[Federal Register Volume 62, Number 95 (Friday, May 16, 1997)]
[Notices]
[Pages 27089-27091]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-12893]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38601; File No. SR-GSCC-97-01]


Self-Regulatory Organizations; Government Securities Clearing 
Corporation; Notice of Filing of Proposed Rule Change Regarding Off-
The-Market Transactions

May 9, 1997.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(the ``Act''),\1\ notice is hereby given that on March 11, 1997, 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 by GSCC. 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. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The proposed rule change consists of modifications to GSCC's rules 
to allow the mitigation of risk arising from the netting and guaranteed 
settlement of off-the-market transactions.

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

    GSCC's fulfillment of its basic mission, which is to ensure that 
the overall settlement process for the Government securities industry 
never fails, has been based on the belief that it is best to be as 
inclusive as possible with regard to the transactions entered into by 
its members. This makes it less likely that the failure of an industry 
participant will have a chain reaction effect and lead to the failure 
of other participants and the settlement process in general.
    Because of this philosophy, GSCC has avoided to the extent possible 
establishing barriers to the inclusion of members' trades in the 
netting process. Thus, absent the potential for a member to fail to 
fulfill its settlement obligations to GSCC and have GSCC cease to act 
for it, GSCC's rules do not provide for limitations on a member's 
ability to submit trading activity based on its financial status or its 
level of overall

[[Page 27090]]

activity. Rather, GSCC's approach has been to let its margining 
processes be the natural limit on a member's level of trading.
    This approach works well because the clearing fund and forward 
margining processes are both dynamic ones. They are not set or capped 
at a specific level but are recalculated and collected daily and thus, 
increase or decrease daily based on (1) the level of members' overall 
historical and current day's net activity with respect to clearing fund 
and (2) the net profitability of members' overall net activity with 
respect to forward margin.
    This inclusive approach to netting eligibility has led GSCC to 
allow trades into its net that have a price that differs significantly 
from the prevailing market price for the underlying security (``off-
the-market transactions''). The large majority of the off-the-market 
transactions that enter the net are not independent trades per se but 
rather reflect exercise of options into which the parties previously 
entered. GSCC continuously monitors its receipt of data on off-the-
market transactions. For monitoring purposes, GSCC considers trades 
that are greater than $1 million in value and that traded at a price 
that is more than one percentage point away from GSCC's system price as 
off-the-market trades.
    The submission by netting members to GSCC of data on an off-the-
market transaction is of particular concern if done on the day before 
the scheduled settlement date of the transaction or if the data is 
submitted earlier than on the day before scheduled settlement date but 
is not compared until that date because it presents GSCC with exposure 
that it has not had the opportunity to appropriately assess and margin. 
As noted above, most of the off-the-market transactions submitted to 
GSCC are options exercises, and ordinarily, an option is settled on the 
business day after the day on which it is exercised.
    As a partial solution to this problem, GSCC intends in the future 
to provide a comprehensive set of comparison, netting, settlement, and 
risk management services for options on Government securities. As a 
more immediate measure, GSCC is seeking authority to take the following 
two-pronged approach to the problem of off-the-market transactions.
    1. Continue to allow off-the-market trades into the net thus 
keeping them eligible for netting, novation, and guaranteed settlement 
but change the loss allocation process so as to allocate all of any 
loss resulting from the liquidation of the off-the-market transaction 
to the remaining counterparty.
    This approach recognizes that allowing off-the market transactions 
into the net has the potential to inappropriately increase the loss 
that GSCC would incur should a member that has engaged in such 
transactions fail and have its net settlement positions liquidated. 
Members not involved in the off-the-market transaction should not have 
to share in the loss allocation that results from its liquidation.
    To avoid this, GSCC is seeking the authority to amend its rules to 
allocate the loss arising from an off-the-market transaction done 
either with a netting member that subsequently is determined to be 
insolvent or with an executing firm that the insolvent member acts for 
as a submitting member directly and entirely to the insolvent member's 
counterparty.
    2. Not pass through to the credit side the mark-to-market amount 
associated with an off-the-market transaction until and unless it is 
paid to GSCC by the debit side.
    The revision to the loss allocation process addresses the inequity 
of how that process applies to a failed member that has engaged in off-
the-market transactions. However, it would expose GSCC to the risk that 
the failed member's counterparty also defaults on its settlement 
obligations to GSCC after that member has received the benefit of the 
off-the-market transaction through the funds-settlement process. If 
that happens, then the allocation of loss still effectively reverts 
back to the other members that were not involved in the off-the-market 
transaction.
    Thus, as a complement to the first proposed, GSCC is seeking the 
ability to ensure that the mark-to-market exposure on the off-the-
market transaction not be inappropriately passed through to a failed 
member's counterparty. GSCC would do this by amending its rules and its 
operational procedures to provide that if the mark-to-market amount 
associated with an off-the-market transaction is not paid to GSCC by 
the debit side on the morning of the business day following the 
submission of the trade (i.e., the debit side fails before it has 
satisfied its funds settlement obligation), the market amount will not 
be paid by GSCC to the credit side. In other words, GSCC will not pass 
through the profit on an off-the-market transaction until and unless it 
has received that profit amount.
    GSCC is proposing as the definition of an off-the-market 
transaction any of the following:
    (1) An options exercise.
    (2) A single transaction that is:
    (i) greater than $1 million in par value and
    (ii) either one percentage point higher than the highest price or 
one percentage point lower than the lowest price for the underlying 
security on the day of the submission of data on the transaction to 
GSCC (with such prices being obtained by GSCC from a third-party source 
such as Bloomberg Financial Services selected by GSCC for this 
purpose).
    (3) A pattern of transactions submitted by two members that if 
looked at as a single transaction would constitute an off-the-market 
transaction.
    The proposed rule changes are consistent with the requirements of 
Section 17A of the Act \3\ and the rules and regulations thereunder 
because it would ensure that the mark-to-market exposure on the off-
the-market transaction not be inappropriately passed through to a 
failed member's counterparty and that the liquidation of an off-the-
market transaction not lead to a significant loss by GSCC.
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    \3\ 15 U.S.C. 78q-1.
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(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

    Written comments relating to the proposed rule change have not yet 
been solicited or received. Members will be notified of the rule change 
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 organizations consents, 
the Commission will:
    (A) by order approve rule proposed such change or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

[[Page 27091]]

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 this submission, all subsequent amendments, all written 
statements with respects 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 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Room in Washington, D.C. 
Copies of such filing will also be available for inspection and copying 
at the principal office of GSCC. All submissions should refer to the 
File No. SR-GSCC-97-01 and should be submitted by June 6, 1997.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-12893 Filed 5-15-97; 8:45 am]
BILLING CODE 8010-01-M