Established in 1973, the Options Clearing Corporation (OCC) is an options clearinghouse that is owned by the four securities exchanges that make markets in listed stock options. These exchanges are the Chicago Board of Options Exchange (CBOE), the American Stock Exchange (AMEX), the Philadelphia Stock Exchange (PHLX), and the Pacific Stock Exchange (PSE). All four exchanges clear all of their option transactions through the OCC. The OCC is regulated by the Securities and Exchange Commission (SEC), and is vital to the operations of the exchanges.
The main role of the OCC is to act as a performance guarantor for all stock options. An option buyer and seller who agree on a price for a standardized stock option will negotiate a deal. The OCC then interposes itself between the buyer and seller, becoming the party to whom delivery is made, and from whom delivery is taken. By becoming the opposite party to every contract, the OCC is substituting its own ability to deliver on the contract for the option writer's ability to deliver, thus guaranteeing performance and eliminating counterparty risk.
For example, the seller, or writer, of an IBM call option with a three-month expiration date is obligated to deliver 100 shares of IBM stock to the buyer at the striking price, if the buyer decides to exercise his or her option. Buyers of call options will exercise their options when it is economically advantageous to do so. Normally, this occurs at the expiration date, if the current stock price exceeds the striking, or exercise, price. Such an option is said to be "in the money," meaning that the buyer will immediately profit from exercising the option. Since an option is an agreement or contract between two parties, the buyer's profit will equal the writer's loss. There is an incentive, however, for the writer of a call that is in the money at the expiration date to simply ignore his or her obligation to deliver the 100 shares of stock. This could occur because of bankruptcy by the writer, or simply his or her unwillingness to incur the financial loss. (Recall that the potential loss from writing call options is virtually unlimited because the stock value has no price ceiling.)
Because the OCC becomes the counterparty to all option trades, the buyer of a call option need not worry about the integrity or financial means of the writer. If the writer of the option defaults on his or her obligation, the buyer is unaffected because the OCC will make the delivery. This, in effect, increases the secondary marketability of stock options. It also reduces transaction costs, since buyers will not need to investigate the writer's credit.
The same is true for buyers and sellers of put options. The writer of a put option agrees to purchase the 100 shares of stock from the put buyer at the exercise price on or before the expiration date, if the buyer so decides to exercise. Put buyers will exercise their options when the current stock price is below the exercise price. Although the put writer's loss is limited, because the stock value can drop only to zero, there is still a financial incentive for the writer to default. But since the OCC is, in effect the counterparty to both sides, the buyer need not worry about the writer's integrity. If the writer defaults, the OCC will purchase the shares from the buyer and take legal action against the writer.
In addition to guaranteeing the performance on all option contracts, another way the OCC increases option marketability and liquidity is by enabling option buyers and writers to terminate their positions in the market at any time, by making an offsetting transaction. A buyer of a call option can in effect, close out his or her position by simply writing a call option with the same exercise price and expiration date. The same holds true for puts; buyers and writers of put options can terminate their positions by taking the opposite position with the same exercise price and expiration date. Because of this possibility, more participants are likely to enter the market, thereby improving the marketability and liquidity of options. Another factor that aids marketability and liquidity is the standardized contract.
The OCC also maintains the financial integrity of the option exchanges and markets through margin requirements that are imposed on option writers. The actual margin requirements are established by the SEC and Federal Reserve Board, with the OCC acting as the clearinghouse. Put or call buyers pay a premium to the writer at the time the contract is entered into. The buyers do not need to post any margin because they will only exercise the option if it is profitable. In other words, after purchasing the put or call option, no further money is at risk. Put and call writers, however, have a future financial obligation if the option expires in-the-money. Therefore, option writers are required to post margins equal to the market value of their obligation as a performance guarantee.
While other clearinghouses also serve traders on the options exchanges, the OCC is the world's largest clearinghouse for financial derivatives. It has a daily liability of $30 billion. It began converting its computer systems for year 2000 compliance in 1985 and has been Y2K compliant since 1996. In June 1998 it became the first clearinghouse to receive a AAA rating from Standard & Poor's, reflecting its leadership in clearance, settlement, and risk management systems.
[ James A. Gerhardinger ,
updated by David P. Bianco ]
"ABN AMRO Chicago Corporation to Acquire Sage Clearing." Harvard Business Review, November/December 1997, 157.
Bailey, Fred. Practical Strategies in Stock Options. Grove City, PA: Center for Futures Education, 1997.
Bere, Carol. "The OCC Sets the Pace." Global Finance, June 1998, 94.
Connors, Laurence A. Connors on Advanced Trading Strategies. Malibu, CA: M. Gordon Publishing, 1998.
Gross, LeRoy. The Conservative Investor's Guide to Trading Options. New York: Wiley, 1998.
Options Traders. 3rd ed. New York: Simon & Schuster, 1998.
Szala, Ginger. "Less Is More: OCC Goes to Institutions." Futures, November 1993, 24-25.
"Y2K Stats: The Options Clearing Corp." PC Week, 6 July 1998, 88.