Recently, the OCC and the U.S. options exchanges announced their adoption of pre- and post-trade risk control principles. They have been designed to enhance the monitoring of trading activity on a real-time basis and reduce the risk of errors or other inappropriate activity that poses a material risk of significant market disruption.
In this third and final part, we present some additional facts to you about this initiative regarding exchange post-trade risk control, credit controls and OCC post-trade risk control.?
EXCHANGE POST-TRADE RISK CONTROL
Obvious Error Rule
The primary purpose and need for an ?obvious error? rule is to properly handle erroneous trades that are not otherwise prevented by market participant and exchange pre-trade controls. Obvious error rules need to adequately address the difficult challenge of properly defining the circumstances under which a particular trade will be deemed an obvious error.
The rules also need to preserve the legitimate expectation of trade certainty, balanced against a market integrity-related need to bust or adjust clear error or mistrade events. Industry participants and exchanges generally agree that obvious error rules need to define errors as precisely and objectively as possible, and resulting actions (i.e., bust, adjust, or let the trade stand) must occur as swiftly as possible so market participants can avoid extended market risk.
All options exchanges have obvious error rules. But the substance, interpretation, and application of existing obvious error rules varies across the exchanges. The options exchanges agreed last September, as a result of the meeting with SEC Chair White, to work together in drafting and implementing a uniform obvious error rule that will address most or all of the objectives noted above.
The exchanges are currently working to develop a uniform obvious error rule. Incorporating within OCC?s exchange risk control standards a requirement that all options exchanges apply an obvious error rule that meets the described objectives will allow OCC to use its central position in this important area.
CREDIT CONTROLS
Development of stronger credit controls in the options industry is an extremely important topic and should be pursued through the joint efforts of OCC and its exchanges. Effective credit controls would be extremely difficult to develop on an individual exchange basis.
Options market participants typically execute transactions on all or at least most of the 12 current options exchanges. This makes it difficult for exchanges to compile an accurate picture of a participant?s current options portfolio.? Some exchange activity-based controls serve to help firms manage credit risk, but such controls are not comprehensive and shouldn?t be considered effective credit controls.
OCC has begun a high priority effort to jointly develop with its exchanges and market participants potential credit control measures to be included in an action plan for consideration by OCC?s Risk Committee and Board.
OCC POST-TRADE RISK CONTROL
In order to further strengthen post-trade controls, OCC is in the process of implementing price filters to identify and send for validation potentially erroneous trades priced significantly away from the market. As an initial step, trades identified with prices exceeding $2,000 will be subject to manual review for reasonability by OCC and exchange staff.
OCC is continuing development of more sophisticated post-trade controls, including an automated price collar that will analyze all incoming options trades on a real-time basis using options pricing models to identify with precision any erroneous trades.