Proper Accounting, Segregation and Net Capital Treatment of Exchange Traded Option Transactions

Proper Accounting, Segregation and Net Capital Treatment of Exchange Traded Option Transactions

The Division of Trading and Markets ("Division") has received several inquiries from futures commission merchants ("FCMs") and contract markets concerning the accounting and segregation treatment of exchange-traded option transactions. The purpose of this interpretation is to provide guidance in these areas.

The Commodity Exchange Act was amended in 1978 to permit commingling by an FCM of customer funds related to option transactions with those related to futures transactions. When the Commission adopted its option pilot program regulations, the Commission amended its pre-existing segregation rules so that funds owing to an FCM's exchange-traded option customers can be commingled with funds owing to the FCM's futures customers, and so that the segregation rules will apply equally to both types of customers. The Commission also added a new definition for the term "customer funds," as that term is used in the Commission's segregation rules for FCMs which means:

all money, securities, and property received by an FCM or by a clearing organization from, for, or on behalf of, customers or option customers:

1) In the case of commodity customers, to margin, guarantee, or secure contracts for future delivery on or subject to the rules of a contract market and all money accruing to such customers as the result of such contracts; and

2) In the case of option customers, in connection with a commodity option transaction on or subject to the rules of a contract market;

(i) To be used as a premium for the purchase of a commodity option for an option customer;

(ii) As a premium payable to an option customer;

(iii) To guarantee or secure performance of a commodity option by an option customer; or

(iv) Representing accruals (including, for purchasers of a commodity option, the market value of such commodity option) to an option customer.1

Because both option and futures transactions are governed by the same segregation provisions, it is imperative that the segregation and accounting treatment of options be as similar as possible to the segregation and accounting treatment of futures. Accordingly, an FCM will be required to mark each of its option customers' accounts to the market each day. That is, the market value of option premiums will be included in the equity of option purchasers and will be deducted from the equity of option grantors. In addition, the long FCM will reflect an unrealized receivable from the clearinghouse or carrying broker FCM and the short FCM will recognize an unrealized obligation to the clearinghouse or carrying broker FCM for the market value of the option.

The following example describes the required entries and calculations in greater detail. Exchange A has two clearing members, B and C. Firm B's customer purchases an option which is granted by Firm C's customer. Both Firm B and Firm C have one additional customer with a commodity futures account. For purposes of this discussion each of these futures customers will have a constant equity of $5,000, $3,000 of which is deposited at the clearinghouse. The premium for the option is $5,000. On the day prior to this transaction Firm B's option customer made a $5,000 cash deposit into his account at Firm B and Firm C's option customer made a $1,000 cash deposit into his account at Firm C. On the day the option is purchased Firm B transmits $5,000 to the clearinghouse2 which passes on the $5,000 to Firm C. The clearinghouse also makes a $6,0003 margin call to Firm C, which is met. Firm B debits its customer's account $5,000 for the purchase of the option, leaving the customer with a cash ledger balance of $0. Firm C credits its customer's account $5,000 which represents the proceeds for granting the option, leaving the customer with a cash ledger balance of $6,000.

Assuming that both firms were properly segregated prior to the option transaction described above, neither firm would have to put its own funds into segregation. The segregation requirement for Firm B is $10,000, and the segregation requirement for Firm C is $6,000. These figures represent the aggregate mark-to-market equity of each firm's customers. Firm B's option customer has a zero cash ledger balance and an option worth $5,000 and its futures customer has an equity of $5,000. Firm B has an unrealized receivable of $5,000 from the clearinghouse representing the market value of the long option, $2,000 cash in its segregated bank account and $3,000 of margin deposited at the clearinghouse on the futures trades.

Firm C's futures customer has an equity of $5,000 and the Firm's option customer's equity is $1,000 (cash ledger balance of $6,000 less a $5,000 unrealized obligation for the option he has granted). Firm C has $9,000 in margin funds on deposit at the clearinghouse ($6,000 for the option transaction and $3,000 for futures trades). In addition, the firm has $2,000 cash in its segregated bank account from the futures customer. Firm C also has an unrealized obligation of $5,000 for the granted option which would be reflected as a reduction of segregated assets.

As the market value of an option increases or decreases, the equity or deficit in the option customers' accounts will be adjusted accordingly. For instance, if the market value of the option used in the above example increased to $7,000 and neither option customer made any further cash deposits, Firm B's option customer would have a $7,000 equity representing the market value of the purchased option and Firm C's option customer would be in deficit by $1,000 ($6,000 cash ledger balance less the $7,000 unrealized obligation for the granted option). Firm C would have to deposit its own funds into segregation to cover this deficit just as it would with a futures account. Conversely, if the market value of the option decreased to $3,000, Firm B's option customer would have a $3,000 equity and Firm C's option customer would also have an equity of $3,000 ($6,000 cash ledger balance less the $3,000 unrealized obligation for the granted option).

It should be noted that if FCMs were not required to mark each option customer's account to the market the account of Firm C's customer would not reflect a deficit balance. Consequently, a segregation system without mark-to-market provisions could result in a shortage of funds available to pay customers in the event of an FCM financial failure.

The Division has also been asked what the treatment will be pursuant to the Commission's minimum financial requirements when a customer who purchases an exchange-traded option does not deposit at least the amount of the full premium prior to the purchase. If it is assumed that Firm B's customer in the previous example had not deposited any funds with Firm B, the customer's account would have a zero equity on the day the option was purchased. The zero equity would result from a $5,000 debit cash ledger balance and an option with a liquidation value of $5,000.

Since Commission Regulation 33.4(a)(2) requires each board of trade to ensure that its clearing organization receives from each of its clearing members, and that each clearing member receives from each person for which it clears commodity option transactions, and that each FCM receives from each of its option customers the full amount of each option premium at the time the option is purchased, it is the position of the Division that Firm B's option customer's account while not liquidating to a deficit would be undermargined by $5,000 as of the close of business on the day the option was purchased.

Commission Regulation 1.17(c)(5)(viii) provides, in pertinent part, that an FCM must take as a charge against its net capital

. . .for undermargined customer commodity futures accounts and commodity option customer accounts, the amount of funds required in each such account to meet maintenance margin requirements of the applicable board of trade or if there are no such maintenance margin requirements, clearing organization margin requirements applicable to such positions, after application of calls for margin or other calls for margin or other required deposits which are outstanding three business days or less. . . .

The method for "counting" the three business days will be the same as the method utilized for a futures account. For example, if the option was purchased on a Monday, Wednesday would be day 1, Thursday would be day 2 and Friday would be day 3. If the premium was not received by the close of business on Friday, the FCM would be required to take a charge against its net capital.

If the market value of the option declined and the customer who purchased the option still had not paid the premium, the customer's account would, of course, be in deficit by the amount of the decline. In such situations if the FCM did not collect the amount of the deficit by the close of business on the day after the deficit occurred, the FCM would be required to exclude the deficit amount from current assets.

The statements made in this interpretation are not rulcs or interpretations of the Commodity Futures Trading Commission, nor are they published as bearing the Commission's approval; they represent interpretations and practices followed by the Division of Trading and Markets in administering the Commodity Exchange Act and the regulations thereunder.

FOR FURTHER INFORMATION CONTACT: Daniel A. Driscoll, Deputy Director, Division of Trading and Markets, Commodity Futures Trading Commission, (202) 254-8955.

Issued in Washington, D.C., on August 12, 1982, by the Division of Trading and Markets.

² This transfer might physically take place on the following day, but it would be recorded as of the date of the option purchase.

³ The margin requirement is equal to the market value of the premium plus the margin requirement on the underlying futures contract of $1,000.