[Federal Register Volume 60, Number 244 (Wednesday, December 20, 1995)]
[Notices]
[Pages 65697-65700]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30907]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36587; File No. 600-28]


Self-Regulatory Organizations; Pro-Trade; Notice of Filing of 
Application for Exemption From Registration as a Clearing Agency

December 13, 1995.
    On September 22, 1994, ProTrade \1\ filed with the Securities and 
Exchange Commission (``Commission'') a Form CA-1 requesting exemption 
from registration as a clearing agency pursuant to section 17A of the 
Securities Exchange Act of 1934 (``Exchange Act'') \2\ and Rule 17Ab2-1 
thereunder.\3\ Since the original filing, ProTrade has supplemented the 
information provided in its Form CA-1 filing with letters dated October 
27, 1994, April 18, 1995, September 26, 1995, and October 2, 1995. The 
Commission is publishing this notice to solicit comments on the 
proposal from interested persons.

    \1\ ProTrade, located in Mercer Island, Washington, was 
incorporated under the laws of the State of Washington in January, 
1986. Joseph A. Zajac, the company's President, owns 100% of 
ProTrade's stock.
    \2\ 15 U.S.C. 78q-1 (1988).
    \3\ 17 CFR 240.17Ab2-1 (1995).
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I. Introduction

    ProTrade proposes to introduce an automated proprietary trading 
system (``System'') for over-the-counter option securities. ProTrade's 
customers, the users of the System, will be authorized to enter bids 
and offers for these options into the System. The System will 
electronically match the bids and offers and provide execution. 
Instantaneously with each execution, the proceeds of the transaction 
will be calculated, and the accounts of the trading parties will be 
debited and credited in settlement.
    Accordingly, the System will combine into a single electronic 
format several functions that usually involve the collective efforts 
of: (1) An option broker-dealer, (2) an options exchange, and (3) an 
options clearing agency. ProTrade asserts that this unity of functions 
will bring new efficiencies to the options marketplace.
    ProTrade has represented that its System will not commence 
operations before ProTrade: (1) has registered as a broker-dealer 
pursuant to the Exchange Act and has become a member of the National 
Association of Securities Dealers, Inc. (``NASD''),\4\ (2) has 
registered the option securities that are to be traded in the System 
pursuant to the Securities Act of 1933 (``Securities Act''),\5\ and (3) 
has received a no-action letter from the Division stating that the 
Division will not recommend enforcement action if ProTrade does not 
register as a securities exchange pursuant to the Exchange Act.\6\

    \4\ For the definitions of ``broker'' and ``dealer'' under the 
Exchange Act, see Sections 3(a) (4) and (5), 15 U.S.C. 78c(a) (4) 
and (5) (1988). See also, Section 15 of the Exchange Act, 15 U.S.C. 
78o (1988), for broker-dealer registration requirements.
    \5\ 15 U.S.C. 77b(1) (1988). ProTrade's options are 
``securities'' as that term is defined in Section 2(1) of the 
Securities Act, 15 U.S.C. 77b(1) (1988). As securities, they must be 
registered pursuant to Sections 5 and 6 of the Securities Act, 15 
U.S.C. 77e and 77f (1988), before they may be traded in interstate 
commerce.
    The issuer of the options for purposes of the Securities Act 
will be ProTrade itself. For the definition of ``issuer,'' see 
Section 2(4) of the Securities Act, 15 U.S.C. 77b(4) (1988).
    \6\ For definition of ``exchange,'' see Section 3(a)(1) of the 
Exchange Act, 15 U.S.C. 78c(a)(1) (1988). See also, Section 6 of the 
Exchange Act, 15 U.S.C. 78f (1988), for exchange registration 
requirements.
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    ProTrade believes that its proposed operations would involve few, 
if any, clearing agency activities within the meaning of the Exchange 
Act. ProTrade also believes that its proposed registration as a broker-
dealer, coupled with the proposed registration of its options under the 
Securities Act, will satisfy the regulatory scheme of the Exchange Act. 
ProTrade has stated that such registrations under both the Exchange Act 
and the Securities Act would provide the necessary and appropriate 
safeguards to protect investors and the public interest.\7\ 
Accordingly, it is ProTrade's belief that an exemption from 
registration as a 

[[Page 65698]]
clearing agency under the Exchange Act is warranted.

    \7\ ProTrade expects to have a net capital of $250,000, the 
amount that ProTrade states it will need to comply with Commission's 
uniform net capital rule, Rule 15c3-1, 17 CFR 240.15c3-1 (1995), as 
a broker-dealer that holds customers' funds (i.e., a clearing 
broker-dealer). The Commission has taken no position on ProTrade's 
interpretation of its requirements under the uniform net capital 
rule.
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II. Description of Proposal

A. The System

1. Background
    ProTrade reports that it has designed and developed the System as a 
``stand-along'' electronic operation that integrates order-entry, 
trade-matching, and execution functions with the back office functions 
of accounting and settlement. ProTrade states that it will interpose 
itself between the trading parties of each trade and that it will 
guarantee performance to each contraparty. The System will be made 
available to a list of qualified customers. As the operator of the 
System, ProTrade will derive revenues from customer fees on all 
transactions effected in the System.\8\

    \8\ ProTrade has stated that it ``will derive most of its 
revenues from typical `discount' broker activities, i.e., accepting 
orders for listed securities on behalf of customers.'' Letter from 
Joseph M. Zajac, President, ProTrade, to Eugene Lopez, Assistant 
Director, Division, Commission, at page 2 (October 15, 1993).
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2. Options Securities
    The System is designed to process over-the-counter options on 
equities, equity indexes, foreign currencies, and interest rates. 
ProTrade plans to have two classes, Class A and Class B, of such 
options. Class A options will be uncertificated, European-style put and 
call options that will be cash settled and that will expire on the last 
trading day of the chosen month of expiration.\9\ Class B options will 
be uncertificated put and call options that will have no standard terms 
and that will be individually negotiated by the trading parties.

    \9\ As European-style options, no positions may be exercised 
before the expiration date.
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3. Customers
    As discussed below under Participation Standards, ProTrade will 
screen its prospective customers to determine whether they meet certain 
financial and operational standards.\10\ Applicants who fail to meet 
ProTrade's standards will be denied customer status and therefore will 
be denied access to the System.\11\ In general, ProTrade expects to 
have a sophisticated customer base including professional investors and 
financial institutions. Each customer will be provided with the 
System's proprietary software, which the customer may use on a personal 
computer for the purpose of entering orders and for performing other 
tasks within the System. ProTrade expects that customers will be able 
to connect with the System either by: (1) a dial-up telephone line 
using a modem or (2) a leased line. ProTrade will provide each customer 
with a unique identification number and a password that will allow 
access to the System.

    \10\ ProTrade has chosen the term ``customers'' for the users of 
its System, as distinct from participants, subscribers, members, or 
other similar terms.
    \11\ At this time, ProTrade has no written standards or criteria 
for acceptance of customers.
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4. Operations
    The System will keep a file of its customers' outstanding bids and 
offers sorted by price and time of receipt. The bids and offers will be 
displayed in a montage or array, and customers will be able to cancel 
or modify their orders at any time prior to execution. Bids and offers 
at the same price will be anonymously matched by the System and will be 
executed on a first-in, first-out basis. The System will accept market 
orders, limit orders, stop orders, and market if touched orders.
    The System will be designed to calculate balances and to settle 
accounts immediately (or within a few seconds) after every execution. 
ProTrade states that each order will be individually processed by the 
System without netting.\12\ Settlement will consist of book-entry 
debits or credits to the customer's account with the customer's account 
being part of ProTrade's segregated broker-dealer bank account. As a 
means of protection, the System is designed to reject any order unless 
the account of the customer that is entering the order has sufficient 
equity to satisfy the order's premium payment or has the required 
collateral.

    \12\ Technically, this described form of post-trade processing 
is known as ``trade-for-trade'' clearing, the simplest form of 
clearing, which involves accounting for each trade on a contract by 
contract basis without netting or at least without the usual types 
of netting. This form of clearing contrasts with the more 
sophisticated forms of clearing such as ``daily balance order'' or 
``continuous net settlement'' where clearing agencies net each of 
their participant's trades and each participant's money credits and 
debits in each security on a daily basis.
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B. System Safeguards

1. Participation Standards
    Customers authorized by ProTrade to use the System will be required 
to meet initial and continuing financial and operational standards, as 
may be determined by the ProTrade Board of Directors and administered 
by ProTrade's management.\13\ Under these standards, customers will be 
screened for margin purposes to determine their creditworthiness. 
Determining factors will be the customers' financial positions and 
their knowledge and experience in trading options and other derivative 
products.

    \13\ At this time, ProTrade has no financial and operational 
standards for customers authorized to use its System.
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    ProTrade will require each applicant to disclose, at a minimum, the 
following information: (1) Trading experience with options and other 
derivatives, (2) annual income and net worth, (3) history of any 
account defaults or failures, (4) experience with computers, and (5) 
existing accounts with other brokers. ProTrade, when it deems it 
necessary, will obtain credit reports on an applicant. Based on its 
subjective review of the above criteria, ProTrade may grant or deny 
customer privileges. Customers also must agree in writing to comply 
with applicable law and with all of ProTrade's rules. ProTrade will 
reserve the right to deny access to the System to any person that, 
among other things, is the subject of a civil injunction or criminal 
conviction for breach of the laws governing securities or commodities 
futures.
2. The System's Data Backup
    ProTrade reports that it will backup its data daily and that the 
System itself will have the ability to regenerate electronically all 
transactions since the previous backup. The System also will be 
supported by backup hardware that can be put on-line in a matter of 
seconds.
    While customers will be provided with ProTrade's software, the 
customers will be responsible for their own electronic equipment or 
hardware. However, if a customer's equipment should break down, the 
customer could submit orders by telephone to ProTrade where a ProTrade 
employee will enter the orders.
3. Margin Payment/Collection
    Once ProTrade has completed its broker-dealer registration, 
ProTrade will be subject to Section 7(c) of the Exchange Act, which 
governs broker-dealer margin requirements.\14\ As a consequence of 
Section 7(c), ProTrade also will be subject to Regulation T of the 
Board of Governors of the Federal Reserve System (``Federal Reserve 
System''), which governs credit extended by broker-dealers,\15\ and it 
will be subject to the NASD's rules governing minimum maintenance 

[[Page 65699]]
margin for option securities held in customers' accounts.\16\

    \14\ 15 U.S.C. 78g (1988).
    \15\ 12 CFR 220 et seq. (1995). See, esp., Sec. 19(f)(2) of 
Regulation T, 12 CFR 220.19(f)(2), which in general refers a broker-
dealer's option margin requirements to the maintenance rules of the 
broker-dealer's self-regulatory organization (``SRO''). In 
ProTrade's case, the SRO would be the NASD.
    \16\ ProTrade will be subject to NASD margin requirements on its 
customers' accounts and specifically the margin requirements for 
options that are not issued by a registered clearing agency. These 
requirements are set forth in the NASD Manual, Rules of Fair 
Practice, Art. III, Sec. 30(f)(2)(D)(iii).
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    ProTrade states that it will treat all of its customers as margin 
customers and will require margin collateral for all short positions. 
ProTrade indicates that its in-house initial margin requirements will 
be higher than the NASD's maintenance margin requirements to insure 
that customers have sufficient funds to cover immediate price moves 
after they open positions. ProTrade further states that it may reject 
customer applicants and that it may suspend active customers if they 
are found not to meet margin standards. ProTrade reports that it has 
programmed its System to reject any order that would open an option 
position if the subject account does not have the necessary funds or 
margin and if an existing account were to become undermargined. 
ProTrade also states that it may choose to vary customer trading 
limits, margin requirements, and position limits according to the 
qualifications of each customer.
    ProTrade represents that its System is designed to calculate 
intraday the margin requirements for each account based upon changes in 
any bid or asked prices that affect an account. The System reportedly 
will provide ProTrade with real-time reports of under-margined accounts 
that will allow prompt margin calls and an enhanced ability to prevent 
account defaults.
4. Default
    In the event that a customer's default becomes imminent, ProTrade 
states that at its discretion it may choose to prevent the default by 
assuming the customer's positions itself and by creating a hedged 
position in the cash market. However, ProTrade does not guarantee that 
it would undertake such bail-out procedures in the face of an imminent 
default and states that any such efforts would depend upon the 
circumstances.
    In the event of the actual occurrence of a customer default, 
ProTrade states that it will guarantee full performance to the 
contraparties. ProTrade does not plan to create a clearing fund in 
support of this guarantee.\17\ ProTrade reports that it is 
contemplating the formation of the other risk management facilities 
such as: (1) A blanket surety bond to be purchased by ProTrade from an 
insurance company or (2) a transactional insurance fee in the form of a 
refundable deposit that would be included in the cost of each 
trade.\18\

    \17\ As a general rule, the Commission has recommended that a 
clearing agency have a clearing fund which: (1) Is composed of user 
contributions based on a formula applicable to all users; (2) is 
held in cash or highly liquid securities; and (3) is limited in 
purpose to protecting participants and the clearing agency from 
participant defaults and from unusual, significant clearing agency 
losses. Securities Exchange Act Release No. 16900 (June 17, 1980), 
45 FR 41920 (order approving standards for clearing agency 
registration).
    However, on one occasion the Commission permitted a clearing 
agency, Delta Government Options Corp. (``Delta'') to register and 
to operate as a clearing agency without a clearing fund. In Delta's 
case, the clearing agency's risk management system was deemed 
adequate, despite the lack of a clearing fund, because Delta had the 
financial backing of an affiliated corporation and had a substantial 
credit facility. Securities Exchange Act Release No. 26450 (January 
12, 1989), 54 FR 2010 (order approving Delta's registration as a 
clearing agency).
    \18\ A transactional insurance fee differs from margin in 
several ways. In brief, margin is collateral deposited by a customer 
with a broker in connection with the specific purchase of specific 
securities, and margin requirements are governed by the Exchange Act 
and the rules and regulations thereunder as well as certain rules of 
the Federal Reserve Board and the appropriate self-regulatory 
organization. Under ProTrade's contemplated transactional insurance 
fee program, ProTrade would debit a customer's account a certain 
amount in connection with each transaction and later credit that 
amount back to the customer's account upon normal settlement of the 
transaction. Currently, ProTrade is considering a debit in the 
vicinity of 5% of the value of each transaction. As stated above, 
ProTrade has not yet decided if it will implement such a program.
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III. Public Interest Statement

    ProTrade believes that exemption from clearing agency registration 
is critical to its entering the option securities business. ProTrade 
maintains that its business plan will provide investors with increased 
access to over-the-counter options through an integrated electronic 
transaction and margin system, which ProTrade claims will lower trading 
costs, create processing efficiencies, ensure more fairness and price 
transparency, and provide a complete audit trail.
    ProTrade asserts that these efficiencies will eliminate the need 
for paperwork, will reduce the time required for order entry and for 
post-trade processing, and will shorten settlement cycles. Thus, 
ProTrade believes that its System will improve the option marketplace.

IV. Specific Request for Comments

A. Statutory Standards

    Section 17A of the Exchange Act directs the Commission to develop a 
national clearance and settlement system through, among other things, 
the registration and regulation of clearing agencies.\19\ This 
statutory scheme contemplates that (1) Clearing agencies will provide 
clearance and settlement functions consistent with statutory goals and 
(2) as self-regulatory organizations, clearing agencies will exercise 
certain regulatory functions in furtherance of other statutory goals.

    \19\ 15 U.S.C. 78q-1 (1988).
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    In fostering the development of a national clearance and settlement 
system generally and in overseeing clearing agencies in particular, 
Section 17A authorizes and directs the Commission to promote and 
facilitate certain goals with due regard for the public interest, the 
protection of investors, the safeguarding of securities and funds, and 
the maintenance of fair competition among brokers, dealers, clearing 
agencies, and transfer agents.\20\ Furthermore, Section 17A, as amended 
by the Market Reform Act of 1990, directs the Commission to use its 
authority to facilitate the establishment of linked or coordinated 
facilities for clearance and settlement of transactions in securities, 
securities options, contracts of sale for future delivery and options 
thereon, and commodity options.\21\

    \20\ For the legislative history of Section 17A of the Exchange 
Act, refer to Report of Senate Committee on Banking, Housing and 
Urban Affairs. Securities Acts Amendments of 1975, Report to 
Accompany S. 249, S. Rep. NO. 75, 94th Cong., 1st Sess. 4-6 (1975).
    \21\ Market Reform Act of 1990, Sec. 5, amending Sec. 17A(a)(2) 
of the Exchange Act, 15 U.S.C. 78q-1(a)(2) (1995 Supp.).
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    Section 17A(b)(1) of the Exchange Act \22\ authorizes the 
Commission to exempt applicants from some or all of the requirements of 
Section 17A if it finds such exemptions are consistent with the public 
interest, the protection of investors, and the purposes of Section 17A 
including the prompt and accurate clearance and settlement of 
securities transactions and the safeguarding of securities and funds. 
Historically, the Commission has granted newly registered clearing 
agencies temporary exemptions from specific statutory requirements 
imposed by Section 17A in a manner that achieves statutory goals.\23\

    \22\ 15 U.S.C. 78q-1(b)(1) (1988).
    \23\ See, e.g., order approving the temporary registration of 
Government Securities Clearing Corporation (``GSCC'') as a clearing 
agency where the Commission temporarily exempted GSCC from 
compliance with the Section 17A(b)(3)(C) requirement of the Exchange 
Act. Securities Exchange Act Release No. 25740 (May 24, 1988), 53 FR 
19839.
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    The Commission recognizes that clearing agencies pose some safety 
and soundness concerns to the marketplace. Accordingly, the Division 
has published standards for clearing agency 

[[Page 65700]]
registration,\24\ and it has exercised significant continuing oversight 
over all aspects of clearing agency operations and functions.\25\ The 
market break of October 1989 and the market break of October 1991 
demonstrated the central role of clearing agencies in the U.S. 
securities markets in reducing risk, improving efficiency, and 
fostering investor confidence in the markets.\26\ In light of the 
foregoing, the Commission believes that any applicant that requests an 
exemption from clearing agency registration should meet standards that 
are substantially similar to those standards required of registered 
clearing agencies in order to assure that the fundamental goals of 
Section 17A of the Exchange Act (i.e., safe and sound clearance and 
settlement) will be achieved. Therefore, commentators are invited to 
address whether granting the proposed exemption to ProTrade (1) would 
further the development of a national clearance and settlement system, 
(2) would promote linked and coordinated clearing facilities (among 
options, futures, and other financial instruments), and (3) would 
promote the maintenance of fair competition.

    \24\ Securities Exchange Act Release No. 16900 (June 17, 1980) 
45 FR 41920 (order approving standards for clearing agency 
registration).
    \25\ Securities Exchange Act Release No. 20221 (September 23, 
1983), 48 FR 45167 (omnibus order granting full registration as 
clearing agencies to The Depository Trust Company, Midwest Clearing 
Corporation, Midwest Securities Trust Company, National Securities 
Clearance Corporation, The Options Clearing Corporation, Pacific 
Securities Depository, Philadelphia Depository Trust Company, and 
Stock Clearing Corporation of Philadelphia).
    \26\ Division of Market Regulation, The October 1987 Market 
Break (February 1988), Chap. 10 (``Clearance and Settlement''), esp. 
pp. 10-48 to 10-56; Division of Market Regulation, Market Analysis 
of October 13 and October 16, 1989, pp. 118-173 (December 1990).
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    Specifically, ProTrade's application raises the question of whether 
the establishment of multiple unlinked securities clearing agencies is 
consistent with Section 17A of the Act. One of the benefits of a single 
clearing agency is centralized default administration. Conversely, the 
introduction of multiple options clearing agencies, including options 
clearing operations that may seem de minimis relative to the overall 
market may have a fragmentation effect that could increase the risks 
entailed in liquidating defaulting customers. Commentators should 
discuss applicable law as well as the costs and benefits of single 
versus multiple clearing facilities for option securities, including 
whether the risk exposure to individual clearing organizations would be 
increased by the fragmentation of the clearing function. Commentators 
also should discuss the effects that stress to the marketplace (e.g., 
high volume and high volatility) possibly could have on such a multiple 
clearing agency system.

B. Fair Competition

    Section 17A of the Exchange Act requires the Commission, in 
exercising its authority under that section, to have due regard for the 
maintenance of fair competition among clearing agencies.\27\ In 
addition, no clearing agency may be registered or granted an exemption 
from registration, if its rules ``impose any burden on competition not 
necessary or appropriate in furtherance of the purposes'' of the 
federal securities laws.\28\ Therefore, the Commission must consider an 
applicant's likely effect on competition in its review of any 
application for registration as a clearing agency or for an exemption 
from such registration and must balance any benefits or hindrances to 
competition against any effects on the other statutory goals.\29\

    \27\ 15 U.S.C. 78q-1(a)(2) (1988).
    \28\ 15 U.S.C. 78q-1(b)(3)(I) (1988).
    \29\ In Bradford National Clearing Corporation v. Securities and 
Exchange Commission, 950 F.2d 1085, 1105 (D.C. Cir. 1978), the court 
said:
    [T]o the extent the legislative history provides any guidance to 
the Commission in taking competitive concerns into consideration in 
its deliberations on the national clearing system, it merely 
requires the [Commission] to ``balance'' those concerns against all 
others that are relevant under the statute.
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    The Commission invites commentators to address whether an exemption 
from registration as a clearing agency for ProTrade would result in 
increased competition among option broker-dealers and among options 
clearing agencies and whether such competition would, for example, 
result in the development of improved systems capabilities, the 
offering of new services, and the lowering of prices to customers. The 
Commission also invites commentators to address whether the proposal 
would impose any burden on competition that is inappropriate under the 
Exchange Act.

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing application by February 16, 1995. 
Such written data, view, and arguments will be considered by the 
Commission in deciding whether to grant ProTrade's request for an 
exemption from registration as a clearing agency. Persons desiring to 
make written submissions should file six copies thereof with the 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549. Reference should be made to File No. 600-28. 
Copies of the application and all written comments will be made 
available for inspection and copying at the Commission's Public 
Reference Room, 450 Fifth Street, NW., Washington, DC 20549.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\30\

    \30\ 17 CFR 200.30-3(a)(16) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-30907 Filed 12-19-95; 8:45 am]
BILLING CODE 8010-01-M