Roles of Options Clearing Corporation
Options are the financial instruments that derive their value from the underlying instrument. Underlying instrument can be Equity, Currency, Commodity, Index, etc. There are basically two forms of trading options I.e. Exchanged traded options and Over the counter options.
Exchange-traded options have standardized contracts and are settled through a clearing house with fulfillment guaranteed by The Options Clearing Corporation (OCC). Since the contracts are standardized, accurate pricing models are often available.
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Over-the-counter options are traded between two private parties and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, the option writer is a well-capitalized institution (in order to prevent credit risk). As OTC options are not traded via clearing corporation, there exists a risk of counterparty default.
Three basic roles which OCC performs are as follows:
- Avoid counterparty risk
- Improving the marketability and liquidity of options by allowing participants to square off their position before expiry
- Maintain the financial integrity through margin requirements
The main role of the Options Clearing Corporation (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.
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For example, the seller of an HDFC call option with a one-month expiration date is obligated to deliver 500 shares of HDFC stock to the buyer at the striking price, if the buyer decides to exercise his or her option. If the option is in the money, the buyer will make a profit by exercising the option contract. Since an option is an agreement or contract between two parties, the buyer’s profit will equal the writer’s loss.
There can be a possibility where the buyer refuse to oblige to deliver the 500 shares of stock. This could occur because of bankruptcy by the writer, or simply his or her unwillingness to incur the financial loss. 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 options trades, the buyer of a call option need not worry about the integrity of 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.
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In addition to avoiding counterparty risk in an options contract, another way the OCC increases option marketability and liquidity are by enabling option buyers and writers to terminate their positions in the market at any time, by making an offsetting transaction (Remember that European options can be exercised only on the expiration date).
A buyer of an option can in effect, close out his or her position by simply writing the same option 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. A standardized contract also adds in the marketability of options.
The OCC also maintains the financial integrity through margin requirements that are imposed on option sellers. The actual margin requirements are established by the SEC and Federal Reserve Board, with the OCC acting as the clearinghouse. Option 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. This is the maximum loss which buyer of an option contract can experience. Options 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.
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