[Federal Register Volume 61, Number 49 (Tuesday, March 12, 1996)]
[Notices]
[Pages 10045-10048]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-5845]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36933; File No. SR-GSCC-96-01]


Self-Regulatory Organizations; Government Securities Clearing 
Corporation; Notice of Filing of a Proposed Rule Change Relating to the 
Enhancement of Risk Management Processes

March 6, 1996.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on January 5, 1996, 
Government Securities Clearing Corporation (``GSCC'') filed with the 
Securities and Exchange Commission (``Commission'') the proposed rule 
change (File No. SR-GSCC-96-01) as described in Items I, II, and III 
below, which items have been prepared primarily by GSCC. The Commission 
is publishing this notice to solicit comments on the proposed rule 
change from interested persons.

    \1\ 15 U.S.C. 78s(b)(1) (1988).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The purpose of the proposed rule change is to modify GSCC's risk 
management processes.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, GSCC included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. GSCC has prepared summaries, set forth in sections (A), 
(B), and (C) below, of the most significant aspects of such 
statements.\2\

    \2\ The Commission has modified the text of the summaries 
prepared by GSCC.
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(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    As a part of GSCC's continuous process of reviewing its risk 
management mechanism, GSCC is seeking approval to make various 
enhancements and revisions to that mechanism. The impetus for certain 
of the enhancements and revisions arose out of the design of the risk 
management process for GSCC's newly implemented netting service for 
repurchase agreements (``repos'') and as the result of recommendations 
made by Commission staff during their inspection of GSCC last year. 
Each of the proposed changes to GSCC's risk management process is 
described in detail below.
(1) Change in the Clearing Fund Formula: Funds Adjustment Component
    A netting member's clearing fund requirement is based on a formula 
designed to take into account the two basic risks posed to GSCC by 
netting members. These risks are: (1) that a member might not pay a 
funds-only settlement amount due to GSCC and (2) that a member might 
not deliver or take delivery of securities that comprise a net 
settlement position. There are three components to the clearing fund 
deposit requirement: (1) the funds adjustment component, (2) the 
receive/delivery settlement component, and (3) the repo volatility 
component. The sum of the three components is a member's total clearing 
fund deposit requirement.
    The first component of the clearing fund is the funds adjustment 
component, which addresses the potential risk that a member might not 
pay a funds-only settlement amount due to GSCC. Historically, this 
component has represented about ten percent of the total clearing fund 
requirement. The funds adjustment component is 125% of the average of a 
member's ten largest funds-only settlement amounts measured on an 
absolute basis during the most recent seventy-five business days.
    Because GSCC did not have an historical data base, the use of the 
additional twenty-five percent cushion was introduced at the start of 
the netting system in 1989 as a conservative measure designed to ensure 
that GSCC's original margin process was a prudent one. GSCC now 
believes that this cushion is no longer necessary because the funds 
adjustment component recently was made more conservative with revisions 
to take into account the ten largest funds amounts over the most recent 
seventy-five business days.\3\ However, under the proposed rule change 
GSCC will retain the right to reinstitute at its discretion all or a 
part of this cushion for a temporary period. For example, GSCC might 
reinstitute this cushion under volatile market conditions.

    \3\ Prior to the implementation of GSCC's netting service for 
repos, GSCC's rules required computation of the average of a 
member's absolute funds amounts over the prior twenty business days. 
Securities Exchange Act Release No. 36491 (November 17, 1995), 60 FR 
61577 (order approving proposed rule change).
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    Moreover, GSCC believes that the use of an average of the ten 
largest amounts leads to an overly conservative measure of funds 
settlement exposure. Thus, GSCC proposes to revise the funds adjustment 
component to require 100% of the average of the twenty largest funds-
only settlement amounts during the most recent seventy-five business 
days.\4\

    \4\ This change will be made to both paragraphs (b) and (d) of 
Rule 4, Section 2 of GSCC's rules. Paragraph (b) applies to bank 
netting members, Category 1 dealer netting members, Category 1 
futures commission merchant netting members, Category 2 inter-dealer 
broker netting members, government securities issuer netting 
members, insurance company netting members, and registered 
investment company netting members. Paragraph (d) applies to 
Category 2 dealer netting members and Category 2 futures commission 
merchant netting members.
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(2) Change in the Clearing Fund Formula: Receive/Deliver Settlement 
Component
    The second component of the clearing fund requirement is the 
receive/deliver settlement component, which is based on the size and 
nature of a member's net settlement positions. The margin collected on 
net settlement positions is determined by applying margin factors that 
are designed to estimate daily security price movements. The factors 
are expressed as percentages and are determined by historical daily 
price volatility.\5\ The product of a security's settlement value and 
its corresponding margin factors is used as proxy for the estimated 
amount of loss to which GSCC is potentially exposed from price changes.

    \5\ See Section 4 below for a discussion of GSCC's margin 
factors.
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    There are four potential receive/deliver contribution amounts 
computed each day for GSCC netting members other than Category 2 dealer 
or Category 2 future commission merchant members.\6\ The four amounts 
are compared daily and the largest amount is included in a member's 
clearing fund

[[Page 10046]]
requirement. The potential contribution amounts are:

    \6\ GSCC's method of calculating the receive/deliver settlement 
component for Category 2 dealer and Category 2 futures commission 
merchant members is set forth below.
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    (i) Post-Offset Margin Amount (``POMA''): The POMA reflects offsets 
of gains against losses in liquidating a member's positions that may be 
expected based on historical experience. The POMA essentially is a 
member's total gross margin (i.e., GSCC's margin factors multiplied by 
the dollar value of a member's current outstanding net settlement 
position) taking into account allowable offset percentages.\7\

    \7\ Margin amounts on receive (long) and deliver (short) 
positions are allowed to offset each other. The extent to which an 
offset is allowed is determined by product and the degree of 
similarity in time remaining to maturity.
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    (ii) Average POMA: The average POMA is based, in the ordinary 
course, on the member's ten highest POMA amounts occurring in the most 
recent seventy-five business days, including the current day's POMA 
amount.
    (iii) Adjusted POMA: The adjusted POMA is calculated the same as 
the POMA with the exception of excluding all trades that are scheduled 
to settle on the current day. This is done based on the assumption that 
those trades will settle on the current day; thus, calculating POMA in 
this manner will more accurately reflect GSCC's settlement exposure 
during the current day.
    (iv) Liquidation Amount: This is a floor amount equalling fifty 
percent of the total gross margin on all long and short positions 
without offsets.
    The liquidation amount is a conservative measure designed to ensure 
that if the margin offsets ordinarily allowed in calculating the 
receive/deliver component do not reflect actual market conditions 
during a liquidation period, GSCC will still have a sufficient level of 
collateral protection. In other words, this minimum requirement 
protects against the risk that during a liquidation period the yield 
curve will be aberrational. In such a situation, collection of a 
minimum amount of margin based on a gross calculation ensures that GSCC 
will have sufficient collateral to cover liquidation losses.
    GSCC believes that the percentage used to compute the liquidation 
amount should be lowered from fifty percent to twenty-five percent. The 
imposition of a fifty percent floor (i.e., fifty percent of the total 
margin on all long and short positions without offsets) has proven to 
be an unduly high minimum. In particular, for a member that engages in 
trading activity on a fully-hedged basis, a fifty percent floor 
effectively negates the benefits afforded by being fully hedged. GSCC 
believes that a twenty-five percent floor amount is sufficient to 
protect GSCC from the risk that its margin offsets will not reflect 
actual market conditions during a liquidation period.
    Moreover, GSCC believes that the use of an average of the ten 
largest POMA amounts in calculating the average POMA leads to an overly 
conservative measure of securities settlement exposure. Thus, GSCC 
proposes to use an average of the twenty largest POMA amounts during 
the most recent seventy-five business days.
    GSCC also is proposing to delete sections (2)(g)(i) and (2)(g)(ii) 
of Rule 4 regarding alternative formulas for the receive/deliver 
settlement component of the required clearing fund deposit. GSCC has 
not found the alternative calculation under subsection (g)(i), which 
disregards when-issued trades that have been issued, to be useful and 
subsection (g)(ii) has been made obsolete by the changes approved in 
GSCC's filing pertaining to its repo netting service.\8\

    \8\ Supra note 3.
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    With respect to Category 2 dealer or Category 2 futures commission 
merchant members, the receive/deliver settlement component is the 
larger of (1) the member's total gross margin without offsets, (2) the 
member's total gross margin without offsets and excluding positions due 
to settle that day, or (3) the average of the member's largest ten 
gross margin amounts over the most recent seventy-five business days. 
For the third calculation, GSCC proposes to use the average of the 
largest twenty gross margin amounts over the most recent seventy-five 
business days.
(3) Change in the Clearing Fund Formula: Repo Volatility Component
    The third component of the clearing fund requirement is the repo 
volatility component. This component was recently added to GSCC's 
clearing fund formula to cover securities' settlement exposure posed by 
repo activity. The repo volatility component is the greater of (1) the 
product of the repo volatility factor and the market value of the 
member's repo transactions taking into account allowable offset 
percentages (``repo offset amount'') or (2) the average of a member's 
ten highest repo offset amounts over the most recent seventy-five 
business days. GSCC proposes to revise the second element of this 
calculation to take the average of a member's twenty highest repo 
offset amounts over the most recent seventy-five business days.
(4) Providing GSCC With Discretion, within Parameters, to Lower Margin 
Factors
    GSCC's Membership and Standards Committee (``Committee') reviews on 
an ongoing basis the appropriateness of its margin factors \9\ by 
examining third-party price volatility data and GSCC's own short-term 
and long-term data covering ninety-five and ninety-nine percent of all 
price movements. However, GSCC is not allowed under its current rules 
to lower any of its margin factors without first obtaining Commission 
approval through a formal rule filing process.

    \9\ As defined in GSCC's rules, margin factors and Category 2 
margin factors are percentages, which GSCC publishes from time to 
time, representing variations weighted by maturity and product type. 
These margin factors are used in GSCC Rule 4, Section 2 to calculate 
the receive/deliver settlement component of the required fund 
deposit for GSCC's members.
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    GSCC believes that it needs flexibility to lower a margin factor 
without first completing the formal rule filing process. Thus, GSCC 
proposes to revise its rules to permit the Committee to lower a margin 
factor subject to a predefined limitation if the Committee determines 
it appropriate based on its review of historical price volatility data 
and if the GSCC Board of Directors approves such a lower margin factor. 
The predefined limitation would provide that GSCC could reduce a margin 
factor to a level that is no lower than the higher of (1) the price 
volatility for that remaining maturity category taking into account 
ninety-five percent of all movements covering the last calendar quarter 
or (2) the price volatility for that remaining maturity category taking 
into account ninety-five percent of all movements covering the last 
calendar year. With respect to the margin factors for Category 2 dealer 
members and futures commission merchant members, the limitation would 
provide that GSCC could reduce a margin factor to a level that is no 
lower than the higher of (1) the price volatility for that remaining 
maturity category taking into account ninety-nine percent of all 
movements covering the last calendar quarter or (2) the price 
volatility for that remaining maturity category taking into account 
ninety-nine percent of all movements covering the last calendar year.
(5) Revision of Certain Margin Factors for Zero-Coupon Government 
Securities Other Than Treasury Bills (``Zeros'')
    As noted above, GSCC's margin factors are based on an assessment of 
historical daily price volatility data. GSCC reviews the accuracy of 
those

[[Page 10047]]
margin factors by consideration of third-party price volatility data 
and its own short-term and long-term data covering ninety-five and 
ninety-nine percent of all price movements. Zeros require different 
margin factors than other Treasury securities because zeros generally 
are subject to greater price volatility than are other Treasury 
securities with the same maturity.
    The applicable margin percentages for zeros range from percentages 
that are the same as those for other Treasury securities with respect 
to shorter-term maturities to two-and-a-half times that applicable to 
other Treasury securities with respect to longer-term maturities. These 
differences initially were based on the differences in the amount of 
haircut factors between zeros and other Treasury securities found in 
the United States Treasury Department's liquid capital requirements for 
government securities brokers and dealers.
    GSCC believes that its current applicable margin factors for zeros 
in the three longest remaining maturity classes are too high.\10\ The 
current margin factor for zeros with a remaining maturity of seven to 
ten years is 1.870 percent, which is well above the price volatility 
that GSCC's internal data show for that category under any measure. 
Measured against GSCC's data at the ninety-nine percent level over the 
past two years, the applicable margin factor is roughly thirty-three 
basis points higher. Thus, GSCC proposes to lower the applicable margin 
factor for the seven to ten years remaining maturity category to 1.50 
percent.

    \10\ GSCC's margin factor schedule for zeros is contained in 
Exhibit B to GSCC's filing. A copy of the filing and all exhibits is 
available for copying and inspection in the Commission's Public 
Reference Room.
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    The margin factor for zeros with a remaining maturity of ten to 
fifteen years is 2.813 percent, which is well above the price 
volatility that GSCC's internal data show for that category under any 
measure. Measured against GSCC's data at the ninety-nine percent level 
over the past two years, the applicable margin factor is almost a point 
higher. Thus, GSCC proposes to lower the applicable margin factor for 
the ten to fifteen years remaining maturity category to 1.813 percent.
    The margin factor of 3.625 percent for zeros with a remaining 
maturity of fifteen years or greater, the longest maturity category, 
also appears to be too high when compared to the price volatility that 
GSCC's internal data show for that category. Again, measured against 
GSCC's data at the ninety-nine percent level over the past two years, 
the applicable margin factor is eighty-nine basis points higher. Thus, 
GSCC proposes to lower the applicable margin factor for the fifteen 
years and higher remaining maturity category to 2.625 percent.
(6) Introduction of a Tiered Surveillance Status Mechanism
    GSCC proposes to place members that pose a heightened level of 
potential risk to GSCC on various levels of surveillance status in 
order to facilitate GSCC's ability to protect itself and its members. 
At the conclusion of their recent inspection of GSCC, Commission staff 
suggested that, in line with what many other clearing agencies have in 
place, GSCC establish different classes of surveillance for its 
members. GSCC believes this suggestion to be an appropriate one because 
it believes that expanding surveillance classes will enable it to 
appropriately categorize the degree of risk posed by a member and to 
react more swiftly to changes in a member's condition. Members will 
also have greater understanding of the specific actions GSCC may take.
    GSCC's current rules require that a member be placed on 
surveillance status if one or more of a number of circumstances is 
present, including but not limited to a significant reorganization or 
change in control or management of the member. In addition, GSCC may 
place a member on surveillance status if one or more of a number of 
factors, such as a member experiencing a condition that could 
materially affect its financial or operational capability so as to 
potentially increase GSCC's exposure to loss or liability, is present.
    GSCC proposes to use three surveillance categories. Under the 
proposed rule change, a member will be placed on Class 1 surveillance 
status if one or more of a number of factors pertaining to its 
financial condition is present, if it has been placed on surveillance 
status by another self-regulatory organization, or if it has been 
upgraded from Class 2 surveillance status within the past three 
calendar months. The financial condition factors that will result in 
Class 1 surveillance status include, but are not limited to (1) a 
member incurring recent significant net losses, (2) a member's required 
fund deposit obligation representing a significant portion of its net 
worth or net capital, and (3) a member experiencing any condition that 
could materially affect its financial or operational capacity. Class 1 
surveillance status will result in GSCC more thoroughly monitoring a 
member's financial condition and activities and will provide GSCC with 
discretion to require a member to make more frequent financial 
disclosures, including interim and/or pro forma reports.
    GSCC will place a netting member on proposed Class 2 surveillance 
status if one or more of a number of factors is present, including but 
not limited to (1) any element of a member's capital position falls 
below the minimum requirements, (2) a member has been upgraded from 
Class 3 surveillance status within the last three calendar months, (3) 
a member temporarily experiences are inability to meet its securities 
settlement obligations to GSCC in a timely fashion, and (4) a member's 
designated examining authority or appropriate regulatory agency has a 
pending action or investigation of the member that could call into 
question the member's ability to meet its obligations to GSCC. In 
addition to the consequences resulting from placement on Class 1 
surveillance status, a member placed on Class 2 surveillance status 
will be required to maintain a required fund deposit in excess of the 
amount ordinarily required, as permitted under GSCC's rules.
    A GSCC netting member will be placed on Class 3 surveillance status 
if GSCC is considering taking action under GSCC Rule 18 (Ceasing to Act 
for a Member) or GSCC Rule 20 (Insolvency of a Member).\11\ A GSCC 
netting member on Class 3 surveillance status shall be placed on a 
final notification list. A netting member will remain on such final 
notification list until the conditions(s) that resulted in its 
assignment to Class 3 surveillance status have improved to an extent 
that GSCC deems appropriate to support reassignment of the member to 
Class 2 surveillance status.

    \11\ Under Rule 18 (Cleasing to Act for a Member), GSCC may 
cease to act for a member upon notice to such member for such 
reasons as: (1) the member has failed to perform its obligations to 
GSCC or materially violated any GSCC rule, procedure, or agreement, 
(2) the member has failed to pay GSCC any payment required, (3) the 
member no longer meets its admissions or continuance standards, or 
(4) the member has been responsible for fraudulent or dishonest 
conduct. Under Rule 20 (Insolvency of a Member), GSCC will cease to 
act for a member if such member meets one of several tests of 
insolvency (e.g., such member files a petition seeking relief under 
the Bankruptcy Code).
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(7) Simplification of the Clearing Fund Deficiency Call Mechanism
    GSCC's rules currently permit GSCC to make clearing fund deficiency 
calls on a same day basis under the following four circumstances: (1) a 
member's current day's required clearing fund deposit exceeds by 
twenty-five percent the value of its clearing fund collateral,

[[Page 10048]]
(2) a member's current day's required clearing fund deposit level 
exceeds by more than $250,000 the value of its clearing fund 
collateral, (3) a member is on surveillance status and its required 
clearing fund deposit as of the current day exceeds the value of its 
clearing fund collateral, or (4) a member's ``clearing fund funds-only 
settlement amount,'' which excludes clearance difference, invoice 
amount, and other miscellaneous amounts, for the current day exceeds by 
more than twenty-five percent its average daily clearing fund funds-
only settlement amount over the most recent twenty business days.\12\

    \12\ The clearance difference is the dollar difference between 
GSCC's system price for a settlement obligation and the actual value 
at which the settlement obligation was settled. The invoice amount 
means all fees that a member owes GSCC.
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    Over the years, the fourth circumstance, a twenty-five percent jump 
in the member's clearing fund funds-only settlement amount, which could 
represent a relatively small dollar amount, has not proven to be 
necessary and has become obsolete as a practical matter. At the 
conclusion of their recent inspection of GSCC, Commission staff 
suggested that GSCC should either monitor the funds-only deficiency 
call requirements or file with the Commission a proposed rule change 
eliminating it. GSCC believes that the funds-only deficiency call 
aspect of the clearing fund is unnecessary and should be eliminated.
    Moreover, because GSCC is proposing the tiered surveillance status 
mechanism, GSCC believes that a clearing fund deficiency call, pursuant 
to which GSCC calls for any amount of deficiency, that is based on a 
member being on surveillance status should be invoked only if a member 
is on Class 2 or Class 3 surveillance status. Finally, since 1989 when 
the netting system was implemented, GSCC's rules have provided that 
GSCC automatically may make a clearing fund deficiency call at the 
beginning of each month. Given the adequacy of the same day deficiency 
call mechanism outlined above, GSCC believes that this monthly 
deficiency call mechanism is no longer appropriate and is therefore 
proposing to delete this provision.
(8) Elimination of the Noon Deadline for Satisfaction of Clearing Fund 
Deficiency Calls
    GSCC issues by telephone call followed by telefax notices calls for 
additional clearing fund deposits by 9:00 a.m. The exact time that each 
telephone call is made is recorded. Under GSCC's current rules, a 
member has until the later of two hours after the receipt of a clearing 
fund deficiency call or noon to satisfy the call.
    Receipt of clearing fund margin as early in the day as possible is 
a fundamental principle behind optimal risk management. GSCC's long 
term goal is to develop an automated mechanism pursuant to which it 
will be in receipt of clearing fund collateral by the time that the 
securities Fedwire opens in the morning, which is currently at 8:30 
a.m.
    As an interim step toward achieving this goal, GSCC is proposing to 
eliminate the 12:00 p.m. alternative deadline for satisfaction of a 
clearing fund deficiency call and to require a member to satisfy a 
deficiency call within two hours after it is received. The practical 
effect of this change is that, in the ordinary course, a member will 
have to satisfy a deficiency call by approximately 11:00 a.m. In order 
to ensure that the elimination of the noon deadline does not produce an 
unduly harsh effect on members, GSCC also is proposing that a clearing 
fund deficiency call does not need to be satisfied before 10:00 a.m. 
regardless of when the call actually is made.
    GSCC believes the proposed rule change will enhance GSCC's risk 
management processes in a prudent manner that is consistent with 
minimizing operational burdens on GSCC netting members and with 
maximizing the members' liquidity. Thus, GSCC believes the proposed 
rule change is consistent with the Section 17A of the Act and the rules 
and regulations thereunder applicable to a self-regulatory 
organization.\13\

    \13\ 15 U.S.C. 78q-1 (1988).
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    GSCC does not believe that the proposed rule will have an impact on 
or impose a burden on competition.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received From Members, Participants, or Others

    Comments on the proposed rule change have not yet been solicited. 
GSCC members will be notified of the rule filing and comments will be 
solicited by an important notice. GSCC will notify the Commission of 
any written comments received by GSCC.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within thirty-five days of the date of publication of this notice 
in the Federal Register or within such longer period (i) as the 
Commission may designate up to ninety days of such date if it finds 
such longer period to be appropriate and publishes its reasons for so 
finding or (ii) as to which the self-regulatory organization consents, 
the Commission will:
    (a) by order approve such proposed rule change or
    (b) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street NW., Washington, DC 20549. Copies 
of the submission, all subsequent amendments, all written statements 
with respect to the proposed rule change that are filed with the 
Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Section, 450 Fifth Street NW., 
Washington, DC 20549. Copies of such filing also will be available for 
inspection and copying at the principal office of GSCC. All submissions 
should refer to the file number SR-GSCC-96-01 and should be submitted 
by April 2, 1996.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\14\

    \14\ 17 CFR 200.30-3(a)(12) (1995).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-5845 Filed 3-11-96; 8:45 am]
BILLING CODE 8010-01-M