[Federal Register Volume 62, Number 203 (Tuesday, October 21, 1997)]
[Notices]
[Pages 54663-54666]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-27818]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39241; File No. SR-DCC-97-06]


Self-Regulatory Organizations; Delta Clearing Corp.; Order 
Approving a Proposed Rule Change Relating to the Clearance and 
Settlement of Mortgage-Backed Securities Repurchase Agreements

October 14, 1997.
    On April 7, 1997, the Delta Clearing Corp. (``DCC'') filed with the 
Securities and Exchange Commission (``Commission'') the proposed rule 
change (File No. SR-DCC-97-06) pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'').\1\ On May 12, May 29, June 
18, and July 9, 1997, DCC amended the proposed rule change. Notice of 
the proposal was published in the Federal Register on July 30, 1997.\2\ 
No comment letters were received. For the reasons discussed below, the 
Commission is approving the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Securities Exchange Act Release No. 38868 (July 23, 1997), 
62 FR 40872.
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I. Description

    The proposal amends DCC's Procedures for the Clearing of Securities 
and Financial Instrument Transactions (``Procedures'') to allow DCC to 
clear and settle repurchase agreements and reverse repurchase 
agreements (``repos'') in which the underlying collateral is book-
entry, mortgage-based securities issued by the Federal National 
Mortgage Association (``FNMA'') or the Federal Home Loan Mortgage 
Corporation (``FHLMC''). Currently, DCC provides clearance and 
settlement services for repos in which the underlying collateral is a 
U.S. Treasury security.\3\
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    \3\ According to DCC, the market for repo transactions in 
mortgage-backed securities is estimated to be approximately 25% to 
40% of the size of of the market for repo transactions in Treasury 
securities. DCC also states that this estimate suggests that the 
outstanding notional size of the market is between $250 billion to 
$400 billion with daily turnover at 10% of the notional size. For a 
description of DCC's procedures regarding the clearance and 
settlement of repos on Treasury securities, refer to Securities 
Exchange Act Release No. 36367 (October 13, 1997), 60 FR 54095 [File 
No. SR-DGOC-94-06] (order approving implementation of new procedures 
allowing for the clearance and settlement of repos on Treasury 
Securities).
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A. Definition of Mortgage-Backed Security

    Under the rule change, a mortgage-backed security \4\ is defined as 
a book-entry security which is directly issued by FNMA or FHLMC and 
whose underlying value is represented by a pool of mortgages 
accumulated by FNMA or FHLMC through its mortgage origination program 
and which is designed to receive principal payments using a 
predetermined principal balance schedule. In addition, the following 
securities are excluded from the definition of mortgage-backed 
securities: (i) Securities which are issued in registered or bearer 
form and therefore cannot be transferred through the Board of Governors 
of the Federal Reserve System's FedWire communication system, (ii) 
securities which are not issued or guaranteed directly by FNMA or 
FHLMC, (iii) securities for which the underlying assets are mortgage-
backed securities rather than a pool of mortgages, and (iv) notional, 
interest only, principal only, accrual, and partial accrual securities 
and floaters and inverse floaters.\5\
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    \4\ The Procedures refer to mortgage-backed securities as 
``mortgage securities.''
    \5\ For the definitions of these terms, refer to Schedule A of 
DCC's filing which is attached as Exhibit A.
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    A mortgage-backed security may be either a fixed rate mortgage-
backed security or an adjustable rate mortgage-backed security. A fixed 
rate mortgage-backed security is defined as a mortgage-backed security 
whose coupon rate is a fixed rate of interest. An adjustable rate 
mortgage-based security (``ARMS'') is defined as a mortgage-backed 
security whose coupon rate is a variable rate of interest consisting of 
an index and a spread to such index and whose underlying collateral 
consists of adjustable rate mortgages with indices and spreads that 
parallel those of the ARMS.\6\
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    \6\ Sample indices include: (1) The CD rate, which is the weekly 
average of secondary market interest rates on six month negotiable 
certificates of deposit as published by the Federal Reserve Board in 
its Statistical Release H. 15 (519), Selected Interest Rates; (ii) 
the LIBOR rate, which is a rate which banks charge others banks for 
U.S. dollar deposits outside the United States for a specified 
period; (iii) the 11th District cost of funds index, which is the 
index made available monthly by the Federal Home Loan Bank Board of 
the cost of funds to members of the Federal Home Loan Bank 11th 
District; and (iv) the Treasury index, which is the weekly average 
yield of the benchmark Treasury securities as published by the 
Federal Reserve Bank. A sample ARMS could bear interest at LIBOR 
plus 50 basis points with LIBOR adjusting periodically as specified 
by the terms of the security.
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B. The Clearing Process

    Mortgage-backed securities repo transactions involve two settlement 
dates. The first settlement date (``on-date'') is the date on which one 
participant (``selling participant'') delivers participant'') in 
exchange for the delivery of cash (``delivery money'') by the 
purchasing participants to the selling participant. The second 
settlement date (``off-date'') is the date on which the purchasing 
participant returns to the selling participant the mortgage-backed 
securities delivered on the on-date in exchange for the return by the 
selling participant of the delivery money together with interest based 
upon a rate agreed to by the participants (``repo rate''). DCC 
generally clears both the on-date and off-date portion of a repo 
transaction. However, there may be certain repo transactions where DCC 
clears only the off-date portion of the transaction.\7\
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    \7\ These transactions are referred to the Procedures as novated 
repos. Securities Exchange Act Release No. 39065 (September 12, 
1997), 62 FR 49547 [File No. SR-DCC-97-03] (order approving proposed 
rule change).
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1. Execution and Reporting of Trades
    Mortgage-backed securities repo transactions to be cleared by DCC 
may be entered into directly between the two participants to a 
transaction and reported to DCC by the participants, or they may be 
entered into between two participants through the facilities of an 
authorized broker and reported to DCC by the authorized broker. The 
terms of the mortgage-backed securities repo transactions will be 
agreed to by the participants prior to the submission of

[[Page 54664]]

trade reports to DCC.\8\ There is an existing practice among mortgage-
backed security traders in which the parties to a transaction may agree 
to a trade amount subject to the right of the delivering party to 
adjust the amount of the trade by over-delivering mortgage-backed 
security collateral within a specified percentage of the amount 
initially agreed to by the parties (i.e., variance). DCC requires that 
such adjustments be made prior to the submission of trade reports to 
DCC and be reflected in the trade reports submitted to DCC.
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    \8\ The trade reports for each mortgage-backed securities repo 
transaction must set forth the identity of the parties to the 
transaction, including which party is the selling participant and 
which party is the purchasing participant; the CUSIP number or 
numbers for the mortgage-backed securities being delivered in 
connection with the repo transaction; the par amount of the 
securities being delivered; the delivery money being delivered by 
the purchasing participant; the trade date and time; the on-date and 
off-date for the transaction; and any details relating to any rights 
of substitution, including the number of rights of substitution to 
be permitted and any restrictions on rights of substitution.
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    Mortgage-backed securities repo transactions with an on-date later 
than the trade date will need to be reported to DCC prior to 6:00 p.m. 
on the trade date. Mortgage-backed securities repo transactions with an 
on-date on the trade date will need to be reported to DCC: (i) Within 
one-half hour after the transaction occurs if the transaction occurs 
prior to 1:30 p.m.; (ii) within five minutes after the transaction 
occurs if the transaction occurs between 1:30 p.m. and 2:15 p.m.; and 
(iii) as soon as possible but in no event later than five minutes after 
the transaction if the transaction occurs after 2:15 p.m.
    With respect to mortgage-backed securities repo transactions 
entered into directly between two participants, each participant will 
forward a trade report to DCC. If DCC does not receive a trade report 
from one of the participants to the transaction, DCC will contact that 
participant within one half-hour of receipt of the trade report to 
confirm the terms of the trade reported by the other participant. When 
DCC receives trade reports from both participants, it will match the 
two trade reports. In order for a transaction to be accepted for 
clearance, the details of the trade reports for the transaction must 
agree. If the details of the trade reports do not match, DCC will 
contact the parties regarding the transaction. Matching of mortgage-
backed securities repo transactions will be done continuously 
throughout the day and at the close of each trading day at 2:30 p.m. 
All trade reports received through an authorized broker will be 
confirmed by DCC either orally or via facsimile with the participants 
to the transaction.
2. Acceptance of Trades
    DCC will be deemed to have accepted a transaction for clearance 
when DCC has matched and verified all the information on the trade 
reports. However, DCC may reject any transaction if it causes a 
participant to exceed its exposure limit \9\ of if the participant has 
been suspended from DCC's clearing system. If a transaction is accepted 
by DCC, DCC will interpose itself as the counterparty to both sides of 
the transaction. Therefore, for any mortgage-backed securities repo 
transactions, DCC will assume the position of the purchasing 
participant with respect to the selling participant and assume the 
position of the selling participant with respect to the purchasing 
participant. Prior to 8:00 a.m. each business day, participants will 
receive a written activity report indicating such participant's 
transactions which were accepted by DCC the previous business day and 
indicating all transactions due to settle that day.
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    \9\ A participant's exposure limit is the limit prescribed for 
each participant by DCC based on the incremental margin due to DCC 
by the participant.
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3. Clearing and Failures to Deliver or Receive
    The details of each transaction accepted by DCC will be sent to 
DCC's clearing bank. Each participant will need to maintain a bank 
account in one or more correspondent banks for margin and trade 
settlements. Because the mortgage-backed securities which DCC proposes 
to clear repos must be maintained in book-entry accounts at Federal 
Reserve Banks and will be delivered through the FedWire, the selected 
correspondent bank must be a depository institution with access to the 
FedWire.
    DCC has established delivery cut-off times. For example, the 
selling participant on the on-date of a mortgage-backed securities repo 
transactions and the purchasing participant on the off-date of a 
mortgage-backed securities repo transaction must deliver mortgage-
backed securities to the clearing bank against payment no later than 
one minute prior to the close of the FedWire system for delivery of 
securities on the settlement date. The clearing bank will redeliver 
such securities to the purchasing participant on the on-date or the 
selling participant on the off-date.
    If the delivering participant fails to deliver mortgage-backed 
securities on the settlement date by one minute prior to the close of 
the FedWire system or the receiving participant does not accept all of 
the mortgage-backed securities on the settlement date by one half-hour 
after the close of the FedWire system, DCC has the option to buy-in or 
sell-out the securities with the cost of buy-in or sell-out being 
charged to the defaulting participant. If DCC effects a buy-in or sell-
out, DCC will give the defaulting participant written notice of the 
buy-in or sell-out which will describe the security, quantity, and 
price.
4. Netting
    As a general rule, repo transactions in mortgage-backed securities 
will be cleared on a delivery versus payment basis. Therefore, the 
delivery of mortgage-backed securities will be required on settlement 
date. However, if a participant has a repo and reverse repo agreement 
with the same underlying collateral and the same on-date or off-date, 
as applicable, the participant's payment and delivery obligations with 
respect to such agreements will be netted. Payment obligations for such 
transactions including repo interest will also be netted.
    Section 2207 of DCC's Procedures requires the purchasing 
participant to forward coupon interest with respect to U.S. Treasury 
securities or mortgage-backed securities to DCC absent an agreement of 
the parties to the contrary, and upon receipt, DCC will forward the 
coupon interest to the selling participant. In the event that repo 
interest on a repo transaction is due from the selling participant on 
the same day that coupon interest with respect to the same transaction 
is required to be paid by the purchasing participant, such payments 
will be netted. If repo interest has accrued but is not yet due with 
respect to a transaction, payments of coupon interest which are 
received by the purchasing participant will not be netted against repo 
interest; instead, the coupon interest will be forwarded to DCC and 
then to the selling participant.
    Unlike U.S. Treasury securities, mortgage-backed securities involve 
principal payments as well as payments of coupon interest. DCC's 
Procedures provide that principal payments, like coupon payments, will 
be forwarded by the purchasing participant upon receipt to DCC and then 
forward by DCC to the selling participant. In the event that a 
principal payment on a mortgage-backed security is received by the 
purchasing participant on the same date on which a payment of repo 
interest is due from the selling participant with respect to a repo 
transaction on such mortgage-backed security, the principal

[[Page 54665]]

payment and the repo interest payments will be netted.

C. Margin

    DCC has adapted its existing margining methodology for U.S. 
Treasury security repos to incorporate exposures from mortgage-backed 
securities repo transactions. Under DCC's current margin 
system,10 every participant is obligated to maintain a 
margin account for the benefit of DCC at DCC's clearing bank. Margin 
will be calculated every business day using a generally available 
source of mortgage-backed security prices. With respect to term repos, 
margin will be based on a mark-to-market amount and an amount based on 
an estimated shortfall from the liquidation of positions on the next 
day. For overnight repos, margin will be based on an intraday mark-to-
market amount.
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    \10\ Section 2201 of DCC's Procedures.
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D. Exposure Limits and MPSE for Mortgage-Backed Securities

    The definition of maximum potential system exposure (``MPSE'') is 
revised to provide that with respect to positions in repo transactions, 
the MPSE for the DCC's clearance and settlement system shall include 
net exposure in mortgage-backed securities adjusted to reflect a 
hypothetical adverse movement in the aggregate of six standard 
deviations in market prices of mortgage-backed securities.11 
The standard deviation is based upon the volatility represented by the 
greatest of the following three amounts: (i) The standard deviation of 
equivalent U.S. Treasury securities for the period of 100 consecutive 
trading days ending on February 19, 1980, (ii) the standard deviation 
of equivalent U.S. Treasury securities for any subsequent period of 100 
consecutive trading days, and (iii) the standard deviation of mortgage-
backed securities during any period of 100 consecutive trading days 
subsequent to January 1, 1990.12
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    \11\ The MPSE is designed to limit the amount of liability that 
DCC is exposed to from the positions of all of its participants. 
Pursuant to DCC's rules, MPSE cannot exceed one third of the amount 
of DCC's credit enhancement facility. For a complete discussion of 
MPSE, refer to Securities Exchange Act Release No. 38646 (May 15, 
1997), 62 FR 28085 (order granting approval of proposed rule change 
relating to definitions of trading limits and MPSE).
    \12\ For U.S. Treasury securities, the standard deviation is 
based upon the volatility during the 100 day period ending February 
19, 1980, or any subsequent period of 100 days in which volatility 
was higher than the 100 day period ending February 19, 1980.
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    For purposes of clauses (i) and (ii) above, DCC will look to U.S. 
Treasury securities which are generally accepted equivalents to the 
applicable mortgage-backed securities. For example, DCC will to treat 
repo transaction in mortgage-backed securities where the underlying 
collateral are FNMA and FHLMC securities with original stated 
maturities of thirty years as equivalent to ten year U.S. Treasury 
securities. When the underlying collateral are FNMA and FHLMC 
securities with original stated maturities of fifteen years, DCC will 
treat these repo transactions as equivalent to five year U.S. Treasury 
securities. Finally, DCC will treat repo transaction in ARMS as 
equivalent to one year U.S. Treasury securities.13
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    \13\ Letter from Stephen K. Lynner, President, DCC (July 16, 
1997).
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E. Substitution of Mortgage-Backed Securities as Underlying Collateral

    The proposed rule change establishes rights of substitution for 
both repos on U.S. Treasury securities and for mortgage-backed 
securities. The right of a selling participant to substitute underlying 
collateral is subject to various conditions and restrictions. For repo 
transactions in U.S. Treasury securities, the following requirements 
apply: (i) A Treasury note or a Treasury bond may be substituted for 
another Treasury note or Treasury bond; (ii) a Treasury bill may be 
substituted for a Treasury bill; and (iii) a Treasury note or Treasury 
bond may not be substituted for a Treasury bill, and a Treasury bill 
may not be substituted for a Treasury note or Treasury bond. For 
mortgage-backed securities repo transactions, the following 
requirements apply: a fixed rate mortgage-backed security may be 
substituted for a fixed or floating rate mortgage-backed security, but 
a floating rate mortgage-backed security may only be substituted for a 
floating rate mortgage-backed security.
    In addition to the foregoing requirements, substitution is subject 
to any restrictions on substitution which have been agreed to by the 
parties at the time of the trade, including restrictions on the number 
of rights of substitution. The right of substitution is also subject to 
the agreement of DCC and the purchasing participant that the fair 
market value of the collateral which the selling participant proposes 
to provide in place of the existing underlying collateral for a 
transaction is at least equal to the fair market value of the existing 
underlying collateral for such transaction. In order to obtain the 
consent of the purchasing participant, DCC will notify the purchasing 
participant of all details of the proposed substitution prior to 12:15 
p.m. New York time on the day of the proposed substitution.

II. Discussion

    Section 17A(b)(3)(F) of the Act and the rules and regulations 
thereunder require that the rules of a clearing agency be designed to 
promote the prompt and accurate clearance and settlement of securities 
transactions and to remove impediments to and perfect the mechanism of 
a national system for the prompt and accurate clearance and settlement 
of securities transactions. The Commission believes that DCC's proposed 
clearance system will assist in the development of the national 
clearance and settlement system by providing a clearance mechanism for 
transactions that are currently settled outside the facilities of a 
registered clearing agency. These trades may benefit from DCC's 
margining and other risk reduction procedures which should decrease the 
likelihood of failure to settle. Furthermore, the number of securities 
movements may be reduced because of DCC's netting of transactions. This 
should result in increased efficiency and promote the prompt and 
accurate clearance and settlement of mortgage-backed repo transactions. 
The Commission therefore believes that the proposed rule change is 
consistent with the Act.
    Because of the novelty and complexity of clearing repos on U.S. 
Treasury securities, the Commission initially limited the average 
principal amount of outstanding repos on U.S. Treasury securities in 
DCC's system over a ten day moving period to $45 billion.\14\ With this 
limitation, the Commission found that DCC has the capacity to 
facilitate the prompt and accurate clearance and settlement of repo 
transactions in U.S. Treasury securities in a safe and sound manner. 
Since the Commission's approval, DCC has implemented several 
enhancements to its clearance and settlement procedures.\15\ 
Nevertheless, the Commission believes that due to the novelty and 
complexity of mortgage-backed repo transactions that, initially, the 
average principal amount of outstanding repos and reverse repos in 
mortgage-backed securities in DCC's system over a ten day moving period 
may reach but not exceed $45 billion. If, as the volume of DCC's 
clearance and settlement of mortgage-backed repo transactions nears $45 
billion, DCC desires to exceed the $45 billion limitation, it must file 
a proposed a rule

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change pursuant to Section 19(b)(2) of the Act. The proposed rule 
change may request either an increase in the volume limitation or 
removal of all volume limitations.
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    \14\ See supra note 4.
    \15\ See Letter from Stephen K. Lynner, President, DCC 
(September 15, 1997).
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III. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposal is consistent with the requirements of the Act and in 
particular with the requirements of Section 17A of the Act and the 
rules and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-DCC-97-06) be and hereby is 
approved.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.

Exhibit A--Schedule A to Delta Clearing Corp; Procedures for the 
Clearing of Securities and Financial Instrument Transactions

Excluded Classes of Mortgage Securities

    Notional--A class having no principal balance and bearing interest 
on the related notional principal balance.
    Interest Only--A class that receives some or all of the interest 
payments made on the underlying mortgage or other assets of a series 
trust and little or no principal. Interest only classes have either a 
nominal or a notional principal balance.
    Principal Only--A class that does not bear interest and is entitled 
to receive only payments of principal.
    Accrual--A class that accretes the amount of accrued interest 
otherwise distributable on such class, which amount will be added as 
principal to the principal balance of such class on each applicable 
distribution date. Such accretion may continue until some specified 
event has occurred or until such accrual class is retired.
    Partial Accrual--A class that accretes a portion of the amount of 
accrued interest thereon, which amount will be added to the principal 
balance of such class on each applicable distribution date, with the 
remainder of such accrued interest to be distributed currently as 
interest on such class. Such accretion may continue until a specified 
event has occurred or until such partial accrual class is retired.
    Floater--A class other than an adjustable rate mortgage security 
with an interest rate that resets periodically based upon a designated 
index and that varies directly with changes in such index.
    Inverse Floater--A class other than an adjustable rate mortgage 
security with an interest rate that resets periodically based upon a 
designated index and that varies inversely with changes in such index.

[FR Doc. 97-27818 Filed 10-20-97; 8:45 am]
BILLING CODE 8010-01-M