Big changes are under way at Options Clearing Corporation, the Chicago-based clearinghouse that is among the world's largest as measured by processing volume. Earlier this year, OCC launched a multi-year effort to modernize the institution's risk management, clearing and data systems. Dubbed the Renaissance Initiative, the project aims to comprehensively redevelop the company's technology. But according to John Davidson, the clearinghouse's chief executive officer, the changes go far deeper.
"We’ve been an organization that had mostly been in maintenance mode for 20 years," Davidson said in an interview with MarketVoice. "Thanks to Craig Donohue’s leadership, we have been changing that historic culture pretty dramatically, and I appreciate that he brought me into the organization to accelerate momentum in our transformation efforts. Craig brought to OCC a new vision that focused on our people, processes and platforms and he created a new culture that encourages our colleagues to be strategic in our decision-making and to act with confidence."
Davidson, who spoke with MarketVoice in March on the sidelines of FIA's annual international futures industry conference in Boca Raton a few months after being named CEO, explained that the vision of Renaissance is to rethink everything OCC does—from adopting industry standards for handling futures contracts to providing on-demand data for collateral management and more transparency into margin calculations.
Davidson has had a long career working on operations and risk issues. He joined OCC in 2017 from Citigroup, where he worked for nine years in several leadership roles including chief compliance officer and chief administrative officer of the bank's risk division. Before that he worked for 12 years at Morgan Stanley as managing director for its institutional operations division. He was also the head of CME's clearinghouse from 1983 to 1993, and under his leadership CME developed SPAN, which became the industry standard for margin methodology.
OCC cleared 5.24 billion derivatives contracts in 2018, a record amount that was up 21% on the previous year. Its strength is in the clearing of options traded on U.S. securities exchanges, but it also clears futures for Cboe and Nasdaq. In contrast to most other derivatives clearinghouses, OCC is structured as a utility, with ownership divided among three major exchange groups but governance controlled by its board of directors, which consists of independent public directors plus representatives from shareholder exchanges and clearing firms.
Those who interact with OCC may not see obvious changes in the next few months, but its Renaissance initiative is already gathering speed on Renaissance. In the following interview, Davidson outlined what clearing members and other market participants can expect as OCC overhauls its technology.
MarketVoice: It's never easy to look around and realize you're behind on technology. Can you explain how OCC found itself in this position, and why it decided to embark on Renaissance?
Davidson: Well, I think the issue clearing members had to confront is that the cost of replacement is enormous, and the Encore system works very well every day. It’s very resilient, it’s volume insensitive, we can handle anything the industry throws at us. And replacing things is a major undertaking. We had underinvested as an institution over the years, and I think we’re correcting that. The most important thing is replacing the technology, but it's also about transforming the entire organization to be even more efficient and effective for market participants.
MV: It’s a multi-year project. What are the phases and how will it be rolled out?
JD: We have three different elements—clearing, risk and data—and slightly different phasing for each. The current Encore system is very tightly integrated together. The core processing, handling matched trades from exchanges, producing reports and the like, is tightly integrated with data in a mainframe. We need to have those function independently. We’re working with Cinnober, a Swedish company just acquired by Nasdaq, on that [the clearing system] and they have been very good partners.
We’re the only CCP [central counterparty] in the world that has 16 different exchanges trading fungible products. Most clearing environments define a product by the exchange on which it trades. But if 16 exchanges trade the same product, you have to have a different hierarchical definition of product, among other sort of fundamentals, in the guts of the system.
So we have a process with Cinnober over the next, potentially, two and a half years, including the testing and implementation timeframe. We’ve already started work on the risk platform and we will continue down that path. Obviously, the key is getting the data in from the core processing platform and storing it, archiving it and being able to retrieve it and use it, both for ourselves and for our clearing members, in a much more agile and quick manner.
MV: After that internal work, clearing members and market participants are going to have to make changes as well, right?
JD: That is key to our strategy. We want to do as much work as we possibly can internally and start to give them better functionality but through the same interfaces. As long as possible, we will keep the APIs for both clearing members and exchanges what they are today. That way, they get more functionality, but they don’t have to make changes.
The biggest challenge with respect to imposing changes on clearing members is that the big ones don’t just do business at OCC. They are everywhere. They have a whole host of technology priorities but constrained budgets. People think, well, when you do a technology change that it’s the little guys that you have to chase to get things done. It’s exactly the opposite. It’s the big guys. Because they’ve got priorities for the entire capital markets institution and in some cases, they’ve got a lot more priorities to juggle.
We will give clearing members a lot of notice when things like the APIs change. But in the meantime, we want to give them as much consistency as possible. We have a very good clearing member operations roundtable as well as a risk advisory group made up of clearing members. We will interact very dynamically with them and give them lots of advance notice to get their input on changes that we’re making.
MV: Speaking of input, there was a phase where you consulted with clearing firms to find out what they thought would be important. So what did they say?
JD: Well, the interesting thing is they are actually quite happy with the operational processes and procedures that OCC uses in general. What they’re probably least happy with is the way we handle futures contracts.
One of the things that the Cinnober system will give us is industry standard futures processing. That is going to be really important. I mean, we’re a bit of a small bump in the road with respect to some of the major futures exchanges, but of growing importance. The way we handle give-ups, the fact that we don’t use the EGUS system or some of the other things that FIA has developed over the years—those are some of the things that need to change, and they will be some of the early benefits that the clearing members will see.
The whole brokerage billing environment has the same issues in the options industry that futures had, what, 15 years ago? OCC needs to provide information so the industry can get out of the manual processing of commissions and do it in a straight-through manner.
We need to be able to give clearing members much closer to real-time reporting on their positions and exposures.
MV: OCC has said that one of the benefits of this project is to improve information transparency. What do you mean by that?
JD: Well, we are in very much a batch end-of-day process with respect to the information that we provide clearing members. The futures industry has developed after-hours trading to a much greater extent than the options industry has. We need to be able to give clearing members much closer to real-time reporting on their positions and exposures.
We also need to have a facility that allows them to do some what-if analysis. We have a pretty crude facility for that in the Encore system today, where you have to manually enter the positions. There needs to be an API.
We look at a clearing member exposure as the whole, right? We’re looking at all of Goldman Sachs, or all of J.P. Morgan. But they in fact have different lines of business that use the risk transfer products. They’re quite happy to meet their funding requirements for our clearing fund, but then they have to apportion the capital charge associated with that requirement across the different businesses. They would like to send us a portfolio of positions and say, what would be the clearing fund requirement for just that chunk of the business? Or just this other chunk? That sort of functionality is what gives them transparency.
Now, it used to be that there was this view in certain CCPs that if the margin models were understood too well by clearing members they could, quote unquote, game the system. That’s just a crazy way to think about the world. Everybody needs to work together to manage the risk in the industry. Suppose I'm a clearing firm and I get a new client. I need to know what that's going to do to my overall portfolio. It’s that sort of interface with information that we think is really important. The more transparency about how our models work and how our stress testing works, the better we'll be.
MV: If you're shifting away from this sort of batch end-of-day kind of structure, does that mean your clearing members will have the ability to calculate risk intra-day? With something like a dashboard, maybe not exactly in real-time, but close?
Suppose I'm a clearing firm and I get a new client. I need to know what that's going to do to my overall portfolio... The more transparency about how our models work and how our stress testing works, the better we'll be.
JD: There will be a dashboard, absolutely, with what I'll call "on demand" data. And each clearing member should have a dashboard. Many of them, internally, probably do. But they don’t necessarily have a dashboard that tells them the central counterparty’s perspective, and, of course, their dashboard is much more complex than ours.
With few exceptions these entities are clearing a number of markets, all interrelated in some manner or another [and] they have clients that are trading those different markets. They’ve got to understand all of those risks from their internal co-mingled perspective. But a CCP is always going to see only a part of the risk picture that the clearing member sees. We've got to provide transparency so they can see the pieces we see and then manage their collateral and other exposures accordingly.
MV: With the clearing piece, you opted to buy what you refer to as commodity components from Cinnober. Why did you not take that approach when it came to risk?
JD: Well, we haven’t finalized that decision with certainty. We are continuing to look at some approaches. But at the end of the day, we do some very sophisticated modeling. OCC clears about 970,000 different instruments, and the relationships among those instruments is quite complex and fairly unique to our environment. We’ve got some very talented quants on our team who have done a lot of work developing the risk-related models. We think it’s more straight forward for us to continue our own development in that, but in a much more flexible environment.
So, we’re not at the end of that process. We are continuing to evaluate. And, obviously, there are pieces of the puzzle. We want to make sure we have the ability to interface with some of the newer technologies, blockchain among them. In all probability those will involve some sort of a service provider role.
MV: Speaking of blockchain, is distributed ledger technology in your future?
JD: We think there are a number of areas where that will be an important application. A little less so in the exchange-traded marketplace, in all probability. One of the most attractive areas is with respect to our securities lending business, where we intermediate stock borrowing and lending. The blockchain can actually take the position from the asset manager through the custodian, to the broker-dealer, to ourselves, and back out that chain, in a much more efficient and effective manner than the current process. In a bilaterally negotiated environment, as opposed to a central limit order book, that’s pretty important.
MV: Turning to data, the third dimension of this initiative, how will the new platform differ from the old, from the perspective of the people who are consuming your data?
JD: It will be a lot more flexible. It will be a lot easier to acquire the data, particularly historic data. It will actually be housed in the cloud, as opposed to in our two on-premises data centers.
Those who clear products will see the biggest benefits. As I said, we need to have on-demand understanding of what exposures are. But risk management from a clearing perspective is not nanosecond-based. We’re not making trading decisions, how to maximize the return on a portfolio. We are making sort of big picture evaluations of what the risk is.
MV: A significant amount of the equity derivatives business is conducted bilaterally. Will this upgrade to your technology get you to a point where you can attract more business from the OTC world?
JD: I don’t know that it will change where they put their business. But it will bring in additional portfolios into the picture in a more synergistic way.
The reason that the OTC equity options business is not centrally cleared today is as much a characteristic of the business itself. The terms are not standardized the way they are in the fixed income or even the credit default swap market.
Having that additional flexibility does give us the ability to move into that market. More importantly it gives the exchanges, who are really the product innovators in this industry, a lot more flexibility. For example, the ability to support some of our exchanges that want to get into non-dollar denominated contracts. That’s another very important building block.
Certainly, intermediating the OTC equity options business is something we look at. But right now, the focus is to deliver the project on time and on budget. I think we’ve brought some good people in to do that. Our board and management team are aligned in our expectations and [our] commitment to delivering results that are good for the industry and the users of our markets.
