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Fed Allows Security Pacific to Create Private Exchange for U.S. Treasury Options

August 07, 1987|MICHAEL A. HILTZIK | Times Staff Writer

NEW YORK — The Federal Reserve Board announced Thursday that it has approved a controversial plan by Security Pacific National Bank to establish what amounts to a private exchange for the trading of some of the riskiest securities known to investors: options on U.S. Treasury securities.

The program amounts to one of the most innovative expansions of bank powers since the 1930s as well as an unprecedented system of trading commodity instruments outside conventional exchanges. Accordingly, it has been bitterly fought for three years by many of the nation's leading commodity exchanges--with which Security Pacific will be competing--and heavily scrutinized by U.S. bank regulators.

The program still faces one last potential obstacle. Banking legislation awaiting President Reagan's signature includes a moratorium until March 1, 1988, on similar expansions of bank powers. Whether that provision applies to Security Pacific's plan is already a matter of disagreement.

"The legislative history of the bill is that clearing activities (the core of the trading program) are not subject to the moratorium," Stephen Lynner, the creator and head of the Security Pacific program, said. "I'm not sure what our next step is, but we're not going to wait until March 1."

But a spokesman for the Securities and Exchange Commission, which regulates most options trading, said the agency is under the impression that the moratorium will render Security Pacific's plans "moot" for the time being. A spokesman for the Federal Reserve Board also said its formal approval order for the options program states that the bill will probably force Security Pacific to wait until the moratorium expires before implementing trading.

The Fed's formal order of approval issued Thursday states that it reserves the right to determine how the banking bill applies to Security Pacific.

Options are contracts that give their buyer the right, but not the obligation, to buy or sell the underlying security at a given price before a set date. In this case the underlying security would be a Treasury security. Under the bank's program, Security Pacific will be both the broker of options on the full range of Treasury securities, from three-month Treasury bills through 30-year bonds, and the clearinghouse for trades in those options.

Although the buyers of options assume the limited risk of losing only the money they pay to purchase the contracts, the issuers face a much greater risk: that the option-holders will exercise the option, forcing the issuers to sell them the underlying security at a price much lower than what the issuer must pay to acquire it, or to buy the security from the option holder at a price much higher than what it can fetch in a resale.

In commodity markets, this risk is generally assumed by professional speculators, ranging from well-heeled individuals to large investment pools. In a process that parallels that used by other exchanges, Security Pacific will establish standards for how much speculators and other traders must put down as "margin," or good-faith money. Margin is typically a percentage of the value of the contract.

Some options and futures on Treasury securities are already traded on registered exchanges.

The Chicago Board Options Exchange trades options in selected long-term T-bonds but not on a wide range of the securities. The Chicago Board of Trade sponsors a market in options on Treasury bond futures. Lynner said Security Pacific hopes to create an active market in options on the full spectrum of Treasury securities.

Lynner declined to say how much trading he expects on the Security Pacific system once it begins, but he did say that the value of outstanding options on Treasury securities--now traded in a mostly informal, over-the-counter manner--has been estimated at as much as $100 billion to $125 billion.

$6-Billion Volume

"Quite frankly, I'd settle for 10% of that," he said. The volume of trading in options on the T-bond future on the Chicago Board of Trade now averages more than $6 billion a day.

Security Pacific will charge users of its system--mainly primary dealers in Treasury securities and large-scale money managers seeking to protect themselves from the risks of changes in interest rates and the prices of the securities--a fee expected to be in the range of $60 to $100 per $1 million in value of the underlying security, Lynner said.

Under the bank's scheme, the guarantor of the options will be a subsidiary of General Electric Credit Corp. Except for $35 million covered by a Security Pacific letter of credit, GECC will bear the risk of any losses due to a default by a participant in a trade, Lynner said. Initially, Security Pacific planned to be the issuer, meaning that it would be pledging its own net worth to cover defaults. Instead, GECC was brought in as a guarantor when the U.S. comptroller of the currency, the regulator of national banks, objected to Security Pacific's shouldering such an open-ended risk.

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