse, from a liquidity standpoint, to a stress scenario whereby one or several clearing members default jointly, and we will compare it with U.S. and EU peers. In particular, we aim at neutralizing regulatory differences in terms of the set of eligible sources of liquidity in a stress scenario and other aspects of the liquidity framework to ensure comparability across the CCPs we rate globally.

Upon the resolution of the CreditWatch placement, we could lower the rating on OCC by one notch if OCC does not move to a "cover 2" from a loss-absorbing perspective. We could also lower the ratings if we believe that OCC has significantly weaker liquidity resources than peers (in a stress scenario whereby one or several clearing members default jointly) that weigh on its clearing and settlement risk assessment.

Alternatively, we could affirm the ratings if:
OCC presents a credible plan to achieve a "cover 2" from a loss-absorbing standpoint.

We evaluate OCC's "cover 1" liquidity resources to be globally comparable with "cover 2" minimum standards that most European and some U.S. CCPs now meet.OCC implements implied volatility as a risk factor for short-dated options (it is already a risk factor for long-dated options) consistent with a rule filing approved by OCC's regulators at the end of 2015.The scope of cross-margining arrangements with ICE and the CME does not expand significantly.

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