[Federal Register Volume 62, Number 132 (Thursday, July 10, 1997)]
[Notices]
[Pages 37093-37104]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-17987]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38810; International Series Release No. 1090; File No.
600-30]
Self-Regulatory Organizations; Emerging Markets Clearing
Corporation; Notice of Filing of Application for Registration as a
Clearing Agency
July 1, 1997.
I. Introduction
On May 30, 1997, the Emerging Markets Clearing Corporation
(``EMCC'') filed with the Securities and Exchange Commission
(``Commission'') an application on Form CA-1 for registration as a
clearing agency pursuant to Section 17A of the Securities Exchange Act
of 1934 (``Exchange Act'') \1\ and Rule 17Ab2-1 thereunder \2\ in order
to perform the functions of a clearing agency with respect to
transactions in U.S. dollar-denominated Brady bonds.\3\ The Commission
is publishing this notice to solicit comments from interested
persons.\4\ Comments are solicited on all aspects of the EMCC
application, and in particular the matters discussed in Section IV of
this notice.
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\1\ 15 U.S.C. 78q-1.
\2\ 17 CFR 240.17Ab2-1.
\3\ On June 2, 1997, and June 17, 1997, EMCC filed amendments to
its application. Copies of the application are available for
inspection and copying at the Commisison's Public Reference Room
\4\ The description set forth in this notice regarding the
structure and operations of EMCC have been largely derived from
information contained in EMCC's Form CA-1 application and publicly
available sources.
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II. Structure of the EMCC System
EMCC is a corporation organized under the laws of the State of New
York. EMCC was formed by the Emerging Markets Traders Association
(``EMTA'') and the International Securities Clearing Corporation
(``ISCC'') in response to an industry initiative to reduce risk in the
clearance and settlement of emerging markets debt instruments.
Initially, EMCC will be owned by EMTA, the National Securities
Clearing Corporation (``NSCC''), and the International Securities
Markets Association (``ISMA''). EMTA will be issued 300 shares (37.5%
of the outstanding shares), NSCC will be issued 300 shares (37.5% of
the outstanding shares), and ISMA will be issued 200 shares (25% of the
outstanding shares).\5\
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\5\ After the initial issuance of shares to EMTA, NSCC, and
ISMA, EMCC intends to issue shares to persons that have contributed
to the EMCC development fund and to finance EMCC's initial
operations in such amounts and at such time as determined by EMCC.
EMCC intends to issue shares no later than June 30, 1998. EMCC will
file a proposed rule change prior to any such issuances.
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EMTA is a trade association organized as a New York not-for-profit
corporation in 1990 by financial institutions to promote the orderly
development of trading markets in emerging market instruments. As of
the end of 1996, EMTA had 154 members, which were mainly broker-dealers
and banks. EMTA had 154 members, which were mainly broker-dealers and
bankers. EMTA owns 100% of the outstanding voting securities of EMTA
Black, Inc. EMTA Black, Inc. in turn owns 100% of the outstanding
voting securities of each of Clear-EM, Inc., Match-EM, Inc., and Net-
Em, Inc. Match-EM, Inc. is the owner of Match-EM, which is an
electronic post-trade confirmation and matching system for Brady bonds
and sovereign loans operated by GE Information Services, Inc. (``GE'').
Match-EM also enables EMTA to disseminate daily market volume and price
data. Match-EM began services in May 1995.
ISMA is an industry association composed of member broker-dealer
firms. ISMA has approximately 820 members in 48 countries. ISMA is
organized under the laws of Switzerland and is registered in the United
Kingdom (``U.K.'') as a designated investment exchange. ISMA owns TRAX,
a trade matching and reporting system started in 1989. U.K. broker-
dealers can use TRAX to fulfill their U.K. reporting requirements.
ISMA's wholly-owned subsidiary, International Securities Market
Association Limited (``ISMA Ltd.''), operates TRAX.
NSCC is a clearing agency registered under Section 17A of the
Exchange Act.\6\ NSCC is owned by the New York Stock Exchange, Inc.,
the American Stock Exchange, Inc., and the National
[[Page 37094]]
Association of Securities Dealers, Inc. NSCC is the parent corporation
of ISCC, which is also registered as a clearing agency under the
Exchange Act.\7\
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\6\ See Securities Exchange Act Release No. 20221 (September 23,
1983), 48 FR 45167 (order approving full registration of NSCC as a
clearing agency.
\7\ See Securities Exchange Act Release No. 26812 (May 12,
1989), 54 FR 21691 (order approving temporary registration of ISCC
as a clearing agency). ISCC continues to operate under its temporary
registration. Securities Exchange Act Release No. 38703 (May 30,
1997), 62 FR 31183.
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III. Description of EMCC Operations
EMCC is being established as a clearing agency initially to
facilitates the clearance and settlement of transactions in U.S.
dollar-denominated Brady bonds.\8\ Currently, Brady bonds are settled
through the facilities of Cedel Bank, Societe anonyme (``Cedel'') and
the Euroclear system, which is operated by the Brussels Office of
Morgan Guaranty Trust Company of New York (``Euroclear'').\9\ As more
fully described below, EMCC will facilities the settlement of Brady
bonds at Cedel and Euroclear (``depositories'').
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\8\ Brady bonds were first issued pursuant to a plan developed
by then U.S. Treasury Secretary Nicholas Brady to assist debt-ridden
countries restructure their sovereign debt into commercially
marketable securities. The plan provided for the exchange of bank
loans for collateralized debt securities as part of an
internationally supported sovereign debt restructuring. Typically,
the collateral would be U.S. Treasury securities. The first Brady
bonds were issued in 1990 for Mexico. Later securities that did not
strictly adhere to the terms of the plan (e.g., such securities may
not have been collateralized) were also referred to as Brady bonds.
The definition of Brady bonds used to denote securities that
will be eligible for processing by EMCC will be somewhat broader
than the traditional usage of the term. As defined in EMCC's rules,
Brady bonds are: (i) any bond or note issued in connection with the
restructuring of indebtedness by a sovereign or an agency or entity
thereof under the auspices of the Brady plan or under any similar
restructuring or financing plan whether or not collateralized and
including bonds or notes issued in exchange thereof or (ii) any
warrant or similar right originally issued attached to a Brady bond.
The term does not include securities offered by a sovereign debtor
to investors through normal underwriting syndication channels.
EMCC intends to offer clearance and settlement services for
other emerging markets debt instruments in the future. EMCC will
file proposed rule changes with the Commission prior to expanding
the categories of securities eligible for processing at EMCC.
\9\ For a description of Cedel, see Securities Exchange Act
Release No. 38328 (February 24, 1997), 62 FR 9225 (order approving
application for limited exemption from registration as a clearing
agency). For a description of Euroclear, see Securities Exchange Act
Release No. 38589 (May 9, 1997), 62 FR 26833 (notice of application
for limited exemption from registration as a clearing agency).
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A. Clearance Services
Brady bonds are traded in an over-the-counter market composed of
dealers and interdealer brokers where trading is either directly
between dealers or between dealers through interdealer brokers.
Generally, Brady bonds that have warrants associated with them are
traded to include the warrants. In order to participate in EMCC,
dealers and interdealer brokers will need to submit transaction data to
a locked-in trade source which will match such data using its own
criteria. Initially, the locked-in trade sources designated by EMCC
will be Match-EM and TRAX.
Upon completion of the matching process, each locked-in trade
source will submit all of its transaction data to EMCC regardless of
whether the counterparties are EMCC members. EMCC will then segregate
all data on trades between two EMCC members to input into EMCC system.
As a result, all EMCC members that decide to use Match-EM or TRAX as a
part of their normal trading process will be locked into settlement at
EMCC and will be unable to select an alternative settlement process.
While EMCC members will be able to delete their trades from EMCC's
clearance system by submitting cancellation instructions through the
locked-in trade source, such action may result in the trade legally
being considered cancelled (i.e., the members would be required to
reconfirm such trades outside of TRAX or Match-EM and therefore would
not receive the benefit of using TRAX's or Match-EM's automated
confirmation system).
EMCC will receive data from the locked-in trade sources three times
each business day: (1) At approximately 8:30 a.m. eastern time (``ET'')
(``early morning transmission''), (2) at approximately 11:30 a.m. ET
(``early midmorning transmission''), and (3) at approximately 9:30 p.m.
ET (``evening transmission''). EMCC will review such data to determine
whether it meets EMCC's and the depositories' operational parameters
and will reject trades that do not meet such parameters.\10\ At
approximately 10:30 a.m. ET and 11:30 p.m. ET, EMCC will send out to
its members and to the locked-in trade sources a report of data that
was rejected because it did not meet the operational parameters. Any
correction or cancellation of data must be done through the locked-in
trade sources.\11\
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\10\ Such parameters include complete information and valid
characters. In addition, EMCC has established a maximum delivery
size of $20 million.
\11\ Any cancellation or correction must be received by EMCC no
later than the early morning transmission two business days after
trade date (``T+2'').
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EMCC will report to each member on its ``accepted trade report''
data on all trades: (a) that are eligible for processing by EMCC (i.e.,
U.S. dollar denominated Brady bonds), (b) that are matched by the
locked-in trade sources, (c) that are received by EMCC on trade date
(``T''), on T+1, and in the early morning transmission on T+2, and (d)
that are not rejected by EMCC based on the operational parameters.
Matched trades that are eligible for processing and that are received
on T+2 in the midmorning transmission will be listed on a ``settlement
instructions only report.'' \12\ Transaction data received by EMCC in
the evening transmission on T+2 and thereafter will not be accepted by
EMCC because it will be unable to submit timely settlement instructions
to the depository.
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\12\ EMCC provides settlement instructions on behalf of its
members with respect to trades listed on the settlement instructions
only report to the depositories for settlement directly between the
members.
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EMCC may also received uncompared transaction data from the locked-
in trade sources. If EMCC does not receive by the early morning
transmission on T+2 updated data from a locked-in trade source
indicating that an uncompared trade has been cancelled or compared,
EMCC will include data on the uncompared trade on the settlement
instructions only report if the submitting member has requested EMCC to
do so pursuant to the member's standing instructions.
Accepted trade reports will be made available to members at
approximately 10:30 a.m. ET and 11:30 p.m. ET. The morning report will
contain data on matched trades received in the early morning
transmission. The evening report will contain data on matched trades
received in the midmorning and evening transmission. The settlement
instructions only report will contain data on matched trades received
in the midmorning transmission on T+2 and data on unmatched trades
received by the midmorning transmission on T+2. At approximately 12:30
p.m. on T+2, EMCC will send settlement instructions to the depositories
based on trade data contained in the accepted trade reports and in the
settlement instructions only report.
B. Risk Management Services
EMCC will interpose itself as the counterparty and guarantor on a
trade-for-trade basis with respect to the trades it reports on its
accepted trade report (``novation'') unless EMCC notifies or has made
information available to its members that trades listed on the accepted
trade report are not assumed and guaranteed because EMCC has ceased to
act for the original
[[Page 37095]]
counterparty.\13\ EMCC's guarantee will be effective with respect to:
(a) trades reported on the evening accepted trade report at the later
of (i) midnight ET or (ii) one half hour after the issuance of the
preliminary margin report \14\ and (b) trades reported on the morning
accepted trade report at the later of (i) 1:00 p.m. ET or (ii) two and
one half hours after issuance of the final margin report.\15\ The
result is a novation of the original contract between the
c'ounterparties, creating an obligation on the part of the seller to
deliver the securities to EMCC and on the part of the purchaser to
receive and pay for the securities delivered by EMCC.
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\13\ EMCC does not interpose itself as the counterparty and
guarantor for transactions reported on the settlement instructions
only report.
\14\ See infra Section IV.C.1.a for a description of the
preliminary margin report.
\15\ See infra Section IV.C.1.a for a description of the final
margin report.
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C. Settlement Services
EMCC will be a member of both Euroclear and Cedel. EMCC will
transmit settlement instructions to the appropriate depository on
behalf of members with EMCC as the counterparty to each side of the
trade. With respect to each transaction reported on an accepted trade
report which has not been deleted, EMCC will send receive and deliver
instructions to the depository at 12:30 p.m. on T+2. If the accepted
trade report indicates that a member has a securities receive
obligation, EMCC will notify the depository to deliver the bonds from
EMCC's account into the member's account against payment on the next
day (``T+3''). If the member had a securities deliver obligation
reflected on the accepted trade report, EMCC will instruct the
depository to deliver the specified quantity of bonds from the member's
account into EMCC's account against the receipt of the corresponding
payment price on T+3.\16\
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\16\ Consistent with industry conventions, EMCC assumes that the
bonds will be delivered with attached warrants unless otherwise
specified.
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Settlement will occur in accordance with the rules of Euroclear or
Cedel. Essentially, the receiver must have sufficient cash or line of
credit to pay for the delivery, and the deliverer must have sufficient
securities to make full delivery.\17\ The depositories will notify EMCC
and its members each day at midnight ET of the status of trades
indicating which have settled and which are still pending. EMCC will
not provide settling trade reports or fail reports to its members.
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\17\ Both Cedel and Euroclear employ mechanisms that can look
beyond the initial counterparties' obligations. Cedel has a
``chaining'' program which scans open transactions until all cash
and securities resulting from same day settlements are reemployed to
settle further transactions for same day value. Therefore, for back-
to-back transfers for equivalent funds, customers may not need to
pay because proceeds from sales are used to settle purchases.
However, Cedel's chaining program is limited when transactions are
sent through its bridge connection with Euroclear. EMCC has informed
the Commission that its members currently do not intend to use Cedel
as a depository. If this changes, EMCC intends to maintain a line of
credit at Cedel of approximately $40 million to allow the receipt
and delivery of securities across the bridge.
Euroclear's chaining program operates somewhat differently. In
scanning open transactions, the Euroclear program will only look to
the next settlement. For example, if a member does not have
sufficient funds to receive securities, Euroclear will review to see
if that member has a corresponding securities deliver obligation to
another member. In such case, Euroclear will complete both
transactions if the counterparty to the deliver obligation has
sufficient funds to pay for the securities. But if the counterparty
to the securities deliver obligation did not have sufficient funds
to settle the transaction, Euroclear, unlike Cedel, would not look
to subsequent settlements for funds and securities. Accordingly, if
EMCC inserts itself as a common counterparty without sufficient
funds to accept deliveries, Euroclear's system will only look to
EMCC's member to determine if sufficient funds exist. Therefore,
EMCC will maintain a line of credit between $60 and $100 million at
Euroclear to reduce settlement inefficiencies. EMCC's line of credit
will permit Euroclear to review not only the available funds of
EMCC's member but also such member's subsequent counterparty, if
any.
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If a member cannot accept delivery of securities because of
insufficient funds, EMCC will generate a fail compensation instruction
and will transmit it to the appropriate depository. Pursuant to that
instruction, the depository will debit the account of the member that
had insufficient funds and credit its counterparty's account an amount
of money based on the depository's overnight borrowing interest rate
multiplied by the amount of funds which were not paid.
With respect to matched transactions reflected on the settlement
instructions only report, EMCC will send instructions on the afternoon
of T+2 to the depository on behalf of the members listed as
counterparties. The depository will be advised to deliver on T+3 bonds
from the account of the member with the deliver obligation to the
account of the member with the receive obligation against payment. EMCC
will not monitor the settlement of these transactions.
With respect to uncompared transactions reflected on the settlement
instructions only report, EMCC will send instructions on the afternoon
of T+2 to the depository on behalf of the member submitting the data
naming the other member as the counterparty to the instruction. EMCC
will not monitor the settlement of these transactions.
D. Buy-ins/Sell-Outs
EMCC's rules will permit a buy-in or a sell-out in the event that a
transaction has not been completed by five days after settlement date
(``SD+5'') as described below. A buy-in or sell-out may be initiated by
the member with the receive or deliver obligation, respectively, by
submitting a pre-advice notice to EMCC. Upon receipt of the pre-advice
notice, EMCC will transmit the pre-advice notice to the corresponding
member with the fail obligation. If the instruments or money covered by
the pre-advice notice are not received within two business days after
the date of the pre-advice notice, then the member that requested the
buy-in or sell-out will need to deliver to EMCC a buy-in or sell-out
notice between two to five business days after issuance of the pre-
advice notice in order to proceed with the buy-in or sell-out. Upon
receipt of the buy-in or sell-out notice, EMCC will transmit a buy-in
or sell-out notice to the member with the fail obligation. Execution of
the buy-in or sell-out will take place through an agent selected by
EMCC on the fifth business day following the issuance of the buy-in or
sell-out notice. EMCC also may initiate a buy-in or sell-out if it
determines that such action is necessary to protect EMCC, its members,
its creditors, or its investors; to safeguard securities or funds in
EMCC's custody or control; or to promote the prompt and accurate
clearance and settlement of securities transactions.
EMCC will also use the buy-in or sell-out procedures for deliver
and receive obligations for warrants. However, if EMCC has ceased to
act for a member with fail obligation prior to the execution of the
buy-in or sell-out, EMCC will undertake the buy-in or sell-out only at
the expense of the member that submitted the pre-advice notice. If EMCC
ceases to act for the defaulting member after the pre-advice notice has
been submitted but before the execution of the buy-in or sell-out, EMCC
will first confirm with the requesting firm that it wants to proceed
with the buy-in at the requesting firm's expense.
E. Release of Clearing Data
Pursuant to EMCC's rules, EMCC may release transaction data of its
members to EMTA in accordance with a written agreement between EMCC and
EMTA. Such data may be used only for the purpose of promoting market
transparency on a noncommercial basis. On June 9, 1997, EMCC and EMTA
entered into a letter agreement that provides for the release of
information relating to the aggregate and per trade
[[Page 37096]]
transaction volumes and prices of trades processed by EMCC.
IV. EMCC's Request for Registration
A. Introduction
Brady bonds are the most actively traded emerging market debt
instrument. In the first quarter of 1997, Brady bonds represented $671
billion of the $1.6 trillion traded in emerging markets instruments.
Brady bonds constitute approximately 12% of the total $1.2 trillion
issued of emerging market instruments.\18\
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\18\ Broward Daily Business Review, May 20, 1997, at A3.
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While Brady bonds currently are cleared and settled either through
Euroclear or Cedel, neither guarantees settlement of these
transactions. Furthermore, dealers have exposure to brokers until the
assumption of risk by clearing firms on the afternoon of T+1. As a
result, parties to a transaction retain a high degree of settlement
risk. EMCC was developed in response to an industry initiative to
reduce risk in the clearance and settlement of emerging market debt
instruments. Therefore, in order to provide the benefits of guaranteed
settlement to the Brady bond market, EMCC seeks registration as a
clearing agency pursuant to Section 17A of the Exchange Act and Rule
17Ab2-1.
B. Goals of Clearing Agency Registration
Section 17A of the Exchange Act directs the Commission to promote
Congressional objectives to facilitate the development of a national
clearance and settlement system for securities transactions.\19\
Registration and regulation of clearing agencies is a key element in
promoting these statutory objectives. Before granting registration to a
clearing agency, Section 17A(b)(3) of the Exchange Act requires that
the Commission make a number of determinations with respect to the
clearing agency's organization, capacity, and rules.\20\ The Commission
has published standards developed by its Division of Market Regulation
which are used in evaluating applications for clearing agency
registration.\21\
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\19\ 15 U.S.C. 78q-1. Section 17A(a)(1) provides:
(1) The Congress finds that--
(A) The prompt and accurate clearance and settlement of
securities transactions, including the transfer of record ownership
and the safeguarding of securities and funds related thereto, are
necessary for the protection of investors and persons facilitating
transactions by and acting on behalf of investors.
(B) Inefficient procedures for clearance and settlement impose
unnecessary costs on investors and persons facilitating transactions
by and acting on behalf of investors.
(C) New data processing and communications techniques create the
opportunity for more efficient, effective, and safe procedures for
clearance and settlement.
(D) The linking of all clearance and settlement facilities and
the development of uniform standards and procedures for clearance
and settlement will reduce unnecessary costs and increase the
protection of investors and persons facilitating transactions by and
acting on behalf of investors.
For legislative history concerning Section 17A, see, e.g.,
Report of Senate Comm. on Housing and Urban Affairs, Securities Acts
Amendments of 1975: Report to Accompany S. 249, S. Rep. No. 75, 94th
Cong., 1st Sess. 4 (1975); Conference Comm. Report to Accompany S.
249, Joint Explanatory Statement of Comm. of Conference, H.R. Rep.
No. 229, 94th Cong., 1st Sess., 102 (1975).
\20\ 15 U.S.C. 78q-1(b)(3). See also Section 19 of the Exchange
Act, 15 U.S.C. 78s, and Rule 19b-4, 17 CFR 240.19b-4, setting forth
procedural requirements for registration and continuing Commission
oversight of clearing agencies and other self-regulatory
organizations.
\21\ Securities Exchange Act Release No. 16900 (June 17, 1980),
45 FR 41920 (``Standards Release''). See also, Securities Exchange
Act Release No. 20221 (September 23, 1983), 48 FR 45167 (omnibus
order granting registration as clearing agencies to The Depository
Trust Company, Stock Clearing Corporation of Philadelphia, Midwest
Securities Trust Company, The Options Clearing Corporation, Midwest
Clearing Corporation, Pacific Securities Depository, National
Securities Clearing Corporation, and Philadelphia Depository Trust
Company).
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C. Safety and Soundness Protections
Sections 17A(b)(3) (A) and (F) of the Exchange Act require that a
clearing agency be organized and its rules be designed to facilitate
the prompt and accurate clearance and settlement of securities
transactions for which it is responsible and to safeguard securities
and funds in its custody or control or for which it is responsible.\22\
In the Standards Release, the Division enumerated certain requirements
that should be met to comply with this standard.
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\22\ 15 U.S.C. 78q-1(b)(3) (A) and (F).
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1. Clearing Fund
The Standards Release stated that a clearing agency should have a
clearing fund which is based on a formula applicable to all users and
is comprised of cash or highly liquid securities. The rules of a
clearing agency should limit the investments that can be made with the
cash portion of its clearing fund to government securities or other
safe and liquid investments. The clearing fund should only be used to
protect participants and the clearing agency (a) from defaults of
participants and (b) from clearing agency losses not resulting from day
to day expenses and not covered by insurance or other resources of the
clearing agency. While the Standards Release stated that a clearing
agency could use temporary applications of the clearing fund in limited
amounts to meet unexpected and unusual requirements for funds, the
regular or substantial use of a clearing fund for operational purposes
would be inappropriate.\23\ The clearing agency should provide for the
maximum assessment to which any participant is subject. Comment is
requested on whether EMCC meets these standards as described below.
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\23\ The Standards Release also stated that there may be
legitimate purposes for which a clearing fund may be used for a
longer period of time so long as (a) the funds are properly
protected, (b) the funds are used to facilitate the process of
clearance and settlement, and (c) the participants and the
Commission approve such use during the registration proceedings.
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a. Clearing Fund Formula. EMCC will maintain and will manage a
clearing fund for the purpose of limiting or eliminating EMCC's
exposure to loss in the event a member would fail to perform its
obligations to EMCC. Each member will be obligated to make deposits to
EMCC's clearing fund. The initial required clearing fund deposit for
each member will be set by EMCC based on the expected nature and level
of the member's activity. The minimum required clearing fund deposit
for each member will be US $1,000,000.
Every day, EMCC will calculate margin in the morning and in the
evening but will only collect margin based on the morning calculation.
EMCC will generally calculate the margin amount as follows: (mark to
market amount + volatility amount) x event risk factor.\24\ The mark
to market
[[Page 37097]]
amount will be based on all trades due to settle on or after that day
and all fails unless EMCC has received notice from the depository that
such trade or fail has settled.\25\ The mark to market amount will be
based on the difference between the market price and the contract value
of the trade. If the net mark-to-market is a credit, the firm will have
a zero mark-to-market.
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\24\ EMCC has represented that it performed a stress test in
which the proposed formula was applied using three months of data on
EMCC eligible transactions obtained from Match-EM. The test assumed
for each member that the market in which such member had its highest
concentration of positions experienced an abnormal negative market
move (i.e., the ``stressed market''). All securities positions for
that member in other countries were run under the baseline
assumptions (i.e., no unusual market movements). The tests assumed
first a 10 strandard deviation market drop in the stressed market
and second a 4 standard deviation market gain in the stressed
market. The test assumed that bonds on the opposite sides of the
stressed market had correlations of 80% while bonds on the same side
of the stressed market had 100% correlation.
However, the test did not attempt to take into account any
spillover effect (i.e., where the sudden drop of prices in a
country's bond market resulted in a similar drop in the bond markets
of other countries with similar risk profiles). EMCC states that it
is difficult to quantify any spillover effects. EMCC believes that
spillover effects are addressed because the test assumes that for
each firm the stressed event occurred in the country in which the
firm was most concentrated and therefore would most adversely effect
the value of the firm's position and also assumes a degree of
deviation from the mean that was substantially higher than was the
case in the Mexican debt crisis.
Under this test, EMCC had no exposure 73.64% of the time. EMCC
had exposure between $1 and $1 million 9.18% of the time. EMCC had
exposure of greater than $10 million 1.7% of the time. The highest
exposures were four occurrences of an exposure of approximately $15
million and one exposure of approximately $50 million.
\25\ EMCC will receive notice at midnight ET (or 6:00 a.m. in
Brussels and Luxembourg) from Euroclear and Cedel of all trades that
have settled. At that time, Euroclear and Cedel have already
completed most of the settlements of that day (i.e., the notice
issued at midnight ET on Friday morning will indicate trades that
will settle Friday at the depository). Some trades will settle
Friday at the depository). Some trades will settle later, but EMCC
will receive notice of them before it begins its processing day.
Thus, when EMCC calculates the margin in the morning and the
evening, it will have received notice of which trades have settled
or failed for the day.
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The volatility amount for the evening calculation will be based on
all trades due to settle on or after that day and all fails unless EMCC
has received notice from the depository that such trade or fail has
settled. The volatility amount for the morning calculation will be
based on all trades due to settle on or after the current day and all
fails calculated as of the prior day whether or not EMCC has received
notice of the settlement of such trades or fails. Thus, the morning
volatility amount will includes trades that have already settled that
day, while the evening volatility amount will only include trades that
have not settled.\26\ In order to calculate the volatility amount, each
security will be placed into one of four liquidity categories based on
the average bid/offer spread, which will determine which volatility
formula will be applied to that security.\27\ The sum of the volatility
amounts for each security will be the clearing member's volatility
amount.\28\
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\26\ The reason for including transactions in the morning
volatility calculation whether or not they have settled is to insure
that data on three days of pending trades is included. EMCC believes
that because it is guaranteeing three days of trades, it is
appropriate that data on three days of trading activity is included
in the volatility calculation. At the time of the morning volatility
calculation, the trades entered into three days before will have
settled, but EMCC will not have received data for the trades entered
into on the current day. Thus, by including data for trades settling
that day, EMCC will be using three days of data. EMCC will calculate
fails as of the prior day because fails calculated as of the current
day would include trades due to settle that day (i.e., these trades
would be doubled counted as trades due to settle that day and fail
trades). With respect to the evening volatility calculation, EMCC
will have received data on trades entered into on that day. Thus, it
is no longer necessary to include trades that have settled that day.
\27\ The four classes and spreads are as follows: L1--\3/8\ or
less; L2--\3/4\ or less; L3--2 or less; L4--greater than 2 or no
trading activity for a certain period of days.
\28\ For each L4 security, the volatility amount is the value of
the position x 30%. For L1, L2, and L3 securities of each issuer,
EMCC will take the larger of the following formula with: (a) the
member's long positions in lines 1 and 2 and short positions in
lines 3 and 4 and (b) the member's short positions in lines 1 and 2
and long positions in lines 3 and 4.
1. (value of long or short L1+L2) x 2 Std, PLUS
2. (value of long or short L3) x 4 Std, PLUS
3. (value of short or long L1+L2) x 2 Std x CC, PLUS
4. (value of short or long L3) x 1 Std x CC
Std. is equal to a one standard deviation move over a five day
holding period based on the higher of a calculation using price data
for one year and three months. CC is the smallest correlation
coefficient between any security of that issuer in which the member
has a short position and any security of that issuer in which the
member has a long position. The correlation coefficient will be
based on one year's pricing data and will be updated daily.
EMCC may adjust the fixed percentage applied to L4 securities or
the number of standard deviations applied to L1, L2, and L3
securities without prior notice in order to increase the volatility
calculations when warranted by circumstances. These adjustments may
be made on a country by country basis or a bond by bond basis either
for all members or for members unduly concentrated.
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The event risk factor, which is designed to give EMCC an additional
cushion against events in countries not covered by two standard
deviations, will initially be set at 1.25. EMCC may adjust the event
risk factor for a member or for all members without prior notice to the
member(s). EMCC also will increase margin requirements by multiplying a
global holiday risk factor to the formula to take into account days on
which U.S. banks are closed but securities markets are open.
The preliminary margin amount will be calculated each evening and
will be reported to members at approximately 11:30 p.m. on a
preliminary margin report. The report will show the member's current
deposit, preliminary margin amount, and preliminary amount due, if any.
However, members will not be required to make any payment to EMCC based
on the preliminary margin report.
The final margin amount will be calculated each morning and will be
reported to members at approximately 10:30 a.m. on a final margin
report. A member's required margin deposit will be equal to the largest
single final daily margin amount computed for that member for the month
during which such margin calculation is being performed and for the
previous calendar month. The final margin report will indicate each
member's current deposit, final margin amount, and final amount due, if
any. A member will be required to pay any obligation with respect to
its margin obligation reflected on the final margin report no later
than the later of 11:30 a.m. ET or one hour after the final margin
report is made available. Margin deficits of less than $100,000 will
not be considered to be a margin deficit. Payment must be made through
the U.S. Fedwire system.
EMCC also will have the authority to collect additional amounts
over and above the daily margin requirement in order to obtain adequate
assurances of the financial responsibility or operational capability of
a member. EMCC has created a policy statement on procedures to follow
in determining whether additional clearing fund deposits are
needed.\29\ EMCC also may collect additional margin if a member has
been placed on surveillance status.\30\
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\29\ Each day, EMCC will calculate a net country position and a
net geographical position for each member. The net country position
will be the sum of the settlement values of the member's position in
L1, L2, and L3 securities plus the sum of the absolute settlement
values of the member's position in L4 securities of each country.
The net geographical position will be the sum of the net country
positions in Latin America, Eastern Europe, Asia, and Africa. An
undue concentration will be deemed to exist for a bank when the net
country position exceeds 20% of net worth or the net geographical
position exceeds 30% of net worth. An undue concentration will be
deemed to exist for a broker-dealer when the net country position
exceeds 50% of excess regulatory capital or the net geographical
position exceeds 80% of excess regulatory capital. Under such
circumstances, EMCC will contact the member to request information
on the nature and magnitude of non-Brady bond exposure and on any
hedging positions. If EMCC is not satisfied with the answers to
these questions, EMCC may request additional clearing fund deposits.
\30\ EMCC will put a member on surveillance status if any of the
following factors are present: (a) The member fails to meet any
financial standard for admission or continuance as a member, (b) the
member's capital position falls below the standards for admission,
(c) the member experiences an inability to meet its money or
securities settlement obligations to EMCC, (d) EMCC's board
determines that a significant reorganization, change in control, or
management of the member is likely to impair the member's ability to
meet its money or securities settlement obligations to EMCC, or (e)
the member has been placed on surveillance status by another self-
regulatory organization or comparable regulatory organization. EMCC
also will have the discretion to put a member on surveillance status
if any of the following factors are present: (a) it experiences a
significant operational problem, (b) the member's positions are
significantly disproportionate to its usual activity in light of
current industry conditions, (c) EMCC receives notification from the
member's designated examining authority or appropriate regulatory
agency or comparable regulatory organization of a pending
investigation or administrative action that could call into question
the member's ability to meet its obligations to EMCC, or (d) the
member experiences any condition that could materially affect its
financial or operational capability so as to potentially increase
EMCC's exposure to loss or liability.
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b. Margin Composition and Investment. Members will be required to
pay margin in cash, U.S. Treasury
[[Page 37098]]
securities, or letters of credit from banks that have been approved by
EMCC. If letters of credit are used as margin, no more than 70% of a
member's requirement may be satisfied with letters of credit and, as a
minimum, the greater of $100,000 or 10% of the member's margin
requirement (up to a maximum of $1,000,000) must be in cash.
Furthermore, no more than 20% of EMCC's total clearing fund may be
letters of credit from any one issuer. If letters of credit are not
used, the greater of $100,000 or 5% of the member's margin requirement
(up to a maximum of $1,000,000) must be in cash. A haircut of 5% will
be applied to letters of credit and treasury securities.
EMCC may invest any cash deposited as margin in securities issued
or guaranteed as to principal or interest by the U.S. or agencies or
instrumentalities of the U.S., repurchase agreements related to EMCC,
or otherwise pursuant to the investment policy adopted by EMCC. If not
invested, cash funds will be deposited by EMCC in its name in a
depository institution selected by EMCC. EMCC will retain all
investment income from cash deposits. Comment is requested as to
whether such investments are consistent with the standard that
investments should be limited to safe and liquid investments such as
government securities.
c. Loss Allocation. EMCC will establish an overnight exposure cap
for each member. This cap will be set at the lesser of (a) 5% of excess
net capital for U.S. broker-dealers, 5% of excess financial resources
for U.K. broker-dealers, and 1% of shareholders' equity for banks or
(b) $20 million. If a member's preliminary margin calculation is in
excess of its overnight exposure cap, the member will be subject to
fines. The loss allocation method applied to trades of an insolvent
member will be dependent upon whether the insolvent member has exceeded
its overnight exposure cap.
When the failed member is not an interdealer broker, EMCC will
classify trades as brokered or direct.\31\ If there was an overnight
exposure cap violation, EMCC will further classify such trades as
trades received by EMCC before the violation (``old trades'') or trades
received by EMCC after the violation (``new trades''). Any collateral
of the defaulting member will be divided between direct trades and
brokered trades in proportion to the amount of losses attributable to
old trades in each category. If there is insufficient collateral to
cover all of the losses attributable to old trades: (a) Losses
attributable to brokered transactions that are old trades will be
allocated pro rata among all members based upon each member's average
final daily margin amount for the prior 30 calendar days \32\ and (b)
losses attributable to direct transactions that are old trades will be
allocated among all the original counterparties in proportion to the
amount of losses created by each member's transactions.
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\31\ If the failed member's counterparty was an interdealer
broker, but the interdealer broker's counterparty on the other side
was not an EMCC member, EMCC will consider the trade to be a direct
trade between the insolvent and the interdealer broker. In other
words, ``brokered trades'' are trades where the interdealer broker
is an EMCC member and EMCC members are on both sides.
\32\ A member that is assessed pursuant to this provision may
limit its assessment to its current margin requirement if it chooses
to terminate its membership.
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After the losses from old trades have been satisfied, EMCC will
determine if any clearing fund collateral of the defaulting member
remains. EMCC will net new trades to obtain a net loss per issue of
securities. Any remaining clearing fund of the defaulting member will
be applied to the smallest loss, then the next remaining smallest loss
until there is no remaining clearing fund of the defaulting member.\33\
EMCC then will segregate the smallest remaining losses up to an amount
that equals the amount of the defaulting member's overnight exposure
cap (``under the cap losses'').\34\ The under the cap losses will be
allocated as follows: (a) losses attributable to direct transactions
will be allocated back to the original counterparties in an amount
equal to the losses attributable to the member's trades and (b) losses
attributable to brokered transactions will be allocated pro rata among
all EMCC members based upon each member's final daily margin amount
calculated with respect to the prior thirty calendar days. Any
remaining losses attributable to new trades will be allocated as
follows: (a) Losses attributable to direct transactions will be
allocated back to the original counterparties in an amount equal to the
losses attributable to the member's trades and (b) losses attributable
to brokered transactions will be allocated first to the interdealer
broker member that was a contraparty to such trade to the extent of the
loss attributable to such trade up to a maximum allocation of $3
million per interdealer broker and then pro rata among members that
were contraparties to interdealer brokers that reach their maximum
allocation and that were on the opposite side of the market in the same
issue of securities creating a loss with the same settlement date and
at approximately the same price.
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\33\ For example, after netting new trades in each issue of
securities, EMCC may determine that there are losses of $2 million,
$4 million, $3 million, and $10 million in four issues and EMCC has
collateral of the defaulting member of $8 million. EMCC will satisfy
the $2 million loss first, then the $3 million loss, then a portion
of the $4 million loss.
\34\ For example, if after netting there are losses of $5
million, $7 million, and $3 million in four issues and the
defaulting member had an overnight exposure cap of $10 million, EMCC
will segregate out the $3 million loss, the $5 million loss, and $2
million of the $7 million loss.
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Different loss allocation rules will apply when the defaulting
member is a broker. In such cases, any collateral of the defaulting
member will be applied first to losses resulting from old trades. If
there are remaining losses from old trades, such losses will be
allocated among all the original contraparties in proportion to the
amount of loss created by each member's transactions. EMCC then will
net new trades to obtain a net loss per issue of securities. Any
remaining clearing fund of the defaulting member will be applied to the
smallest loss, then the next remaining smallest loss until there is no
remaining clearing fund. Any remaining loss after application of
clearing fund will be allocated back to the contraparties to the
transactions giving rise to such loss to the extent of the loss
attributable to such transactions.
d. Use of Clearing Fund. EMCC's rules will provide that the use of
clearing fund deposits is limited to satisfaction of losses or
liabilities of EMCC arising from the failure of a member to satisfy an
obligation to EMCC or as an incident to the clearance and settlement by
EMCC and to provide EMCC with a source of collateral to meet its
temporary financing needs. If EMCC pledges any part of the clearing
fund deposits for more than 60 days as a source of temporary financing,
EMCC will by the 74th day consider such amount to be a loss and will
allocate such loss in accordance with the loss allocation rules.
Comment is requested whether EMCC's proposed uses of its clearing fund
are consistent with the requirement that temporary applications of the
clearing fund should be used only in limited amounts to meet unexpected
and unusual requirements for funds and that the regular or substantial
use of a clearing fund for operational purposes would be inappropriate.
2. Standard of Care
The Division stated in the Standards Release that the rules of a
clearing agency should provide that it is liable to a participant for
failure to deliver the participant's securities resulting from (i) the
negligence or misconduct of the clearing agency, the clearing agency's
[[Page 37099]]
subcustodian or agent, or any of their respective employees, (ii) the
placement of fully-paid participant securities of a lien or charge of
any kind in favor of the clearing agency, the clearing agency's
subcustodian or agent, or any person claiming through any one or more
of them, (iii) larceny, (iv) mysterious disappearance, or (v) any other
cause for which the clearing agency has assumed responsibility. Since
the date of the Standards Release, the Commission has further clarified
its position on clearing agency liability, stating that clearing
agencies should perform their functions under a high standard of care
and at a minimum custody services should be performed under an ordinary
negligence standard.\35\ The Commission also has stated that custody
functions include all functions related to transaction processing and
the safekeeping of customer funds and securities.\36\
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\35\ Securities Exchange Act Release Nos. 26154 (October 3,
1988), 53 FR 39556 (registration order of the Intermarket Clearing
Corporation [``ICC'']); 26450 (January 12, 1989), 54 FR 2010
(registration order of the Delta Government Options Corp.
[``DGOC'']); 26812 (May 12, 1989), 54 FR 21691 (registration order
of ISCC); and 27611 (January 12, 1990), 55 FR 1890 (second
registration order of DGOC).
\36\ See, e.g., ICC registration order, supra note 35.
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As proposed, EMCC's member's agreement, executed between EMCC and
each member, will provide that EMCC is not subject to any liability
under the agreement, including any liability with respect to EMCC's
failure to provide any services under the agreement or EMCC's rules,
except for losses resulting from EMCC's gross negligence, criminal act,
or willful misconduct in connection with its duties. The agreement
further will provide that EMCC will not be liable for any consequential
or special damages which may result from EMCC's failure to perform its
obligations under the agreement.
EMCC's rules will provide that EMCC will have no responsibility for
errors which may occur in any transmission of data to EMCC except in
the case of EMCC's gross negligence. EMCC`s rules also will provide
that EMCC will have no liability for errors made by it in the
conversion of data from a yield basis to a price basis or vice versa or
from the comparison of such converted data if EMCC has acted in good
faith and takes prompt action to correct any error.
The Commission preliminarily believes that EMCC's proposed standard
of care is inconsistent with the Exchange Act and prior Commission
positions. Because EMCC's actions bear directly upon the safeguarding
of securities and funds, the Commission believes that EMCC's activities
constitute custodial functions for which a negligence standard is
appropriate. Furthermore, the Commission has never approved a gross
negligence standard as a blanket standard of liability for a fully
functioning clearing agency.\37\ The Commission invites comment upon
the appropriateness of EMCC's proposed standard of liability.
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\37\ While the Commission approved the temporary registration of
the Government Securities Clearing Corporation (``GSCC'') under a
gross negligence standard, such clearing agency's functions at the
time were limited to comparison of data. In addition, the Commission
urged GSCC to adopt a negligence standard for all functions
affecting member settlements, including comparison of data.
Securities Exchange Act Release No. 25740 (May 24, 1988), 53 FR
19839. GSCC continues to operate under its temporary registration.
Securities Exchange Act Release No. 38698 (May 30, 1997), 62 FR
30911.
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3. Processsing Capacity
ISCC has agreed pursuant to a service agreement to perform services
for EMCC with respect to EMCC's clearing agency activities. ISCC will
furnish the services necessary to conduct EMCC's operations for a fee
designed to cover ISCC's costs. ISCC will provide EMCC with technical
services in the following areas: data processing, operations, planning
and development, communications, and research and development.
Currently, ISCC has seven employees. Such employees' duties are
generally limited to operational functions. ISCC currently provides
limited clearing agency services. Many of ISCC's functions are
performed by NSCC or by the International Depository & Clearing, L.L.C.
(``IDC''). IDC is a company equally owned by NSCC and The Depository
Trust Company, both registered clearing agencies. However, IDC is not
regulated in any manner. The Commission invites comments as to whether
ISCC has sufficient capacity to act as the facilities manager and
operate another clearing agency.
ISCC may use outside parties to fulfill its commitments to EMCC.
Specifically, NSCC through ISCC will provide EMCC with management and
administrative services in the following areas: financial, personnel,
corporate communications, marketing, regulatory or compliance, and
legal. The Securities Industry Automation Corporation (``SIAC''),
through ISCC and NSCC, also will provide EMCC with managerial,
clerical, and data processing services. In addition, ISCC will rely on
employees of IDC for product development, marketing and sales,
planning, participant services, and executive (i.e., decison making)
functions. The Commission asks for comment as to whether these service
arrangements are appropriate, and particularly whether it is
appropriate that an unregulated entity such as IDC perform the above
functions for a clearing agency.
In addition, as discussed above, EMCC has no independent capacity
to match trades. Instead, it relies on Match-EM and TRAX for such
services, neither of which is regulated in the U.S. EMCC has
represented that it has no contractual agreement with either GE (the
operator of Match-EM) or ISMA Ltd. (the operator of TRAX) that would
permit it to review their operational capabilities. Because the failure
of Match-EM or TRAX could result in EMCC being unable to fulfill its
clearance and settlement functions with respect to those trades which
either Match-EM or TRAX should have matched and reported to EMCC, the
Commission requests comment on whether the current arrangement is
consistent with EMCC's obligations to ensure that it has sufficient
operational capability. Specifically, the Commission believes that at a
minimum, EMCC should obtain sufficient information to be able to make a
determination that Match-EM and TRAX are operating in a manner that
ensures that they will be able to accurately match and to report trades
on a timely basis to EMCC. Furthermore, the Commission believes that it
should have access to the materials that EMCC has relied on to make
this determination. Comment is requested as to whether other conditions
should be applied.
4. Audit Committee and Internal Audit Department
The Standards Release stated that clearing agencies should have an
audit committee composed of nonmanagement directors. A nonmanagement
director is a director who is not associated with the clearing agency
other than in a user capacity or with any entity which furnishes
securities processing services to the clearing agency. The audit
committee should have responsibility for reviewing the work performed
by the clearing agency's independent public accountant.
EMCC's bylaws will provide that the board of directors may appoint
an audit committee consisting of three or more directors other than
officers of EMCC. The audit committee will have responsibility for
reviewing with the independent certified public accountants the scope
of their auditing procedures and the financial statements of EMCC to be
certified by the accountants. The Commission notes that EMCC's bylaws
do not prohibit the directors that are representatives of
[[Page 37100]]
NSCC, ISMA, and EMTA from serving on the audit committee. Comment is
requested as to whether the relationship and the services provided by
NSCC, ISMA, and EMTA are such that the individuals representing these
entities on EMCC's board should not serve on the audit committee.
The Standards Release stated that a clearing agency should have an
internal audit department which is adequately staffed with qualified
personnel. NSCC's internal audit department will perform EMCC's
internal auditing functions.
5. Securities, Funds, and Data Controls
The Standards Release provides that a clearing agency should have
off-site storage of up-to-date files, written procedures detailing
steps involved in handling funds and securities, and emergency
mechanisms for establishing and maintaining communications with
participants and other entities. In addition, clearing agencies should
have adequate insurance.
EMCC has represented that through its facilities manager, SIAC, it
has access to two computer sites in different locations, both of which
are capable of being operated independently and are capable of handling
total participant activity. Data received will be automatically written
to both sites. EMCC has provided a detailed written statement of
security measures that will be used to prevent unauthorized access to
EMCC's processing facilities. EMCC maintains blanket bond insurance and
all risk insurance.
D. Fair Representation
Section 17A(b)(3)(C) of the Exchange Act requires that the rules of
a clearing agency provide for fair representation of the clearing
agency's shareholders or members and participants in the selection of
the clearing agency's directors and administration of the clearing
agency's affairs. This section contemplates that users of a clearing
agency have a significant voice in the direction of the affairs of the
clearing agency.
1. Governance Procedures
EMCC's board will have a total of 21 directors, divided into four
classes. The first three classes will consist of five directors each
(``participant directors''). The fourth class will have six directors,
consisting of one director selected by EMTA, one director selected by
ISMA, two directors selected by NSCC, and two directors selected by the
EMCC board. The term of office of the participant directors will be
three years, with the term of one class of directors expiring each
year.\38\ Participant directors may not serve for more than six
consecutive years. The term of the fourth class will be one year.
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\38\ The term of the initial directors in class one will expire
in 1998, the term of the initial directors in class two will expire
in 1999, and the term of the initial directors in class three will
expire in 2000.
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Members may nominate individuals to serve as participant directors
by filing with EMCC's Secretary at least thirty days prior to the date
of the annual meeting a petition signed by the lesser of five percent
of the participants or ten participants.\39\ A nominating committee
selected by the board will also select individuals to serve as
participant directors. If any member files a petition for participant
director, EMCC's Secretary will mail ballots to all members. Members
will then be provided the opportunity to vote for participant
directors.\40\
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\39\ Only one director may be selected which is an officer of
any single participant or its affiliate.
\40\ Members will have three votes for each $1.00 of average
clearing fund deposits during the twelve month period ending on the
last day of the second month prior to the date of determination and
two votes for each $1.00 of the average monthly fee payable or paid
by the member to EMCC during the same twelve month period.
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2. Provision of Information to Participants
The Standards Release stated that participants should have
sufficient information concerning a clearing agency's affairs to
participate meaningfully in its administration. Clearing agencies
should furnish participants with audited annual financial statements,
an annual report on internal accounting control prepared by an
independent public accountant, and notices of any proposed rule
changes.
The Standards Release stated that the annual financial statements
should be provided within 60 days following the close of the clearing
agency's fiscal year prepared in accordance with generally accepted
accounting principles. EMCC's rules will provide that EMCC will
undertake to provide to all members audited financial statements and a
report prepared by independent public accountants within 60 days
following the close of its fiscal year. EMCC also will undertake to
provide unaudited financial statements to its members within 30 days
following the close of each of EMCC's fiscal quarters.
The Standards Release stated that the report on internal accounting
control should be based on a study and an evaluation which was made for
the purpose of reporting on the clearing agency's overall system of
internal accounting control. The report should disclose any material
weaknesses discovered and any corrective action taken or proposed to be
taken. The report should be furnished to all participants promptly
after it becomes available and no later than 60 days after the period
covered by the report. EMCC indicated in its Form CA-1 that it intends
to prepare an annual internal accounting control report. However, EMCC
does not provide that such report will be given to its participants.
As discussed in the Standards Release, the notice of proposed rule
changes should be provided to participants prior to or as soon as
possible after filing with the Commission and should provide a
description of the rule change, its purpose, and its effect. EMCC's
rules will provide that it will immediately notify all members and
registered clearing agencies of all proposals it has made to change,
revise, add, or repeal any rule, including a brief description of the
proposal, its purpose, and its effect.
E. Participant Standards
Section 17A(b)(3)(B) of the Exchange Act enumerates certain
categories of persons that a clearing agency's rules must authorize as
potentially eligible for access to clearing agency membership and
services.\41\ In addition, a clearing agency may accept specific
categories of persons other than those enumerated, but a clearing
agency should be cognizant of the impact that participation may have on
the safety of the clearing agency and should provide safeguards to
protect against that risk. Section 17A(b)(4)(B) of the Exchange Act
contemplates that a registered clearing agency have financial
responsibility, operational capability, experience, and competency
standards that are used to accept, deny, or condition participation of
any participants or any category of participants enumerated in Section
17A(b)(3)(B), but that these criteria may not be used to unfairly
discriminate among participants. In addition, the Exchange Act
recognizes that a clearing agency may discriminate among persons in the
admission to or the use of the clearing agency if such discrimination
is based on standards of financial responsibility, operational
capability, experience, and competence.
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\41\ The classes are registered brokers or dealers, registered
clearing agencies, registered investment companies, banks, and
insurance companies.
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1. Members
EMCC will provide services to those organizations, entities, or
persons that
[[Page 37101]]
qualify as members under EMCC's rules, that apply to EMCC to act for
them, whose applications are approved by EMCC, and that have
contributed to EMCC's clearing fund. A partnership, corporation,
limited liability company, or other organization, entity, or individual
will be qualified to become a member of EMCC if it satisfies at least
one of the following qualifications: (a) it is a broker or dealer
registered under the Exchange Act; (b) it is a broker or dealer
registered or regulated under the laws of the jurisdiction other than
the U.S. in which it is organized or established; (c) it is a bank or
trust company, including a trust company having limited power, which is
a member of the Federal Reserve System or is supervised and examined by
state or federal authorities in the U.S. having supervision and
examined by the banking regulator in the jurisdiction other than the
U.S. in which it is organized or established; or (e) if it does not
qualify under (a) through (d) but is the successor or assigns of any
member and has demonstrated to the board of directors that its business
and capabilities are such that it could use EMCC's services without
undue risk, then such successor or assigns may become a member for the
limited purpose of winding up its business with EMCC in an orderly
manner. Initially, only broker-dealers that are organized under the
laws of the U.K. will be eligible for admission under (b) above.
Comment is requested as to the advisability of admission of non-U.S.
participants and whether the proposed admission standards provide
sufficient protection to EMCC and the national clearance and settlement
system.
After the issuance of shares to persons which have contributed to
the development fund for the organization and initial operation of
EMCC,\42\ all applicants that EMCC accepts for membership will be
required to be either a shareholder of EMCC or an affiliate or
subsidiary of a shareholder of EMCC. EMCC may deny an application to
become a member or to use one or more services of EMCC upon a
determination by EMCC that EMCC does not have adequate personnel,
space, data processing capacity, or other operational capability at
such time to perform its services for the applicant or member without
impairing the ability of EMCC to provide services for its existing
members, to assure the prompt, accurate, and orderly processing and
settlement of securities transactions, or to otherwise carry out its
functions. However any such applications which are denied will be
approved as promptly as the capabilities of EMCC permit.
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\42\ See supra note 5.
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2. Financial Reports
All applicants for admission to EMCC will need to provide a copy of
the applicant's financial statements for the two fiscal years ending
immediately preceding the year in which application is made, certified
without qualification by the applicant's independent certified public
accountants. To the extent that such audited financial statements are
not prepared in accordance with U.S. generally accepted accounting
principles (``GAAP''), the applicant will be required to provide EMCC
with a discussion of the material variations of such accounting
principles from U.S. GAAP.
A U.S. broker-dealer applicant will need to provide copies of the
its Form X-17A-5 FOCUS Reports (``FOCUS Reports'') or Form G-405
Reports on Finances and Operations (``FOGS Reports'') for the last 24
months if a monthly filer or the last eight quarters if a quarterly
filer submitted to its designated examining authority and any
supplemental reports required to be filed with the Commission pursuant
to Exchange Act Rule 17a-11 \43\ or 17 C.F.R. Section 405.3. A bank
applicant will need to provide all quarterly financial statements
covered by the last audited financial statement plus all subsequent
quarterly financial statements. A U.S. bank applicant also will need to
provide copies of its three most recent Consolidated Reports of
Condition and Income (``Call Reports'') submitted to its appropriate
regulatory agency and, to the extent not contained within such Call
Reports or to the extent that the applicant does not have Call Reports,
information containing each of the applicant's capital levels and
ratios, as such levels and ratios are required to be provided to its
appropriate regulatory agency. A non-U.S. bank applicant also will need
to provide all material regulatory filings made with its primary
regulator in its home country over the prior two years. If the
applicant is a U.K. broker-dealer subject to regulation by the
Securities Futures Association (``SFA''), it will need to provide EMCC
with its SFA monthly reports and returns for the prior twenty-four
months and if necessary and feasible, financial statements prepared in
accordance with U.S. GAAP.
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\43\ 17 CFR 240.17a-11.
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If required by EMCC, an applicant will need to provide a
certificate of the chief executive or chief financial officer of the
applicant that no material adverse changes have occurred in the
financial condition of the applicant since the date of the most recent
financial statements, FOCUS Report, FOGS Report, Call Report, or
comparable reports to regulatory authorities, as applicable, filed with
EMCC; that the applicant has not guaranteed the obligations of any
other person; and that the applicant is not subject to any other
contingent liabilities, except as set forth in such financial
statements, FOCUS Report, FOGS Report, Call Report, comparable reports
to regulatory authorities, or the certificate.
3. Admission Criteria for Members
The board or the membership and risk committee of the board may
approve an application to become a member upon a determination that
such applicant meets the applicable admission criteria. The applicant
must have adequate personnel, physical facilities, books and records,
accounting systems, and internal procedures to enable it to
satisfactorily handle transactions and communicate with EMCC, to
fulfill anticipated commitments to and meet the operational
requirements of EMCC with necessary promptness and accuracy, and to
conform to any condition and requirement that EMCC reasonably deems
necessary for its protection or that of its members.
The applicant must have an established business history of a
minimum of three years or personnel with sufficient operational
background and experience to ensure, in the judgment of the board, the
ability of the firm to conduct its business. The applicant must agree
to make and have sufficient financial ability to make all anticipated
payments required to be made to EMCC. The applicant must be in
compliance with the capital requirements imposed by its designated
examining authority or appropriate regulatory agency, any other self-
regulatory organizations, and any other regulatory authority or self-
regulatory authority to which it is subject by statute, regulation, or
agreement. The applicant cannot be subject to an order of statutory
disqualification as defined in Section 3(a)(39) of the Exchange Act
\44\ or an order of similar effect issued by a federal or state banking
authority in the U.S. or any non-U.S. regulator.
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\44\ 15 U.S.C. 78c(a)(39).
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EMCC must have received no substantial information that would
reasonably and adversely reflect on the applicant or any associated
person to such an extent that the applicant should be denied membership
in EMCC. However, no application will be denied on such basis unless
the board has
[[Page 37102]]
reasonable grounds to believe that the applicant or any associated
person meets a disqualification criteria specified in EMCC's rules.\45\
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\45\ For example, disqualification criteria will include closer
than normal surveillance by the applicant's designated examining
authority or appropriate regulatory agency, violations of the
federal securities laws, convictions of any criminal offense
involving securities transactions, or any injunction against
engaging in securities transactions.
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In addition, if the applicant is a bank, it must have net worth as
of the end of the quarter prior to the effective date of its membership
determined in accordance with U.S. GAAP of at least $500 million.
However, an applicant bank may be accepted if it has a net worth of at
least $200 million if the membership and risk committee of EMCC's board
of directors makes a formal findings that will become part of EMCC's
books and records to the effect that other credit factors of the
applicant compensate for the lower net worth.\46\
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\46\ In making such determination, EMCC will consider the
applicant's return on average assets, capital to total assets ratio,
non-performing assets to total assets ratio, and liquid assets to
total assets ratio. EMCC also will consider the ratings assigned to
the applicant by a nationally recognized statistical rating
organization, any significant off balance sheet items, and the
applicant's risk management controls.
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If the applicant is a U.S. broker or dealer, its aggregate
indebtedness/excess net capital ratio must be less than 950% or its
excess net capital/aggregate debit items ratio must be in excess of
5.25% and its excess net capital must equal at least $100 million.
However, a U.S. broker-dealer applicant may have excess net capital of
at least $50 million if the membership and risk committee of EMCC's
board of directors makes a formal findings that will become part of
EMCC's books and records to the effect that other credit factors of the
applicant compensate for the lower excess net capital.\47\
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\47\ EMCC will consider any ratings assigned by a nationally
recognized statistical rating organization, any significant adverse
off-balance sheet items, and the applicant's significant business
lines as compared to its internal risk management controls and short
term funding arrangements.
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If the applicant is a U.K. broker or dealer, its financial
resources must be at least 120% of its financial resources requirement
and its excess financial resources must equal at least $100 million.
However, the applicant may have excess financial resources of at least
$50 million if the membership and risk committee of EMCC's board of
directors makes a formal finding that will become part of EMCC's books
and records to the effect that other credit factors of the applicant
compensate for the lower excess financial resources.\48\
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\48\ EMCC will consider any rating assigned by a nationally
recognized statistical rating organization, any significant adverse
off-balance sheet items, and the applicant's significant business
lines as compared to its internal risk management controls and short
term funding arrangements.
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If a U.S. broker applicant is applying to become an interdealer
broker member, it must have excess net capital of at least $10 million
and must agree to submit trading data to EMCC in such instruments as
requested by EMCC. EMCC will determine the interdealer broker's
potential margin calls, and the interdealer broker must demonstrate an
ability to meet such margin calls and loss allocation assessments. The
interdealer broker can demonstrate this ability by agreeing to submit
to EMCC only transactions with EMCC members on both sides and by
demonstrating a low error rate.\49\
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\49\ If an interdealer broker has a margin payment because one
of its contraparties fails to submit data on a trade prior to 8:00
a.m. ET on T+1, the contraparty must compensate the interdealer
broker for the cost of financing the payment obligation and may be
subject to fine by EMCC.
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During the first six months of EMCC's operations, EMCC will permit
an interdealer broker to become an EMCC member which does not meet the
$10 million excess net capital requirement if it meets an alternate
criterion. Such applicant must maintain a clearing relationship with an
EMCC member which is not an interdealer broker. Pursuant to the
clearing relationship, the clearing firm must take the place of the
interdealer broker on T+1 on all trades which do not have EMCC members
on both sides. The interdealer broker will have a fixed clearing fund
deposit in lieu of the required margin deposit. However, EMCC will
calculate each day for such interdealer broker a preliminary and final
required fund deposit excluding any positions that resulted from a
systems failure of a contraparty resulting in a failure to submit trade
data. If the required fund deposit exceeds the broker's fixed deposit,
EMCC will not guarantee any transactions to the broker until its
required fund deposit is equal to or lower than its fixed deposit.\50\
However, EMCC will guarantee completion of the interdealer broker's
trades to the original EMCC contraparties.\51\ In addition, if the
interdealer broker's required fund deposit exceeds its fixed deposit,
the interdealer broker will not be subject to assessment for loss
allocations \52\ and the interdealer broker will be charged a market
rate of interest on the difference between its required fund deposit
and its fixed deposit. EMCC will notify all dealer members whenever an
interdealer broker's required fund deposit exceeds its fixed deposit.
Comment is requested as to whether this alternative standard provides
sufficient protection to EMCC. Specifically, EMCC will be guaranteeing
trades to EMCC members in the event that an interdealer broker becomes
insolvent even though it will not have collected margin from the broker
to cover the loss. Furthermore, this provision does not set forth any
minimum excess net capital requirements for brokers to meet before
becoming EMCC members. Comment is requested as to whether such
provisions are consistent with a clearing agency's obligations to have
appropriate membership standards.
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\50\ The interdealer broker could lower its required fund
deposit by depositing additional funds with EMCC. If it does not
deposit additional funds, its required fund deposit will exceed its
fixed deposit until at least the end of the next month (because its
required fund deposit is based on the highest margin calculation
during the current month and the prior month).
\51\ Because EMCC is not guaranteeing trades to the broker, if a
dealer contraparty becomes insolvent, the broker is responsible for
completing the trade to its contraparty on the other side. As a
result, the nondefaulting EMCC dealer member does not receive the
benefit of EMCC's guarantee of brokered trades. If the broker is
unable to complete the trade, EMCC will then guarantee the broker's
trade to its EMCC member contraparty. However, the trade is treated
as a direct trade between the broker and its contraparty. Thus,
under the loss allocation rules, the dealer would be allocated a
greater portion of its loss than if the broker had not exceeded its
fixed deposit requirement.
\52\ Because EMCC is not guaranteeing trades to the interdealer
broker, there would be no loss from direct trades entered into with
the broker. Therefore, there would be no reason to assess the broker
for such loss.
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The foregoing financial responsibility standards are minimum
requirements, and the board may impose greater standards based upon the
level of the anticipated positions and obligations of an applicant, the
anticipated risk associated with the volume and types of transactions
an applicant proposes to process through EMCC, and the overall
financial condition of an applicant. If an applicant does not itself
satisfy the above minimum capital requirements, the board may include
for such purposes the capital of an affiliate of the applicant if the
affiliate has delivered to EMCC a guaranty, satisfactory in form and
substance to the board, of the obligations of the applicant to EMCC.
4. Membership Agreement
Each applicant to become a member of EMCC will be required to sign
a membership agreement pursuant to which the applicant agrees to abide
by the rules of EMCC. Under the agreement, the member's books and
records must at all times be open to inspection by EMCC, and EMCC must
be furnished with all such information in respect of the member's
business and
[[Page 37103]]
transactions as EMCC may require. However, upon ceasing to be a member,
EMCC cannot inspect such member's books and records or require
information relating to transactions that occurred after the time when
it ceased to be a member.
The member must agree to submit to the jurisdiction of the courts
of the state of New York and the U.S. District Court for the Southern
District of New York and to appoint a person acceptable to EMCC as its
agent to receive on its behalf service of process. Under the agreement,
membership in EMCC and use of EMCC's services is governed by the laws
of the state of New York. The member must agree that any judgment
obtained in an action or proceeding may be enforced in the courts of
any jurisdiction where the applicant or any of its property may be
found, and the applicant must irrevocably submit to the jurisdiction of
each such court in respect of any such action or proceeding. To the
fullest extent permitted by law, members must waive all immunity
whether on the basis of sovereignty or otherwise from jurisdiction,
attachment both before and after judgment, and execution to which it
might otherwise be entitled in any action or proceeding in any county
or jurisdiction relating in any way to the agreement or to any
transaction.
The membership agreement also provides EMCC with an additional
source of information for risk control purposes. Upon the request of
and at no charge to EMCC, members must provide research that they
provide to any of their customers relating to EMCC eligible instruments
and events or conditions which might affect the price of EMCC eligible
instruments.
F. Capacity To Enforce Rules
Section 17A(b)(3)(A) of the Exchange Act provides that a clearing
agency must be organized and have the capacity to enforce (subject to
any rule or order of the Commission pursuant to Section 17(d) or
19(g)(2) of the Exchange Act) compliance by its participants with the
rules of the clearing agency. In order to do so, a clearing agency must
have procedures for determining whether a participant is experiencing
financial or operational difficulties. Sections 17A(b)(3) (G) and (H)
require that the rules of a clearing agency provide that its
participants shall be appropriately disciplined for violations of any
provision of those rules and provide fair procedures for disciplining
participants, denying participation in the clearing agency to any
person, prohibiting or limiting access to the clearing agency's
services, and reviewing summary suspensions.
1. Financial Standards
EMCC's Rule 13 will authorize EMCC to examine the financial
responsibility and operational capability of any member or applicant to
become a member and to require a member to furnish EMCC with adequate
assurances of its financial responsibility and operational capability.
Pursuant to this rule, a member may be required to provide additional
assurances with respect to financial responsibility and operational
capability, including additional reporting by a member of its financial
or operational condition; increased clearing fund deposits by a member;
and other assurances as may be required by EMCC.
EMCC also will have general continuance standards that require a
member to promptly inform EMCC in the event that it no longer is in
compliance with any of the relevant standards for membership or any
materially adverse change. The board may require additional financial
reporting if the member no longer meets the standards for admission to
membership, it has violated any rule of EMCC, it fails to satisfy in a
timely manner any obligation to EMCC, there is a material change in
control or financial condition of such member, or the board determines
that it is necessary or advisable to protect EMCC, its other members,
or its creditors or investors, to safeguard securities and funds in the
custody or control of EMCC, or to promote the prompt and accurate
processing, clearance, or settlement of securities transactions. The
board must also make a determination as to whether the member should be
placed on surveillance status consistent with its rules.\53\
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\53\ See supra note 30.
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2. Ceasing to Act
Section 17A(b)(5)(C) provides that a clearing agency may summarily
suspend and close the accounts of a participant that has been and is
expelled or suspended from any self-regulatory organization; that is in
default of any delivery of funds or securities to the clearing agency;
or that is in such financial or operational difficulty that the
clearing agency determines and so notifies the appropriate regulatory
agency for such participant that such suspension and closing of
accounts are necessary for the protection of the clearing agency, its
participants, creditors, or investors.
Upon providing notice to the member, EMCC may at any time cease to
act for a member if the board of directors determines that adequate
cause exists to do so.\54\ EMCC may cease to act either with regard to
a particular transaction or with regard to transactions generally. EMCC
will promptly notify all members when it ceases to act for a member. A
member for which EMCC has ceased to act may request a hearing to review
EMCC's decision.
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\54\ Such cause may exist if one or more of certain factors are
found, including: the member has failed to perform any of its
obligations or has failed to make any required payment to EMCC; the
member is no longer in compliance with the admissions standards or
continuance standards; the board has reasonable grounds to believe
the member has been responsible for any fraudulent or dishonest
conduct or breach of fiduciary duty or has made any material
misstatement to EMCC in connection with its application to be a
member or any EMCC service; the board has reasonable grounds to
believe the member is in financial or operation difficulty; the
member is in breach of any requirement imposed by an appropriate
regulatory agency, self-regulatory organization, or any regulatory
body; the member is not paying its debts as they become due or is
otherwise involved in a bankruptcy proceeding; the member is
dissolved or ceases to carry on its business; the member contests
the validity of any agreement with EMCC; the member fails to perform
its contracts with EMCC; or the board has reasonable grounds to
believe that ceasing to act is necessary either for the protection
of EMCC or for any of the other members or to facilitate the orderly
and continuous performance of EMCC's services.
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If certain factors are present, EMCC will treat a member as
insolvent.\55\ EMCC will notify all members of the treatment of the
member as insolvent. Upon a determination of insolvency, EMCC will
immediately cease to act for such member. EMCC will delete all trades
of that member to which EMCC's guaranty has not attached except trades
that the board determines will promote an orderly market. EMCC will
then close out the guaranteed trades and the trades that the board has
accepted. EMCC will close out by buying in or selling out securities
deliverable by or to the insolvent. The close out procedure will be
completed by EMCC as promptly as practicable after EMCC has given
notice of the treatment of the member as insolvent.
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\55\ Such circumstances include: the member provides notice to
EMCC that it is insolvent; the board or any regulatory body
determines that the member is insolvent; a court order is entered
adjudging the member to be insolvent; the member files or consents
to the filing of a petition seeking bankruptcy relief; the member
makes a general assignment to its creditors; the member is
dissolved; or a resolution is passed by the member that it be wound
up, liquidated, or dissolved.
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3. Hearing Procedures
Section 17A(b)(5) of the Exchange Act provides that in any
proceeding to determine whether a participant should be denied
participation, prohibited or limited with respect to access to the
[[Page 37104]]
clearing agency's services, or disciplined, the clearing agency must
notify the participant of the specific grounds of the denial of
services or the changes brought against the member. The clearing agency
must provide the member with an opportunity to be heard on the grounds
of the denial or to defend against any charges. The clearing agency
must keep a record of the proceeding.
A member may request a hearing by filing with EMCC a written
request setting forth the contested action of EMCC. Within seven
business days after filing the request or three business days in the
case of summary action, the objecting member must provide EMCC with a
detailed written statement setting forth the contested action and the
basis for objection. EMCC will notify the member in writing of the date
and place of the hearing at least five business days prior to the
hearing.
The hearing will be before a panel drawn from participant directors
on the membership committee unless the contested action was taken by
the membership committee. In such a case, the panel will be drawn from
participant directors on the executive committee. The Committee will
select the members of the panel. The objecting member will have an
opportunity to be heard and may be represented by counsel. The panel
will make a decision within ten business days after conclusion of the
hearing. Although the panel's decision is considered final, the board
may overturn any decision adverse to the member.
G. Equitable Allocation of Dues, Fees, and Charges
Section 17A(b)(3)(D) of the Exchange Act requires that the rules of
the clearing agency provide for the equitable allocation of reasonable
dues, fees, and other charges among its participants. EMCC's proposed
fee schedule provides that it will charge $5 for input, $7.50 for late
instructions after 9:00 p.m. on T, $25 for late instructions after
11:00 a.m. on T+1, and $7.50 for net settlement.\56\
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\56\ The Commission understands that EMCC may adjust its fee
schedule soon after being registered (providing that the Commission
grants EMCC registration).
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H. Burden on Competition
Section 17A(b)(3)(I) of the Exchange Act requires that the rules of
a clearing agency not impose any burden on competition not necessary or
appropriate in furtherance of the purpose of the Exchange Act. As
discussed in Section III.A., EMCC will automatically receive data on
all trades of EMCC members that have been submitted to TRAX or Match-
EM. EMCC members do not have the ability to exclude trades from the
EMCC clearance system unless they confirm trades without using TRAX's
and Match-EM's automated confirmation system. Although EMCC's rules do
not require that EMCC members submit all of their eligible trades to
EMCC, as a practical matter EMCC members that want to obtain the
benefit of Match-EM or TRAX must settle at EMCC. The Commission is
concerned that this aspect of EMCC's operations could either force EMCC
members to settle all their eligible trades at EMCC or result in trades
being excluded from automated processing.\57\ In addition, EMCC's
arrangements with the locked-in trade sources could result in
inhibiting future clearing agencies from beginning operations. Comment
is requested as to whether this aspect of EMCC's operations is
consistent with the Exchange Act.
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\57\ To exclude trades from EMCC settlement, EMCC members would
be forced to use manual processes to confirm trades. Members may
want to exclude trades from EMCC's system for various reasons. For
example, if the trade would cause a member to exceed its overnight
exposure cap, it may want to process the trade through other means.
In addition, brokers may have agreed to only submit trades to EMCC
with EMCC members on both sides. Information on such trades would
then be generally unavailable which would reduce market
transparency.
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V. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing application by August 11, 1997. Such
written data, views, and arguments will be considered by the Commission
in deciding whether to grant Euroclear's request for exemption from
registration. 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. 600-30. Copies of the application and all
written comments will be 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.\58\
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\58\ 17 CFR 200.30-3(a)(16).
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Jonathan G. Katz,
Secretary.
[FR Doc. 97-17987 Filed 7-9-97; 8:45 am]
BILLING CODE 8010-01-M