Keeping reform on track
30 May 2017
Craig Donohue of OCC highlights the work being put into ensuring stability for the US listed equity options market
Image: Shutterstock
Over the past two years OCC, in its role as a systemically important financial market utility, has taken on a leadership role in advocating for the US listed equity options market with global policymakers on key legislative and regulatory issues.
It was in that context that, during the recent annual Options Industry Conference, I was asked by a member of the media if there was anything that kept me up at night. My answer: financial tax reform.
US President Donald Trump’s administration and certain members of Congress leading the respective tax committees have indicated that tax reform is a priority this year, and proposals are being drafted to ensure introductions of bills to comprehensively reform the tax code. House ways and means committee chairman Kevin Brady and Senate finance committee chairman Orrin Hatch are leading congressional consideration of tax proposals in the 115th Congress.
These comprehensives tax reform proposals may include a financial products tax reform proposal that is based on prior legislation introduced by former House ways and means committee chairman Dave Camp. Such a proposal, if enacted, and others like it could make the use of listed equity options much less attractive to market participants than under current law. In this respect, the proposals would treat all listed equity options as sold at the end of the year, treat appreciated stock as sold if a taxpayer enters into an option to manage risk associated with owning the stock, and radically alter the tax treatment of stock while a related option position is outstanding.
Enacting these proposals would adversely affect individuals and other taxpayers using listed equity options to manage the risks associated with their investments in publicly traded stocks. It would discourage the use of options by distorting rational economic and risk management decision-making and replacing the well-established and relatively simple tax rules for listed equity options with a burdensome and overly complicated regime.
In addition to the broader efforts outlined above by chairmen Brady and Hatch, congressman Tom Reed, a member of the House ways and means committee, is leading efforts to develop a financial products tax reform draft that is intended to be more refined than the proposals noted above. OCC and the US Securities Markets Coalition have been meeting with the congressman and his staff to explain the issues raised by previous financial product tax proposals and to advocate for a different approach in the forthcoming legislative package.
In its role as an advocate for the US listed equity options markets, OCC understands the importance of these potential tax issues to our participating exchanges, clearing firms and market participants. Along with the coalition, we will continue to work to educate key members of Congress on the importance of having a viable US listed equity options market that functions effectively and efficiently on behalf of investors.
We also continue to work with US and global regulators to reiterate our belief that the implementation of the standardised approach for counterparty credit risk (SA-CCR) is important for an orderly and liquid listed option markets. Market makers are the primary source of liquidity in the listed options market and thus are critical to its proper functioning. Their ability to hedge the risks associated with the large options portfolios they maintain to provide such liquidity is critical to their commitment to supply market liquidity.
Market makers’ approach to managing risk is being affected by the requirement that clearing firms use the current exposure method (CEM) under the risk weighted asset and leverage ratios to measure their exposures to the portfolios of their market maker clearing clients. The application of CEM, which neglects to consider the hedging benefits between options on the same underlying security and other attributes unique to options, results in vastly increased capital charges for clearing members that clear for market makers. Such risk-insensitive capital charges fundamentally threaten clearing members’ business models and their ability to clear for such critical liquidity providers in the options market, which in turn could negatively affect the overall options market and related markets.
While the Basel Committee on Banking Supervision has adopted the SA-CCR methodology as a replacement for the CEM methodology in the context of the risk weighted asset ratio and has led an effort to reconsider the application of the CEM methodology within the leverage ratio, the lack of progress toward the uniform and national adoption of a SA-CCR-based methodology continues to create serious economic disincentives for market participants in the exchange-traded derivatives space. The adoption of a methodology based on SA-CCR for clearing members to measure their exposure to their clearing clients should dramatically reduce the unintended consequences the listed options industry currently faces under the CEM methodology.
Further, even if a SA-CCR-based methodology is adopted globally, the timing of implementation across the US and Europe, if not aligned, could result in significant regulatory arbitrage across these two jurisdictions. This arbitrage could impair liquidity in the options markets and undermine the central clearing models, which would be counter to the steps regulators across the globe have been pursuing in recent years pursuant to the post-financial crisis reforms to shape the over-the-counter derivatives markets to resemble the exchange-traded markets. The post-crisis financial reforms have clearly favoured central clearing and transparent trading of derivatives contracts to ensure that these markets become more standardised and transparent, and above all, serve to mitigate systemic risk.
These are admirable goals that regulators and market participants should desire, and which OCC and the US Securities Markets Coalition aspire to achieve.
It was in that context that, during the recent annual Options Industry Conference, I was asked by a member of the media if there was anything that kept me up at night. My answer: financial tax reform.
US President Donald Trump’s administration and certain members of Congress leading the respective tax committees have indicated that tax reform is a priority this year, and proposals are being drafted to ensure introductions of bills to comprehensively reform the tax code. House ways and means committee chairman Kevin Brady and Senate finance committee chairman Orrin Hatch are leading congressional consideration of tax proposals in the 115th Congress.
These comprehensives tax reform proposals may include a financial products tax reform proposal that is based on prior legislation introduced by former House ways and means committee chairman Dave Camp. Such a proposal, if enacted, and others like it could make the use of listed equity options much less attractive to market participants than under current law. In this respect, the proposals would treat all listed equity options as sold at the end of the year, treat appreciated stock as sold if a taxpayer enters into an option to manage risk associated with owning the stock, and radically alter the tax treatment of stock while a related option position is outstanding.
Enacting these proposals would adversely affect individuals and other taxpayers using listed equity options to manage the risks associated with their investments in publicly traded stocks. It would discourage the use of options by distorting rational economic and risk management decision-making and replacing the well-established and relatively simple tax rules for listed equity options with a burdensome and overly complicated regime.
In addition to the broader efforts outlined above by chairmen Brady and Hatch, congressman Tom Reed, a member of the House ways and means committee, is leading efforts to develop a financial products tax reform draft that is intended to be more refined than the proposals noted above. OCC and the US Securities Markets Coalition have been meeting with the congressman and his staff to explain the issues raised by previous financial product tax proposals and to advocate for a different approach in the forthcoming legislative package.
In its role as an advocate for the US listed equity options markets, OCC understands the importance of these potential tax issues to our participating exchanges, clearing firms and market participants. Along with the coalition, we will continue to work to educate key members of Congress on the importance of having a viable US listed equity options market that functions effectively and efficiently on behalf of investors.
We also continue to work with US and global regulators to reiterate our belief that the implementation of the standardised approach for counterparty credit risk (SA-CCR) is important for an orderly and liquid listed option markets. Market makers are the primary source of liquidity in the listed options market and thus are critical to its proper functioning. Their ability to hedge the risks associated with the large options portfolios they maintain to provide such liquidity is critical to their commitment to supply market liquidity.
Market makers’ approach to managing risk is being affected by the requirement that clearing firms use the current exposure method (CEM) under the risk weighted asset and leverage ratios to measure their exposures to the portfolios of their market maker clearing clients. The application of CEM, which neglects to consider the hedging benefits between options on the same underlying security and other attributes unique to options, results in vastly increased capital charges for clearing members that clear for market makers. Such risk-insensitive capital charges fundamentally threaten clearing members’ business models and their ability to clear for such critical liquidity providers in the options market, which in turn could negatively affect the overall options market and related markets.
While the Basel Committee on Banking Supervision has adopted the SA-CCR methodology as a replacement for the CEM methodology in the context of the risk weighted asset ratio and has led an effort to reconsider the application of the CEM methodology within the leverage ratio, the lack of progress toward the uniform and national adoption of a SA-CCR-based methodology continues to create serious economic disincentives for market participants in the exchange-traded derivatives space. The adoption of a methodology based on SA-CCR for clearing members to measure their exposure to their clearing clients should dramatically reduce the unintended consequences the listed options industry currently faces under the CEM methodology.
Further, even if a SA-CCR-based methodology is adopted globally, the timing of implementation across the US and Europe, if not aligned, could result in significant regulatory arbitrage across these two jurisdictions. This arbitrage could impair liquidity in the options markets and undermine the central clearing models, which would be counter to the steps regulators across the globe have been pursuing in recent years pursuant to the post-financial crisis reforms to shape the over-the-counter derivatives markets to resemble the exchange-traded markets. The post-crisis financial reforms have clearly favoured central clearing and transparent trading of derivatives contracts to ensure that these markets become more standardised and transparent, and above all, serve to mitigate systemic risk.
These are admirable goals that regulators and market participants should desire, and which OCC and the US Securities Markets Coalition aspire to achieve.
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