Leading US options clearinghouse continues to draw regulatory fire for lax management

Options Clearing Corp.’s $22 million regulatory fine last month shows that the main clearinghouse for US stock-options trading is still struggling to fix all the legal, compliance and management problems that have vexed it for a decade.

The penalty was imposed as the Chicago-based clearinghouse overhauls its 20-year-old technology and transfers core functions to the cloud in a long-term effort to upgrade clearing and risk management by 2025.

Options Clearing has repeatedly run afoul of the Securities and Exchange Commission and the Commodity Futures Trading Commission — incurring two fines and two critical examination letters — dating to 2013. Some infractions have involved repeat shortcomings that were supposed to have been addressed.

The latest fine was, in part, for failure to set up procedures to manage operational threats — a deficiency that also led to a $20 million penalty in 2019.

Six years before that, an SEC letter said examination findings raised “a serious concern about systemic weaknesses” at the clearinghouse’s operations and risk management, including insufficient oversight of senior executives.

Slow to adapt

Options Clearing proved slow to adapt its technology, internal controls and risk oversight to regulatory crackdowns in the wake of the 2008 financial crisis and the 2010 Dodd-Frank Act. During this clampdown, top management consisted of executives who had been with the company for several decades but have since left.

The clearinghouse is now undertaking a transformation that began in 2019 while also trying to safely bridge the gap to a new era. The challenge is complicated by a doubling of volume since 2014 and an increase in volatility, putting unprecedented pressure on clearing and settlement infrastructure.

In a prepared statement, CEO-elect Andrej Bolkovic voiced confidence that the clearinghouse “will continue to deliver our critical services each day while comprehensively transforming and modernizing our technology infrastructure across our clearing, risk-management and data-management systems.”

A former OCC board member, Bolkovic is due to become the chief executive sometime this spring, after John Davidson retires.

Clearinghouses serve as guarantors of trades by collecting collateral — known as margin — from member firms to ensure that the loss from a trader default won’t ripple through markets. Regulators consider clearinghouses a bulwark against financial instability. Options Clearing, the sole US clearinghouse for exchange-listed options, provides clearing and settlement services to 19 exchanges and trading platforms.

Penalty

The fine last month was not only related to operational risk-management procedures but also to a failure to promptly report a key operational shortcoming to the SEC.

Regulators traced these shortcomings to “deficiencies in certain internal controls, human errors and oversight failures.” As a result, OCC’s clearing fund was underfunded by as much as $588 million at times between October 2019 and May 2021.

SEC enforcement chief Gurbir Grewal called it “troubling” that the clearinghouse “violated the very rules designed to ensure the stability and efficiency of those markets.” At the same time, the agency acknowledged that the clearing fund had enough resources to meet certain trader-default obligations in “extreme but plausible” market conditions.

As part of its parallel settlement, the CFTC noted its “concern” that operational breaches cited in the 2019 settlement persisted until May 2021. The earlier fine was the first by the SEC under clearinghouse rules adopted three years earlier.

Options Clearing also has been the subject of two critical SEC examination letters.

In 2017, SEC examiners found the OCC had multiple deficiencies, including “violations and material weaknesses” in its policies, procedures and controls that could lead to “future violations of securities laws,” the Wall Street Journal reported.

Earlier, in 2013, the SEC cited a dozen deficiencies following a two-and-a-half-year examination. These included insufficient board oversight of senior management, lax safeguards against board conflicts of interest, and risk-management failures for monitoring trading-firm members.

“The excessive number of repeat findings raises a serious concern about OCC’s overall commitment to establishing a culture of regulatory compliance, and more specifically, its ability to timely and adequately address the staff’s findings,” the 22-page letter said, according to news reports.

The “pattern” of findings, the letter said, “raises a serious concern about systemic weaknesses” in OCC’s risk management and operations.

Michael Cahill, who started as CEO in January 2014 and announced his retirement nine months later, said of the SEC letter: “We weren’t doing things wrong,” according to Crain’s Chicago Business. He called the letter “the juiciest crap they could find on us.” He had been at the clearinghouse for 32 years.

Wayne Luthringshausen, who helped found the clearinghouse in 1973, served as chairman for 36 years and CEO for 40 years before retiring at the end of 2013. He was head of the organization during the SEC exam.

Regulators’ prodding

Regulators’ prompting has helped drive a number of initiatives, some of which are well underway.

In 2012, a Treasury-led panel of financial regulators designated the clearinghouse a Systemically Important Financial Market Utility, or SIFMU, subjecting it to heightened oversight. The group feared that Options Clearing’s collapse could pose a threat to US financial stability.

A 2016 SEC rule imposed enhanced standards for the operation and governance of clearinghouses that are systemically important or involved in complex transactions.

“Since receiving our SIFMU designation in 2012,” OCC Chair Craig Donohue said in a prepared statement, the clearinghouse “has made continuous investments in our present-day and long-term resiliency, transforming the way we approach our responsibilities.”

Donohue, who previously had been CME Group’s chief executive, has been OCC chair since 2014 and was simultaneously chief executive from 2016 to 2019. Donohue had been serving on an interim basis when he stepped down as CEO of his own accord, and he and the board agreed to hire a replacement.

The 2019 SEC order called the hiring of a CEO one of the clearinghouse’s “cooperation and remedial efforts” that the SEC considered in accepting a settlement offer. The board’s increase in expenditures for risk management, compliance, legal and information technology played a similar role, the order said.

Initiatives

In 2019, Options Clearing undertook a long-term effort to overhaul its technology infrastructure, including its clearing, settlement, data management, and risk-management systems. The new platform, called Ovation, is due to be externally tested in 2024 and to launch in 2025.

This initiative includes a transfer of core functions to the Amazon Web Services cloud with the aim of providing more resiliency, security and scalability. Options Clearing became the first SIFMU to seek regulatory approval for a cloud transfer, and the SEC issued a “notice of no objection” last year.

Separately, in 2020, the clearinghouse got formal approval for its capital management policy, intended to reduce systemic risk, increase market transparency, and provide efficiencies to market users. The clearinghouse’s capital has soared 10-fold from $25 million in 2014.

Also, in 2018, it began implementing a financial safeguards framework that seeks to improve clearing fund methodology and enhance resources.

In trading options, individual and institutional investors enter contracts that give the holder the option to buy or sell a security without an obligation to close the deal. The option, a form of derivatives, is a way for investors to speculate on price direction or hedge a stock position depending on how they believe the stock will perform over a certain time period.

Investors work with banks such as Bank of America or brokerages like Interactive Brokers to place desired trades on exchanges such as the Chicago Board Options Exchange.