FINRA Proposes Amendments to its Rule on Margin Requirements

Transcription

1 FINRA Proposes Amendments to its Rule on Margin Requirements SUMMARY On May 31, 2012, the SEC published for comment a proposal by FINRA to amend Rule 4210, which establishes margin requirements. The proposed amendments would replace the current margin requirements for specific option spread strategies with broad requirements for all spreads utilizing similar methodologies; DISCUSSION eliminate the ability to count the current market value of non-margin eligible equity securities towards the maintenance margin requirements for all securities held long and clarify certain other requirements for non-margin eligible equity securities; clarify the maintenance margin requirements for non-equity securities; eliminate the current exemption from the free-riding prohibition for designated accounts ; eliminate the special definition of exempt account used in the context of maintenance margin requirements for OTC put and call options on U.S. Government and agency debt securities; and eliminate the requirement to stress test portfolio margin accounts in the aggregate. FINRA filed its proposed rule amendment with the SEC on May 23, 2012, and the SEC published the proposal for comment on May REVISION OF THE DEFINITIONS OF AND MARGIN TREATMENT REGARDING CERTAIN OPTION SPREAD STRATEGIES FINRA has proposed to replace its current requirements for specific option spread strategies with rules that broadly address a range of spread strategies used by investors. Rule 4210(f)(2)(A) currently defines specific option spread strategies, including variations on the butterfly, calendar and condor spread strategies, and specifies margin requirements applicable to them. However, in recognition that investors use other strategies not defined in the rules, but which may have risk profiles similar to the defined New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 strategies, FINRA proposes to broaden the definition of spread to reflect strategies that are similar in risk profile. Rule 4210(f)(2)(A)(xxxii) will define spread to mean a long and short position in different call option series, put option series, or a combination of call and put option series that collectively have a limited risk or reward profile and meet the following conditions: all options must have the same underlying security or instrument; all long and short option contracts must be either all American-style or all European-style; all long and short option contracts must be all listed 2 or over-the-counter ( OTC ); the aggregate underlying contract value of the long versus short contracts within option types must be equal; and the short option(s) must expire on or before the expiration date of the long option(s). The margin required for short option contracts within a spread would be the lesser of: the margin required by Rule 4210(f)(2)(E); or the maximum potential loss 3 of the short option contract. Long option contracts within a spread must be paid for in full. The proceeds of the short options may be applied towards the cost of the long options and/or any other margin requirement. FINRA also clarified that OTC options must be issued and guaranteed by the same carrying broker-dealer and the carrying broker-dealer must be a FINRA member. 4 FINRA has also proposed to make conforming revisions to Rule 4210(f)(2)(N), governing margin requirements for spreads that are permitted in cash accounts. In broadening the definition of spreads, FINRA proposes to eliminate the margin requirements specific to certain strategies, including specific margin requirements for all butterfly-, condor- and calendar- type spreads. 5 These changes are reflected in proposed revisions to Rule 4210(f)(2)(H). CLARIFICATION OF MAINTENANCE MARGIN REQUIREMENT FOR NON-MARGIN ELIGIBLE EQUITY SECURITIES Due to the less liquid nature of non-margin eligible equity securities and the more limited ability of a broker-dealer to use these securities to satisfy a margin call, FINRA proposes to eliminate the current maintenance margin requirement of 25% of market value in the case of non-margin eligible equity securities held long, as provided in Rule 4210(c)(1). Any non-margin eligible equity securities would therefore require a maintenance margin of 100% of their current market value. 6 FINRA notes that certain provisions of Regulatory Notice would be superseded by the proposed amendments. Firms may no longer extend maintenance loan value on non-margin eligible equity securities either to satisfy maintenance margin deficiencies or when used to collateralize non-purpose loans, except as otherwise permitted by FINRA in writing. A firm will be allowed to extend credit on a nonmargin eligible security, equity or non-equity, only to the extent that the security is collateralizing a nonpurpose loan debit and such security can be liquidated in a period not exceeding 20 business days -2-

3 (based on a rolling 20-business-day median trading volume). The maintenance loan value for the nonmargin eligible security would be calculated based on the maintenance margin requirements for a margineligible security. If the security cannot be liquidated within 20 business days, then the security would not be entitled to a maintenance loan value. In such case, a 100% maintenance margin would be required, along with a deduction to net capital, pursuant to Rule 15c3-1 and, if applicable, FINRA Rule 4110(a). However, for offshore mutual funds that permit daily redemptions or liquidations and are affiliated with U.S. registered investment companies, FINRA intends to allow broker-dealers to extend maintenance loan values to collateralize a non-purpose loan, based on a 25% maintenance margin requirement. Additionally, FINRA has proposed the following changes related to non-margin eligible equity securities: Amend Rule 4210(f)(8)(B)(iii) to provide for margin maintenance requirements of 25% for margin-eligible equity securities and 100% for non-margin eligible equity securities (based on all trades made during the day). Add a new paragraph (E) to Rule 4210(g)(7) to clarify the maintenance margin requirements for non-margin eligible equity securities held in a portfolio margin account. Any non-margin eligible equity securities held long would require a maintenance margin equal to 100% of the current market value of the security at all times. Any non-margin eligible equity securities held short would require a maintenance margin equal to 50% of the current market value of the security at all times. Clarify Rule 4210(g)(7)(D) to state that while non-margin eligible securities are not eligible for portfolio margin treatment, such securities may be carried in a portfolio margin account, provided that the member uses strategy-based margin requirements, unless the securities are subject to the other provisions of Rule 4210(g). CLARIFICATION OF MAINTENANCE MARGIN REQUIREMENTS FOR NON-EQUITY SECURITIES FINRA proposes to clarify the maintenance margin requirements for non-equity securities held in a margin account. Paragraph (c)(4) of rule 4210 establishes the maintenance margin requirement for each bond held short in a margin account, and paragraph (e)(2)(c) establishes the maintenance margin requirements on any positions in specified non-equity securities that are inconsistent with the requirements in paragraph (c)(4). As a result of several inquiries about the appropriate maintenance margin requirement for any short non-equity security, FINRA proposes to clarify that the margin requirements in paragraph (c)(4) would apply to non-margin eligible, non-equity securities held short, while the margin requirements in paragraph (e)(2)(c) would apply to the specified margin-eligible nonequity securities held short or long. 7 ELIMINATION OF THE CURRENT EXEMPTION FROM THE PROHIBITION ON FREE-RIDING FOR DESIGNATED ACCOUNTS Free-riding, the financing of the purchase of a security out of the proceeds of its sale, is generally prohibited in cash accounts by Rule 4210(f)(9), but exemptions are provided for broker-dealers and designated accounts. 8 FINRA proposes to eliminate the exemption for designated accounts, explaining -3-

4 that it believes such accounts should be treated in the same way as any other customer with regard to free-riding. CONSOLIDATION OF THE DEFINITION OF EXEMPT ACCOUNT The proposed rule amendments would eliminate the separate definition of exempt account currently used exclusively in Rule 4210(f)(2)(E)(iv). Rule 4210(f)(2)(E)(iv) establishes reduced maintenance margin requirements for OTC put and call options on U.S. Government and U.S. Government agency debt securities, and includes a definition of exempt account that is older than the definition in paragraph (a)(13) that is used elsewhere in the rule 9 and sets a lower dollar threshold for an account to qualify as an exempt account. Due to the passage of time since the Rule 4210(a)(13) definition was implemented in 2003, 10 and noting that the older definition was retained only to grandfather then-existing credit transactions, FINRA states that maintaining separate definitions is no longer necessary and proposes to delete the older definition in Rule 4210(f)(2)(E)(iv). ELIMINATION OF AGGREGATE STRESS TESTING ON PORTFOLIO MARGIN ACCOUNTS As part of FINRA s requirements to monitor the risk exposure of portfolio margin accounts, members are currently required under Rule 4210(g)(1)(D) to stress test portfolio margin accounts both on an individual account basis and in the aggregate. FINRA proposes to eliminate the aggregate stress test requirement, stating that the stress testing of individual accounts, which the rule would continue to require, is sufficient to adequately monitor risk exposure. * * * Copyright Sullivan & Cromwell LLP

5 ENDNOTES See SR-FINRA , Proposed Rule Change Relating to FINRA Rule 4210 Margin Requirements (May 23, 2012), available at /P126250, and SEC Release No , Notice of Filing of Proposed Rule Change Relating to FINRA Rule 4210 Margin Requirements (May 31, 2012), available at rules/sro/ finra/2012/ pdf. FINRA Rule 4210(f)(2)(A)(xxvi) (to be renumbered as Rule 4210(f)(2)(A)(xxiv) as part of the proposed rule amendments) defines a listed option as an option contract that is traded on a national securities exchange and is issued and guaranteed by a registered clearing agency. Maximum potential loss would be determined by computing the intrinsic value of the options at price points for the underlying security or instrument that are set to correspond to every exercise price present in the spread. The intrinsic values are netted at each price point, and the maximum potential loss is the greatest loss, if any. If the options are not so issued and guaranteed by the same broker-dealer, then the short option contracts must be separately margined pursuant to FINRA Rule 4210(f)(2)(E)(iii) or (E)(iv). FINRA intends to retain the margin requirements only for the specific spread strategy of a long box spread consisting of European-style options, currently Rule 4210(f)(2)(H)(v)(g) (to be renumbered as Rule 4210(f)(2)(H)(v)(e)), as it is the only spread strategy that allows loan value. See FINRA Regulatory Notice (April 2011). FINRA also proposes to clarify that paragraphs (e)(2)(b), (F) and (G) apply to both long and short positions. The term generally refers to certain regulated financial institutions, states and their political subdivisions and certain pension and profit sharing plans. See FINRA Rule 4210(a)(4). See FINRA Rule 4210(e)(2)(F), (G) and (H) for situations providing for reduced margin requirements for exempt accounts currently subject to the definition of exempt account found in Rule 4210(a)(13). The definition found in Rule 4210(a)(13) was updated by the NYSE and NASD in 2003 for all purposes except that of Rule 4210(e)(2)(F), see Securities Exchange Act Release No (August 25, 2003), 68 FR (September 2, 2003) (Order Approving File No. SR-NASD ), and Securities Exchange Act Release No (August 19, 2003), 68 FR (August 26, 2003) (Order Approving File No. SR-NYSE-98-14). -5-

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