PORTFOLIO MARGIN and CROSS-MARGIN AN OVERVIEW OF THE BROAD BASED INDEX OPTION PILOT PROGRAMS FOR CUSTOMERS Richard Lewandowski - Chicago Board Options Exchange

2 History  Past and current margining of listed options and securities underlying listed options.  Studies of the 1987 market crash advocate cross-margining. “Report of the Presidential Task Force on Market Mechanisms” (the “Brady Commission”) “The October 1987 Market Break” (SEC) “Working Group on Financial Markets” (Dept. of the Treasury, FRB, SEC and CFTC)  Net Capital - haircuts on options strategy based prior to April SEC no-action letter in April 1994 allows portfolio methodology. SEC changes Net Capital Rule in Sept to formally allow portfolio methodology as an alternative to strategy based requirements. Proposed customer program will parallel haircut methodology. Portfolio Margin and Cross-Margin Pilot Plan Proposal

3 History  Since April 1986, OCC has utilized portfolio margin.  Since 1988, Futures Commission Merchants (“FCM”) have applied a portfolio (SPAN) margin requirement.  Final changes to Reg. T (effective April 1, 1998) Permit portfolio margining as an alternative to Reg. T. Self-regulatory organization (“SRO”) rules needed to implement portfolio margining SEC approval required.  Portfolio Margin Committee formed - recommendations made. Portfolio Margin and Cross-Margin Pilot Plan Proposal

4 Plan Overview  Joint effort by CBOE, OCC, NYSE, AMEX, CME and CBOT to implement portfolio margin system for customers.  An alternative to the current “position” or “strategy” based margin.  Pilot program initially. Limits a firm’s gross portfolio margin requirements to 1,000 percent of its net capital. Firms can select accounts as they deem appropriate. Participant criteria may be modified based on the pilot experience.  Plan also provides for cross-margin - margin requirement determined using the same portfolio margin facility.  Pilot will only permit portfolio margining of: Broad based U.S. listed securities index options Related exchange traded funds (i.e., SPDRS, DIAMONDS) Related index futures and options on those futures.  No stock baskets permitted at this time. Portfolio Margin and Cross-Margin Pilot Plan Proposal

5 Plan Overview  Portfolio margining objective - determine margin based on potential risk in a portfolio as a whole.  Margin required is derived based on the greatest projected net loss in an account given various scenarios of underlying price increases and decreases and implied volatility changes. Positions grouped by class. Gain or loss on each position is calculated for assumed moves in the underlying, both up and down. Theoretical pricing formula is employed for options gains / losses. Netting of gains / losses within class groups. Offsets (gains) applied between classes, if eligible. Greatest loss is the portfolio margin requirement for that class. Total of class requirements is overall portfolio margin requirement. Per contract minimum of $37.50 (.375 X $100 multiplier). Firms can impose an “add-on” (house) requirement if desired. Portfolio Margin and Cross-Margin Pilot Plan Proposal

6 Plan Overview  Option theoretical values supplied by The Options Clearing Corporation. Provides for uniform margin requirements across broker-dealers.  Broker-dealers organize customer positions into a firm or vendor supplied spreadsheet.  Portfolio margin requirement calculated within the spreadsheet application using option theoretical values obtained from the OCC.  Process is the same as is currently in place for computing haircuts under the Securities & Exchange Commission’s capital rule.  Market ranges for computing gains and losses: high-cap broad based indexes % / -8% of the closing price of the index non-high- cap broad based indexes --- +/- 10% of the closing price of the index Portfolio Margin and Cross-Margin Pilot Plan Proposal

7 Plan Overview  Portfolio margin computation done at close of each business day.  Portfolio margin requirement is both the initial and maintenance margin requirement - not necessary to determine whether an increase in the requirement is due to a new commitment or adverse market moves.  Margin call arises if requirement greater than net liquidating equity in the portfolio margin account (cross-margin account).  Margin call must be met by the end of business on T+1 (one day settlement). Portfolio Margin and Cross-Margin Pilot Plan Proposal

8 Plan Overview  Liquidating or hedging to meet a margin call is allowed.  Minimum Equity Requirement. Account equity of at least five million dollars. Accounts may be aggregated if same owner. Not applicable to a broker-dealer, an affiliate of the clearing broker-dealer, or to the cross-margining activity of a member of a national futures exchange. Firms may impose a higher minimum equity (house) requirement if desired.  Equity call must be met by T+3 (three business day settlement). If equity call not met, no new orders may be accepted (except opening orders that reduce margin requirement).  Account guarantees prohibited (for equity or margin). Portfolio Margin and Cross-Margin Pilot Plan Proposal

9 Plan Overview  Required Disclosure Firm must provide customer with a standard disclosure statement prior to opening a portfolio margin and/or cross-margin account. Customers must sign an attestation acknowledging that they have received the disclosure document and are aware of the risks involved. Not applicable to broker-dealers, affiliates of the clearing broker-dealer, and members of futures exchanges.  To offer cross-margining, a broker-dealer must: also be an FCM and either be a clearing FCM or have an affiliate that is a clearing FCM.  Cross-margin account would be a securities account. SEC customer protection rules and SIPC coverage apply.  Internal risk analysis procedures required of each firm. Portfolio Margin and Cross-Margin Pilot Plan Proposal

10 Portfolio Margin and Cross-Margin Pilot Plan Proposal Plan Overview  CBOE filed a rule change with the SEC in January 2002 to go forward with the pilot.  NYSE filed a similar rule change with the SEC in May  Final work to be completed before the pilot can begin: Customer Protection changes at the SEC and CFTC concerning cross-margin account SIPC protection for non-securities products and balances in a cross-margin account Hypothecation of customers’ long options positions at the clearing house level (SEC)