Amendment to Margin Rules to Establish a Portfolio Margin Pilot Program
Portfolio Margin Program
|Legal and Compliance
On February 12, 2007, NASD filed with the Securities and Exchange Commission (SEC) for immediate effectiveness a rule change to amend Rule 2520 to permit members to margin certain products according to a prescribed portfolio margin methodology on a pilot basis. NASD also amended Rule 2860 to require that a disclosure statement and written acknowledgement for use with the proposed portfolio margin program be furnished to customers using a portfolio margin account.1
Rules 2520 and 2860, as amended, are set forth in Attachment A of this Notice. The portfolio margin program will operate on a pilot basis starting on April 2, 2007, and ending July 31, 2007, unless the SEC approves an extension of the pilot or adoption of the program on a permanent basis.
Questions regarding this Notice may be directed to Susan M. DeMando, Associate Vice President, Financial Operations, at (202) 728-8411, or Kathryn M. Moore, Assistant General Counsel, Office of General Counsel, at (202) 974-2974.
Background and Discussion
Section 7(a) of the Securities Exchange Act of 1934 (the Exchange Act) authorizes the Board of Governors of the Federal Reserve System to prescribe the rules and regulations regarding credit that may be extended by broker-dealers on securities to their customers as set forth in Regulation T. Currently, Rule 2520 (Margin Requirements) prescribes minimum maintenance margin requirements for customer accounts held by members based on position or strategy-based margin requirements. This methodology applies prescribed margin percentage requirements to each security position and/or strategy, either long or short, held in a customer's account. The Board of Governors of the Federal Reserve System, in its amendments to Regulation T in 1998, permitted self-regulatory organizations to implement portfolio margin rules, subject to SEC approval.2
Accordingly, NASD has amended Rule 2520 to allow members on a pilot basis, subject to specified conditions, to elect to apply a portfolio margin methodology to all margin equity securities,3 listed options, security futures products,4 unlisted derivatives,5 warrants, index warrants and related instruments.6 In addition, a member, provided that it is a Futures Commission Merchant (FCM) and is either a clearing member of a futures clearing organization or has an affiliate that is a clearing member of a futures clearing organization, is permitted to combine an eligible participant's related instruments with listed index options, unlisted derivatives, options on exchange traded funds (ETF), index warrants and underlying instruments,7 and compute a margin requirement for such combined products on a portfolio margin basis.
The rule change is substantially similar to recent margin rule amendments by the New York Stock Exchange (NYSE) and the Chicago Board Options Exchange (CBOE), which were approved by the SEC.8 Consistent with the NYSE and CBOE programs, the rule change is available as a pilot beginning on April 2, 2007, and ending on July 31, 2007, unless the SEC approves an extension of the pilot or adoption of the program on a permanent basis.
Portfolio margining is a margin methodology that sets margin requirements for an account based on the greatest projected net loss of all positions in a product class or group9 using computer modeling to perform risk analysis using multiple pricing scenarios. These scenarios are designed to measure the theoretical loss of the positions given changes in both the underlying price and implied volatility inputs to the model. Accordingly, the margin required is based on the greatest loss that would be incurred in a portfolio if the value of its components move up or down by a predetermined amount.
Under the rule change, a gain or loss on each position in the portfolio is calculated on each of 10 equidistant points along a range representing a potential percentage increase and decrease in the value of the instrument or underlying instrument in the case of a derivative product. For portfolios of only highly capitalized broad-based indexes, the range is between a market increase of 6 percent and a decrease of 8 percent. For non-highly capitalized broad-based indexes, the range is +/- 10 percent. For portfolios of equity options, narrow-based index options and/or security futures, the risk-array for computing the portfolio margin requirement is up/down market moves of +/-15 percent.
For options with the same underlying security (or index in the case of an index option), the underlying security itself and any related futures, options on futures or security futures products could be combined as a portfolio for purposes of computing a portfolio margin requirement. The SEC-approved theoretical options pricing model is used to derive position values at each valuation point for the purpose of determining the gain or loss.10 The gains and losses are netted to derive a potential portfolio gain or loss for the point. The margin requirement for the portfolio is the amount of the greatest loss among the calculation points. Certain portfolios are allowed offsets such that, at the same valuation point, a gain in one portfolio may reduce or offset the loss in another portfolio. The amount of offset allowed between portfolios is the same that is permitted under SEC Rule 15c3-1a for computing a broker-dealer's Net Capital. The margin requirement for each portfolio then is added together to calculate the total margin requirement for the portfolio margin account.
In addition, the rule change prescribes a minimum margin requirement of $0.375 for each listed option, unlisted derivative, security futures product, and related instrument multiplied by the contract or instrument's multiplier.
Generally, a customer benefits from portfolio margining in that margin requirements calculated on net position risk are generally lower than strategy-based margin methodologies currently in place. In permitting margin computation based on actual net risk, members no longer are required to compute a margin requirement for each individual position or strategy in a customer's account.
Monitoring and Risk Management
As a pre-condition to permitting portfolio margining, a member is required to establish a comprehensive written risk analysis methodology to assess the potential risk to the member's capital over a specified range of possible market movements. The written risk analysis methodology must include procedures and guidelines for (1) obtaining and reviewing account documentation and financial information to assess the amount of credit to be extended to eligible participants; (2) the determination, review and approval of credit limits to each eligible participant, and across all eligible participants, utilizing a portfolio margin account; (3) monitoring credit risk exposure to the member's capital, on both a intra-day and end of day basis, including the type, scope and frequency of reporting to senior management; (4) the use of stress testing of portfolio margin accounts in order to monitor market risk exposure from individual accounts and in the aggregate; (5) the regular review and testing of the procedures by an independent unit; (6) managing the impact of credit extended related to portfolio margin accounts on the member's overall risk exposure; (7) the appropriate response by management when credit extensions have been exceeded; and (8) determining when additional margin may need to be collected.
A member is required to periodically review its credit extension activities for consistency with its guidelines and determine if the data necessary to apply portfolio margining is accessible on a timely basis, and information systems are available to adequately capture, monitor, analyze and report relevant data.
Approval Required to Use Portfolio Margin Methodology
A member that wishes to use a portfolio margin methodology must file an application with NASD, or the member's designated examining authority (DEA) if other than NASD, and receive approval from NASD or the member's DEA if other than NASD, prior to establishing a portfolio margin methodology for eligible participants. The application must be fully documented and should address, at minimum, the following:
Members seeking approval to participate in the portfolio margining pilot must submit the application providing the information set forth above to Susan M. DeMando, Associate Vice President, Financial Operations, 1735 K Street, NW, Washington, D.C. 20006. In order for members to be eligible for approval by the effective date of the pilot on April 2, 2007, the application must be submitted to NASD no later than March 2, 2007.
The rule change permits the following persons to engage in portfolio margining: (1) any broker or dealer registered pursuant to Section 15 of the Exchange Act; (2) any member of a national futures exchange to the extent that listed index options, unlisted derivatives, options on ETFs, index warrants or underlying instruments hedge the member's index futures; and (3) any person approved to engage in uncovered option contracts, and if security futures are to be included in the account, approval for such transactions is also required. However, an eligible participant under category (3) may not establish or maintain positions in unlisted derivatives unless minimum equity of at least five million dollars is established and maintained with the member. If the account of an eligible participant subject to the five million dollar requirement falls below such minimum requirement, it must be restored within three business days. A member is prohibited from accepting new opening orders beginning on the fourth business day, except for new opening orders entered solely for the purpose of reducing market risk, where the result would be to lower margin requirements.
Under the rule change, eligible participants are required to satisfy a margin deficiency in a portfolio margin account within three business days by the deposit of additional funds and/or securities, or by the establishment of a hedge that would reduce margin requirements. In the event the deficiency is not satisfied after three business days, the member must liquidate positions to eliminate the deficiency. A member is required to deduct from its Net Capital the amount of any margin deficiency not satisfied by the close of business on the next business day after the business day on which the deficiency arises, and continuing until the deficiency is satisfied. Members should not permit an eligible participant to make a practice of meeting a portfolio margin deficiency by liquidation and are required to identify accounts that periodically liquidate positions to eliminate margin deficiencies. However, liquidation to eliminate margin deficiencies that are caused solely by adverse price movements may be disregarded.
Members are permitted to use a specific securities margin account or a sub-account of a margin account clearly identified as a portfolio margin account. The account must be separate from any other securities account. In the event a portfolio margin account is a subaccount of a regular margin account, a member is allowed to use excess equity in the regular margin account to meet a margin deficiency in the portfolio margin account. In addition, securities, including money market funds, that are not eligible for portfolio margin treatment are allowed to be carried in a portfolio margin account for their collateral value, subject to the margin requirement applicable in a regular securities margin account.
The day trading restrictions in Rule 2520 do not apply to a portfolio margin account that establishes and maintains at least five million dollars in equity, provided that a member has the ability to monitor the intra-day risk associated with day trading. A portfolio margin account that does not establish and maintain at least five million dollars in equity is otherwise subject to the day trading restrictions. However, if the position or positions day traded were part of a hedge strategy, the day trading restrictions do not apply. A "hedge strategy" for purposes of the rule means a transaction or a series of transactions reduces or offsets a material portion of the risk in a portfolio. Members are expected to monitor portfolio margin accounts to detect and prevent circumvention of the day trading requirements.
Net Capital Treatment
Under the rule change, the aggregate portfolio margin and maintenance requirements may not exceed ten times the member's Net Capital, as computed under SEC Rule 15c3-1. This requirement places a ceiling on the amount of portfolio margin a broker-dealer can extend to its customers.
NASD Rule 2860(b)(11) prescribes requirements for the delivery of options disclosure documents concerning the opening of customer accounts. Under the rule change, members are required to provide every portfolio margin customer with a written risk disclosure statement at or prior to the initial transaction in a portfolio margin account. The disclosure will be in a format prescribed by NASD or in a format developed by the member, provided it contains substantially similar information as in the prescribed NASD format and has received the prior written approval of NASD. NASD will issue a subsequent Notice to Members to set forth the language required in the written disclosure statement.
The rule change establishes a pilot program that begins on April 2, 2007, and ends on July 31, 2007, to conform to the time periods of the similar portfolio margin pilot programs of the NYSE and CBOE.
As discussed above, members seeking approval to participate in the portfolio margining pilot must submit an application that includes the specified information to Susan M. DeMando, Associate Vice President, Financial Operations, 1735 K Street, NW, Washington, D.C. 20006. In order for members to be eligible for approval by the effective date of April 2, 2007, applications must be submitted to NASD no later than March 2, 2007.
1See SR-NASD-2007-013 filed on February 12, 2007. Under Section 19(b) of the Securities Exchange Act of 1934, the SEC has the authority to summarily abrogate this type of rule change within 60 days of filing.
2See Federal Reserve System, "Securities Credit Transactions; Borrowing By Broker and Dealers"; Regulations G, T, U and X; Dockets Nos. R-0905, R-0923 and R-0944, 63 FR 2806 (January 16, 1998).
3 For purposes of the rule, the term "margin equity security" uses the definition at Section 220.2 of Regulation T of the Board of Governors of the Federal Reserve System.
4 For purposes of the rule, "security futures product" uses the definition at Section 3(a)(56) of the Exchange Act.
5 For purposes of the rule, the term "unlisted derivatives" is defined in Rule 2520(g)(2)(H).
6 For purposes of the rule, the term "related instrument" is defined in Rule 2520(g)(2)(D).
7 For purposes of the rule, the term "underlying instrument" is defined in Rule 2520(g)(2)(G).
8See Exchange Act Release No. 54918 (December 12, 2006), 71 FR 75790 (December 18, 2006) (SR-NYSE-2006-13, relating to further amendments to the NYSE's portfolio margin pilot program); Exchange Act Release No. 54125 (July 11, 2006), 71 FR 40766 (July 18, 2006) (SR-NYSE-2005-93, relating to amendments to the NYSE's portfolio margin pilot program); Exchange Act Release No. 52031 (July 14, 2005) 70 FR 42130 (July 21, 2005) (SR-NYSE-2002-19, relating to the NYSE's original portfolio margin pilot). See also Exchange Act Release No. 54919 (December 12, 2006), 71 FR 75781 (December 18, 2006) (SRCBOE- 2006-014, relating to amendments to the CBOE's portfolio margin pilot); Exchange Act Release No. 52032 (July 14, 2005) 70 FR 42118 (July 21, 2005) (SR-CBOE-2002-03, relating to the CBOE's original portfolio margin pilot).
9 Products would be grouped into a single portfolio that is based on the same index or issuer.
10 Currently, the only model that is approved by the SEC is The Options Clearing Corporation's Theoretical Intermarket Margining System (TIMS).
New language is underlined.
2520. Margin Requirements
As an alternative to the "strategy-based" margin requirements set forth in paragraphs (a) through (f) of this Rule, members may elect to apply the portfolio margin requirements set forth in this paragraph (g) to all margin equity securities,1 listed options, security futures products (as defined in Section 3(a)(56) of the Exchange Act), unlisted derivatives, warrants, index warrants and related instruments, provided that the requirements of paragraph (g)(6)(B)(i) of this Rule are met.
In addition, a member, provided that it is a Futures Commission Merchant ("FCM") and is either a clearing member of a futures clearing organization or has an affiliate that is a clearing member of a futures clearing organization, is permitted under this paragraph (g) to combine an eligible participant's related instruments as defined in paragraph (g)(2)(D), with listed index options, unlisted derivatives, options on exchange traded funds ("ETF"), index warrants and underlying instruments and compute a margin requirement for such combined products on a portfolio margin basis.
The portfolio margin provisions of this Rule shall not apply to Individual Retirement Accounts ("IRAs").
Members must monitor the risk of portfolio margin accounts and maintain a comprehensive written risk analysis methodology for assessing the potential risk to the member's capital over a specified range of possible market movements of positions maintained in such accounts. The risk analysis methodology shall specify the computations to be made, the frequency of computations, the records to be reviewed and maintained, and the person(s) within the organization responsible for the risk function. This risk analysis methodology must be filed with NASD, or the member's designated examining authority ("DEA") if other than NASD, and submitted to the Commission prior to the implementation of portfolio margining. In performing the risk analysis of portfolio margin accounts required by this Rule, each member shall include in the written risk analysis methodology procedures and guidelines for:
For purposes of this paragraph (g), the following terms shall have the meanings specified below:
|Portfolio Type||Up / Down Market Move
(High & Low Valuation Points)
|High Capitalization, Broad-based Market Index2||+6% / -8%|
|Non-High Capitalization, Broad-based Market Index3||+/- 10%|
|Any other eligible product that is, or is based on, an equity security or a narrow-based index||+/- 15%|
Theoretical pricing models must be approved by the Commission.
The application of the portfolio margin provisions of this paragraph (g) is limited to the following:
A margin deficit in the portfolio margin account of an eligible participant may not be considered as satisfied by excess equity in another account. Funds and/or securities must be transferred to the deficient account and a written record created and maintained. However, if a portfolio margin account is carried as a sub-account of a margin account, excess equity in the margin account (determined in accordance with the rules applicable to a margin account other than a portfolio margin account) may be used to satisfy a margin deficit in the portfolio margin sub-account without having to transfer any funds and/or securities.
The amount of margin required under this paragraph (g) for each portfolio shall be the greater of:
For the purposes of this paragraph (g), all eligible products shall be valued at current market prices. Account equity for the purposes of paragraphs (g)(9)(A) and (g)(10)(A) shall be calculated separately for each portfolio margin account by adding the current market value of all long positions, subtracting current market value of all short positions, and adding the credit (or subtracting the debit) balance in the account.
The day trading restrictions promulgated under paragraph (f)(8)(B) of this Rule shall not apply to portfolio margin accounts that establish and maintain at least five million dollars in equity, provided that a member has the ability to monitor the intra-day risk associated with day trading. Portfolio margin accounts that do not establish and maintain at least five million dollars in equity will be subject to the day trading restrictions under paragraph (f)(8)(B) of this Rule, provided the member has the ability to apply the applicable day trading requirement under this Rule. However, if the position or positions day traded were part of a hedge strategy, the day trading restrictions will not apply. A "hedge strategy" for purposes of this Rule means a transaction or a series of transactions that reduces or offsets a material portion of the risk in a portfolio. Members are expected to monitor these portfolio margin accounts to detect and prevent circumvention of the day trading requirements.
1 For purposes of this paragraph (g) of the Rule, the term "margin equity security" utilizes the definition at Section 220.2 of Regulation T of the Board of Governors of the Federal Reserve System.
2 In accordance with paragraph (b)(1)(i)(B) of SEC Rule 15c3-1a (Appendix A to SEC Rule 15c3-1), 17 CFR 240.15c3-1a(b)(1)(i)(B).
3See footnote 2.
The special written disclosure statement describing the nature and risks of portfolio margining, and acknowledgement for an eligible participant signature, required by Rule 2520(g)(5)(C) shall be in a format prescribed by NASD or in a format developed by the member, provided it contains substantially similar information as in the prescribed NASD format and has received the prior written approval of NASD.