[Federal Register Volume 61, Number 162 (Tuesday, August 20, 1996)]
[Notices]
[Pages 43103-43105]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-21157]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37565; File No. SR-GSCC-96-07]


Self-Regulatory Organizations; Government Securities Clearing 
Corporation; Notice of Proposed Rule Change Modifying the Rights and 
Responsibilities of Interdealer Broker Netting Members

August 14, 1996.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on July 2, 1996, the 
Government Securities Clearing Corporation (``GSCC'') filed with the 
Securities and Exchange Commission (``Commission'') the proposed rule 
change as described in Items I, II, and III below, which items have 
been prepared primarily by GSCC. On July 22, 1996, GSCC amended the 
filing.\2\ The Commission is publishing this notice to solicit comments 
on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\ Letter from Karen Walraven, Vice President and Associate 
Counsel, GSCC, to Jerry W. Carpenter, Assistant Director, Division 
of Market Regulation, Commission (July 18, 1996).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    GSCC proposes to modify its rules governing the rights and 
responsibilities of interdealer broker (``IDB'') netting members.

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.\3\
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    \3\ 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 the 
Statutory Basis for, the Proposed Rule Change

    At the time of the implementation of GSCC's netting system in 1989, 
IDBs were given distinct rights and obligations with regard to loss 
allocation, clearing fund margin, and funds-only settlement as a result 
of their status as agents for partially disclosed principals that do 
not take positions for their own accounts. Since 1989, the volume and 
types of transactions submitted by IDBs to GSCC have increased 
significantly.
    As a result of the continuing changes in the government securities 
marketplace, various revisions have been proposed or have been made 
regarding the status of IDBs under GSCC's rules. These changes include: 
(i) The creation of a second category of IDB membership designed to 
allow IDBs with higher levels of net worth and excess net or liquid 
capital to do a limited amount of business away from GSCC members,\4\ 
(ii) the establishment of a $10 million minimum net/liquid capital 
requirement for Category 1 IDB's,\5\ (iii) the imposition of strict 
limitations on Category 1 IDB's scope of business allowing them to do 
business in eligible securities with other netting members and 
grandfathered firms, and (iv) in conjunction with the next planned 
phase of repo netting, which will include repos done on a blind 
brokered basis, the determination to allow IDBs to submit to GSCC 
eligible repo business but only with netting members on both sides of 
the transaction.\6\ GSCC has reviewed its rules governing loss 
allocation and clearing fund requirements for IDBs in relation to the 
risks posed by IDBs to determine what amendments are appropriate.
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    \4\ Securities Exchange Act Release No. 32722 (August 1, 1993), 
58 FR 42993 [SR-GSCC-93-01] (order approving proposed rule change 
modifying participation standards). Unless otherwise indicated, the 
term IDB refers to both Category 1 and Category 2 IDBs. Under 
current rules, Category 1 IDBs act exclusively as brokers and trade 
with GSCC netting members and certain grandfathered nonmember firms 
and must maintain $10 million in net or liquid capital. Category 2 
IDBs may transact up to 10% of their trading volume with nonmembers 
and must maintain $25 million in net worth and $10 million in excess 
net or liquid capital.
    \5\ Securities Exchange Act Release No. 37343 (June 20, 1996), 
61 FR 33564 [SR-GSCC-96-02] (order approving rule change modifying 
minimum financial criteria for Category 1 IDB netting membership).
    \6\ Securities Exchange Act Release No. 37482 (July 25, 1996), 
61 FR 40275 [SR-GSCC-96-04] (order approving proposed rule change 
relating to IDB netting members participating in the netting and 
settlement services for repos).
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1. Loss Allocation
    Currently, if a loss or liability is incurred due to the failure of 
a GSCC netting member to meet its obligations, GSCC looks first to the 
clearing fund and forward margin collateral that the failed member 
maintains with GSCC. If the collateral is insufficient to cover the 
entire loss, GSCC looks back the number of days needed to capture an 
amount of trading that is equal to the amount of the liquidated 
positions of the failed member.\7\ The loss is then allocated based on 
the counterparties to the trading activity captured.
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    \7\ Recently, GSCC proposed modifying the loss allocation 
procedure to capture a level of trading activity that is at least 
five times the dollar value amount of the securities of the 
defaulting member that are liquidated. Securities Exchange Act 
Release No. 37548 (August 9, 1996) [File No. SR-GSCC-96-05].
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    To the extent that the defaulting member's trading activity 
represents direct transactions with other netting members (i.e., the 
counterparties to the trade are netting members trading directly with 
each other without using the services of a broker), a portion of the 
loss equivalent to such trading activity is allocated on a pro rata 
basis based on the dollar value of the trading activity of each non-IDB 
netting member with the defaulting member netted and novated on the day 
of default as defined in GSCC Rule 4, Section 8(a)(v).\8\
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    \8\ Supra note 7.
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    To the extent that the defaulting member's trading activity 
represents member brokered transactions (i.e., a brokered transaction 
where both the buyside and sellside counterparties to

[[Page 43104]]

the IDB are netting members), such loss is allocated as follows: (i) 
Ten percent of the loss is allocated to the IDBs on an equal basis, up 
to $1.6 million per calendar year for each IDB, regardless of the level 
of trading activity each IDB had with the defaulting member and (ii) 
the other ninety percent of the loss is allocated among all other 
netting members pro rata based on the dollar value of each netting 
member's trading activity with the defaulting member channeled through 
IDBs.
    To the extent that the defaulting member's trading activity 
represents nonmember brokered transactions (i.e., a brokered 
transaction where either the buyside or sellside counterparty to the 
IDB is a nonmember), such loss is allocated as follows: (i) Ten percent 
of the loss is allocated to the IDBs on an equal basis, up to $1.6 
million per calendar year for each IDB, regardless of the level of 
trading activity each IDB had with the defaulting member and (ii) the 
other ninety percent of the loss is allocated among Category 2 IDBs pro 
rata based on the dollar value of each Category 2 IDB's trading 
activity with the defaulting member.
    GSCC is proposing to raise the percentage of a loss arising from 
member or nonmember brokered transactions allocated collectively to the 
IDBs to fifty percent with a dollar cap on each IDB's potential 
liability as discussed below. GSCC believes this change is appropriate 
because the volume of transactions submitted by IDBs for netting and 
guaranteed settlement has increased significantly since the netting 
system became operational in 1989 and is expected to rise significantly 
with the introduction of netting services for brokered repos. Brokered 
transactions represent a potential risk to GSCC because the IDBs are 
principals vis-a-vis GSCC and may have settlement obligations to GSCC 
as the result of uncompared trades and trades with nonmembers. GSCC 
also believes that this proposed change will result in a fairer loss 
allocation methodology because the IDBs will share on a collective 
basis equally with the dealers any loss allocation arising from 
brokered transactions. By placing a dollar cap on each IDB's share of a 
loss, the IDBs will continue to be protected from unusually large loss 
allocations.
    Furthermore, GSCC proposes that each IDB's individual share of the 
collective broker allocation should be allocated pro rata based on the 
dollar value of its trading activity with the defaulting member instead 
of an equal allocation. GSCC believes that the practice of mutualizing 
losses among the IDBs should be discontinued. By implementing this 
change, an IDB will no longer be subject to an allocation of a portion 
of a loss arising from the default of a firm with which the IDB never 
traded. This manner of loss allocation provides IDBs with greater 
incentive to assess the creditworthiness of their counterparties.
    Currently, the loss amount allocated to each IDB is capped at $1.6 
million per calendar year for losses attributable to member or 
nonmember brokered transactions.\9\ The use of a per calendar year cap 
ignores the possibility that there may be multiple lost events in a 
calendar year and, thus, may not protect sufficiently GSCC and its 
members from loss. GSCC proposes that the maximum amount of loss that 
should be allocated to each IDB should be based on a per loss 
allocation event as opposed to a calendar year maximum. Although it is 
unlikely, there is potential for more than one loss event to occur 
during a calendar year, and a loss allocation cap based on a calendar 
year maximum would allow an IDB that has hit its calendar year cap to 
use GSCC's netting system for the remainder of the year on a risk-free 
basis. A per loss allocation event standard creates a more appropriate 
economic incentive to IDBs to manage counterparty credit risk.
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    \9\ As noted above, Category 2 IDBs are subject to an unlimited 
loss allocation, based on trading volume, for losses related to 
nonmember brokered transactions. GSCC is not proposing any changes 
to this postion of the loss allocation provisions.
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    In order to protect sufficiently GSCC and its members from loss, it 
is necessary that any loss allocation cap sufficiently reflect the 
exposure posed to GSCC by an IDB and provide an adequate incentive for 
IDBs to manage effectively their counterparty credit risk. GSCC 
proposes that the maximum amount of loss that should be allocated to an 
individual IDB should be raised to $5 million per loss allocation 
event. GSCC believes that an increase in the maximum loss that can be 
allocated to an IDB is reasonable in that IDBs pose an increased risk 
to the netting system. However, a balance should be maintained between 
protecting GSCC and its members from a loss and applying a loss 
allocation methodology that may be so onerous as to disenable an IDB 
from meeting GSCC's standards. A cap of $5 million per loss allocation 
event would seem to strike that appropriate balance. Furthermore, the 
$4.2 million excess net/liquid capital requirement that was applied for 
many years to Category 1 IDBs was linked to the $1.6 million maximum 
loss allocation figure. With the recent increase in the excess capital 
requirements to $10 million, an increase in the maximum amount of loss 
that can be allocated to an IDB seems reasonable. The proposed increase 
will protect more effectively GSCC and its members from lossess, while 
setting the maximum amount of loss that could be allocated to each IDB 
at less than the IDB's full capital requirement will ensure that the 
IDB's excess capital would not be depleted entirely in one loss 
allocation event.
2. Clearing Fund and Funds Settlement
    Currently, Category 1 IDBs have a fixed clearing fund obligation of 
$1.6 million. Category 2 IDBs must maintain a clearing fund deposit of 
at least $1.6 million. Category 1 and Category 2 IDBs also have 
different clearing fund deposit composition requirements. For Category 
1 IDBs, $100,000 of the deposit must be in cash (while other netting 
members must maintain ten percent of the total deposit required in 
cash), and the remaining portion of the deposit can be made up of 
eligible letters of credit or eligible securities. Category 2 IDBs must 
maintain at least $100,000 of their clearing fund in cash or ten 
percent if their clearing fund deposit exceeds $1.6 million, and no 
more than seventy percent of the deposit can consist of eligible 
letters of credit.
    GSCC believes that if the maximum loss allocation for the IDBs is 
raised to $5 million per loss allocation event, the required clearing 
fund deposit should also be raised. GSCC proposes that Category 1 IDBs 
should have a fixed $5 million clearing fund requirement while Category 
2 IDBs should have a minimum $5 million clearing fund requirement. The 
cash component of the clearing fund requirements for Category 1 IDBs 
should remain at a fixed $100,000 amount, and they should continue to 
be permitted to meet the remainder of their clearing fund requirement 
(now $4.9 million) all or in part by the pledge of letters of credit. 
Category 1 IDBs will be subject to all of the surveillance requirements 
of Section 3 of GSCC Rule 4, with GSCC having the authority to increase 
the amount of clearing fund deposit for any IDB on surveillance status. 
Category 2 IDBs will be subject to the same clearing fund deposit 
composition requirements as other non-Category 1 IDB netting members: 
ten percent of their required fund deposit ($500,000) must be in cash, 
and no more than seventy percent of the remaining total can consist of 
eligible letters of credit.
    By aligning an IDB's required clearing fund deposit with the 
maximum per loss allocation event, GSCC will have access to the funds 
necessary to cover a member's default. Continuing to waive

[[Page 43105]]

the general limitations placed on netting members posting cash and 
letters of credit collateral for Category 1 IDBs should reduce the 
hardship of raising the clearing fund deposit requirement. However, 
because Category 2 IDBs represent a higher risk of loss for GSCC, they 
should be subject to the more stringent standards applied to non-
Category 1 IDB netting members.
    Category 1 IDBs are not required under GSCC's current rules to 
participate in the daily funds-only settlement process.\10\ GSCC 
believes that requiring all IDBs to participate in the morning funds-
only settlement process is necessary at this time because of the 
required pass-through of forward margin credits, which became effective 
with the 1995 implementation of the first phase of netting services for 
repurchase agreements (``repos'').\11\ If the forward margin debits are 
not submitted to GSCC in the morning funds-only settlement, GSCC will 
be unable to pass through the forward margin credits. Thus, all netting 
members must participate in the morning funds-only settlement process. 
This rule change should not result in any major changes for the IDBs, 
as the single Category 1 IDB and all Category 2 IDBs already 
participate in the funds-only settlement process as a matter of 
practice.
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    \10\ Until recently, Tullett & Tokyo Securities was the only 
Category 1 IDB, and they participate in the morning funds-only 
settlement.
    \11\ Securities Exchange Act Release No. 36941 (November 17, 
1995), 60 FR 61577 [SR-GSCC-95-02] (order approving a proposed rule 
change relating to the netting and risk management services for non-
same-day-settling aspects of next-day and forward-settling repo 
transactions).
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    In addition, the proposed rule change will eliminate the exception 
in Section 3 of GSCC Rule 11 that permits IDBs to exclude trades from 
GSCC's netting system if the inclusion of such trade will result in the 
IDB having a net settlement position other than zero. GSCC Rule 11, 
Section 3 will continue to permit netting members to exclude repo 
transactions from the netting system in accordance with GSCC Rule 18.
    GSCC believes the proposed rule changes are consistent with the 
requirements of Section 17A of the Act and the rules and regulations 
thereunder, because they will result in a more fair and appropriate 
loss allocation methodology and a higher level of margin protection for 
GSCC and thereby will promote the safeguarding of securities and funds 
in GSCC's custody or control or for which GSCC is responsible.

B. Self-Regulatory Organization's Statement on Burden on Competition

    GSCC does not believe that the proposed rule change will have an 
impact 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 or 
received. 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 N.W., Washington, D.C. 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 N.W., 
Washington, D.C. 20549. Copies of such filing will also be available 
for inspection and copying at the principal office of GSCC. All 
submissions should refer to File No. SR-GSCC-96-07 and should be 
submitted by September 10, 1996.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\12\
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    \12\ 17 CFR 200.30-3(a)(12) (1995).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-21157 Filed 8-19-96; 8:45 am]
BILLING CODE 8010-01-M