A Messy Battle Brews in the Options Market
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A Messy Battle Brews in the Options Market
Craig Donohue, CEO of the only U.S. options clearinghouse, is clashing with traders over his plans
‘We think this is the right plan,’ the OCC’s Craig Donohue said. Photo: Lyndon French for The Wall Street Journal
3 Comments
By
Gunjan Banerji
Aug. 22, 2018 8:00 a.m. ET
Craig Donohue’s turnaround plan for the nation’s options clearinghouse has hit a roadblock.
Mr. Donohue has boosted the prominence of Options Clearing Corp., which acts as a guarantor for every trade in the U.S. listed options market. Clearinghouses—critical parts of the financial system—came under greater scrutiny after the last financial crisis and are responsible for preventing potential defaults from rippling through markets.
Options Middleman
The OCC, the options market's only clearinghouse, started paying dividends to owners in 2015—a move opposed by traders who pay clearing fees.
Old Method
Clearing members pay fees.
1
OCC spends money on operating expenses.
2
OCC refunds excess fees to its clearing members.
3
New Method
Clearing members pay fees.
1
OCC spends money on expenses, restores reserves.
2
Roughly half of remainder goes to shareholders.
3
Roughly half is refunded to clearing members.
4
Sources: Court documents; SEC comment letters; OCC financial statements
But after four years at the helm, the OCC’s executive chairman and chief is locked in a fierce battle with options traders who oppose his plan to boost income for OCC shareholders—three publicly listed exchange-operators—while trimming returns to traders.
A group of trading firms and smaller, competing exchanges, including Susquehanna International Group LLP and Virtu Financial Inc., made the unusual move of suing the Securities and Exchange Commission in 2016 for approving the OCC proposal early that year, throwing the plan’s fate up in the air. The SEC is currently re-reviewing it on the order of a U.S. appeals court. A spokesman for the SEC declined to comment.
Though the plan remains in place and has been paying dividends to shareholders, its future is unknown. Shareholder payouts have been climbing since their inception in 2015, hitting a high in 2017, according to OCC financial statements and comments to the SEC.
Mr. Donohue defended his actions in an interview last November. “I’m confident that we did a professional and thorough job,” he said. “We think this is the right plan.” OCC had no additional comment this week.
The conflict is a setback for Mr. Donohue, a Chicago-area native who made a name for himself leading exchange giant CME Group Inc. During his time there, he helped oversee $20 billion in acquisitions and the company went through an initial public offering—the first U.S. exchange to go public.
Fat ChecksPayouts to OCC owners have swelled, stokinga feud in the options world.Sources: SEC comment letters; OCCNote: Shareholders contributed $150 million.
%Return on shareholder cash infusionReturn on net capital2015’16’170510152025
Now the OCC is mired in uncertainty over the capital plan that Mr. Donohue helped devise years ago. In a separate pressure point, the SEC is investigating how the OCC handled a bout of market volatility this year, raising questionsabout an entity essential to the market’s financial plumbing.
Just before Mr. Donohue became chief in 2014, the SEC hit OCC with a range of criticisms on how it manages risk. After the 2008 financial crisis, OCC was deemed one of a handful of financial institutions considered “systemically important.” This designation led to Mr. Donohue’s overhaul. When he joined the OCC, the clearinghouse had only enough cash to operate for about six weeks, he said in the November interview. He helped raise its cash stockpiles to $247 million from $25 million, giving it a bigger cushion to buffer against losses.
Mr. Donohue also raised the OCC’s visibility. In late 2017, the firm’s executives rang the closing bell at Nasdaq Inc. in Times Square—the first time in its four-decade existence that the clearinghouse participated in the tradition.
“He’s taking his CME reinvention hat over to OCC,” said Craig Pirrong, a professor at the University of Houston who has consulted for exchanges.
For decades, OCC’s potential to generate cash had sat untapped. It essentially operated as a nonprofit utility for the industry. Money made from clearing fees was spent mostly on bare-bone expenses, and leftover cash was returned to members, like banks and other firms that give traders access to clearing.
Under the new plan spearheaded by Mr. Donohue, money is paid to the shareholders, which are the three biggest options-exchange operators— Intercontinental Exchange Inc.’s New York Stock Exchange, Nasdaq and Cboe Global Markets Inc.—in return for cash posted by the exchanges to OCC.
On the RiseRevenue at OCC has soared since 2014.Source: OCC
.millionRevenuesExpenses2008’10’12’14’16-400-300-200-1000100200300$400
Options traders say the plan could hurt investors by making it more onerous to trade and potentially crimping liquidity in the markets, affecting how difficult it is to swoop in and out of positions. They say it exploits the clearinghouse’s monopolistic position, since all listed options trades funnel through the central entity. Smaller exchange competitors have argued it gives the owner exchanges an additional stream of revenue and an unfair advantage in the fiercely competitive options market.
The shareholder returns “create a ‘golden goose’” that produces “outsized returns into perpetuity to the sole benefit of those shareholder exchanges,” wrote David Thompson, a lawyer representing Susquehanna, Virtu and smaller exchanges at Cooper & Kirk PLLC in January.
A spokesman said the OCC is committed to a structure as an industry utility and still gives refunds to clearing members.
In a blow to the OCC, Chief Judge Merrick Garland of the U.S. Court of Appeals ordered the SEC to re-evaluate the OCC’s proposal last year, saying it didn’t do a rigorous job of determining whether the shareholder payouts hurt investors. “That is a central issue: if the dividend rate represents an unnecessary windfall for shareholders,” he wrote.
Pretty PennyIt's gotten costlier to trade options in recentyears as OCC has ramped up fees.Average fee per contractSource: OCC
.cents2008’09’10’11’12’13’14’15’16’170.00.51.01.52.02.53.03.54.0
If the SEC rejects the proposal after its review, Mr. Donohue will have to return to the drawing board and devise a new plan to meet regulator demands.
People who have worked with Mr. Donohue describe him as shrewd, precise and competitive. Equipped with a law degree and two master’s degrees, he is known for sporting plaid blazers and driving a white Bentley convertible with “DONOHUE” on the vanity plate, they say.
Potentially adding uncertainty, the NYSE recently considered selling its stake in OCC, according to people with knowledge of the matter. The Depository Trust & Clearing Corp., a clearinghouse for stocks and bonds, approached the OCC about a potential merger, but those talks have since cooled, according to the people.
The DTCC is “continually assessing opportunities to enhance our support of clients, improve operational efficiencies and strengthen risk management across the industry,” a spokesman said. “There is nothing specific to report at this time.” Representatives of the NYSE and the OCC declined to comment on the matter.
At the heart of the OCC’s recent conflict is whom the clearinghouse is supposed to serve: exchange owners or options traders.
Cboe, the NYSE and Nasdaq were all once member-owned organizations that went public. Their transformations into publicly traded, for-profit entities remains a contentious topic of debate on Wall Street.
Critics of Mr. Donohue’s plan have pointed to the DTCC as an example of how clearinghouses should run, saying that it hasn’t paid excessive profits to shareholders or hurt competition.
“Exchanges and clearers have these natural monopoly positions,” said the University of Houston’s Mr. Pirrong. “Their decisions have big impacts on how wealth and revenue is distributed among the industry.”
Craig Donohue, CEO of the only U.S. options clearinghouse, is clashing with traders over his plans
‘We think this is the right plan,’ the OCC’s Craig Donohue said. Photo: Lyndon French for The Wall Street Journal
3 Comments
By
Gunjan Banerji
Aug. 22, 2018 8:00 a.m. ET
Craig Donohue’s turnaround plan for the nation’s options clearinghouse has hit a roadblock.
Mr. Donohue has boosted the prominence of Options Clearing Corp., which acts as a guarantor for every trade in the U.S. listed options market. Clearinghouses—critical parts of the financial system—came under greater scrutiny after the last financial crisis and are responsible for preventing potential defaults from rippling through markets.
Options Middleman
The OCC, the options market's only clearinghouse, started paying dividends to owners in 2015—a move opposed by traders who pay clearing fees.
Old Method
Clearing members pay fees.
1
OCC spends money on operating expenses.
2
OCC refunds excess fees to its clearing members.
3
New Method
Clearing members pay fees.
1
OCC spends money on expenses, restores reserves.
2
Roughly half of remainder goes to shareholders.
3
Roughly half is refunded to clearing members.
4
Sources: Court documents; SEC comment letters; OCC financial statements
But after four years at the helm, the OCC’s executive chairman and chief is locked in a fierce battle with options traders who oppose his plan to boost income for OCC shareholders—three publicly listed exchange-operators—while trimming returns to traders.
A group of trading firms and smaller, competing exchanges, including Susquehanna International Group LLP and Virtu Financial Inc., made the unusual move of suing the Securities and Exchange Commission in 2016 for approving the OCC proposal early that year, throwing the plan’s fate up in the air. The SEC is currently re-reviewing it on the order of a U.S. appeals court. A spokesman for the SEC declined to comment.
Though the plan remains in place and has been paying dividends to shareholders, its future is unknown. Shareholder payouts have been climbing since their inception in 2015, hitting a high in 2017, according to OCC financial statements and comments to the SEC.
Mr. Donohue defended his actions in an interview last November. “I’m confident that we did a professional and thorough job,” he said. “We think this is the right plan.” OCC had no additional comment this week.
The conflict is a setback for Mr. Donohue, a Chicago-area native who made a name for himself leading exchange giant CME Group Inc. During his time there, he helped oversee $20 billion in acquisitions and the company went through an initial public offering—the first U.S. exchange to go public.
Fat ChecksPayouts to OCC owners have swelled, stokinga feud in the options world.Sources: SEC comment letters; OCCNote: Shareholders contributed $150 million.
%Return on shareholder cash infusionReturn on net capital2015’16’170510152025
Now the OCC is mired in uncertainty over the capital plan that Mr. Donohue helped devise years ago. In a separate pressure point, the SEC is investigating how the OCC handled a bout of market volatility this year, raising questionsabout an entity essential to the market’s financial plumbing.
Just before Mr. Donohue became chief in 2014, the SEC hit OCC with a range of criticisms on how it manages risk. After the 2008 financial crisis, OCC was deemed one of a handful of financial institutions considered “systemically important.” This designation led to Mr. Donohue’s overhaul. When he joined the OCC, the clearinghouse had only enough cash to operate for about six weeks, he said in the November interview. He helped raise its cash stockpiles to $247 million from $25 million, giving it a bigger cushion to buffer against losses.
Mr. Donohue also raised the OCC’s visibility. In late 2017, the firm’s executives rang the closing bell at Nasdaq Inc. in Times Square—the first time in its four-decade existence that the clearinghouse participated in the tradition.
“He’s taking his CME reinvention hat over to OCC,” said Craig Pirrong, a professor at the University of Houston who has consulted for exchanges.
For decades, OCC’s potential to generate cash had sat untapped. It essentially operated as a nonprofit utility for the industry. Money made from clearing fees was spent mostly on bare-bone expenses, and leftover cash was returned to members, like banks and other firms that give traders access to clearing.
Under the new plan spearheaded by Mr. Donohue, money is paid to the shareholders, which are the three biggest options-exchange operators— Intercontinental Exchange Inc.’s New York Stock Exchange, Nasdaq and Cboe Global Markets Inc.—in return for cash posted by the exchanges to OCC.
On the RiseRevenue at OCC has soared since 2014.Source: OCC
.millionRevenuesExpenses2008’10’12’14’16-400-300-200-1000100200300$400
Options traders say the plan could hurt investors by making it more onerous to trade and potentially crimping liquidity in the markets, affecting how difficult it is to swoop in and out of positions. They say it exploits the clearinghouse’s monopolistic position, since all listed options trades funnel through the central entity. Smaller exchange competitors have argued it gives the owner exchanges an additional stream of revenue and an unfair advantage in the fiercely competitive options market.
The shareholder returns “create a ‘golden goose’” that produces “outsized returns into perpetuity to the sole benefit of those shareholder exchanges,” wrote David Thompson, a lawyer representing Susquehanna, Virtu and smaller exchanges at Cooper & Kirk PLLC in January.
A spokesman said the OCC is committed to a structure as an industry utility and still gives refunds to clearing members.
In a blow to the OCC, Chief Judge Merrick Garland of the U.S. Court of Appeals ordered the SEC to re-evaluate the OCC’s proposal last year, saying it didn’t do a rigorous job of determining whether the shareholder payouts hurt investors. “That is a central issue: if the dividend rate represents an unnecessary windfall for shareholders,” he wrote.
Pretty PennyIt's gotten costlier to trade options in recentyears as OCC has ramped up fees.Average fee per contractSource: OCC
.cents2008’09’10’11’12’13’14’15’16’170.00.51.01.52.02.53.03.54.0
If the SEC rejects the proposal after its review, Mr. Donohue will have to return to the drawing board and devise a new plan to meet regulator demands.
People who have worked with Mr. Donohue describe him as shrewd, precise and competitive. Equipped with a law degree and two master’s degrees, he is known for sporting plaid blazers and driving a white Bentley convertible with “DONOHUE” on the vanity plate, they say.
Potentially adding uncertainty, the NYSE recently considered selling its stake in OCC, according to people with knowledge of the matter. The Depository Trust & Clearing Corp., a clearinghouse for stocks and bonds, approached the OCC about a potential merger, but those talks have since cooled, according to the people.
The DTCC is “continually assessing opportunities to enhance our support of clients, improve operational efficiencies and strengthen risk management across the industry,” a spokesman said. “There is nothing specific to report at this time.” Representatives of the NYSE and the OCC declined to comment on the matter.
At the heart of the OCC’s recent conflict is whom the clearinghouse is supposed to serve: exchange owners or options traders.
Cboe, the NYSE and Nasdaq were all once member-owned organizations that went public. Their transformations into publicly traded, for-profit entities remains a contentious topic of debate on Wall Street.
Critics of Mr. Donohue’s plan have pointed to the DTCC as an example of how clearinghouses should run, saying that it hasn’t paid excessive profits to shareholders or hurt competition.
“Exchanges and clearers have these natural monopoly positions,” said the University of Houston’s Mr. Pirrong. “Their decisions have big impacts on how wealth and revenue is distributed among the industry.”
The article says: "At the heart of the OCC’s recent conflict is whom the clearinghouse is supposed to serve: exchange owners or options traders."
I actually don't agree. The heart of the matter should be who are the ones who ultimately guarantees behind all those potential counterparty risks in times of crisis, who is the one who's going to ultimately put their money down and say "no matter what happens, bring it!! I've got you covered", exchange owners or the clearing members. These are the people who should be rewarded for their efforts with payouts, refunds, whatever you want to call it because those are the ones who will be there with the money when s*** hit the fan. It shouldn't be some opportunistic, self-serving entities who are just there getting a piece of the pie when there are pieces to be had on the table but take off at the first opportunity as soon as they see the slightest raindrops and leave the others holding the bag while they've already cleaned out the funds that were supposed to be there for the rainy days.
But then again, OCC is like the insurance company of the last resort for the option market. And just like insurance companies, they collect premiums which is like the fees that we all pay to OCC on every single option trade we do and then when s*** hits the fan, we get insurance payout, the guarantee that the option won't fail. But also like insurance companies, there are shareholders and shareholders of insurance companies get very lucrative dividends so shouldn't shareholders of OCC get paid as well? But there is a difference between shareholders of insurance companies and shareholders of OCC. Shareholders of insurance companies usually don't have much conflict of interest whereas shareholders of OCC, being that they are the exchanges where all those option trades took place do have a vested interest in OCC; they are like the ones who own the insurance companies but at the same time also own the hospitals where all the healthcare takes place.
So I guess, instead of asking whether shareholders should be paid dividend, a more probing question should be should exchanges that have vested interest in option clearing corp. be allowed as shareholders invest in OCC at all in the first place? Shouldn't OCC be independent and impartial and be solely funded by member clearing firms? And if the exchanges want to have a piece of the pie, maybe they should become clearing members instead and put their money in to guarantee during the time of a storm. If they want rewards, they need to have obligations too.
I actually don't agree. The heart of the matter should be who are the ones who ultimately guarantees behind all those potential counterparty risks in times of crisis, who is the one who's going to ultimately put their money down and say "no matter what happens, bring it!! I've got you covered", exchange owners or the clearing members. These are the people who should be rewarded for their efforts with payouts, refunds, whatever you want to call it because those are the ones who will be there with the money when s*** hit the fan. It shouldn't be some opportunistic, self-serving entities who are just there getting a piece of the pie when there are pieces to be had on the table but take off at the first opportunity as soon as they see the slightest raindrops and leave the others holding the bag while they've already cleaned out the funds that were supposed to be there for the rainy days.
But then again, OCC is like the insurance company of the last resort for the option market. And just like insurance companies, they collect premiums which is like the fees that we all pay to OCC on every single option trade we do and then when s*** hits the fan, we get insurance payout, the guarantee that the option won't fail. But also like insurance companies, there are shareholders and shareholders of insurance companies get very lucrative dividends so shouldn't shareholders of OCC get paid as well? But there is a difference between shareholders of insurance companies and shareholders of OCC. Shareholders of insurance companies usually don't have much conflict of interest whereas shareholders of OCC, being that they are the exchanges where all those option trades took place do have a vested interest in OCC; they are like the ones who own the insurance companies but at the same time also own the hospitals where all the healthcare takes place.
So I guess, instead of asking whether shareholders should be paid dividend, a more probing question should be should exchanges that have vested interest in option clearing corp. be allowed as shareholders invest in OCC at all in the first place? Shouldn't OCC be independent and impartial and be solely funded by member clearing firms? And if the exchanges want to have a piece of the pie, maybe they should become clearing members instead and put their money in to guarantee during the time of a storm. If they want rewards, they need to have obligations too.
I think this may be more about the exchanges(the current owners) exchanging stock when OCC goes public. Not 100% certain. Right now all OCC members get a rebate of a portion of the OCC fee and this number is substantial. I think this may be more of a way to placate the existing owner at the expense of the clearing members.
Despite What You Read, The Options Industry Is Doing Great
A recent Wall Street Journal article claims a behind-the-scenes battle in the options industry threatens investors. But the industry has never been stronger, as indicated by continued increases in volume as well as an improvement in liquidity across the market, notes TABB Group’s Russell Rhoads.
An article in the Wall Street Journal this week once again is putting a negative spotlight on the options industry (“A Messy Battle Brews in the Options Market”). The Options Clearing Corporation (OCC) is the target du jour, along with some commentary about Craig Donohue, CEO of the OCC, who has done a solid job in the role. The article even brings up how he dresses, what kind of car he drives, and that he has vanity plates. What does that have to do with the industry?
The whole article is old news. The core of the article is a lawsuit that was filed in 2016. The quotes from Craig Donohue used in the article are from last November. And a quote from the lawyer representing some trading firms and smaller competing exchanges in the lawsuit is from a letter dated in January.
The article notes that the OCC was deemed a systematically important financial institution and needed to raise capital. This was in response to the global financial crisis in 2008. What was not mentioned was that the OCC did a stellar job during the dark days of 2008. Also, the article fails to mention that the OCC has an AA+ credit rating from Standard & Poor’s. S&P even posted a notice this week reaffirming this rating. To offer some perspective, the AA+ rating is held by only 1% of the more than 9,000 entities covered by S&P. OCC is a very financially strong entity and has become much stronger under Mr. Donohue’s leadership.
The WSJ article shines a light on the OCC’s plan to boost dividends for its shareholders, the three largest options exchange operators. These exchanges collectively paid $150 million to OCC to increase its capital buffer after the financial crisis. In return, the exchanges became owners of the clearinghouse. And as owners that risked their own capital to strengthen the financial backbone of the clearinghouse, they are receiving dividends. According to the article, “Options traders say the plan could hurt investors by making it more onerous to trade and potentially crimping liquidity in the markets, affecting how difficult it is to swoop in and out of positions.” But the plan has been in place for several years and the industry has never been stronger, as indicated by continued increases in volume as well as an improvement in the liquidity across the whole options market.
[Related: “US Options Volume on Pace for Record Year Despite Drop Off, Lower Volatility in Q2”]
TABB Group estimates options volume is on track this year to exceed 5 billion contracts for the first time. Even more significant is the trend with respect to the quality of the market: The average bid/ask spread across the options industry was 0.22 in July 2018 and has narrowed each month since the market volatility in February. The last time markets were this tight (which is a good thing for traders) was in September 2013.
Bottom line: The options industry is growing, the quality of markets is favorable for traders, and the OCC is one of the most financially solid entities in the United States.
A recent Wall Street Journal article claims a behind-the-scenes battle in the options industry threatens investors. But the industry has never been stronger, as indicated by continued increases in volume as well as an improvement in liquidity across the market, notes TABB Group’s Russell Rhoads.
An article in the Wall Street Journal this week once again is putting a negative spotlight on the options industry (“A Messy Battle Brews in the Options Market”). The Options Clearing Corporation (OCC) is the target du jour, along with some commentary about Craig Donohue, CEO of the OCC, who has done a solid job in the role. The article even brings up how he dresses, what kind of car he drives, and that he has vanity plates. What does that have to do with the industry?
The whole article is old news. The core of the article is a lawsuit that was filed in 2016. The quotes from Craig Donohue used in the article are from last November. And a quote from the lawyer representing some trading firms and smaller competing exchanges in the lawsuit is from a letter dated in January.
The article notes that the OCC was deemed a systematically important financial institution and needed to raise capital. This was in response to the global financial crisis in 2008. What was not mentioned was that the OCC did a stellar job during the dark days of 2008. Also, the article fails to mention that the OCC has an AA+ credit rating from Standard & Poor’s. S&P even posted a notice this week reaffirming this rating. To offer some perspective, the AA+ rating is held by only 1% of the more than 9,000 entities covered by S&P. OCC is a very financially strong entity and has become much stronger under Mr. Donohue’s leadership.
The WSJ article shines a light on the OCC’s plan to boost dividends for its shareholders, the three largest options exchange operators. These exchanges collectively paid $150 million to OCC to increase its capital buffer after the financial crisis. In return, the exchanges became owners of the clearinghouse. And as owners that risked their own capital to strengthen the financial backbone of the clearinghouse, they are receiving dividends. According to the article, “Options traders say the plan could hurt investors by making it more onerous to trade and potentially crimping liquidity in the markets, affecting how difficult it is to swoop in and out of positions.” But the plan has been in place for several years and the industry has never been stronger, as indicated by continued increases in volume as well as an improvement in the liquidity across the whole options market.
[Related: “US Options Volume on Pace for Record Year Despite Drop Off, Lower Volatility in Q2”]
TABB Group estimates options volume is on track this year to exceed 5 billion contracts for the first time. Even more significant is the trend with respect to the quality of the market: The average bid/ask spread across the options industry was 0.22 in July 2018 and has narrowed each month since the market volatility in February. The last time markets were this tight (which is a good thing for traders) was in September 2013.
Bottom line: The options industry is growing, the quality of markets is favorable for traders, and the OCC is one of the most financially solid entities in the United States.
Conflict of interest. If the exchanges receive refunds and dividends they have the incentive to have the clearing fee's paid by traders raised. Ie. milking options traders even more than they do today.
Could not the cash buffer be built up gradually from fee's alone and the OCC keep't as a non-profit organization for everyone's benefit. They can stipulate that the cash buffer be keep't constantely at 300 million and all excess above that level be refunded to exchanges.
Could not the cash buffer be built up gradually from fee's alone and the OCC keep't as a non-profit organization for everyone's benefit. They can stipulate that the cash buffer be keep't constantely at 300 million and all excess above that level be refunded to exchanges.