AMENDMENTS TO NYSE RULES 431 AND 726 THAT EXPAND CUSTOMER PORTFOLIO MARGINING
 

Information Memo  06-86  is available for viewing or printing with Adobe Acrobat
 
Number 06-86 12/21/2006
 
ATTENTION:   CHIEF EXECUTIVE OFFICER, FINANCIAL & OPERATIONS OFFICER, MANAGING PARTNERS, CREDIT AND MARGIN DEPARTMENTS, COMPLIANCE AND LEGAL DEPARTMENTS
 
TO:   ALL MEMBER ORGANIZATIONS
 
SUBJECT:   AMENDMENTS TO NYSE RULES 431 AND 726 THAT EXPAND CUSTOMER PORTFOLIO MARGINING
 



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.

_______________________________________
Grace B. Vogel
Executive Vice President
Member Firm Regulation


_______________________________________
1 See Release No. 34-54918 (December 12, 2006) 71 FR 75790 (December 18, 2006) (SR-NYSE-2006-13).
2 See Release No. 34-52031 (July 14, 2005) 70 FR 42130 (July 21, 2005) (SR-NYSE-2002-19). See also NYSE Information Memo 05-56, dated August 18, 2005 for additional information.
3 The Exchange also plans to submit a filing to the SEC that will make the Initial and Expanded Pilots permanent.
4 Prior to these amendments, member organizations were subject, pursuant to NYSE Rule 431, to strategy or positioned-based margin requirements. This methodology applied specific margin percentage requirements as prescribed in Rule 431 to each security position and/or strategy, either long or short, held in a customer’s account, irrespective of the fact that not all security prices (e.g., those of options) change equally (in percentage terms) with a change in the price of the underlying security. When utilizing a portfolio margin methodology offsets are fully realized, whereas under strategy or position-based methodology, positions and or groups of positions comprising a single strategy are margined independently of each other and offsets between them do not efficiently impact the total margin requirement.
5 See Release No. 34-54125 (July 11, 2006) 71 FR 40766 (July 18, 2006) (SR-NYSE- 2005-93). See also NYSE Information Memo 06-57, dated August 2, 2006 for additional information.
6 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, excluding a non-equity security.
7 The price range for computing a portfolio margin requirement is the same parameter required under Appendix A of Rule 15c3-1a under the Securities Exchange Act of 1934 for computing deductions to a firm’s net capital for proprietary positions. Currently the only theoretical model qualified pursuant to Rule 15c3-1a under the Exchange Act is the Theoretical Intermarket Margin System ("TIMS") administered by The Options Clearing Corporation.
8 See Rule 431(g)(5)(A).