[Federal Register Volume 63, Number 212 (Tuesday, November 3, 1998)]
[Rules and Regulations]
[Pages 59362-59434]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-29007]


      

[[Page 59361]]

_______________________________________________________________________

Part II





Securities and Exchange Commission





_______________________________________________________________________



17 CFR Parts 200, 240, and 249



OTC Derivatives Dealers; Final Rule

  Federal Register / Vol. 63, No. 212 / Tuesday, November 3, 1998 / 
Rules and Regulations  

[[Page 59362]]



SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 200, 240, 249

[Release No. 34-40594; File No. S7-30-97]
RIN 3235-AH16


OTC Derivatives Dealers

AGENCY: Securities and Exchange Commission.
ACTION: Final rule.

-----------------------------------------------------------------------

SUMMARY: The Securities and Exchange Commission is adopting rules and 
rule amendments under the Securities Exchange Act of 1934 that tailor 
capital, margin, and other broker-dealer regulatory requirements to a 
class of registered dealers, called OTC derivatives dealers, that are 
active in over-the-counter derivatives markets. Registration as an OTC 
derivatives dealer under these rules is optional and is an alternative 
to registration as a broker-dealer under the traditional broker-dealer 
regulatory structure. It is available only to entities that engage in 
dealer activities in eligible over-the-counter derivative instruments 
and that meet certain financial responsibility and other requirements.
EFFECTIVE DATE: The rules and rule amendments shall become effective on 
January 4, 1999.
FOR FURTHER INFORMATION CONTACT:

General

    Catherine McGuire, Chief Counsel, Patrice M. Gliniecki, Special 
Counsel, or Laura S. Pruitt, Special Counsel, at (202) 942-0073, 
Division of Market Regulation, Securities and Exchange Commission, 450 
Fifth Street, NW, Mail Stop 10-1, Washington, DC 20549.

Financial Responsibility and Books and Records

    Michael Macchiaroli, Associate Director, at (202) 942-0132, Thomas 
K. McGowan, Assistant Director, at (202) 942-0177, Christopher Salter, 
Attorney, at (202) 942-0148, Victoria Pawelski, Attorney, at (202) 942-
4169, Matt Hughey, Accountant, at (202) 942-0143, or Gary Gregson, 
Statistician, at (202) 942-4156, Division of Market Regulation, 
Securities and Exchange Commission, 450 Fifth Street, NW, Mail Stop 10-
1, Washington, DC 20549.
SUPPLEMENTARY INFORMATION:

Table of Contents

I. Executive Summary
    A. Introduction
    B. The Proposing Release
    C. Final Rules and Rule Amendments
    1. General
    2. Scope of Permissible Securities Activities
    a. Eligible OTC Derivative Instruments
    b. Cash Management Securities Activities
    c. Ancillary Portfolio Management Securities Activities
    3. Intermediation of Securities Transactions
    4. Exemptions for OTC Derivatives Dealers
    a. Exemption from SRO Membership
    b. Exemption from Certain Margin Requirements
    c. Exemption from SIPA
    5. Section 11(a) of the Exchange Act
    6. Net Capital Requirements
    7. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
    8. Recordkeeping and Reporting
II. Discussion: New Rules and Amended Rules
    A. Definitions
    1. Rule 3b-12; Definition of OTC Derivatives Dealer
    2. Rule 3b-13; Definition of Eligible OTC Derivative Instrument
    3. Proposed Rule 3b-14; Definition of Permissible Derivatives 
Counterparty
    4. Proposed Rule 3b-16; Definition of Hybrid Security
    5. Rules 3b-14 and 3b-15; Definitions of Cash Management
    Securities Activities and Ancillary Portfolio Management
    Securities Activities
    a. Rule 3b-14; Cash Management Securities Activities
    i. Counterparty Collateral
    ii. Cash Management
    iii. Financing
    b. Rule 3b-15; Ancillary Portfolio Management Securities 
Activities
    i. Hedging
    ii. Arbitrage
    iii. Trading
    iv. Documentation of Activities
    B. Amendment to Rule 15b1-1; Registration with the Commission
    C. Rule 15a-1; Securities Activities of OTC Derivatives Dealers
    1. Scope of Permissible Securities Activities
    2. Commission Orders Regarding OTC Derivatives Dealers' 
Activities
    3. Intermediation of Securities Transactions
    4. Communications Regarding Securities Transactions
    5. Confirmation of Securities Transactions
    6. Position Limits
    D. Exemptions for OTC Derivatives Dealers
    1. Rule 15b9-2; Exemption from SRO Membership
    2. Rule 36a1-1; Exemption from Certain Margin Requirements
    3. Rule 36a1-2; Exemption from SIPA
    E. Rule 11a1-6; Transactions for Certain Accounts of OTC 
Derivatives Dealers
    F. Net Capital Requirements for OTC Derivatives Dealers
    1. Overview of Amendments to Rule 15c3-1
    2. Reasons for Allowing OTC Derivatives Dealers to Use Value-at-
Risk Models
    3. Discussion of Net Capital Requirements
    a. Rule 15c3-1(a)(5)
    b. Appendix F
    i. Application Requirement
    ii. Market Risk
    iii. Credit Risk
    iv. Qualitative Requirements for Value-at-Risk Models
    v. Quantitative Requirements for Value-at-Risk Models
    G. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
    H. Recordkeeping and Reporting
    1. Amendments to Rules 17a-3 and 17a-4; Books and Records to be 
Maintained by OTC Derivatives Dealers
    2. Amendments to Rule 17a-11; Notification Requirements
    3. Rule 15c3-4; Internal Risk Management Control Systems for OTC 
Derivatives Dealers
    4. Rule 17a-12; Reports to be Made by OTC Derivatives Dealers
    5. Amendments to Form X-17A-5
III. Costs and Benefits of the Rules and Rule Amendments
    A. Comments and Survey
    B. Benefits
    1. Regulatory Capital Effects
    2. Operational Cost Savings
    3. Decreased Margin Requirements
    C. Costs
    1. Costs of Combining Activities into One Operation
    2. Registration as an OTC Derivatives Dealer
    3. Risk Management Adjustments
    4. Books and Records Requirements
    5. Regulatory Reporting
    6. Regulation U Margin Requirements
    D. Conclusion
IV. Efficiency, Competition, and Capital Formation
V. Summary of Final Regulatory Flexibility Analysis
    A. Need for the Rules and Rule Amendments
    B. Small Entities Subject to the Rules
    C. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    D. Alternatives to Minimize Effect on Small Entities
VI. Paperwork Reduction Act
VII. Statutory Authority
Text of Rules and Rule Amendments

I. Executive Summary

A. Introduction

    Over-the-counter (``OTC'') derivative instruments are important 
financial management tools employed by many corporations, financial 
institutions, governmental entities, and other end-users. Participants 
in the OTC derivatives markets engage in transactions involving a wide 
range of instruments in order to effectively manage risks associated 
with their business activities or their financial assets.
    Whether OTC derivatives transactions are structured as interest 
rate swaps, cross currency swaps, equity swaps, basis swaps, total 
return swaps, asset swaps, credit swaps, or options, they share certain 
characteristics.\1\ For

[[Page 59363]]

example, each has a value or return related to the value or return of 
an underlying asset. Asset classes can consist of securities or 
virtually any other financial instrument, financial measure, or 
physical commodity, such as interest rates, securities indices, foreign 
currencies, metals or energy products, or spreads between the values of 
different assets. More importantly, each of these instruments can 
provide users with a carefully tailored method for managing a variety 
of risks.\2\
---------------------------------------------------------------------------

    \1\ Swaps are contracts that typically allow the parties to the 
contract to exchange cash flows related to the value or performance 
of certain assets, rates, or indices for a specified period of time. 
See generally Peter A. Abken, Beyond Plain Vanilla: A Taxonomy of 
Swaps, Financial Derivatives Reader (Robert W. Kolb, ed.) (1992). 
Most swaps are based on currencies or interest rates. Swaps that 
provide for an exchange of values based on the value or performance 
of equity securities make up a small, but growing, share of the 
swaps market. Options are instruments that generally provide the 
holder, in exchange for the payment of a premium, with benefits of 
favorable movements in the underlying asset or index with limited or 
no exposure to losses from unfavorable price movements. Typically, 
OTC options provide for cash settlement, rather than the delivery of 
the underlying asset. Credit derivatives function like contingent 
options to the extent payments under the contract are triggered by 
the occurrence of a credit event, such as a decline in an issuer's 
credit rating or default in performance under a debt obligation.
    \2\ See, e.g., Clifford W. Smith, Jr., Charles W. Smithson, and 
D. Sykes Wilford, Managing Financial Risk, Financial Derivatives 
Reader (Robert W. Kolb, ed.) (1992); Group of Thirty, Derivatives: 
Practices and Principles (July 1993), Financial Derivatives: Actions 
Needed to Protect the Financial System, United States General 
Accounting Office Report (May 1994).
---------------------------------------------------------------------------

    OTC derivative instruments, for example, can be used by 
corporations and local governments to lower funding costs, or by 
multinational corporations to manage risk associated with fluctuating 
exchange rates. They can also be used by portfolio managers to manage 
volatility in investment portfolios or to obtain exposure to different 
assets without taking a position in the cash markets. Because of the 
benefits these instruments offer, the derivatives markets have grown 
significantly over the past two decades.\3\
---------------------------------------------------------------------------

    \3\ The International Swaps and Derivatives Association 
(``ISDA'') estimates that, as of December 31, 1996, the combined 
notional amount of globally outstanding interest rate swaps, 
currency swaps, and interest rate options has grown to over $29 
trillion. See ``ISDA Market Survey,'' ISDA Internet web site (http:/
/www.isda.org).
---------------------------------------------------------------------------

    The traditional broker-dealer regulatory structure under the 
Securities Exchange Act of 1934 (``Exchange Act),\4\ however, has not 
permitted a firm to operate a competitive OTC derivatives business in 
the United States that involves the broad range of OTC derivative 
instruments currently available to participants in these markets. While 
some of these OTC derivative instruments are securities, others are 
not. OTC options on equity securities or on U.S. government securities, 
for example, are securities within the meaning of section 3(a)(10) of 
the Exchange Act.\5\ Firms that effect transactions in these or other 
OTC derivative instruments that are securities in the United States are 
required to register as broker-dealers under section 15(b) of the 
Exchange Act \6\ and fulfill all requirements applicable to other 
securities broker-dealers, including Exchange Act rules governing 
margin and capital.
---------------------------------------------------------------------------

    \4\ 15 U.S.C. 78a et seq.
    \5\ 15 U.S.C. 78c(a)(10)
    \6\ 15 U.S.C. 78o(b).
---------------------------------------------------------------------------

    Traditional U.S. broker-dealer regulation seems particularly 
restrictive when contrasted with OTC derivatives activities that are 
conducted outside of the broker-dealer regulatory regime. Firms located 
off-shore can often structure their securities activities in a manner 
that will avoid or lessen the regulatory burdens imposed on broker-
dealers under U.S. law. For example, off-shore firms can often avoid 
registering as broker-dealers in the United States if they engage in 
securities transactions only with non-U.S. persons, or if they comply 
with the requirements of Rule 15a-6 under the Exchange Act.\7\
---------------------------------------------------------------------------

    \7\ 17 CFR 240.15a-6.
---------------------------------------------------------------------------

    Similarly, because U.S. banks are excluded from the Exchange Act 
definitions of ``broker'' and ``dealer,'' \8\ they are not subject to 
U.S. broker-dealer regulation. They, therefore, may engage in a broad 
range of OTC derivatives activities in accordance with guidance issued 
by their appropriate banking regulators.\9\ In addition, firms that 
effect transactions only in OTC derivative instruments that are not 
securities are not subject to U.S. broker-dealer regulation.
---------------------------------------------------------------------------

    \8\ See Section 3(a)(4) of the Exchange Act (15 U.S.C. 
78c(a)(4)) (defining broker) and Section 3(a)(5) of the Exchange Act 
(15 U.S.C. 78c(a)(5)) (defining dealer). The exclusion for banks 
from the definitions of ``broker'' and ``dealer'' under the Exchange 
Act is available only to those banking institutions that satisfy the 
definition of ``bank'' set forth in Section 3(a)(6) of the Exchange 
Act (15 U.S.C. 78c(a)(6)).
    \9\ Banking regulators have issued guidance to banks engaging in 
derivatives activities. See e.g., Federal Financial Institutions 
Examination Council, Supervisory Policy Statement on Investment 
Securities and End-User Derivatives Activities, 63 FR 20191 (Apr. 
23, 1998); Federal Reserve Board, Trading and Capital-Markets 
Activities Manual (1998) (including discussions of various 
derivative instruments, such as credit derivatives); Federal Reserve 
SR Letter 97-21, Risk Management and Capital Adequacy of Exposures 
Arising from Secondary Market Credit Activities (July 11, 1997); 
Federal Reserve SR Letter 97-18, Application of Market Risk Capital 
Requirements to Credit Derivatives (June 13, 1997); FDIC FIL 62-96, 
Supervisory Guidance for Credit Derivatives (Aug. 19, 1996); Federal 
Reserve SR Letter 96-17, Supervisory Guidance for Credit Derivatives 
(Aug. 12, 1996); OCC Bulletin 96-43, Credit Derivatives (Aug. 12 
1996); OCC Bulletin 96-25, Fiduciary Risk Management of Derivatives 
and Mortgage-Backed Securities (Apr. 30, 1996); OCC Bulletin 94-31, 
Questions and Answers for BC-277 (May 10, 1994); and Risk Management 
of Financial Derivatives, OCC Banking Circular No. 277 (Oct. 1993).
---------------------------------------------------------------------------

    The potential costs of broker-dealer regulation, as applied to 
dealers in OTC derivative instruments, have affected the way U.S. 
securities firms conduct business in the OTC derivatives markets. In 
many instances, U.S. securities firms have decided to separate their 
securities activities from their non-securities activities. These firms 
often place their non-securities OTC derivatives activities in 
separate, unregistered affiliates located in the United States, and 
conduct some or all of their securities OTC derivatives activities from 
abroad. However, fragmenting a firm's OTC derivatives business in this 
manner may hinder its ability to manage risk and compete for business.
    For example, U.S. securities firms have voiced concerns regarding 
their ability to manage counterparty credit risk effectively under the 
traditional broker-dealer regulatory regime. Typically, in order to 
reduce credit exposure to a single counterparty, dealers in OTC 
derivative instruments enter into master agreements with their 
counterparties that provide for netting of the outstanding financial 
obligations existing between the dealers and their counterparties. As 
these firms have pointed out, it would be more efficient and effective 
to conduct both securities and non-securities OTC derivatives 
transactions with a counterparty through a single legal entity, subject 
to appropriately tailored regulatory requirements, rather than through 
multiple legal entities. The firms have also indicated that certain 
counterparties prefer to deal with a firm through a single entity that 
is capable of transacting business across a broad range of OTC 
derivative instruments.

B. The Proposing Release

    In response to the concerns raised by firms seeking to conduct an 
OTC derivatives business in the United States, the Commission proposed 
to establish a form of limited broker-dealer regulation that would give 
the firms an opportunity to conduct business in a vehicle subject to 
modified regulation appropriate to the OTC derivatives markets.\10\ 
This form of limited broker-dealer regulation was intended to allow 
securities firms to establish dealer

[[Page 59364]]

affiliates, referred to as ``OTC derivatives dealers,'' that would be 
able to compete more effectively with banks and foreign dealers in 
global OTC derivatives markets, while also maintaining standards 
necessary to ensure investor protection.
---------------------------------------------------------------------------

    \10\ Exchange Act Release No. 39454 (Dec. 17, 1997), 62 FR 67940 
(Dec. 30, 1997) (``Proposing Release'').
---------------------------------------------------------------------------

    In the Proposing Release, the Commission specifically solicited 
comment on the extent to which persons eligible to become registered as 
OTC derivatives dealers believed that the proposal would address 
competitive inequalities that discouraged securities firms from 
conducting an OTC derivatives business in the United States. Commenters 
were also asked to express their views on the application of the 
Commission's broker-dealer rules to OTC derivatives dealers and whether 
additional amendments or exemptions were needed for this class of 
dealers.
    The Commission received twenty-one comment letters in response to 
the proposed rules and rule amendments, including comments from, among 
others, industry representatives, self-regulatory organizations, and 
other regulators.\11\ The majority of the commenters endorsed the 
Commission's initiative to develop an alternative regulatory framework 
for OTC derivatives dealers. These commenters supported the 
Commission's intent to provide a regulatory framework for OTC 
derivatives dealers that would enable these dealers to compete more 
effectively with both banks and foreign dealers in OTC derivatives 
markets. They often noted in particular their support of the 
Commission's efforts to address the regulatory costs imposed by 
existing capital requirements on securities firms seeking to operate an 
OTC derivatives business in the United States.\12\
---------------------------------------------------------------------------

    \11\ The staff of the Division of Market Regulation has prepared 
a summary of the comment letters received on the proposed rules and 
rule amendments entitled ``Comment Summary for Proposing Release on 
OTC Derivatives Dealers'' (hereinafter referred to as ``Comment 
Summary''). Copies of the comment letters and the Comment Summary 
have been placed in Public Reference File No. S7-30-97 and are 
available for inspection in the Commission's Public Reference Room.
    \12\ See Letters cited in Section II., n.1 of the Comment 
Summary.
---------------------------------------------------------------------------

    The commenters, however, also suggested that the Commission modify 
the proposed rules and rule amendments in various ways to more 
accurately reflect the manner in which firms conduct an OTC derivatives 
business. Many commenters stressed the need for the alternative 
regulatory regime to establish a practical commercial framework for the 
conduct of this business and to provide U.S. securities firms with 
flexibility in structuring their derivatives activities.

C. Final Rules and Rule Amendments

1. General
    After considering the comment letters, the Commission is adopting 
rules and rule amendments that will allow U.S. securities firms to 
establish separately capitalized entities that may engage in dealer 
activities in eligible OTC derivative instruments, which include both 
securities and non-securities OTC derivative instruments. OTC 
derivatives dealers are also permitted to engage in certain additional 
securities activities related to conducting an OTC derivatives 
business. A firm engaging in the permitted activities has the option of 
registering with the Commission under Section 15(b) of the Exchange 
Act\13\ as an OTC derivatives dealer, subject to specially tailored 
capital, margin, and various other requirements.
---------------------------------------------------------------------------

    \13\ 15 U.S.C. 78o(b).
---------------------------------------------------------------------------

    These tailored requirements are intended, in part, to improve the 
efficiency and competitiveness of U.S. securities firms active in 
global OTC derivatives markets. By permitting U.S. securities firms to 
conduct both securities and non-securities OTC derivatives activities 
through a single legal entity, the new structure will enable the firms 
to enter into more comprehensive netting arrangements with 
counterparties and thus more effectively manage credit risk. End-users 
should also benefit as a result of a reduction in the legal risks that 
arise when securities firms structure their derivatives activities in a 
manner that avoids U.S. broker-dealer registration.\14\ As noted by one 
commenter, all participants in the OTC derivatives markets have a vital 
interest in ensuring that OTC derivatives transactions are available in 
a framework where the legal rights and obligations of the parties to an 
agreement are certain and enforceable.\15\ The new regulatory regime 
for OTC derivatives dealers is intended to help provide that legal 
certainty to these markets.
---------------------------------------------------------------------------

    \14\ See, e.g., Comment Letter from the End-Users of Derivatives 
Association, Inc. (``EUDA Letter''). p. 1.
    \15\ See Comment Letter from the International Swaps and 
Derivatives Association, Inc. (``ISDA Letter''), pp. 1-2.
---------------------------------------------------------------------------

    As a ``dealer'' under the Exchange Act,\16\ an OTC derivatives 
dealer remains subject to all other rules applicable to ``fully 
regulated broker-dealers,'' \17\ unless otherwise provided by the new 
rules and rule amendments. In addition, the Commission wishes to 
emphasize that purchasers and sellers of OTC derivative instruments 
that are securities will continue to be protected by the general anti-
manipulation and anti-fraud provisions, including Section 17(a) of the 
Securities Act of 1933,\18\ and Section 9(a) \19\ and 10(b) \20\ of the 
Exchange Act, and Rule 10b-5 thereunder.\21\
---------------------------------------------------------------------------

    \16\ See Section 3(a)(5) of the Exchange Act (15 U.S.C. 
78c(a)(5)).
    \17\ For purposes of this release, the term ``fully regulated 
broker-dealer'' means a broker or dealer that is registered with the 
Commission under section 15(b) of the Exchange Act (15 U.S.C. 
78o(b)), but that is not an OTC derivatives dealer, and therefore is 
subject to all statutes, rules, and regulations imposed on broker-
dealers under the transitional broker-dealer regulatory regime, 
including membership in a securities self-regulatory organization.
    \18\ 15 U.S.C. 78q(a).
    \19\ 15 U.S.C. 78i(a).
    \20\ 15 U.S.C. 78j(a).
    \21\ 17 CFR 240.10b-5. See, e.g., In the Matter of BT Securities 
Corporation, Exchange Act Release No. 35136 (Dec. 22, 1994).
---------------------------------------------------------------------------

    An OTC derivatives dealer also remains subject to all applicable 
statutes, rules, and regulations of other U.S. financial regulators. In 
particular, to the extent that the Commodity Exchange Act (``CEA'') 
\22\ and the rules and regulations adopted under the CEA apply to the 
activities of an OTC derivatives dealer, the new regulatory structure 
in no way alters the application of these laws to the activities of an 
OTC derivatives dealer.
---------------------------------------------------------------------------

    \22\ 7 U.S.C. 1 et seq.
---------------------------------------------------------------------------

2. Scope of Permissible Securities Activities
    In order to take advantage of the new regulatory regime for 
conducting an OTC derivatives dealer business in the United States, an 
OTC derivatives dealer must, among other things, limit its securities 
activities to those specified in Rules 3b-12 and 15a-1. In general, 
these rules provide that an OTC derivatives dealer's securities 
activities must be limited to (1) engaging in dealer activities in 
eligible OTC derivative instruments (as defined in Rule 3b-13) that are 
securities; (2) issuing and reacquiring securities that are issued by 
the dealer, including warrants on securities, hybrid securities, and 
structured notes; (3) engaging in cash management securities activities 
(as defined in Rule 3b-14); (4) engaging in ancillary portfolio 
management securities activities (as defined in Rule 3b-15); and (5) 
engaging in such other securities activities that the Commission 
designates by order.\23\ An OTC

[[Page 59365]]

derivatives dealer must also be affiliated with a fully regulated 
broker-dealer.\24\
---------------------------------------------------------------------------

    \23\ The alternative regulatory framework generally does not 
limit the non-securities activities of an OTC derivatives dealer, 
provided that the dealer complies with financial responsibility and 
internal risk management controls requirements. An OTC derivatives 
dealer's non-securities activities are also restricted under this 
framework by the practical limitations imposed by the definitions of 
``cash management securities activities'' and ``ancillary portfolio 
management securities activities.''
    \24\ As proposed, the alternative regulatory framework defined 
the term ``permissible derivatives counterparty,'' and required that 
an OTC derivatives dealer's counterparties be limited to such 
persons. In response to commenters' concerns, and in light of the 
protections afforded through other provisions of the alternative 
regulatory framework, the final rules do not restrict the persons 
that may act as counterparties in OTC derivatives transactions. The 
final rules, however, do not exempt OTC derivatives dealers or their 
fully regulated broker-dealer affiliates from counterparty 
limitations imposed under any other applicable regulatory or self-
regulatory requirements.
---------------------------------------------------------------------------

    The Commission has defined the terms ``cash management securities 
activities'' and ``ancillary portfolio management securities 
activities.'' \25\ These two terms replace the term ``permissible risk 
management, arbitrage, and trading transactions,'' which was included 
in the Proposing Release. The new terms serve substantially the same 
purpose as the proposed term in that they describe the additional 
securities activities in which an OTC derivatives dealer may engage in 
connection with its OTC derivatives dealer business. As a practical 
matter, a firm seeking to register as an OTC derivatives dealer will 
need to be able to conduct these additional securities activities, such 
as engaging in certain financing and hedging transactions, in order to 
compete effectively with other market participants.
---------------------------------------------------------------------------

    \25\ See Rules 3b-14 (17 CFR 240.3b-14) and 3b-15 (17 CFR 
240.3b-15).
---------------------------------------------------------------------------

    The final rules and rule amendments also contain restrictions to 
prevent U.S. securities firms from moving their general securities 
dealing activities into the new OTC derivatives dealer entity, or from 
using these entities for substantial proprietary trading activities. 
For example, the definitions of both ``cash management securities 
activities'' and ``ancillary portfolio management securities 
activities'' include limitations to prevent an OTC derivatives dealer 
from engaging in dealing activities in cash market instruments or from 
establishing a proprietary trading desk.
    In addition, an OTC derivatives dealer's securities activities must 
consist primarily of dealer activities in eligible OTC derivative 
instruments that are securities, issuing and reacquiring its issued 
securities, and cash management securities activities. Thus, if the 
securities activities of an OTC derivatives dealer were to consist only 
or primarily of ancillary portfolio management securities activities, 
the dealer would be in violation of the rules.
    a. Eligible OTC Derivative Instruments. As noted above, an OTC 
derivatives dealer is permitted to engage in dealer activities in 
``eligible OTC derivative instruments,'' as that term is defined in 
Rule 3b-13. The term is defined broadly to encompass the wide range of 
securities and non-securities OTC derivative instruments currently 
existing in the derivatives markets, as well as to allow for the 
inclusion of reasonably similar instruments that market participants 
may develop in the future. The types of instruments that generally 
satisfy the criteria set forth in Rule 3b-13 include interest rate 
swaps, currency swaps, securities swaps, commodity swaps, OTC options 
on similar asset classes, long-dated forwards on securities, and 
forwards relating to assets other than securities. Other types of 
instruments also satisfy the criteria in the rule.
    Short-dated securities forwards, however, are excluded from the 
definition of eligible OTC derivative instrument, as are securities 
derivative instruments that are listed or traded on a national 
securities exchange or on Nasdaq. Except as otherwise determined by the 
Commission by order, a securities derivative instrument that is one of 
a class of fungible instruments that are standardized as to their 
material economic terms is also excluded from the definition.
    The new regulatory framework also allows an OTC derivatives dealer 
to issue and reacquire its issued securities, including hybrid 
securities. For purposes of Rules 3b-12 and 15a-1, which describe the 
permissible securities activities of an OTC derivatives dealer, the 
term ``hybrid security'' is defined as a security that incorporates 
payment features economically similar to the OTC derivative instruments 
that are enumerated in the definition.\26\ The term ``hybrid security'' 
is used only in the context of an OTC derivatives dealer's permissible 
securities activities under the rules, and is not intended to have a 
broader application.
---------------------------------------------------------------------------

    \26\ See Rules 3b-12(d) (17 CFR 240.3b-12(d)) and 15a-1(e) (17 
CFR 240.15a-1(e).
---------------------------------------------------------------------------

    b. Cash Management Securities Activities. An OTC derivatives dealer 
may engage in ``cash management securities activities,'' as defined in 
Rule 3b-14. Under the rule, an OTC derivatives dealer may engage in 
cash management securities activities in connection with its 
permissible securities activities or its non-securities activities 
(that involve eligible OTC derivative instruments or other financial 
instruments). Cash management securities activities include (1) any 
acquisition or disposition of collateral provided by a counterparty, or 
any acquisition or disposition of collateral to be provided to a 
counterparty; (2) cash management; and (3) financing of certain 
positions of the dealer. Any securities trading activities associated 
with cash management by an OTC derivatives dealer must be at a level 
commensurate with the dealer's bona fide operational needs, taking into 
consideration the Commission's capital requirements for the dealer and 
the amount of capital needed by the dealer to satisfy counterparties' 
credit requirements.
    c. Ancillary Portfolio Management Securities Activities. An OTC 
derivatives dealer may also engage in ``ancillary portfolio management 
securities activities,'' as defined in Rule 3b-15. These securities 
activities must be limited to transactions in connection with the OTC 
derivatives dealer's dealer activities in eligible OTC derivative 
instruments, the issuance of securities by the dealer, or such other 
securities activities that the Commission designates by order. They 
must also (1) be conducted for the purpose of reducing the dealer's 
market or credit risk or consist of incidental trading activities for 
portfolio management purposes; and (2) be limited to risk exposures 
within the market, credit, leverage, or liquidity risk parameters set 
forth in the trading authorizations granted to the associated person 
(or to the associated person's supervisor) who executes the transaction 
for the dealer, and in the written guidelines approved by the dealer's 
governing body and included in the dealer's internal risk management 
control system (as required under new Rule 15c3-4). Rule 3b-15 also 
requires that ancillary portfolio management securities activities be 
conducted only by associated persons of the dealer who perform 
substantial duties for the dealer in connection with its dealer 
activities in eligible OTC derivative instruments.
    Again, the limitations on an OTC derivatives dealer's ancillary 
portfolio management securities activities under Rule 3b-15 are aimed 
at preventing a fully regulated broker-dealer from moving its 
securities book into its OTC derivatives dealer affiliate or otherwise 
permitting the OTC derivatives dealer to engage in substantial 
proprietary securities trading activities. An OTC derivatives dealer's 
ability to engage in incidental securities trading activities for 
portfolio management purposes under Rule 3b-15, however, recognizes

[[Page 59366]]

that the dealer may to a limited extent engage in securities trading 
activity that may not be for the specific purpose of reducing its 
market or credit risk.
    The new regulatory structure for OTC derivatives dealers 
incorporates the concept of managing risk on a portfolio-wide basis and 
does not expressly limit the range of permissible ancillary portfolio 
management securities activities. Instead, these activities are limited 
by the requirement that they not give rise to risk exposures that, on 
an aggregate portfolio basis, exceed the risk limits adopted for the 
dealer's business under the rules. They are also limited by other 
requirements that serve to ensure that the OTC derivatives dealer does 
not engage in dealer activities in securities that are not eligible OTC 
derivative instruments. The final rules are intended to be flexible and 
to accommodate current business practices of OTC derivatives dealers. 
Because the rules define a broad scope of permissible securities 
activities, however, the restrictions on proprietary trading and 
dealing in cash market instruments may prove inadequate. Rule 15a-1 
therefore preserves the Commission's ability to clarify, by order, 
whether certain securities activities are within the scope of ancillary 
portfolio management securities activities.\27\
---------------------------------------------------------------------------

    \27\ See Rule 15a-1(b)(4) (17 CFR 240.15a-1(b)(4)).
---------------------------------------------------------------------------

3. Intermediation of Securities Transactions
    Rule 15a-1 generally requires that all securities transactions of 
an OTC derivatives dealer, including securities OTC derivatives 
transactions, be effected through its fully regulated broker-dealer 
affiliate.\28\ The intermediation requirement is designed, in part, to 
ensure that all securities transactions remain subject to existing 
sales practice standards and to reduce the risk that counterparties 
will mistakenly view an OTC derivatives dealer as a fully regulated 
broker-dealer. Certain professional counterparties, however, are less 
likely to need or expect the protections offered by the fully regulated 
broker-dealer under this framework. Therefore, the rules provide two 
limited exceptions to the broker-dealer intermediation requirement for 
securities transactions.
---------------------------------------------------------------------------

    \28\ See Rule 15a-1(c) (17 CFR 240.15a-1(c)). An OTC derivatives 
dealer may issue and reacquire its issued securities through an 
unaffiliated fully regulated broker-dealer. Id.
---------------------------------------------------------------------------

    First, an OTC derivatives dealer is not required to use its fully 
regulated broker-dealer affiliate to effect securities transactions 
with a registered broker or dealer, a bank acting in a dealer capacity, 
a foreign broker or dealer, or an affiliate of the OTC derivatives 
dealer, provided that the counterparty is acting as principal. Second, 
if an OTC derivatives dealer engages in an ancillary portfolio 
management securities activity involving a foreign security, it is not 
required to effect that securities transaction through its fully 
regulated broker-dealer affiliate if a registered broker or dealer, a 
bank, or a foreign broker or dealer is acting as agent for the OTC 
derivatives dealer.
    In addition, any person that solicits a potential counterparty to 
engage in a securities transaction with an OTC derivatives dealer, or 
otherwise has any contact with the counterparty regarding the 
transaction, generally must be a registered representative of the fully 
regulated broker-dealer affiliate.\29\ These persons may be dual 
employees of both the OTC derivatives dealer and the fully regulated 
broker-dealer. However, if the counterparty is a registered broker or 
dealer, a bank acting in a dealer capacity, a foreign broker or dealer, 
or an affiliate of the OTC derivatives dealer, employees of the OTC 
derivatives dealer may solicit or have other forms of contact with the 
counterparty, even if they are not also registered representatives of 
the fully regulated broker-dealer. This is consistent with the 
exception for these same counterparties from the general requirement 
that an OTC derivatives dealer's securities transactions be effected 
through its fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------

    \29\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)). The rule provides 
an exception for clerical and ministerial activities that are 
conducted by associated persons of the OTC derivatives dealer.
---------------------------------------------------------------------------

    In addition, the rule does not require registered representatives 
of the fully regulated broker-dealer affiliate to be involved in 
contacts with foreign counterparties, in certain situations. Contacts 
with a foreign counterparty may generally be conducted by an associated 
person of a foreign broker or dealer who is not resident in the United 
States, if the foreign broker or dealer is affiliated with the OTC 
derivatives dealer and is registered under applicable local law. This 
approach recognizes the global nature of the OTC derivatives markets, 
and the practical limitations imposed by requiring registered 
representatives of the fully regulated broker-dealer affiliate to 
participate in all such contacts. Any resulting securities transaction, 
however, must generally be effected through the OTC derivatives 
dealer's fully regulated broker-dealer affiliate.
4. Exemptions for OTC Derivatives Dealers
    The final rules and rule amendments provide exemptions from certain 
provisions of the Exchange Act to OTC derivatives dealers due to, among 
other things, the unique nature of this business. Specifically, OTC 
derivatives dealers are exempted from (a) membership in a securities 
self-regulatory organization (``SRO''); (b) certain margin requirements 
under the Exchange Act; and (c) the provisions of the Securities 
Investor Protection Act of 1970\30\ (``SIPA''), including membership in 
the Securities Investor Protection Corporation (``SIPC'').\31\
---------------------------------------------------------------------------

    \30\ 15 U.S.C. 78aaa et seq.
    \31\ In 1996, Congress added section 36 to the Exchange Act (15 
U.S.C. 78mm), which gives the Commission broad authority to exempt 
any person from any of the provisions of the Exchange Act. The 
exemptions from certain margin requirements under the Exchange Act 
and from SIPA were adopted using this new exemptive authority.
---------------------------------------------------------------------------

    a. Exemption from SRO Membership. Under Rule 15b9-2, OTC 
derivatives dealers are exempt from membership in an SRO. SRO 
membership for OTC derivatives dealers, and the additional regulation 
it entails, is not warranted at this time. As a practical matter, 
certain SRO rules are not consistent with the OTC derivatives dealer 
regulatory structure, and accordingly, should not apply directly to the 
OTC derivatives dealer. In addition, with limited exceptions, all 
securities transactions of an OTC derivatives dealer must be effected 
through its fully regulated broker-dealer affiliate, which will be an 
SRO member. As a result, SRO rules, including sales practice 
requirements, will generally apply to these securities transactions.
    While the Commission had proposed that the designated examining 
authority (``DEA'') of the OTC derivatives dealer's fully regulated 
broker-dealer affiliate would review the OTC derivatives dealer's 
activities for violations of Commission rules, the New York Stock 
Exchange (``NYSE'') and the National Association of Securities Dealers, 
Inc. (``NASD'') expressed serious concerns with overseeing OTC 
derivatives dealers on a contractual basis (without the dealers being 
SRO members). The Commission staff, therefore, will examine OTC 
derivatives dealers to ensure compliance with Commission rules.
    b. Exemption from Certain Margin Requirements. Federal regulations 
that govern the collateral, or margin, that must be collected by 
dealers in connection with securities transactions have created certain 
competitive inequalities between registered broker-

[[Page 59367]]

dealers and other entities, including banks, that conduct an OTC 
derivatives business. Registered broker-dealers that extend credit for 
the purpose of purchasing or carrying securities are required to comply 
with the provisions of Regulation T.\32\ The margin requirements for 
banks are contained in Regulation U.\33\
---------------------------------------------------------------------------

    \32\ 12 CFR 220.1.
    \33\ 12 CFR 221.1.
---------------------------------------------------------------------------

    After the Commission issued the Proposing Release, several 
amendments to Regulation T were adopted that reduced the regulatory 
distinctions between broker-dealers and other lenders.\34\ In general, 
Regulation T and Regulation U permit lenders to extend good faith 
credit against all non-equity securities and set specific limits on the 
amount of credit lenders can extend on equity securities.\35\ However, 
several differences between Regulation T and Regulation U still remain, 
such as margin requirements for short OTC options. U.S. securities 
firms have indicated that because of these differences, applying 
Regulation T to their OTC derivatives business would continue to 
unnecessarily inhibit their ability to compete in the derivatives 
markets with banks and other lenders subject to Regulation U.
---------------------------------------------------------------------------

    \34\ See Securities Credit Transactions, Borrowing by Brokers 
and Dealers, Docket Nos. R-0905, R-0923, and R-0944, 63 FR 2806 (Jan 
16, 1998).
    \35\ See, e.g., 12 CFR 221.2(f).
---------------------------------------------------------------------------

    Given the nature of the bilateral financial instruments and the 
relative sophistication of the counterparties in the OTC derivatives 
markets, and the safeguards against excessive leverage contained in 
Regulation U, the requirements of Regulation U are more appropriate for 
the lending that occurs in these markets. Accordingly, under Rule 36a1-
1, transactions involving extensions of credit by an OTC derivatives 
dealer are exempt from the provisions of Section 7(c) of the Exchange 
Act \36\ and Regulation T, provided that the OTC derivatives dealer 
complies with Section 7(d) of the Exchange Act \37\ and Regulation 
U.\38\
---------------------------------------------------------------------------

    \36\ 15 U.S.C. 78g(c).
    \37\ 15 U.S.C. 78g(d).
    \38\ Because Regulation U is promulgated pursuant to Section 
7(d) of the Exchange Act, an OTC derivatives dealer remains subject 
to that provision. In addition, Rule 36a1-1 (17 CFR 240.36a1-1) 
applies only to extensions of credit by an OTC derivatives dealer. 
Section 7 of the Exchange Act continues to apply to persons 
extending credit to an OTC derivatives dealer. Credit extended to an 
OTC derivatives dealer, like credit extended to a fully regulated 
broker-dealer, however, is excepted from section 7 of the Exchange 
Act is it satisfies the conditions for such exceptions contained in 
section 7.
---------------------------------------------------------------------------

    c. Exemption from SIPA. Under Rule 36a1-2, OTC derivatives dealers 
are exempt from the provisions of SIPA, including membership in SIPC. 
The application of SIPA's liquidation provisions to an OTC derivatives 
dealer in bankruptcy could undermine certain provisions of the 
bankruptcy code applicable to the dealer's business. As a result, the 
application of SIPA to OTC derivatives dealers would create legal 
uncertainty about the rights of counterparties in transactions with OTC 
derivatives dealers in the event of dealer insolvency. This uncertainty 
could impair the ability of securities firms electing to register OTC 
derivatives dealers to compete effectively with banks and foreign 
dealers, which are not subject to similar legal uncertainty.
5. Section 11(a) of the Exchange Act
    Rule 11a1-6 provides an exception under section 11(a) of the 
Exchange Act \39\ for certain transactions effected by a fully 
regulated broker-dealer for the account of its OTC derivatives dealer 
affiliate. Section 11(a) makes it unlawful for a member of a national 
securities exchange to effect transactions on that exchange for certain 
accounts, including its own account or the account of an associated 
person.
---------------------------------------------------------------------------

    \39\ 15 U.S.C. 78k(a).
---------------------------------------------------------------------------

    This general prohibition, however, is subject to numerous 
exceptions. Among these is a general exception under section 
11(a)(1)(G) for a member's proprietary transactions, where the member 
is primarily engaged in a public securities business, as indicated by 
certain calculations involving the member's gross revenues from the 
preceding fiscal year (the ``business mix'' test), and the transactions 
``yield,'' in accordance with Commission rules, priority, parity, and 
precedence to transactions for accounts of persons who are not members, 
or associated with members, of the exchange.\40\
---------------------------------------------------------------------------

    \40\ See 15 U.S.C. 78k(a)(1)(G).
---------------------------------------------------------------------------

    Rule 11a1-2 under the Exchange Act generally permits a member to 
effect a transaction for the account of an associated person if the 
member could have effected the transaction for its own account. The 
rule, however, requires that the associated person independently meet 
the ``business mix'' test in order for the member to rely on the 
exception provided under Section 11(a)(1)(G) for transactions effected 
for the account of that associated person.
    Because an OTC derivatives dealer will be a newly created entity, 
it will not be able to demonstrate that it meets this test. 
Accordingly, new Rule 11a1-6, like existing Rule 11a1-2, allows a fully 
regulated broker-dealer member to effect a transaction on the exchange 
for the account of an affiliated OTC derivatives dealer if the member 
would have been permitted to effect the transaction for its own 
account. Rule 11a1-6 allows the fully regulated broker-dealer to rely 
on the exception under section 11(a)(1)(G) for transactions it effects 
for its OTC derivatives dealer affiliate even if that affiliate does 
not meet the ``business mix'' test. The fully regulated broker-dealer 
and the OTC derivatives dealer must comply with all other requirements 
of section 11(a).
6. Net Capital Requirements
    The net capital rule has been amended to include an alternative net 
capital regime for OTC derivatives dealers. Under the amendments, an 
OTC derivatives dealer will be subject to higher minimum capital 
requirements than a fully regulated broker-dealer. The OTC derivatives 
dealer, however, may also be authorized by the Commission to use value-
at-risk (``VAR'') models to calculate capital charges for market risk 
and to take alternative charges for credit risk than those currently 
prescribed. The minimum capital requirements for an OTC derivatives 
dealer are tentative net capital of at least $100 million and net 
capital of at least $20 million. Under the circumstances, these minimum 
amounts will provide a sufficient liquid capital cushion for entities 
that elect to register as an OTC derivatives dealer.
    In order to use VAR models to calculate capital charges for market 
risk and to take alternative charges for credit risk, under new 
Appendix F to Rule 15c3-1, an OTC derivatives dealer must file an 
application with, and obtain authorization from, the Commission. The 
application, among other things, must describe the OTC derivatives 
dealer's VAR model or models, including the manner in which the model 
or models meet the requirements specified in Appendix F, and the 
dealer's internal risk management controls system (as required under 
Rule 15c3-4). The OTC derivatives dealer must also describe in the 
application any non-marketable securities that it wants to include in 
its VAR calculation.
    An OTC derivatives dealer's VAR model must meet certain qualitative 
and quantitative requirements under Appendix F that parallel rules 
currently followed by U.S. banking agencies. To meet the qualitative 
requirements, among other things, an OTC derivatives dealer must 
integrate its VAR model into the firm's daily risk management process, 
and subject its VAR model to stress tests, internal and external 
audits, and backtesting. The quantitative requirements contain 
statistical

[[Page 59368]]

parameters for VAR measures using a time horizon that is appropriate in 
the regulatory capital context, as well as risk factors that must be 
addressed in any model used. These parameters include the use of a ten-
day holding period and a 99% confidence level.
    An OTC derivatives dealer applying Appendix F must also compute a 
two-part credit risk capital charge, calculated on a counterparty-by-
counterparty basis. The first part of the charge is calculated based on 
the net replacement value of all outstanding transactions with each 
counterparty after taking into account netting arrangements and 
possession of liquid collateral multiplied by a counterparty factor 
derived from the creditworthiness of that counterparty. The second part 
of the credit risk charge is a concentration charge that is also based 
on the creditworthiness of a particular counterparty, but that only 
applies when the net replacement value in the account of that 
counterparty exceeds 25% of the OTC derivatives dealer's tentative net 
capital.
    Under Rule 15c3-4, an OTC derivatives dealer using Appendix F is 
also required to establish a comprehensive system of internal controls 
for monitoring and managing risks associated with its business 
activities. The establishment of a system of controls is an important 
element of the Commission's regulatory regime for OTC derivatives 
dealers. The risks that an OTC derivatives dealer's system of internal 
controls must specifically address include market, credit, leverage, 
liquidity, legal, and operational risks associated with conducting an 
OTC derivatives business.
    The Commission will authorize an OTC derivatives dealer to use 
Appendix F if it determines that the dealer has met the requirements 
set forth in the rules relating to its VAR model and internal risk 
management control systems. In addition, an OTC derivatives dealer must 
file an application with the Commission before making any material 
changes to its VAR model or internal risk management control systems 
and receive authorization before implementing any such changes.
7. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
    Under the new regulatory structure, a counterparty to an OTC 
derivatives transaction generally will not be considered a ``customer'' 
for purposes of Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3, the 
Commission's hypothecation and customer protection rules, and will not 
be protected by SIPA. In particular, except as otherwise agreed to in 
writing, if an OTC derivatives dealer notifies its counterparty that it 
will not segregate the collateral and may use the counterparty's 
collateral to further its own business operations, including 
commingling and pledging the counterparty's assets, the counterparty 
will not be considered a ``customer'' of the dealer for purposes of 
Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3.
8. Recordkeeping and Reporting
    The rules governing recordkeeping and reporting for an OTC 
derivatives dealer have also been modified. The rules will remain 
substantially the same as for fully regulated broker-dealers, but they 
have been tailored to the business of OTC derivatives dealers. 
Reporting will be required only on a quarterly basis. The reports will 
include, among other things, information from the dealer regarding its 
VAR computations, as well as various credit concentration information.

II. Discussion: New Rules and Amended Rules

    After consideration of the issues raised in comment letters 
concerning the alternative regulatory structure for OTC derivatives 
dealers, the Commission is adopting new Rules 3b-12, 3b-13, 3b-14, 3b-
15, 11a1-6, 15a-1, 15b9-2, 15c3-4, 17a-12, 36a1-1, and 36a1-2 \41\ 
under the Exchange Act.\42\ The Commission is also amending Rule 30-3 
of the Commission's rules of practice \43\ and Exchange Act Rules 8c-1, 
15b1-1, 15c2-1, 15c2-5, 15c3-1, 15c3-2, 15c3-3, 17a-3, 17a-4, 17a-5, 
and 17a-11.\44\ In addition, the Commission is revising Form X-17A-5 
(FOCUS report).\45\
---------------------------------------------------------------------------

    \41\ 17 CFR 240.3b-12, 240.3b-13, 240.3b-14, 240.3b-15, 
240.11a1-6, 240.15a-1, 240.15b9-2, 240.15c3-4, 240.17a-12, 240.36a1-
1, and 240.36a1-2.
    \42\ 15 U.S.C. 78a et seq.
    \43\17 CFR 200.30-3.
    \44\ 17 CFR 240.8c-1, 240.15b1-1, 240.15c2-1, 240.15c2-5, 
240.15c3-1, 240.15c3-2, 240.15c3-3, 240.17a-3, 240.17a-4, 240.17a-5, 
and 240.17a-11.
    \45\ 17 CFR 249.617.
---------------------------------------------------------------------------

A. Definitions

    The final rules set forth definitions of four new terms: (1) OTC 
derivatives dealer; (2) eligible OTC derivative instrument; (3) cash 
management securities activities; and (4) ancillary portfolio 
management securities activities. Although the Commission had also 
proposed to define the term ``permissible derivatives counterparty,'' 
the Commission has determined that it is unnecessary to use the term in 
the final rules and rule amendments. In addition, the Commission is not 
adopting a separate rule defining ``hybrid security,'' as proposed, but 
rather is including a definition of ``hybrid security'' only for 
purposes of the final rules that use the term. The definitions of the 
new terms, and the reasons for adopting them in their revised forms, 
are described below.
1. Rule 3b-12; Definition of OTC Derivatives Dealer
    As proposed, Rule 3b-12 would have defined OTC derivatives dealer 
to mean any dealer that limited its securities activities to (1) 
engaging as a counterparty in transactions in eligible OTC derivative 
instruments with permissible derivatives counterparties; (2) issuing 
and reacquiring issued securities through a fully regulated broker or 
dealer; or (3) engaging in other securities transactions that the 
Commission designated by order. The OTC derivatives dealer would also 
have been permitted to engage in ``permissible risk management, 
arbitrage, and trading transactions,'' in connection with any of these 
securities activities.
    The proposed definition of OTC derivatives dealer was intended to 
identify a category of dealers that would primarily be engaged as 
counterparties in OTC derivatives transactions. The proposed definition 
also recognized that these dealers would need to engage in certain 
limited securities trading activities in connection with their OTC 
derivatives dealing activities in order to operate a competitive 
business. The Proposing Release, however, emphasized that an OTC 
derivatives dealer should not be able to take advantage of the modified 
regulatory requirements to engage in activities better suited to full 
broker-dealer regulation.\46\
---------------------------------------------------------------------------

    \46\ Proposing Release, Section II.A.1., n.17, 62 FR at 67942, 
n.17.
---------------------------------------------------------------------------

    Several commenters requested that the Commission clarify that the 
non-securities activities in which an OTC derivatives dealer would be 
permitted to engage would not be limited in either scope or volume 
(subject only to capital considerations).\47\ The commenters were 
concerned that the language in the summary of the Proposing Release 
stating that registration as an OTC derivatives dealer was available 
only to entities acting primarily as counterparties in privately 
negotiated OTC derivatives transactions was

[[Page 59369]]

potentially inconsistent with the ability of these entities to engage 
in any non-securities activities.\48\ In response to these comments, 
the Commission has revised the definition of OTC derivatives dealer to 
emphasize that the definition limits only the securities activities 
\49\ of a dealer seeking to operate an OTC derivatives business under 
the new framework.\50\
---------------------------------------------------------------------------

    \47\ See Comment Summary, Section IV.A.1.; Comment Letter from 
the Securities Industry Association's (``SIA'') OTC Derivative 
Products Committee, dated April 6, 1998 (``SIA Letter I''), p. 5; 
Comment Letter from Merrill Lynch & Co., Inc. (``Merrill Lynch 
Letter''), p. 4.
    \48\ See, e.g., SIA Letter I, p. 5.
    \49\ As a practical matter, the non-securities activities of an 
OTC derivatives dealer are limited by the capital requirements and 
by the limits imposed on cash management and ancillary portfolio 
management securities activities under this regulatory structure. 
This parallels the system for fully regulated broker-dealers, which 
does not prohibit non-securities activities by definition, but 
rather imposes practical limitations on those activities under the 
financial responsibility rules.
    \50\ In its comment letter, the Commodity Futures Trading 
Commission (``CFTC'') stated that the proposal for the alternative 
regulatory framework for OTC derivatives dealers extended beyond the 
Commission's authority to regulate securities. See Comment Letter 
from the CFTC (``CFTC Letter''), p. 1. While the proposal was 
appropriately restricted in scope to fall within the Commission's 
statutory jurisdiction, the revisions made to Rule 3b-12 (17 CFR 
240.3b-12), as well as to the other rules and rule amendments, that 
strengthen the focus of the new regulatory framework on the 
securities activities of an OTC derivatives dealer serve to clarify 
the scope of the Commission's jurisdiction.
---------------------------------------------------------------------------

    Several commenters also questioned the proposed definition's limits 
on the scope of securities activities in which an OTC derivatives 
dealer could engage.\51\ Merrill Lynch & Co., Inc. (``Merrill Lynch'') 
suggested that an OTC derivatives dealer should be permitted to engage 
in a full range of activities in securities derivative instruments 
(including acting as a dealer in such instruments).\52\ Merrill Lynch 
also noted that there were numerous types of securities principal 
transactions in which an OTC derivatives dealer would need to engage to 
support its derivatives business. It expressed concern that any 
limitation on the nature or scope of such transactions could 
unnecessarily restrict, and in certain cases could increase the risk 
of, the dealer's derivatives business.\53\ Other commenters believed 
that monitoring the limitations in the proposed rule could create 
unnecessary burdens for both the dealers and the Commission, and that 
the limitations were not always consistent with the manner in which an 
OTC derivatives business is currently conducted.\54\
---------------------------------------------------------------------------

    \51\ See letters cited in Section IV.A.2. of the Comment 
Summary.
    \52\ Merrill Lynch Letter, p. 4.
    \53\ Merrill Lynch Letter, p. 5. Similarly, the SIA commented 
that, so long as an OTC derivatives dealer limited its securities 
dealing activities to transactions in eligible OTC derivative 
instruments with permissible derivatives counterparties, it was 
neither necessary nor desirable to limit the non-dealing securities 
activities of an OTC derivatives dealer. SIA Letter I, p. 6.
    \54\ E.g., SIA Letter I, p. 6.
---------------------------------------------------------------------------

    Commenters also addressed the issue that the alternative regulatory 
structure for OTC derivatives dealers is not intended to permit U.S. 
securities firms to move their general securities dealing activities 
into an OTC derivatives dealer affiliate or to establish proprietary 
securities trading desks in the new entity.\55\ In this regard, the 
Government Finance Officers Association (``GFOA'') questioned whether 
the proposal provided sufficient safeguards to ensure that a firm did 
not move its dealer activity in cash market instruments, such as stocks 
and bonds, to an OTC derivatives dealer.\56\ Other commenters, however, 
believed that the proposal contained enough restrictions on securities 
dealing activities to avoid such behavior by an OTC derivatives dealer 
acting in good faith.\57\
---------------------------------------------------------------------------

    \55\ See, e.g, Proposing Release, Section II.A.1., n.17, 62 FR 
67942, n.17.
    \56\ Comment Letter from the Government Finance Officers 
Association (``GFOA Letter''), p. 3.
    \57\ E.g., Comment Letter from Morgan Stanley Dean Witter 
(``MSDW Letter''), p. 10. In addition, one commenter suggested a 
simple prohibition on that business instead of a series of detailed 
and complex prophylactic limitations on the permissible activities 
of an OTC derivatives dealer. Comment Letter from Salomon Smith 
Barney (``Salomon Smith Barney Letter''), p. 2.
---------------------------------------------------------------------------

    Taking these comments into account, the final rule provides that an 
OTC derivatives dealer is a dealer that is affiliated with a registered 
broker or dealer (other than an OTC derivatives dealer) and whose 
securities activities are limited to (1) engaging in dealer \58\ 
activities in eligible OTC derivative instruments that are securities; 
(2) issuing and reacquiring securities that are issued by the dealer, 
including warrants on securities, hybrid securities,\59\ and structured 
notes;\60\ (3) engaging in cash management securities activities (as 
defined in Rule 3b-14); (4) engaging in ancillary portfolio management 
securities activities (as defined in Rule 3b-15); and (5) engaging in 
such other securities activities that the Commission designates by 
order.
---------------------------------------------------------------------------

    \58\ When used in the context of eligible OTC derivative 
instruments (as defined in Rule 3b-13 (17 CFR 240.3b-13) or in the 
context of OTC derivative instruments in general, the term 
``dealer'' activities includes buying, selling, and entering into 
OTC derivative instruments. See Section 3(a)(5) of the Exchange Act 
(15 U.S.C. 78c(a)(5)) (defining dealer).
    \59\ See Section II.A.4. below, discussing the definition of the 
term ``hybrid security.''
    \60\ In the Proposing Release, the requirement that an OTC 
derivatives dealer issue or reacquire its issued securities through 
a fully regulated broker or dealer (other than an OTC derivatives 
dealer) was set forth in proposed Rule 3b-12(a)(2), as well as in 
proposed Rule 15a-1(a)(1)(ii), regarding the permissible securities 
activities of an OTC derivatives dealer. This requirement, however, 
has been omitted from final Rule 3b-12, and included only in final 
Rule 15a-1(c). In this regard, while the securities transactions of 
an OTC derivatives dealer generally must be effected through an 
affiliated fully regulated broker-dealer, an OTC derivatives dealer 
may issue and reacquire its issued securities through an 
unaffiliated fully regulated broker-dealer. See Rule 15a-1(c) (17 
CFR 240.15a-1(c)) (discussed in Section II.C.3. below).
---------------------------------------------------------------------------

    As detailed in Section II.A.5. below, the Commission has defined 
the terms ``cash management securities activities'' and ``ancillary 
portfolio management securities activities.'' These two terms replace 
the term ``permissible risk management, arbitrage, and trading 
transactions,'' which was included in the Proposing Release. The new 
terms serve substantially the same purpose as the proposed term in that 
they describe the additional securities activities in which an OTC 
derivatives dealer may engage in connection with its OTC derivatives 
business. As a practical matter, a firm seeking to register as an OTC 
derivatives dealer will need to be able to conduct these additional 
securities activities, such as engaging in certain financing and 
hedging transactions, in order to compete effectively with other market 
participants.
    The focus of the alternative regulatory structure for OTC 
derivatives dealers, however, is on providing a regulatory vehicle that 
will allow a U.S. securities firm to establish a separately capitalized 
entity through which to book an OTC derivatives business. As a result, 
the final rules, including the definitions of ``cash management 
securities activities'' and ``ancillary portfolio management securities 
activities'' contain appropriate limitations to prevent an OTC 
derivatives dealer from engaging in dealing activities in cash market 
instruments or in substantial proprietary trading activities.
    Rule 3b-12, as adopted, also requires that the securities 
activities of an OTC derivatives dealer consist primarily of engaging 
in dealer activities in eligible OTC derivative instruments that are 
securities, issuing and reacquiring its issued securities, and engaging 
in cash management securities activities. Thus, if the securities 
activities of an OTC derivatives dealer were to consist only or 
primarily of ancillary portfolio management securities activities, the 
OTC derivatives dealer would be in violation of the rule. For instance, 
an OTC derivatives dealer that trades in exchange-traded futures 
contracts may not engage in securities activities that consist only or 
primarily of managing the risks of those futures transactions.

[[Page 59370]]

    In addition, Rule 3b-12 expressly states that an OTC derivatives 
dealer's securities activities may not consist of any securities 
activities other than those included in the rule, including engaging in 
any transaction in any security that is not an eligible OTC derivative 
instrument, except for cash management securities activities, ancillary 
portfolio management securities activities, and such other securities 
activities that the Commission may designate by order. This position is 
consistent with the general principle that a broker-dealer is not 
permitted to move dealer activities in cash market instruments into the 
OTC derivatives dealer.\61\
---------------------------------------------------------------------------

    \61\ As stated in the Proposing Release, except to the extent 
expressly permitted under the rules and rule amendments, an OTC 
derivatives dealer may not engage directly or indirectly in any 
activity that may otherwise cause it to be a ``dealer'' as defined 
in Section 3(a)(5) of the Exchange Act (15 U.S.C. 78c(a)(5)). This 
includes, but is not limited to, without regard to the security, (1) 
purchasing or selling securities as principal from or to customers; 
(2) carrying a dealer inventory in securities (or any portion of an 
affiliated broker-dealer's inventory); (3) quoting a market in or 
publishing quotes for securities (other than quotes on one side of 
the market on a quotations system generally available to non-broker-
dealers, such as a retail screen broker for government securities) 
in connection with the purchase or sale of securities permitted 
under Rule 15a-1; (4) holding itself out as a dealer or market-maker 
or as being otherwise willing to buy or sell one or more securities 
on a continuous basis; (5) engaging in trading in securities for the 
benefit of others (including any affiliate), rather than solely for 
the purpose of the OTC derivatives dealer's investment, liquidity, 
or other permissible trading objective; (6) providing incidental 
investment advice with respect to securities; (7) participating in a 
selling group or underwriting with respect to securities; or (8) 
engaging in purchases or sales of securities from or to an 
affiliated broker-dealer except at prevailing market prices. See 
Proposing Release, Section II.A.4., n.24, 62 FR at 67944, n.24.
---------------------------------------------------------------------------

    As some commenters noted, the ability of the Commission to issue 
orders under Rule 15a-1(b)(1) identifying other permissible securities 
activities in which an OTC derivatives dealer may engage should help to 
mitigate concerns that the definition sets forth specific limitations 
on the securities activities of these entities.\62\ As provided in the 
Proposing Release, the Commission is amending Rule 30-3 of the Rules of 
Practice to delegate its authority to issue these orders to the 
Director of the Division of Market Regulation.\63\
---------------------------------------------------------------------------

    \62\ See, e.g., SIA Letter I, pp. 6-7. See also Rule 15a-1(b)(1) 
(17 CFR 240.15a-1(b)(1)) and Section II.C.2. below, discussing the 
ability of the Commission to issue orders under Rule 15a-1(b) (17 
CFR 240.15a-1(b)) regarding the securities activities of OTC 
derivatives dealers.
    \63\ Proposing Release, Section II.C., n.27, 62 FR at 67944, 
n.27. See Rule 30-3(a)(64) (17 CFR 200.30-3(a)(64)).
---------------------------------------------------------------------------

2. Rule 3b-13; Definition of Eligible OTC Derivative Instrument
    An OTC derivatives dealer is permitted to engage in dealer 
activities in eligible OTC derivative instruments, as that term is 
defined in Rule 3b-13. As proposed, Rule 3b-13 would have defined 
``eligible OTC derivative instrument'' to mean any agreement, contract, 
or transaction (1) that is not part of a fungible class of agreements, 
contracts, or transactions that are standardized as to their material 
economic terms; (2) that is based, in whole or in part, on the value 
of, any interest in, any quantitative measure of, or the occurrence of 
any event relating to, one or more securities, commodities, currencies, 
interest or other rates, indices, or other assets, or involve certain 
long-dated forward contracts, specifically contracts to purchase or 
sell a security on a firm basis at least one year following the 
transaction date; \64\ and (3) that is not entered into and traded on 
or through an exchange, an electronic marketplace, or similar facility 
supervised or regulated by the Commission, or any other multilateral 
transaction execution facility.\65\
---------------------------------------------------------------------------

    \64\ The concern with forwards is that an OTC derivatives dealer 
should not be able to engage in dealer activities in short-dated 
securities forwards that may in effect replicate cash market 
instruments or in certain government securities forwards, such as 
Government National Mortgage Association (GNMA) forwards.
    \65\ Proposing Release, Section II.A.2., 62 FR at 67942.
---------------------------------------------------------------------------

    Several commenters criticized this proposed definition.\66\ For 
example, the SIA argued that the proposed definition failed to include 
certain important categories of transactions, such as transactions that 
are based on the occurrence or nonoccurrence of specified events, but 
that do not technically relate to one or more securities, commodities, 
and the like, although they are associated with financial consequences, 
such as credit derivatives.\67\ Morgan Stanley Dean Witter argued that 
the requirement that eligible OTC derivative instruments be based on at 
least one of an enumerated list of underlying assets could 
unnecessarily limit these dealers' activities in rapidly evolving 
products while Commission approval was being sought on a product-by-
product basis.\68\
---------------------------------------------------------------------------

    \66\ See letters cited in Section IV.B. of the Comment Summary.
    \67\ SIA Letter I, pp. 9-10; see also Merrill Lynch Letter, p. 
7.
    \68\ MSDW Letter, p. 6.
---------------------------------------------------------------------------

    The SIA also suggested alternative definitions of ``eligible OTC 
derivative instrument'' and recommended that the Commission clarify 
that it was not intending to construe or expand the definition of 
``security'' under the Exchange Act.\69\ Several commenters asked that 
the Commission clarify what instruments would be considered 
``securities'' OTC derivative instruments and ``non-securities'' OTC 
derivative instruments for purposes of the rules.\70\ Merrill Lynch 
agreed in principle with the approach of proposed Rule 3b-13, but also 
suggested that an OTC derivatives dealer be able to seek expedited 
interpretative guidance for new derivative instruments.\71\
---------------------------------------------------------------------------

    \69\ SIA Letter I, p. 10. See also Comment Letter from SIA, 
dated October 16, 1998 (``SIA Letter II''), pp. 2-3.
    \70\ EUDA Letter, p. 2; GFOA Letter, p. 1; Comment Letter from 
the New York Stock Exchange (``NYSE Letter''), p. 3.
    \71\ Merrill Lynch Letter, p. 7.
---------------------------------------------------------------------------

    Several commenters were also concerned that the proposed definition 
required that forwards have a duration period of one year or more in 
order to qualify as an eligible OTC derivative instrument, and 
suggested shorter periods, such as one month or two weeks.\72\ The SIA 
suggested that, in including a duration period for forwards, the 
definition should distinguish between government securities forwards 
and forwards involving non-government securities.\73\ In addition, the 
SIA maintained that those securities forwards having material features 
of a type described in the definition of eligible OTC derivative 
instrument should qualify as eligible OTC derivative instruments.\74\
---------------------------------------------------------------------------

    \72\ SIA Letter I, pp. 9-10; Merrill Lynch Letter, p. 7; Comment 
Letter from D.E. Shaw & Co. L.P. (``DESCO Letter''), p. 7.
    \73\ SIA Letter II, p. 2.
    \74\ Id. 
---------------------------------------------------------------------------

    Several commenters raised concerns with the use of concepts from 
the CEA in defining the term eligible OTC derivative instrument. In its 
comment letter, the Commodity Futures Trading Commission (``CFTC'') 
noted that the proposed definition relied on criteria that were similar 
to, but not the same as, the criteria for qualifying transactions under 
the CFTC's part 35 swaps exemption.\75\ The CFTC stated that a 
registered OTC derivatives dealer could effect transactions that would 
be permissible under the proposed rules, but that would not be exempted 
under part 35 from the provisions of the CEA, and thus market 
participants might face legal uncertainty concerns in entering into 
certain derivatives transactions.
---------------------------------------------------------------------------

    \75\ CFTC Letter, pp. 11-12. The CFTC's Part 35 regulations 
exempt certain swap transactions from most provisions of the CEA, 
provided that the transaction is conducted solely between ``eligible 
swap participants,'' as defined in part 35 (17 CFR part 35).
---------------------------------------------------------------------------

    On a similar note, two commenters were concerned that the proposed

[[Page 59371]]

definition adopted concepts from the CEA in excluding transactions that 
were standardized or traded on ``an exchange, an electronic 
marketplace, or similar facility supervised or regulated by the 
Commission, or any other multilateral transaction execution facility.'' 
\76\ The SIA argued that the text potentially could exclude from the 
definition a broad range of transactions involving exempt securities, 
as well as transactions that did not involve securities at all, which 
it believed should not be excluded from the proposed definition. The 
SIA also opined that the proposed language would spawn significant 
uncertainty over its scope.\77\ Morgan Stanley Dean Witter similarly 
claimed that the use of terms contained in the CEA that were not 
commonly understood in the securities law context caused the definition 
of ``eligible OTC derivative instrument'' to be ambiguous.\78\
---------------------------------------------------------------------------

    \76\ SIA Letter I, pp. 9-10; MSDW Letter, pp. 7-8.
    \77\ SIA Letter I, p.9.
    \78\ MSDW Letter, pp. 7-8.
---------------------------------------------------------------------------

    In response to these comments, the Commission has revised the 
definition of eligible OTC derivative instrument in several ways. As 
adopted, Rule 3b-13 defines eligible OTC derivative instrument to mean, 
subject to certain exceptions, any contract, agreement, or transaction 
that provides, in whole or in part, on a firm or contingent basis, for 
the purchase or sale of, or is based on the value of, or any interest 
in, one or more commodities, securities, currencies, interest or other 
rates, indices, quantitative measures, or other financial or economic 
interests or property of any kind, or that involves any payment or 
delivery that is dependent on the occurrence or nonoccurrence of any 
event associated with a potential financial, economic, or commercial 
consequence, or any combination or permutation of the foregoing.\79\ 
The term eligible OTC derivative instrument, however, does not include 
certain forwards on securities, securities listed or traded on a 
national securities exchange or on Nasdaq, or fungible securities 
derivative instruments that are standardized as to their material 
economic terms.\80\
---------------------------------------------------------------------------

    \79\ Rule 3b-13(a) (17 CFR 240.3b-13(a).
    \80\ See Rule 3b-13(b) (17 CFR 240.3b-13).
---------------------------------------------------------------------------

    Rule 3b-13 defines eligible OTC derivative instrument broadly to 
encompass the wide range of securities and non-securities OTC 
derivative instruments currently existing in the derivatives markets, 
as well as to allow for the inclusion of reasonably similar instruments 
that market participants may develop in the future. The types of 
instruments that generally satisfy the criteria set forth in Rule 3b-13 
include interest rate swaps, currency swaps, equity swaps, swaps 
involving physical commodities (such as metals or petroleum), OTC 
options on equities (including equity indices), OTC options on U.S. 
government securities, OTC debt options (including options on debt 
indices), options on physical commodities, long-dated forwards on 
securities, and forwards relating to other types of assets. Other types 
of instruments also satisfy the criteria in the rule.
    The definition of eligible OTC derivative instrument has also been 
revised to omit terms commonly understood in the context of the CEA. As 
a technical matter, exchange-traded futures will now fall within the 
definition of eligible OTC derivative instrument. As discussed in 
Section II.A.1. above, however, the rules limit only the securities 
activities of an OTC derivatives dealer, and, subject to appropriate 
capital treatment and compliance with internal risk management controls 
requirements, an OTC derivatives dealer generally may engage in any 
non-securities activities. Thus, the new regulatory structure does not 
limit an OTC derivatives dealer's ability to engage in futures 
activities, which is consistent with the current approach toward the 
regulation of general securities broker-dealers. The activities of an 
OTC derivatives dealer, however, must comply with any and all 
applicable laws, including the CEA to the extent it applies to any 
particular transaction.
    In response to comments raised by the SIA,\81\ the final rule also 
distinguishes between government securities forwards and other 
securities forwards with respect to duration periods. Rule 3b-13 
generally excludes from the definition of eligible OTC derivative 
instrument forwards on a government security that settle within twelve 
months, and certain other securities forwards that satisfy the 
definition of ``eligible forward contract'' \82\ that settle within 
four months.\83\ Although the duration period for an ``eligible forward 
contract'' is shorter than the original proposal of one year for all 
securities forwards, the periods better reflect the manner in which an 
OTC derivatives business is conducted and will continue to constrain an 
OTC derivatives dealer from improperly engaging in the types of forward 
transactions that should occur in its fully regulated broker-dealer 
affiliate.\84\ The final rule has also been revised to include as 
eligible OTC derivative instruments those securities forwards that have 
material economic features primarily of a type described in the 
definition of eligible OTC derivative instrument (other than the 
provision for the purchase and sale of a security on a firm basis).
---------------------------------------------------------------------------

    \81\ See supra note 73.
    \82\ For purpose of Rule 3b-13, the term ``eligible forward 
contract'' means ``a forward contract that provides for the purchase 
or sale of a security other than a government security, provided 
that, if such contract provides for the purchase or sale of margin 
stock (as defined in Regulation U of the Regulations of the Board of 
Governors of the Federal Reserve System, 12 CFR part 221), such 
contract either (1) provides for the purchase or sale of such stock 
by the issuer thereof (or an affiliate that is not a bank or a 
broker or dealer); or (2) provides for the transfer of transaction 
collateral in an amount that would satisfy the requirements, if any, 
that would be applicable assuming the OTC derivatives dealer party 
to such transaction were not eligible for the exemption from 
Regulation T of the Regulations of the Board of Governors of the 
Federal Reserve System, 12 CFR part 220, set forth in (Rule 36a1-1).
    \83\ In its comment letter, the SIA requested guidance regarding 
the application of the duration requirement for securities forwards 
in the context of certain transaction structures that require a 
forward to be market-to-market and repriced. See SIA Letter II, p. 
2, n.1. For example, a contract may provide that it is to be 
periodically marked-to-market and repriced with a settlement payment 
to be made on each repricing date in an amount equal to the change 
in the value of the underlying security. Id. In response to the 
SIA's request, under Rule 3b-13, where a securities forward 
transaction provides for reset or repricing dates, such dates will 
be viewed as settlement dates, and will cause the forward to be 
separated into shorter duration periods, only if the parties can 
close out the transaction on such dates. For example, if a one-year 
securities forward resets monthly to mitigate the credit risk 
associated with the transaction, and the parties can close out the 
forward on the reset date, for purposes of Rule 3b-13, the 
transaction will be regarded as separate one-month forward 
transaction. If, however, the parties are not able to close out the 
forward, or otherwise discharge their obligations under the contract 
by accelerating all or part of the originally scheduled physical 
settlement, on the reset dates, then the reset dates will not be 
viewed as separate settlement dates.
    \84\ A fully regulated broker-dealer is not permitted to move 
its securities book to the OTC derivatives dealer by forwarding out 
its positions and then reversing those transactions. See Rule 15a-
1(a) (17 CFR 240.15a-1(a).
---------------------------------------------------------------------------

    The definition of eligible OTC derivative instrument excludes 
securities derivative instruments that are listed or traded on an 
exchange or on Nasdaq. Similarly, the definition excludes those 
securities derivative instruments that are one of a class of fungible 
instruments that are standardized as to their material economic terms. 
With respect to the exclusion for certain fungible instruments, the 
Commission has retained the authority under Rule 15a-1(b)(2) to 
determine by order that a securities derivative instrument that is one 
of a class of fungible instruments that are standardized as to their 
material economic terms is within the scope of eligible OTC derivative 
instrument. This

[[Page 59372]]

authority will permit the Commission, in limited circumstances, to 
expand the types of securities derivative instruments in which an OTC 
derivatives dealer may engage in dealer activities. The Commission is 
amending Rule 30-3 of the Rules of Practice to delegate this authority 
to the Director of the Division of Market Regulation.\85\
---------------------------------------------------------------------------

    \85\ See Rule 30-3(a)(65) (17 CFR 200.30-3(a)(65). See also 
Section II.C.2. below, discussing the ability of the Commission to 
issue orders under rule 15a-1(b) (17 CFR 240.15a-1(b) regarding the 
securities activities of OTC derivatives dealers.
---------------------------------------------------------------------------

    As noted above, the Commission responded to commenters' concerns by 
adopting an expansive definition of eligible OTC derivative instrument, 
with few exclusions. The final rule thereby permits an OTC derivatives 
dealer to deal in a broad array of financial instruments in order to 
accommodate current business practices.\86\ Because of this 
accommodation, however, the Commission has also reserved the authority 
under Rule 15a-1(b) to issue orders clarifying whether certain 
contracts, agreements, or transactions are within the scope of eligible 
OTC derivative instrument.\87\
---------------------------------------------------------------------------

    \86\ The Commission will consider the economic realities of a 
securities transaction, and not the label assigned to the 
transaction, for purposes of determining whether a particular 
transaction is permitted under the alternative regulatory framework. 
See, e.g., In the Matter of BT Securities Corporation, Exchange Act 
Release No. 35136 (Dec. 22, 1994). For example, an OTC derivatives 
dealer may not engage in a forward transaction that would otherwise 
not be permitted under the framework in the guise of options or 
other permitted transactions.
    \87\ See Rule 15a-1(b)(3) (17 CFR 240.15a-1(b)(3). Unlike other 
provisions contained in these rules that permit the expansion of OTC 
derivatives dealers' activities, this authority has not been 
delegated to the staff.
---------------------------------------------------------------------------

    The final rules, however, do not define the term ``securities OTC 
derivative instrument,'' which is intended to encompass OTC derivative 
instruments that are securities. The term ``security'' is defined in 
section 3(a)(10) of the Exchange Act,\88\ and the final rules do not 
interpret or amend the definition of ``security'' under the Exchange 
Act. Staff guidance will continue to remain available regarding the 
applicability of the federal securities laws to any particular OTC 
derivative instrument.\89\
---------------------------------------------------------------------------

    \88\ 15 U.S.C. 78c(a)(10).
    \89\ Questions on this subject should be addressed to the Office 
of Chief Counsel, Division of Market Regulation, Securities and 
Exchange Commission, 450 Fifth Street, NW, Mail Stop 10-1, 
Washington, DC 20549, (202) 942-0073
---------------------------------------------------------------------------

3. Proposed Rule 3b-14; Definition of Permissible Derivatives 
Counterparty
    Proposed Rule 3b-14 defined those entities and natural persons that 
would have been eligible to engage in an OTC derivatives transaction 
with an OTC derivatives dealer. As the Proposing Release noted, these 
persons included the same persons who currently are eligible to effect 
transactions with swaps dealers under the CFTC's Part 35 
regulations.\90\ The Proposing Release also sought specific comment on 
whether the definition of permissible derivatives counterparty should 
be expanded to include natural persons having at least $5 million in 
total assets who entered into OTC derivatives transactions to hedge 
existing or anticipated assets or liabilities.\91\
---------------------------------------------------------------------------

    \90\ Proposing Release, Section II.A.3., 62 FR at 67942.
    \91\ Id.
---------------------------------------------------------------------------

    Most commenters suggested that a broad range of persons should be 
able to act as permissible derivatives counterparties, and believed 
that the definition should be expanded, at a minimum, to include 
natural persons having at least $5 million in total assets as 
proposed.\92\ The SIA opined that these natural persons were 
appropriate counterparties and would benefit from having access to risk 
mitigation products that could be tailored to their individual 
circumstances and objectives.\93\
---------------------------------------------------------------------------

    \92\ See letters cited in Section IV.C. of the Comment Summary.
    \93\ SIA Letter I, p. 10.
---------------------------------------------------------------------------

    A few commenters, however, raised concerns that the proposed group 
of permissible derivatives counterparties could include unsophisticated 
persons who would need the protections provided by the securities sales 
practice requirements.\94\ D.E. Shaw & Co. noted that an OTC 
derivatives dealer would have to rely upon information provided by the 
counterparty as to its total assets or net worth, and suggested that an 
OTC derivatives dealer should only be required to have a ``reasonable 
belief'' that the counterparty was a ``permissible derivatives 
counterparty.'' \95\
---------------------------------------------------------------------------

    \94\ See, e.g., NYSE Letter, p. 3; EUDA Letter, p. 2.
    \95\ DESCO Letter, pp. 7-8.
---------------------------------------------------------------------------

    The CFTC, in turn, raised concerns that conflicts might arise 
between the Commission's rules and the CFTC's rules in connection with 
the proposed definition of permissible derivatives counterparty, 
particularly if the definition were expanded to include parties who 
would not be eligible swap participants under the CFTC's Part 35 
regulations. The CFTC suggested that if an OTC derivatives dealer were 
to enter into a transaction with a permissible derivatives counterparty 
that was not an eligible swap participant, the transaction would be 
outside the exemption of the Part 35 regulations, and could therefore 
constitute an illegal futures or commodity option contract.\96\
---------------------------------------------------------------------------

    \96\ CFTC Letter, p. 12.
---------------------------------------------------------------------------

    In response to commenters' concerns, and in light of the 
protections afforded through other provisions of the alternative 
regulatory framework, the final rules do not restrict the persons that 
may act as counterparties in OTC derivatives transactions with an OTC 
derivatives dealer. Instead, the final rules contain certain safeguards 
designed to protect an OTC derivatives dealer's counterparties, as well 
as to prevent trading in standardized and fungible OTC derivative 
instruments that are securities.
    In particular, Rule 15a-1 requires, subject to limited exceptions, 
an OTC derivatives dealer to effect any securities transaction through 
its fully regulated broker-dealer affiliate, subject to all applicable 
sales practice requirements.\97\ In addition, Rule 3b-13 excepts from 
the definition of eligible OTC derivative instrument those securities 
contracts that are one of a class of fungible instruments that are 
standardized as to their material economic terms.\98\ The elimination 
of counterparty restrictions also addresses concerns that confusion 
about the applicability of the CEA could arise as a result of any 
differences between the terms ``permissible derivatives counterparty'' 
and ``eligible swap participant.'' As noted above, this rulemaking does 
not affect the applicability of the CEA to any particular transaction.
---------------------------------------------------------------------------

    \97\ Rule 15a-1(c) (17 CFR 240.15a-1(c)).
    \98\ Rule 3b-13(b)(2)(ii) (17 CFR 240.3b-13(b)(2)(ii)).
---------------------------------------------------------------------------

4. Proposed Rule 3b-16; Definition of Hybrid Security
    As proposed, Rule 3b-16 would have defined hybrid security to mean 
a security that incorporates payment features economically similar to 
options, forwards, futures, swap agreements, or collars involving 
currencies, interest rates, commodities, securities, or indices (or any 
combination, permutation, or derivative of such contract or underlying 
interest). The definition of hybrid security did not raise many 
comments.
    The CFTC, however, expressed concerns that, in proposing a 
definition of hybrid security, no consideration was given to the scope 
of the exemption for hybrid instruments contained in the CFTC's Part 34 
regulations.\99\ The CFTC

[[Page 59373]]

noted that some of the instruments that would qualify as ``acceptable'' 
hybrid securities were actually futures or commodity option contracts 
that were not exempted under the CFTC's Part 34 regulations and could 
thus be illegal under the CEA.\100\
---------------------------------------------------------------------------

    \99\ CFTC Letter, p. 13. Hybrid instruments are depository 
instruments or securities instruments, such as debt or equity 
securities, that have one or more commodity-dependent components 
with payment features similar to commodity futures or commodity 
option contracts. Under the CFTC's part 34 regulations, such 
instruments may be exempt from regulation under the CEA if the sum 
of the commodity-dependent values of the commodity-dependent 
components of the instrument is less than the commodity-dependent 
value of the commodity-independent component. 17 CFR part 34.
    \100\ CFTC Letter, p. 13.
---------------------------------------------------------------------------

    The term hybrid security, however, is limited to securities that 
incorporate the enumerated payment features. In addition, the 
alternative regulatory framework employs the term only in the context 
of an OTC derivatives dealer's ability to issue and reacquire its 
issued securities (including hybrid securities) under Rules 3b-12 and 
15a-1. Moreover, as stated previously, an OTC derivatives dealer 
remains subject to all other applicable statutes, rules, and 
regulations. To the extent that the offer and sale of hybrid securities 
by an OTC derivatives dealer are covered by the CEA, the transactions 
would need to be structured to qualify for available exemptions. 
Nevertheless, because of the limited use of the term under the 
alternative regulatory framework, the Commission is not adopting a 
separate rule defining ``hybrid security,'' but rather is including a 
definition of the term only for purposes of Rules 3b-12 and 15a-1.
    Certain revisions have been made to the definition of ``hybrid 
security'' to achieve conformity with the revisions to the final 
definition of eligible OTC derivative instrument as set forth in Rule 
3b-13.\101\ Accordingly, for purposes of Rules 3b-12 and 15a-1, a 
``hybrid security'' is defined to mean a security that incorporates 
payment features economically similar to options, forwards, futures, 
swap agreements, or collars involving currencies, interest or other 
rates, commodities, securities, indices, quantitative measures, or 
other financial or economic interests or property of any kind, or any 
payment or delivery that is dependent on the occurrence or 
nonoccurrence of any event associated with a potential financial, 
economic, or commercial consequence (or any combination, permutation, 
or derivative of such contract or underlying interest).\102\
---------------------------------------------------------------------------

    \101\ See discussion at Section II.A.2. above See also SIA 
Letter II, p. 3, n.2.
    \102\ See Rules 3b-12(d) (17 CFR 240.3b-12(d)) and 15a-1(e) (17 
CFR 240.15a-1(e)).
---------------------------------------------------------------------------

5. Rules 3b-14 and 3b-15; Definitions of Cash Management Securities 
Activities and Ancillary Portfolio Management Securities Activities
    Proposed Rule 3b-15 would have permitted an OTC derivatives dealer 
to engage in a limited range of securities activities, described under 
the rule as ``permissible risk management, arbitrage, and trading 
transactions,'' in connection with the dealer's business as a 
counterparty in eligible OTC derivative instruments and as an issuer of 
securities. As discussed above, the focus of the alternate regulatory 
system for OTC derivatives dealers is to permit U.S. securities firms 
to establish a separately capitalized booking vehicle for an OTC 
derivatives business. However, in order to operate a competitive 
business, an OTC derivatives dealer must also be able to engage in 
limited securities trading activities in connection with its OTC 
derivatives dealing business. This includes the ability to take 
possession of and sell counterparty collateral, to invest short-term 
cash balances, to engage in certain financing transactions, and to 
manage risks associated with its OTC derivatives positions or its 
issuance of securities.
    These related securities activities, however, must be subject to 
appropriate limitations to prevent an OTC derivatives dealer from 
engaging in dealing activity in cash market instruments. An OTC 
derivatives dealer should not be provided with an unfair regulatory 
advantage over a fully regulated broker-dealer due to the availability 
of modified capital and margin requirements. In addition, an entity 
that engages in comprehensive securities dealing activity should be 
subject to full broker-dealer regulation, including existing capital 
and margin requirements, and be subject to supervision by an SRO.
    Moreover, appropriate limitations on the related securities 
activities of an OTC derivatives dealer must be in place to prevent the 
dealer from engaging in substantial proprietary securities trading 
activities. The alternative regulatory framework is not intended to 
allow an OTC derivatives dealer to operate in a manner similar to an 
active securities trader, such as a hedge fund. Accordingly, under the 
final rules, an OTC derivatives dealer may not engage in any 
transaction in any security that is not an eligible OTC derivative 
instrument, with the exception of activities permitted under final 
Rules 3b-14 and 3b-15, as discussed below.\103\
---------------------------------------------------------------------------

    \103\ See Rules 3b-12(c) (17 CFR 240.3b-12(c)) and 15a-1(a)(3) 
(17 CFR 240.15a-1(a)(3)).
---------------------------------------------------------------------------

    Under the regulatory framework, as proposed, the definition of 
``permissible risk management, arbitrage, and trading transactions'' 
attempted to carefully define activities associated with managing the 
risk of an OTC derivatives dealer's business, while excluding other 
securities dealing and proprietary trading activities. Based on the 
comments received on the scope of ``permissible risk management, 
arbitrage, and trading transactions,'' however, the final rules have 
been restructured to more accurately reflect the types of cash 
management and portfolio management activities engaged in by dealers in 
OTC derivative instruments. Therefore, as noted above, the Commission 
is not adopting a definition of ``permissible risk management, 
arbitrage, and trading transactions,'' but rather is defining two new 
terms: ``cash management securities activities'' and ``ancillary 
portfolio management securities activities.'' \104\
---------------------------------------------------------------------------

    \104\ With certain exceptions (see Section II.C.3. below), all 
cash management securities activities and ancillary portfolio 
management securities activities must be effected through an OTC 
derivatives dealer's fully regulated broker-dealer affiliate. See 
Rule 15a-1(c) (17 CFR 240.15a-1(c)).
---------------------------------------------------------------------------

    a. Rule 3b-14; Cash Management Securities Activities. An OTC 
derivatives dealer may engage in ``cash management securities 
activities,'' as defined in Rule 3b-14. Under the rule, an OTC 
derivatives dealer may engage in cash management securities activities 
in connection with its securities activities as permitted under Rule 
15a-1 (discussed in Section II.C.1. below) or its non-securities 
activities that involve eligible OTC derivative instruments or other 
financial instruments. Cash management securities activities are 
limited to (1) any taking possession of, and any subsequent sale or 
disposition of, collateral provided by a counterparty, or any 
acquisition of, and any subsequent sale or disposition of, collateral 
to be provided to a counterparty; (2) cash management; and (3) 
financing of certain positions of the dealer. Each of these three 
categories of cash management securities activities is discussed in 
more detail below.
    i. Counterparty Collateral. Proposed Rule 3b-15(a) would have 
allowed an OTC derivatives dealer to take possession of and sell 
counterparty collateral, in connection with the dealer's business as a 
counterparty in eligible OTC derivative instruments and as an issuer of 
securities. The SIA

[[Page 59374]]

argued that this provision unduly restricted the scope of activities, 
and requested that the rule be modified to allow an OTC derivatives 
dealer to engage in (1) any disposition of collateral provided by a 
counterparty; and (2) the acquisition of, and any subsequent sale or 
disposition of, collateral to be provided to a counterparty.\105\
---------------------------------------------------------------------------

    \105\ SIA Letter I, p. 8.
---------------------------------------------------------------------------

    To allow an OTC derivatives dealer to take appropriate action with 
respect to counterparty collateral, an OTC derivatives dealer's 
activities should not be limited to taking possession of and selling 
collateral, but should also extend to other dispositions of the 
collateral. Therefore, Rule 3b-14(a), as adopted, has been revised to 
expand the permissible activities of an OTC derivatives dealer with 
respect to counterparty collateral.
    Rule 3b-14(a), like proposed Rule 3b-15(a), does not limit any use 
of the counterparty collateral consistent with the agreements entered 
into between dealers and their counterparties. As the End-Users of 
Derivatives Association, Inc. (``EUDA'') noted, many end-users deny 
counterparties free use of posted collateral because it may expose the 
pledging party to significant additional credit risk.\106\ In this 
regard, Rule 3b-14 is not intended to have any effect on individually 
negotiated collateral support agreements or any rehypothecation rights 
contained in these agreements.
---------------------------------------------------------------------------

    \106\ EUDA Letter, p. 3.
---------------------------------------------------------------------------

    ii. Cash Management. Rule 3b-14(b), as adopted, permits an OTC 
derivatives dealer to engage in cash management activities in 
connection with the dealer's securities activities (as permitted under 
Rule 15a-1) or its non-securities activities that involve eligible OTC 
derivative instruments or other financial instruments.\107\ Rule 3b-
14(b) applies only to managing cash of the OTC derivatives dealer, and 
not of its affiliates. Thus, any securities trading activities 
associated with cash management by an OTC derivatives dealer must be at 
a level commensurate with the OTC derivatives dealer's bona fide 
operational needs, taking into consideration the Commission's capital 
requirements for the OTC derivatives dealer and the amount of capital 
needed to satisfy the credit requirements of counterparties.
---------------------------------------------------------------------------

    \107\ As proposed, Rule 3b-15(b) would have permitted an OTC 
derivatives dealer to engage in transactions involving cash 
management, in connection with the dealer's business as a 
counterparty in eligible OTC instruments and as an issuer of 
securities. Proposing Release, Section II.A4., 62 FR at 67943. No 
commenters specifically addressed permitted cash management 
practices.
---------------------------------------------------------------------------

    Cash management securities activities must also be limited to 
trading in instruments that are sufficiently liquid and otherwise 
recognized as appropriate cash management instruments. In addition, 
these activities may not involve moving government securities 
repurchase agreement or other trading books from a fully regulated 
broker-dealer into its OTC derivatives dealer affiliate.
    iii. Financing. Under proposed Rule 3b-15(d), an OTC derivatives 
dealer generally would have been permitted to engage in financing 
transactions in connection with its business as a counterparty in 
eligible OTC derivative instruments and as an issuer of securities. The 
proposed rule would also have required that these financing activities 
be limited to transactions involving securities positions established 
through the taking possession of or sale of counterparty collateral, 
cash management, or hedging activity. The SIA regarded these 
limitations as unduly restrictive, and believed that an OTC derivatives 
dealer should be permitted to finance any aspect of its permitted 
activities, subject to compliance with Section 7(c) or (d) of the 
Exchange Act, as applicable.\108\
---------------------------------------------------------------------------

    \108\ SIA Letter I, p. 8.
---------------------------------------------------------------------------

    In response to these concerns, Rule 3b-14(c) provides that an OTC 
derivatives dealer may finance through securities transactions any 
position of the dealer acquired in connection with its permissible 
securities activities or its non-securities activities that involve 
eligible OTC derivative instruments or other financial instruments. 
Proposed Rule 3b-15 would have permitted financing of certain 
securities positions by means of repurchase and reverse repurchase 
agreements, buy/sell transactions,\109\ and lending and borrowing 
transactions. The final rule eliminates the list of restrictions on the 
types of transactions in which an OTC derivatives dealer may engage to 
finance its positions. However, a broker-dealer may not run such things 
as a repurchase agreement, stock lending, or buy/sell book out of an 
affiliated OTC derivatives dealer in order, for example, to have access 
to financing for the OTC derivatives dealer's business.
---------------------------------------------------------------------------

    \109\ A buy/sell transaction is in many respects the economic 
equivalent of a repurchase transaction. The principal respect in 
which it differs is that title to the instrument that is the subject 
of the transaction passes to another party. See Proposing Release, 
Section II.A.4., n.22, 62 FR at 67943, n.22.
---------------------------------------------------------------------------

    b. Rule 3b-15; Ancillary Portfolio Management Securities 
Activities. In addition to cash management securities activities, an 
OTC derivatives dealer may engage in ``ancillary portfolio management 
securities activities,'' as defined in Rule 3b-15. Under the rule, 
these securities activities must be limited to transactions in 
connection with the OTC derivatives dealer's dealer activities in 
eligible OTC derivative instruments, the issuance of securities by the 
dealer, or such other securities activities that the Commission may 
designate by order. They must also (1) be conducted for the purpose of 
reducing the market or credit risk of the dealer or consist of 
incidental trading activities for portfolio management purposes; and 
(2) be limited to risk exposures within the market, credit, leverage, 
and liquidity risk parameters set forth in both the trading 
authorizations granted to the associated person (or to the associated 
person's supervisor) who executes the transaction for, or on behalf of, 
the dealer, and the written guidelines approved by the dealer's 
governing body and included in the dealer's internal risk management 
control system.\110\ Rule 3b-15 also requires that ancillary portfolio 
management securities activities be conducted only by associated 
persons of the dealer who perform substantial duties for or on behalf 
of the dealer in connection with its dealer activities in eligible OTC 
derivative instruments.
---------------------------------------------------------------------------

    \110\ As discussed in Section II.H.3. below, Rule 15c3-4 (17 CFR 
240.15c3-4) requires an OTC derivatives dealer to establish, 
document, and maintain a system of internal controls for monitoring 
and managing risk associated with its business activities.
---------------------------------------------------------------------------

    The limitations on an OTC derivatives dealer's portfolio management 
activities under Rule 3b-15 are aimed at preventing the fully regulated 
broker-dealer from moving its securities book into its OTC derivatives 
dealer affiliate, establishing a proprietary trading desk in the OTC 
derivatives dealer, or authorizing personnel or trading units 
specifically to engage in proprietary trading activities.\111\ These 
activities are not within the scope of an OTC derivatives dealer's 
primary role as a booking vehicle for OTC derivatives transactions, and 
a firm engaging in

[[Page 59375]]

these activities would be in violation of the rules.\112\
---------------------------------------------------------------------------

    \111\ See also Section II.A.1. above, discussing the limitations 
on securities activities imposed under Rule 3b-12. In short, the 
scope of permissible portfolio management securities activities is 
further limited by the requirement under Rule 3b-12 that the 
securities activities of an OTC derivatives dealer consist primarily 
of engaging in dealer activities in eligible OTC derivative 
instruments that are securities, issuing and requiring securities 
that are issued by the dealer, and cash management securities 
activities. See Rule 3b-12(b) (17 CFR 240.3b-12(b)).
    \112\ See Rule 15a-1 (17 CFR 240.15a-1), and discussion in 
Section II.C. below.
---------------------------------------------------------------------------

    Rule 3b-15, however, does permit an OTC derivatives dealer to 
engage in incidental securities trading activities for portfolio 
management purposes. In permitting this, the rule recognizes that an 
OTC derivatives dealer may to a limited extent engage in a securities 
trading activity for portfolio management purposes that may not 
necessarily be for the specific purpose of reducing the dealer's market 
or credit risk.\113\ This provision of the rule, however, is not 
intended to permit an OTC derivatives dealer to engage in substantial 
securities trading that is not for the purpose of reducing the dealer's 
market or credit risk arising out of its dealer activities in eligible 
OTC derivative instruments (or its issuance of securities).
---------------------------------------------------------------------------

    \113\ For example, a firm that has a long position in equity 
volatility as a result of OTC derivatives transactions with 
counterparties is not required to engage in ancillary portfolio 
management securities activities that reduce that volatility 
exposure. Instead, for example, a firm that believes that equity 
volatility exposure. Instead, for example, a firm that believes that 
equity volatility is underpriced in the market could enter into 
exchange-listed derivatives transactions to create or increase 
existing long volatility exposure. Similarly, a firm whose OTC 
derivatives portfolio included risk exposure to a particular asset 
category or credit could enter into non-OTC derivatives transactions 
in securities that would effectively convert that exposure to a 
different asset category or credit.
---------------------------------------------------------------------------

    As discussed more fully below, the Commission has responded to 
commenters by easing the restrictions on the non-dealing securities 
activities of OTC derivatives dealers and by broadly defining ancillary 
portfolio management securities activities. The final rules are 
intended to be flexible and to accommodate current business practices 
of OTC derivatives dealers. Because, as drafted, the rule defines a 
broad scope of permissible activities, the restrictions on proprietary 
trading and dealing in cash markets may prove inadequate. Thus, Rule 
15a-1(b)(4) preserves the Commission's ability to clarify, by order, 
whether certain securities activities of an OTC derivatives dealer are 
within the scope of ancillary portfolio management securities 
activities.\114\
---------------------------------------------------------------------------

    \114\ See Rule 15a-1(b)(4) (17 CFR 240.15a-1(b)(4)). The 
Commission is not delegating this authority to its staff.
---------------------------------------------------------------------------

    Because the commenters generally focused on the categories of 
activities identified in the definition of ``permissible risk 
management, arbitrage, and trading transactions'' under proposed Rule 
3b-15, each of these categories is discussed separately below.
    i. Hedging. Under proposed Rule 3b-15(c), an OTC derivatives dealer 
would have been permitted to ``hedge an element of market or credit 
risk associated with one or more existing or anticipated transactions 
in eligible OTC derivative instruments or the issuance of securities, 
including warrants on securities, hybrid securities, or structured 
notes.'' This is the only section of the proposed rules that 
specifically addressed the risk management practices of an OTC 
derivatives dealer. For that reason, some commenters believed that the 
Commission should more clearly define what activities would be 
considered ``hedging activity.'' \115\ They essentially did not want an 
OTC derivatives dealer to be limited to hedging only those risks 
arising in connection with the dealer's business as a counterparty in 
eligible OTC derivative instruments and as an issuer of securities, but 
rather wanted the firm to be able to manage risks on a portfolio-wide 
basis through hedging or other risk management techniques.
---------------------------------------------------------------------------

    \115\ See, e.g., Comment Letter from the Association of the Bar 
of the City of New York, Committee on Futures Regulation (``ABCNY 
Committee Letter''), p. 3; see also letters cited in Section 
IV.F.1.b. of the Comment Summary.
---------------------------------------------------------------------------

    For instance, the SIA regarded the limitation on the ``hedging'' 
activities listed in the proposed rule as unduly restrictive, and 
believed that an OTC derivatives dealer should be permitted to ``engage 
in any risk management transaction that is designed to implement 
management's decision as to the market risk profile the firm wishes to 
obtain.'' \116\ In this regard, the SIA commented that dealers do more 
than just hedge their positions, and that many dealers take on levels 
of risk consistent with certain risk parameters. The SIA also claimed 
that an OTC derivatives dealer should be permitted to manage the risks 
associated with cash management, financing, and other permissible 
securities positions, in addition to the risks arising from permissible 
derivative and hybrid positions.\117\ D.E. Shaw & Co., in turn, stated 
that an OTC derivatives dealer should also be able to engage in risk 
management activities that involve the hedging of ``liquidity, legal, 
or operational risks, or any other risks for which derivative hedging 
products are developed.'' \118\
---------------------------------------------------------------------------

    \116\ SIA Letter I, p. 8.
    \117\ Id. See also Merrill Lynch Letter, p. 5. In a later 
comment letter, the SIA also stated that, so long as an OTC 
derivatives dealer's securities activities consisted primarily of 
conducting an OTC derivatives dealing business, an OTC derivatives 
dealer should be permitted to engage in cash market securities 
trading activities for portfolio management purposes, provided that 
these activities did not give rise to portfolio risk exposures that, 
on an aggregate basis, exceeded the risk management parameters for 
the dealer's business pursuant to proposed Rule 15c3-4. SIA Letter 
II, p. 1. It maintained that this approach would permit the dealers 
to engage in portfolio management activities consistent with the 
manner in which such firms currently manage their OTC derivatives 
businesses, but would still preclude firms from establishing OTC 
derivatives dealers to conduct a proprietary trading business in 
cash market securities. Id. While Rule 3b-15, as adopted, has been 
revised in response to the SIA's comments, the rule includes 
additional limitations as a means of permitting reasonable portfolio 
management securities activities, while also prohibiting overly 
broad securities trading activities.
    \118\ DESCO Letter, p. 7.
---------------------------------------------------------------------------

    As discussed earlier, in response to comments received regarding 
the manner in which dealers in OTC derivative instruments conduct their 
business activities, the Commission has restructured the final rules to 
better reflect current firm practices. As a result, Rule 3b-15, as 
adopted, incorporates the concept of managing risk on a portfolio-wide 
basis, and omits any reference to the term ``hedging.'' Thus, the rule 
does not expressly limit the range of permissible portfolio management 
securities activities. Instead, these activities are limited by the 
requirement that they not give rise to risk exposures that, on an 
aggregate portfolio basis, exceed the risk limits adopted for the 
dealer's business under Rule 15c3-4,\119\ as well as other requirements 
that serve to ensure that the OTC derivatives dealer does not engage in 
dealer activities in cash market securities or substantial proprietary 
trading activities.
---------------------------------------------------------------------------

     \119\ In addition to the risk parameters set forth in the 
written guidelines included in the dealer's internal risk management 
control system under Rule 15c3-4 (17 CFR 240.15c3-4), the 
appropriate levels of risk assumed by an OTC derivatives dealer are 
also to be determined by the dealer through trading authorizations 
or limits placed on the associated person executing a transaction on 
the dealer's behalf. See Rule 3b-15(a)(3)(i) (17 CFR 240.3b-
15(a)(3)(i)).
---------------------------------------------------------------------------

    ii. Arbitrage. Under proposed Rule 3b-15(e), an OTC derivatives 
dealer would have been permitted to engage in a transaction involving 
arbitrage, provided that any arbitrage involving securities was limited 
to arbitrage of a securities position that was acquired in connection 
with the taking possession of or selling of counterparty collateral, 
cash management, or hedging activity.\120\ The SIA requested that

[[Page 59376]]

permissible arbitrage activities be expanded to include (1) arbitrage 
of eligible OTC derivatives instruments; (2) arbitrage of short 
securities positions; and (3) arbitrage of prospective securities 
purchases or sales under permitted forward arrangements.\121\
---------------------------------------------------------------------------

     \120\ The Proposing Release further stated that permissible 
arbitrage transactions would be limited to transactions involving 
closely related cash market and derivative instruments that were 
effected close to one another in time for purposes of taking 
advantage of price disparities in different markets. An example 
would include transactions involving the purchase or sale of an 
equity security and the acquisition of an option on the same equity 
security that were effected close together in time, taking into 
consideration market liquidity and hours of market operations. 
Proposing Release, Section II.A.4., n.23, 62 FR at 67943, n.23.
    \121\ SIA Letter I, p. 8. See also Section IV.F.1.d. of the 
Comment Summary.
---------------------------------------------------------------------------

    The final rules do not use the term ``arbitrage'' in describing the 
scope of risk management activities in which an OTC derivatives dealer 
may engage. Instead, the rules are intended to permit any portfolio 
management transaction, including arbitrage transactions, that meet the 
conditions in the rules. As a practical matter, however, a firm 
engaging in an OTC derivatives business typically does not engage in 
``arbitrage'' transactions that would not otherwise qualify as an 
ancillary portfolio management securities activity. Rule 3b-15 allows a 
firm to manage its positions and make a profit, provided that the 
activities occur in connection with its derivatives dealing business 
(or the issuance of securities) and meet the other conditions set forth 
in the rule.
    iii. Trading. To avoid inadvertent violations of the proposed rules 
through an inability to properly document the purpose of a transaction, 
proposed Rule 3b-15(f) would have allowed the OTC derivatives dealer to 
engage in a limited number of certain additional trading transactions. 
In particular, an OTC derivatives dealer generally would have been 
permitted to engage in no more than 150 additional securities 
transactions per year relating to a securities position acquired in 
connection with the taking possession of or selling of counterparty 
collateral, cash management, or hedging activity. Proposed Rule 3b-
15(f) would have further required an OTC derivatives dealer engaging in 
any such trading transaction to maintain and enforce written policies 
and procedures reasonably designed to achieve compliance with the other 
provisions of proposed Rule 3b-15.
    Commenters generally criticized proposed Rule 3b-15(f).\122\ This 
provision was essentially crafted to create a limited ``safe harbor'' 
to protect dealers from committing inadvertent violations of the 
proposed rules because of their inability to properly document the 
purpose of a transaction. The majority of commenters, however, had 
difficulty understanding or applying the provision. For example, the 
SIA expressed concern that the limitation on trading activities might 
inadvertently exclude the purchase or disposition of securities 
delivered or received, or to be delivered or received, by the OTC 
derivatives dealer pursuant to the terms of an eligible OTC derivative 
instrument.\123\ It also recommended that the proposed 150 transaction 
basket be clarified to indicate that the basket was not intended to 
place a limit on the number of securities transactions that could be 
entered into by an OTC derivatives dealer if such transactions could be 
demonstrated to relate to permitted activities.
---------------------------------------------------------------------------

    \122\ See Section IV.F.1.e. of the Comment Summary.
    \123\ SIA Letter I, pp. 8-9.
---------------------------------------------------------------------------

    Several commenters thought the 150 transaction limit was too low. 
For example, the SIA believed that the proposed basket was potentially 
too small and would not adequately reflect the character and scope of a 
particular firm's activities.\124\ As an alternative, several 
commenters recommended that the size of any such basket be related to 
the scope of the OTC derivatives dealer's activities rather than a 
specified number of transactions.\125\ The Committee on Futures 
Regulation of the Association of the Bar of the City of New York 
suggested that, instead of an arbitrary number of ``allowable'' 
transactions per year, the Commission, through its examination process, 
make determinations of whether a securities transaction was entered 
into with a good faith belief that it satisfied one of the purposes set 
forth in the rule.\126\
---------------------------------------------------------------------------

    \124\ Id.
    \125\ E.g., SIA Letter I, p. 9; Merrill Lynch Letter, p. 6.
    \126\ ABCNY Committee Letter, p. 3.
---------------------------------------------------------------------------

    In response to these comments, the Commission has not included a 
safe harbor provision in either Rule 3b-14 or Rule 3b-15 allowing for 
inadvertent violations of the rules. Rather, under the final rules, an 
OTC derivatives dealer may engage in cash management securities 
activities and ancillary portfolio management securities activities, as 
those terms are defined in Rules 3b-14 and 3b-15.
    iv. Documentation of Activities. Proposed Rule 3b-15(f), which 
contained the 150 transaction ``safe harbor,'' also generated concern 
regarding whether an OTC derivatives dealer would be required to 
document the purpose of each individual transaction. Commenters argued 
that, to the extent the rules required individual transaction 
documentation, they were inconsistent with portfolio management 
practices. Instead, commenters suggested that dealers be allowed to 
demonstrate on a portfolio-wide basis that their cash market 
transactions were consistent with the restrictions set forth in the 
rules.\127\
---------------------------------------------------------------------------

    \127\ See Section IV.F.2. of the Comment Summary.
---------------------------------------------------------------------------

    As discussed in the Proposing Release, the nature of risk 
management activities makes it difficult to determine whether a 
particular transaction satisfies the requirements set forth in the 
rules.\128\ The requirement that an OTC derivatives dealer develop 
reasonable procedures for ensuring compliance with the restrictions in 
the rules was intended, in fact, to accommodate current portfolio risk 
management practices. The rules do not require that documentation of 
the intended purposes of individual securities trades be maintained by 
the OTC derivatives dealer. Rather, an OTC derivatives dealer must 
develop reasonable procedures for ensuring compliance with the 
restrictions set forth in the rules and for demonstrating the 
relationship between its risk management activities and the positions 
it maintains on a portfolio-wide basis.\129\
---------------------------------------------------------------------------

    \128\ Proposing Release, Section II.A.4., 62 FR at 67943.
    \129\ See Section II.H.3. below, discussing Rule 15c3-4 (17 CFR 
240.15c3-4), which addresses internal risk management control 
systems for OTC derivatives dealers.
---------------------------------------------------------------------------

B. Amendment to Rule 15b1-1; Registration With the Commission

    Under the proposed amendments to Rule 15b1-1,\130\ a firm seeking 
to register as an OTC derivatives dealer would have been required to 
register with the Commission by filing Form BD, the Uniform Application 
for Broker-Dealer Registration.\131\ No comments were received 
regarding these proposed amendments. Accordingly, the amendments to 
Rule 15b1-1 are being adopted as proposed.
---------------------------------------------------------------------------

    \130\ 17 CFR 240.15b1-1.
    \131\ 17 CFR 249.501.
---------------------------------------------------------------------------

    A firm that elects to register as an OTC derivatives dealer must 
file an application for registration on Form BD, in accordance with the 
instructions on the form. The form must be filed with the Central 
Registration Depository, a computer system operated by the NASD. In 
completing Item 10 of the form, which asks an applicant to disclose its 
planned business activities, an OTC derivatives dealer must respond by 
checking ``other'' and writing in that it proposes to engage in the 
business of an OTC derivatives dealer.\132\ Some OTC

[[Page 59377]]

derivatives dealers may also be required to comply with Exchange Act 
provisions applicable to government securities activities.\133\ For 
instance, if an OTC derivatives dealer were to write an option on a 
government security, it would be considered to be a government 
securities dealer. Pursuant to Section 15C(a)(1)(B)(i),\134\ a broker 
or dealer effecting, inducing, or attempting to induce the purchase or 
sale of a government security must file with the appropriate regulatory 
agency written notice that it is a government securities broker or 
dealer.\135\ As a result, an OTC derivatives dealer that engages in 
government securities transactions must also file notice of such 
activities with the Commission, by checking ``yes'' in response to Item 
13A on Form BD.
---------------------------------------------------------------------------

    \132\ See also Section II.F.3.b.i. below, discussing the 
requirement that an OTC derivatives dealer send an application to 
the Commission with respect to the dealer's use of VAR models to 
calculate net capital.
    \133\ In this regard, the SIA noted in its comment letter that 
an OTC derivatives dealer registered with the Commission that 
engages in transactions in eligible OTC derivative instruments that 
government securities would exempt from registration as a government 
securities dealer under Exchange Act Section 15C (15 U.S.C. 78o-5), 
subject to the notice requirement under Exchange Act section 
15c(a)(1)(B) (15 U.S.C. 78o-5(a)(1)(B). SIA Letter I, p. 13.
    \134\ 15 U.S.C. 78o-5(a)(1)(B)(i).
    \135\ It must similarly file a written notice when it ceases to 
act as a government securities broker or dealer. 15 U.S.C. 78o-
5(a)(1)(B)(i). See also Section 3(a)(44) of the Exchange Act (15 
U.S.C. 78c(a)(44)) (defining government securities dealer).
---------------------------------------------------------------------------

C. Rule 15a-1; Securities Activities of OTC Derivatives Dealers

1. Scope of Permissible Securities Activities
    Proposed Rule 15a-1 would have permitted an OTC derivatives dealer 
to (1) engage as a counterparty in transactions in eligible OTC 
derivative instruments with permissible derivatives counterparties; (2) 
issue and reacquire issued securities, including warrants on 
securities, hybrid securities, and structured notes; and (3) engage in 
other securities transactions that the Commission designated by order. 
In connection with these activities, an OTC derivatives dealer would 
also have been permitted to engage in permissible risk management, 
arbitrage, and trading transactions, as defined in proposed Rule 3b-15.
    Because Rule 15a-1 describes the securities activities in which an 
OTC derivatives dealer may engage, it parallels the requirements 
contained in Rule 3b-12, which defines the term ``OTC derivatives 
dealer.'' Thus, the comments addressing proposed Rule 15a-1 were 
generally consistent with those concerning proposed Rule 3b-12.\136\ 
The SIA urged that the rule be simplified by (1) making the proposed 
regulatory category available to ``dealers who are not engaged in the 
business of buying and selling securities other than securities that 
are eligible OTC derivative instruments''; and (2) deleting the 
proposed restrictions on non-dealing activities in securities contained 
in proposed Rule 15a-1.\137\
---------------------------------------------------------------------------

    \136\ See Section II.A.1. above. For example, several commenters 
believed that the scope of permissible securities transactions under 
proposed Rule 15a-1 should be expanded, and that the proposed rule 
would unduly restrict the activities of an OTC derivatives dealer. 
See, generally, letters cited in Sections IV.A. and IV.E. of the 
Comment Summary.
    \137\ SIA Letter I, pp. 6-7.
---------------------------------------------------------------------------

    As discussed earlier, however, the new regime is not intended to 
permit an OTC derivatives dealer to engage in substantial proprietary 
securities trading activities. Rather, the purpose of the alternative 
regulatory framework is to allow U.S. securities firms to elect to 
establish a separately capitalized vehicle in which to book a client-
oriented OTC derivatives business. As a result, the restrictions on 
these activities in Rule 15a-1 are necessary.
    For the reasons discussed above and in Section II.A.1. with respect 
to the definition of OTC derivatives dealer, the Commission has revised 
Rule 15a-1 to provide that the securities activities of OTC derivatives 
dealer must be limited to (1) engaging in dealer activities in eligible 
OTC derivative instruments that are securities; (2) issuing and 
reacquiring securities that are issued by the dealer, including 
warrants on securities, hybrid securities, and structured notes; \138\ 
(3) engaging in cash management securities activities; (4) engaging in 
ancillary portfolio management securities activities; and (5) engaging 
in such other securities activities that the Commission designates by 
order. In addition, an OTC derivatives dealer's securities activities 
must consist primarily of engaging in dealer activities in eligible OTC 
derivative instruments that are securities, issuing and reacquiring its 
issued securities, and engaging in cash management securities 
activities.\139\
---------------------------------------------------------------------------

    \138\ D.E. Shaw & Co. requested clarification regarding the 
ability of an OTC derivatives dealer to issue and reacquire its 
issued securities through a fully regulated broker-dealer. It asked 
whether the phrase meant that the fully regulated broker-dealer must 
be the issuer of the security or whether the fully regulated broker-
dealer must act as principal or agent in the purchase of securities 
from, or the sale of securities to, the customer. D.E. Shaw & Co. 
also asked whether the OTC derivatives dealer could be the issuer of 
the security, as long as the OTC derivatives dealer complied with 
the registration, confirmation, and similar requirements set forth 
in the proposed rule. DESCO Letter, p. 9. In short, under Rule 15a-
1, an OTC derivatives dealer may only issue its own securities, or 
reacquire its own securities, through a fully regulated broker-
dealer; it may not act in a sales capacity or directly reacquire its 
securities from holders of such securities, except in limited 
circumstances with respect to certain counterparties. See Rule 15a-
1(c) (17 CFR 240.15a-1(c)).
    \139\ As noted in Section II.A.1. above, although the rules 
limit the securities activities of OTC derivatives dealers, the 
Commission has retained the authority under Rule 15a-1 to identify 
other permissible securities activities for these entities. See Rule 
15a-1(b)(1) (17 CFR 240.15a-1(b)(1)). This authority has been 
delegated to the Director of the Division of Market Regulation. See 
Rule 30-3(a)(64) (17 CFR 200.30-3(a)(64).
---------------------------------------------------------------------------

    The alternative regulatory framework for OTC derivatives dealers, 
as adopted, also includes a provision requiring that the dealer develop 
procedures to help ensure that it does not engage in securities 
activities beyond those permitted under Rule 15a-1. As discussed 
further in Section II.H.3. below, new Rule 15c3-4 requires an OTC 
derivatives dealer to establish, document, and maintain a system of 
internal risk management controls to assist it in managing the risks 
associated with its business activities. As part of its obligations 
under Rule 15c3-4, an OTC derivatives dealer's written guidelines must 
include and discuss the dealer's procedures to prevent it from engaging 
in securities transactions that are not permitted under Rule 15a-1. In 
addition, Rule 15c3-4 requires the OTC derivatives dealer's management 
to periodically review the dealer's business activities for consistency 
with risk management guidelines, including whether procedures are in 
place to prevent the dealer from engaging in any impermissible 
securities transaction.
2. Commission Orders Regarding OTC Derivatives Dealers' Activities
    Under Rule 15a-1(b), the Commission by order, entered upon its own 
initiative or after considering an application for exemptive relief, 
may clarify or expand the scope of permissible securities activities in 
which an OTC derivatives dealer may engage or the scope of eligible OTC 
derivative instruments. As discussed in earlier sections of this 
release, such orders may (1) identify other permissible securities 
activities in which an OTC derivatives dealer may engage; (2) determine 
that a class of fungible instruments that are standardized as to their 
material economic terms is within the scope of eligible OTC derivative 
instrument; (3) clarify whether certain contracts, agreements, or 
transactions are within the scope of eligible OTC derivative 
instrument; or (4) clarify whether certain securities activities are 
within the scope of ancillary portfolio management securities 
activities.
    Applications for exemptive orders under Section 15a-1(b) should be 
filed

[[Page 59378]]

in accordance with Commission procedures set forth in Rule 0-12 under 
the Exchange Act.\140\ The Commission may issue such orders to the 
extent they are necessary or appropriate in the public interest, and 
consistent with the protection of investors. In considering such 
orders, the Commission will consider whether the securities activities 
are of the type and nature of activities in which an OTC derivatives 
dealer may engage under Rule 15a-1, including whether such activities 
are integrated into, or integral to, the OTC derivatives dealing 
business of OTC derivatives dealers.
---------------------------------------------------------------------------

    \140\ 17 CFR 240.0-12.
---------------------------------------------------------------------------

3. Intermediation of Securities Transactions
    Proposed Rule 15a-1 would have required an OTC derivatives dealer 
to effect all securities transactions through a fully regulated broker-
dealer. Accordingly, under proposed Rule 15a-1, all applicable SRO 
sales practice requirements would have applied to the securities 
transactions of an OTC derivatives dealer.
    Several commenters argued that a fully regulated broker-dealer 
should not be required to intermediate every securities 
transaction.\141\ The SIA maintained that the interpositioning of a 
broker-dealer was not necessary, particularly given the sophisticated 
character of the permissible derivatives counterparties, the active 
participation by such counterparties in structuring instruments to 
fulfill their particular needs, and the consensual negotiation of the 
terms of individual transactions.\142\ The SIA further stated that, at 
a minimum, an OTC derivatives dealer should not be required to effect 
securities transactions through a fully regulated broker-dealer (1) 
where the counterparty to the transaction was a bank, broker-dealer, 
government securities broker, government securities dealer, or 
supranational organization; or (2) in connection with risk management, 
financing, arbitrage, or other trading transactions in which the OTC 
derivatives dealer was not acting in its capacity as a dealer, but 
rather as an investor or end-user.\143\ The SIA also objected to the 
intermediation requirement in the context of offshore transactions 
involving foreign securities.\144\
---------------------------------------------------------------------------

    \141\ See letters cited in Section IV.E.1. of the Comment 
Summary.
    \142\ SIA Letter I, p. 11.
    \143\ SIA Letter I, p. 11. Similarly, D.E. Shaw & Co. argued 
that, in order to level the playing field with non-U.S. broker-
dealers, an OTC derivatives dealer should be permitted to transact 
business directly (without a U.S. broker-dealer intermediary) with 
all parties with whom a non-U.S. broker-dealer could effect business 
under Rule 15a-6(a)(4) under the Exchange Act (17 CFR 240.15a-
6(a)(4)), including a registered broker or dealer or a bank acting 
in a broker or dealer capacity. Likewise, it believed that where the 
OTC derivatives dealer itself is the counterparty to a securities 
derivatives transaction, the OTC derivatives dealer should not be 
required to effect the securities transaction through a fully 
regulated broker-dealer in connection with risk management, 
financing, arbitrage, or other trading transactions. DESCO Letter, 
p. 4.
    \144\ SIA Letter II, pp. 3-4. The SIA argued that the proposed 
broker-dealer intermediation requirement in the context of offshore 
transactions involving foreign securities could create significant 
burdens on registrants, without meaningful corresponding benefits. 
According to the SIA, if offshore transactions involving foreign 
securities are required to be intermediated by the fully regulated 
broker-dealer affiliate, firms might be required to register their 
non-U.S. offices as branch offices of their fully regulated U.S. 
broker-dealer (with potentially adverse tax, licensing, or other 
regulatory consequences) or to confront prohibitive logistical 
obstacles to compliance with the proposed requirement. The SIA was 
also concerned about the application of this provision to OTC 
derivatives transactions arranged and effected by employees resident 
in a foreign office of an OTC derivatives dealer with a counterparty 
that is also resident in a foreign jurisdiction. In this regard, it 
noted that local law may require that the transaction be effected 
through a locally registered entity, so that a transaction would 
have to be intermediated by two separate entities. For that reason, 
it suggested an exception to Rule 15a-1 for permissible securities 
transaction with foreign counterparties that are arranged and 
effected by non-U.S. resident employees of an OTC derivatives 
dealer.
---------------------------------------------------------------------------

    D.E. Shaw & Co. also questioned whether an OTC derivatives dealer 
needed to effect a securities transaction through an affiliated broker-
dealer. It claimed that an OTC derivatives dealer should also be able 
to effect these transactions through a bank or broker-dealer with which 
it had a working relationship.\145\ Other commenters questioned the 
proposed rule's distinction between securities transactions and non-
securities transactions, and claimed that if sales practice protection 
was warranted for securities transactions, then counterparties should 
receive similar protection for non-securities transactions undertaken 
with an OTC derivatives dealer.\146\ The Chicago Board Options Exchange 
(``CBOE''), in turn, sought clarification as to which specific SRO 
sales practice rules would apply to a fully regulated broker-dealer 
effecting securities transactions for an OTC derivatives dealer's 
counterparties.\147\
---------------------------------------------------------------------------

    \145\ DESCO Letter, p. 3. D.E. Shaw & Co. stated that the 
restriction to use affiliates limited flexibility and placed an 
unnecessary burden on U.S. firms conducting a domestic derivatives 
business.
    \146\ See, e.g., GFOA Letter, pp. 2-3; EUDA Letter, p. 2.
    \147\ Comment Letter from the Chicago Board Options Exchange 
(''CBOE Letter''), p. 5. The CBOE asserted that there is currently a 
disparity between NASD and NYSE options sales practice rules as 
applied to listed options, and argued that this disparity, as well 
as any other disparity between sales practice rules' application to 
qualified counterparties' OTC derivatives transactions and their 
listed options transactions, should be remedied.
---------------------------------------------------------------------------

    Based on the comments received, Rule 15a-1, as adopted, provides 
certain limited exceptions to the requirement that securities 
transactions of an OTC derivatives dealer be effected through its fully 
regulated broker-dealer affiliate.\148\ However, the rule has not been 
revised, as requested by some commenters, to eliminate the 
intermediation requirement in connection with cash management or 
ancillary portfolio management securities transactions in which the OTC 
derivatives dealer is not acting as a dealer, but rather as an investor 
or end-user.\149\ Accordingly, all cash management securities 
activities and ancillary portfolio management securities activities of 
an OTC derivatives dealer must be effected by a fully regulated broker-
dealer, unless the transaction is subject to one of the limited 
exceptions discussed below.\150\
---------------------------------------------------------------------------

    \148\ As noted earlier, an OTC derivative dealer may issue and 
reacquire its issued securities through an unaffiliated fully 
regulated broker-dealer. See Rule 15a-1(c) (17 CFR 240.15a-1(c)).
    \149\ See supra note 143 and accompanying text.
    \150\ In addition, the Commission has not revised Rule 15a-1 to 
extend sales practice requirements to non-securities transactions. 
As a general matter, sales practice requirements arising under the 
federal securities laws and SRO rules apply only to the securities 
transactions of broker-dealers.
---------------------------------------------------------------------------

    The requirement that securities transactions be effected through a 
fully regulated broker-dealer is designed, in part, to ensure that all 
securities transactions remain subject to existing sales practice 
standards.\151\ The requirement is also intended to prevent any 
regulatory disparity from arising between an OTC derivatives dealer, 
which is subject to modified capital and margin requirements, and a 
fully regulated broker-dealer in connection with conducting securities 
transactions. In addition, it is designed to reduce the risk that 
counterparties will mistakenly view an OTC derivatives dealer as a 
fully regulated broker-dealer, rather than as a booking vehicle for 
derivatives transactions.\152\
---------------------------------------------------------------------------

    \151\ Unless otherwise expressly provided in the rules and rule 
amendments, the fully regulated broker-dealer must comply with all 
applicable sales practice requirements when effecting any securities 
transaction for, or on behalf of, an OTC derivatives dealer.
    \152\ For these same reasons, an OTC derivatives dealer may not 
effect a securities transaction through an unaffiliated broker-
dealer, except in limited circumstances, or through a bank.
---------------------------------------------------------------------------

    However, if the counterparty to a securities transaction is acting 
as principal and is itself either a registered broker or dealer 
(including another OTC

[[Page 59379]]

derivatives dealer), a bank acting in a dealer capacity, a foreign 
broker or dealer,\153\ or an affiliate of the OTC derivatives 
dealer,\154\ the counterparty is less likely to require the protections 
afforded by sales practice requirements. In addition, these 
counterparties are not likely to mistakenly believe that an OTC 
derivatives dealer is a fully regulated broker-dealer engaging in 
general securities transactions. Therefore, an OTC derivatives dealer 
is not required to use its fully regulated broker-dealer affiliate to 
effect securities transactions with these listed entities. This 
exception, however, applies only when the counterparty is acting as a 
principal (that is, for its own account), and not as agent for one of 
its customers.\155\
---------------------------------------------------------------------------

    \153\ The term ``foreign broker or dealer'' as used in Rule 15a-
1 means ``any person not resident in the United States (including 
any U.S. person engaged in business as a broker or dealer entirely 
outside the United States, except as otherwise permitted by 
Sec. 240.15a-6 (17 CFR 240.15a-6)) that is not an office or branch 
of, or a natural person associated with, a registered broker or 
dealer, whose securities activities, if conducted in the United 
States, would be described by the definition of `broker' in section 
3(a)(4) of the Act (15 U.S.C. 78c(a)(4)) or `dealer' in section 
3(a)(5) of the Act (15 U.S.C. 78c(a)(5)).'' See See 15a-1(g) (17 CFR 
240.15a-1(g)). In general, a foreign bank may be able to satisfy the 
terms of this definition.
    \154\ For purposes of Rule 15a-1, the term ``affiliate'' means 
``any organization (whether incorporated or unincorporated) that 
directly or indirectly controls, is controlled by, or is under 
common control with, the OTC derivatives dealer.'' See Rule 15a-1(f) 
(17 CFR 240.15a-1(f)).
    \155\ With respect to offshore transactions involving foreign 
securities, Rule 15a-1 has not been revised to the extent suggested 
by some commenters (see supra note 144), in part because of concerns 
regarding the application of sales practice protections to foreign 
counterparties and the proper maintenance of books and records 
regarding those transactions. However, the general requirement that 
communications regarding securities transactions be conducted by 
associated persons of the affiliated fully regulated broker-dealer 
has been revised to reflect the fact that firms operate OTC 
derivatives businesses on a global basis, See Rule 15a-1(d) (17 CFR 
240.15a-1(d)) (further discussed in Section II.C.4. below).
---------------------------------------------------------------------------

    There is a second limited exception to Rule 15a-1(c), as adopted. 
If an OTC derivatives dealer engages in a transaction that is an 
ancillary portfolio management securities activity involving a foreign 
security,\156\ it is not required to effect that transaction through 
its fully regulated broker-dealer affiliate if a registered broker or 
dealer, a bank, or a foreign broker or dealer is acting as agent for 
the OTC derivatives dealer.\157\ This exception will permit an OTC 
derivatives dealer to select one of these professional intermediaries 
to represent it in foreign markets when purchasing or selling foreign 
securities for hedging or portfolio management purposes.
---------------------------------------------------------------------------

    \156\ For purposes of Rule 15a-1, the term foreign security 
means ``any security (including a depositary share issued by a 
United States bank, provided that the depositary share is initially 
offered and sold outside the United States in accordance with 
Regulation S (17 CFR 230.901 through 230.904)) issued by a person 
not organized or incorporated under the laws of the United States, 
provided the transaction that involves such security is not effected 
on a national securities exchange or on a market operated by a 
registered national securities association; or a debt security 
(including a convertible debt security) issued by an issuer 
organized or incorporated under the laws of the United States that 
is initially offered and sold outside the United States in 
accordance with Regulation S (17 CFR 230.901 through 230.904).'' See 
Rule 15a-1(h) [17 CFR 240.15a-1(h)].
    \157\ See Rule 15a-1(c)(2) (17 CFR 240.15a-1(c)(2)). Rule 15c3-4 
(17 CFR 240.15c3-4) requires that an OTC derivatives dealer's 
written guidelines include the dealer's procedures to prevent it 
from improperly relying on the exceptions to Rule 15a-1(c) and (d) 
(discussed in Section II.C.4. below).
---------------------------------------------------------------------------

4. Communications Regarding Securities Transactions
    The requirement that securities transactions be effected through a 
fully regulated broker-dealer means that the OTC derivatives dealer's 
counterparties in these transactions will be considered customers of 
the fully regulated broker-dealer. Therefore, any person that solicits 
a potential counterparty to engage in a securities transaction with an 
OTC derivatives dealer, or otherwise has any contact with the 
counterparty regarding the transaction, generally must be a registered 
representative of the fully regulated broker-dealer affiliate.\158\ As 
noted in the Proposing Release, these persons may be dual employees of 
the fully regulated broker-dealer and the OTC derivatives dealer, 
subject to appropriate supervision by both firms.\159\
---------------------------------------------------------------------------

    \158\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)).
    \159\ Fully regulated broker-dealers are responsible for 
supervising only the securities activities of these dual employees. 
They are not responsible for supervising a dual employee's non-
securities OTC derivatives activities conducted on behalf of the OTC 
derivatives dealer.
---------------------------------------------------------------------------

    The SIA, however, argued that all employees of the OTC derivatives 
dealer having contact with counterparties to OTC derivatives 
transactions effected through a fully regulated broker-dealer should 
not have to be employees of the fully regulated broker-dealer and be 
licensed as registered representatives of that firm.\160\ D.E. Shaw & 
Co. claimed that the requirement for any person discussing the terms of 
a securities transaction with a counterparty to be a registered 
representative of the fully regulated broker-dealer was broader than 
current NASD requirements. It therefore requested clarification that 
the proposed rule would not expand the types of activities that would 
require registration of associated persons.\161\
---------------------------------------------------------------------------

    \160\ SIA Letter I, p. 12.
    \161\ DESCO Letter, p. 4.
---------------------------------------------------------------------------

    Under the final rule, whether a registered representative of an OTC 
derivatives dealer's fully regulated broker-dealer affiliate must be 
involved in all contacts with a counterparty relating to a securities 
transaction depends on the nature of the counterparty. Under Rule 15a-
1(d), if the counterparty is a registered broker or dealer, a bank 
acting in a dealer capacity, a foreign broker or dealer, or an 
affiliate of the OTC derivatives dealer, a registered representative of 
the fully regulated broker-dealer affiliate does not have to be 
involved in the contact. Thus, employees of the OTC derivatives dealer 
may solicit or otherwise contact these enumerated counterparties, even 
if the employees are not also registered representatives of the fully 
regulated broker-dealer.\162\
---------------------------------------------------------------------------

    \162\ This is consistent with the exception set forth in Rule 
15a-1(c)(1) (17 CFR 240.15a-1(c)(1)).
---------------------------------------------------------------------------

    In addition, in some circumstances, registered representatives of 
the fully regulated broker-dealer affiliate are not required to be 
involved in contacts with foreign counterparties. Under Rule 15a-1(d), 
contacts with a foreign counterparty may generally be conducted by an 
associated person of a foreign broker or dealer who is not resident in 
the United States, if the foreign broker or dealer is affiliated with 
the OTC derivatives dealer and is registered by a foreign financial 
regulatory authority in the jurisdiction in which the counterparty is 
resident or the associated person is located.\163\ Any resulting 
securities transaction, however, must generally be effected through the 
OTC derivatives dealer's fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------

    \163\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)) and Rule 15a-1(i) 
(17 CFR 240.15a-1(i)). See also supra note 155 and accompanying 
text. This approach responds to commenters' concerns that it would 
be inefficient and impractical to require a registered 
representative of the OTC derivatives dealer's fully regulated 
broker-dealer affiliate to conduct all contacts with all foreign 
counterparties concerning permissible securities activities with the 
OTC derivatives dealer.
---------------------------------------------------------------------------

    The new regulatory structure for OTC derivatives dealers does not 
expand on the types of activities that require registration of 
associated persons under existing SRO rules. For example, to the extent 
contact with an OTC derivatives dealer's counterparty regarding a 
securities transaction involves only clerical or ministerial activities 
that currently may be conducted by an unregistered associated person of 
a fully regulated broker-dealer, then the employee of the OTC 
derivatives dealer performing such activities need not be a registered 
representative.\164\ Persons performing clerical and ministerial

[[Page 59380]]

functions may also be dual employees of the OTC derivatives dealer and 
the fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------

    \164\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)).
---------------------------------------------------------------------------

5. Confirmation of Securities Transactions
    Rule 10b-10 under the Exchange Act \165\ requires broker-dealers to 
send a written confirmation of each securities transaction with a 
customer at or before completion of the transaction, containing certain 
material information about the transaction. The Proposing Release 
stated that in a securities transaction between an OTC derivatives 
dealer and a counterparty (or customer) effected through a fully 
regulated broker-dealer, the OTC derivatives dealer and the fully 
regulated broker-dealer would each be responsible for sending a 
confirmation to the counterparty under the rule.\166\ It further stated 
that certain customers could choose not to receive two confirmations 
for each securities transaction, but rather could instruct the OTC 
derivatives dealer and the fully regulated broker-dealer to send one 
joint confirmation on behalf of both parties.\167\
---------------------------------------------------------------------------

    \165\ 17 CFR 240.10b-10.
    \166\ Proposing Release, Section 11.C., n.28, 62 FR at 67944, 
n.28.
    \167\ Id.
---------------------------------------------------------------------------

    The SIA agreed that the counterparty to any securities transaction 
would be a customer of the fully regulated broker-dealer and that the 
fully regulated broker-dealer would have an obligation to deliver a 
confirmation to the counterparty; however, the SIA argued that the 
counterparty would not be a customer of the OTC derivatives dealer and, 
accordingly, the OTC derivatives dealer should not be required to 
deliver a confirmation.\168\ D.E. Shaw & Co. also questioned whether 
there were any benefits in requiring multiple confirmations that would 
justify the additional costs and paperwork. Instead, it believed that 
the fully regulated broker-dealer should take responsibility for 
sending out a joint confirmation accurately disclosing the respective 
roles of the fully regulated broker-dealer and the OTC derivatives 
dealer.\169\ In addition, the SIA and D.E. Shaw & Co. noted that if 
each dealer were jointly and severally liable for a joint confirmation, 
then the requirement to obtain customer consent to the sending of a 
joint confirmation was unnecessary and burdensome.\170\
---------------------------------------------------------------------------

    \168\ SIA Letter I, pp. 11-12.
    \169\ DESCO Letter, p. 5.
    \170\ SIA Letter I, p. 12; DESCO Letter, p. 5.
---------------------------------------------------------------------------

    In response to the comments, the proposed requirement that the 
fully regulated broker-dealer and the OTC derivatives dealer each have 
to send a separate confirmation, unless the customer instructs them to 
send a single joint confirmation, has been revised. Although generally 
both the fully regulated broker-dealer and the OTC derivatives dealer 
will be responsible for sending a confirmation, disclosing their 
respective roles in the transactions, the two firms may establish 
procedures through which the fully regulated broker-dealer will send a 
joint confirmation on behalf of both firms in satisfaction of Rule 10b-
10.\171\
---------------------------------------------------------------------------

    \171\ A joint confirmation, sent on behalf of both the OTC 
derivatives dealer and the fully regulated broker-dealer effecting 
the transaction must disclose all of the information required of 
either party under the rule, including, but not limited to, the 
identity of the security, the trade price, and the date and time of 
the trade, the identity of each party and its capacity in the 
transaction, the fact that the OTC derivatives dealer is not a 
member of SIPC, and any transaction-related compensation earned by 
either the fully regulated broker-dealer or the OTC derivatives 
dealer in connection with the transaction. Both the OTC derivatives 
dealer and the fully regulated broker-dealer will be considered 
fully responsible for the contents of the joint confirmation. The 
decision by the two firms to send a joint confirmation will not 
otherwise affect the obligations of either party to the customer 
under the anti-fraud provisions of the federal securities laws. In 
addition, in the event that an OTC derivatives dealer engages in a 
securities transaction that is not required to be effected through a 
fully regulated broker-dealer under rule 15a-1 (17 CFR 240.15a-1), 
then the OTC derivatives dealer must comply with the provisions of 
Rule 10b-10 (17 CFR 240.10b-10), to the extent such provisions apply 
to the transaction.
---------------------------------------------------------------------------

6. Position Limits
    Several commenters questioned the application of SRO position 
limits to an OTC derivatives dealer's activities.\172\ The SIA, for 
example, argued that an OTC derivatives dealer should either be subject 
to a more realistic SRO position limit regime than was currently 
applicable under NASD rules or be exempted from the application of SRO 
position limits with respect to OTC securities options booked through a 
fully regulated broker-dealer affiliate.\173\ The CBOE argued that the 
rules would result in a competitive disparity between OTC and listed 
index derivatives, because, as stated by the CBOE, an OTC derivatives 
dealer's transactions in OTC equity options would be exempt from NASD 
and CBOE position limits, but transactions in listed index and equity 
options would not be exempt.\174\ As a result, it recommended that the 
Commission eliminate listed options position limits entirely.\175\
---------------------------------------------------------------------------

    \172\ See Section IV.J.1. of the Comment Summary.
    \173\ SIA Letter I, p. 16. D.E. Shaw & Co. also sought 
clarification that the requirement for executing securities OTC 
derivatives transactions through a fully regulated broker-dealer was 
not intended to subject OTC derivatives dealers to the options 
position limits set forth in NASD rules. In is view, these position 
limits constituted a competitive disadvantage for U.S. securities 
firms as against banks and foreign dealers. DESCO Letter, pp. 2-3.
    \174\ CBOE Letter, p. 2.
    \175\ CBOE Letter, p. 3.
---------------------------------------------------------------------------

    The final rules and rule amendments do not change the current 
application of position limits to securities transactions effected by a 
broker-dealer on behalf of an OTC derivatives dealer. Therefore, 
securities OTC derivatives transactions that are effected through 
fully-regulated broker-dealers, which are members of SROs, will 
continue to be subject to applicable SRO position limits.\176\ However, 
in order to permit an OTC derivatives dealer to carry out its business 
using portfolio risk management techniques, the Commission encourages 
the NASD to revise its rules to recognize as ``hedged'' those OTC 
option positions of an OTC derivatives dealer that are hedged on a 
delta neutral basis.\177\
---------------------------------------------------------------------------

    \176\ See Rule 2860 of the NASD's Conduct Rules.
    \177\ The Commission's support for recognizing options positions 
hedged on a delta neutral basis as properly exempted from SRO 
position limits is equally applicable to all option market 
participants for options traded over-the-counter or on exchanges. 
Therefore, the NASD and options exchange SROs are encouraged to 
submit rule changes that will recognize delta neutral hedges for 
both listed and OTC options.
---------------------------------------------------------------------------

D. Exemptions for OTC Derivatives Dealers

    Collectively, the rules and rule amendments adopted in this final 
rulemaking establish a new class of broker-dealers that will enjoy 
certain exemptions from full broker-dealer registration and regulation, 
subject to special requirements and conditions on their operations. 
Although an OTC derivatives dealer will be exempt from SRO membership, 
regular broker-dealer margin requirements, and SIPA (as discussed 
below), an OTC derivatives dealer's securities activities will be 
limited by Rule 15a-1.\178\
---------------------------------------------------------------------------

    \178\ See supra Section II.C.
---------------------------------------------------------------------------

1. Rule 15b9-2; Exemption From SRO Membership
    Proposed Rule 15b9-2 would have exempted an OTC derivatives dealer 
from membership in a SRO,\179\ provided that it entered into an 
agreement with

[[Page 59381]]

the examining authority designated pursuant to section 17(d) of the 
Exchange Act \180\ for its registered broker-dealer affiliate. Under 
this agreement, the DEA would have been expected to conduct a review of 
the activities of the OTC derivatives dealer, report to the Commission 
any potential violation of the Commission's rules, and evaluate the 
dealer's procedures and controls designed to prevent violations.\181\ 
The OTC derivatives dealer would also have been subject to direct 
examination by Commission staff.
---------------------------------------------------------------------------

    \179\ In general, registered broker-dealers must become members 
of an SRO. See Section 15(b)(8) of the Exchange Act (15 U.S.C. 
78o(b)(8)). This SRO membership requirement ensures that securities 
transactions meet SRO sales practice requirements, that employees of 
SRO member firms who sell securities satisfy certain uniform 
licensing requirements, that SRO members satisfy maintenance margin 
and financial responsibility requirements, and that member firms 
adhere to certain principles of trade and business conduct. See 
sections 15(b)(8) and 15A(g)(3) of the Exchange Act (15 U.S.C. 
78o(b)(8); 15 U.S.C. 78o-3(g)(3)).
    \180\ 15 U.S.C. 78q(d).
    \181\ See Proposing Release, Section II.D.2., 62 FR at 67946.
---------------------------------------------------------------------------

    The SRO commenters believed that an OTC derivatives dealer should 
become a member of either the DEA of its registered broker-dealer 
affiliate or another SRO.\182\ In supporting this position, these 
commenters noted such things as (1) the DEA is in the best position to 
examine the OTC derivatives dealer given its surveillance and 
examination knowledge of the registered broker-dealer affiliate; (2) 
SRO rules impose certain supervisory obligations directly on each 
member; and (3) SRO membership is necessary to ensure an OTC 
derivatives dealer's cooperation during an examination.\183\ In order 
to avoid conflict between the new regime and SRO rules, however, both 
the NYSE and the NASDR recognized that an OTC derivatives dealer member 
should not be subject to all SRO rules (such as margin rules), but 
should only be subject to rules that applied to the dealer's unique 
business.\184\
---------------------------------------------------------------------------

    \182\ NYSE Letter, p. 2; Comment Letter from NASD Regulation 
(''NASDR Letter''), pp. 1-2. The NYSE objected to any structure that 
would cause the DEA to be considered merely an agent of the 
Commission, in part because it believed that such an approach would 
have broad procedural ramifications. It also stated that the 
proposal to have the DEA review the activities of OTC derivatives 
dealers on a contractual basis, absent membership, would be 
prohibited by the Exchange's Constitution. NYSE Letter, p. 2. NASDR 
also opposed the proposal that an OTC derivatives dealer would not 
be required to be a member of an SRO if it entered into an agreement 
with the DEA for its broker-dealer affiliate, because it believed it 
would create a difficult precedent and might impede effective 
oversight of this new type of entity. NASDR Letter, pp. 1-2.
    \183\ See section IV.H. of the Comment Summary.
    \184\ NYSE Letter, p. 2; NASDR Letter, p. 3.
---------------------------------------------------------------------------

    In contrast, securities firms generally opposed any plan that would 
require OTC derivatives dealers to become members of an SRO.\185\ More 
than one commenter suggested that the oversight function should be 
performed only by Commission staff, and that it might be appropriate to 
establish a new SRO designed to oversee the activities of OTC 
derivatives dealers.\186\
---------------------------------------------------------------------------

    \185\ SIA Letter I, p. 14; MSDW Letter, pp. 20-21; DESCO Letter, 
p. 3, n.2.
    \186\ See, e.g., SIA Letter I, p. 14.
---------------------------------------------------------------------------

    The Commission has determined that it is not necessary to require 
OTC derivatives dealers to become members of an SRO and be subject to 
the full range of SRO regulation at this time. Moreover, because the 
NYSE and the NASD expressed serious concerns with overseeing OTC 
derivatives dealers on a contractual basis, the Commission staff will 
examine OTC derivatives dealers to ensure compliance with Commission 
rules. This approach will provide the Commission staff with valuable 
experience regarding the activities of dealers in OTC derivative 
instruments. In addition, the expected small number of initial 
registrants also supports direct Commission examination of OTC 
derivatives dealers at this time.
    In granting the Commission authority under Section 15(b)(9) to 
exempt a class of brokers or dealers from the requirement of SRO 
membership, Congress recognized that certain types of broker-dealers 
could be regulated effectively by the Commission without the direct 
oversight of an SRO. Given that certain SRO rules, such as margin 
rules, are not consistent with the OTC derivatives dealer regulatory 
scheme and that securities transactions generally will be effected 
through a broker-dealer that will be a member of an SRO,\187\ the 
Commission believes that SRO membership and the additional regulation 
it would entail is not currently warranted. Accordingly, the Commission 
finds that exempting OTC derivatives dealers from the SRO membership 
requirement is consistent with the public interest and the protection 
of investors.
---------------------------------------------------------------------------

    \187\ See Rule 15a-1(c) (17 CFR 240.15a-1(c)).
---------------------------------------------------------------------------

2. Rule 36a1-1; Exemption From Certain Margin Requirements
    As part of any OTC derivatives transaction, a dealer may require 
its counterparty to deposit collateral with the dealer to provide some 
assurance of the counterparty's ability to perform. Both the ability of 
the dealer to collect collateral to secure payment under an OTC 
derivative instrument and the amount of collateral the dealer must 
collect currently depend on the regulatory status of the dealer. 
Federal regulations that govern the collateral, or margin, that must be 
collected by dealers in connection with securities transactions have 
created certain competitive inequalities between registered broker-
dealers and other entities, including bank dealers, that conduct an OTC 
derivatives business. Registered broker-dealers that extend credit for 
the purpose of purchasing or carrying securities are required to comply 
with the provisions of Regulation T.\188\ The margin requirements for 
banks are contained in Regulation U.\189\
---------------------------------------------------------------------------

    \188\ 12 CFR 220.1.
    \189\ 12 CFR 220.1.
---------------------------------------------------------------------------

    As noted above, despite the recent amendments to Regulation T,\190\ 
there remain several differences between Regulation T and Regulation 
U.\191\ For example, the two regulations differ with respect to the 
margin requirements for short OTC options. Compliance with the more 
restrictive requirements of Regulation T places broker-dealers at a 
competitive disadvantage with banks and other derivatives dealers by 
preventing them from offering credit in securities OTC derivatives 
transactions on terms that are as favorable as those offered by the 
other dealers.
---------------------------------------------------------------------------

    \190\ See Securities Credit Transactions, Borrowing by Brokers 
and Dealers, Docket Nos. R-0905, R-0923, and R-0944, 63 FR 2806 
(Jan. 16, 1998).
    \191\ See Section I.C.4.b. above.
---------------------------------------------------------------------------

    Under proposed Rule 36a1-1, extensions of credit by an OTC 
derivatives dealer in permissible securities transactions generally 
would have been exempt from Section 7 of the Exchange Act (and 
Regulation T), provided that the OTC derivatives dealer complied with 
other federal margin requirements applicable to non-broker-dealer 
lenders (i.e., Regulation U). While the SIA noted its full support for 
the proposal, it raised certain technical issues that could result from 
the codification of the proposed provisions.\192\ Morgan Stanley Dean 
Witter also supported the proposed rule, and stated that application of 
Regulation U would provide sufficient safeguards against excessive 
leverage and would permit an OTC derivatives dealer to extend credit on 
a broader range of OTC derivative products.\193\ It also stated that 
the SIA's clarifications were appropriate, and encouraged the 
Commission to reassess whether additional exemptive relief would be 
warranted in the future.\194\
---------------------------------------------------------------------------

    \192\ SIA Letter I, pp. 14-15.
    \193\ MSDW Letter, pp. 19-20.
    \194\ MSDW Letter, App. A, p. ii.
---------------------------------------------------------------------------

    In response to the comments received, the Commission has revised 
Rule 36a1-1 to clarify that transactions involving the extension of 
credit by an OTC derivatives dealer are exempt from the provisions of 
section 7(c) of the Exchange Act,\195\ provided that the OTC 
derivatives dealer complies with section

[[Page 59382]]

7(d) of the Exchange Act.\196\ Because Regulation U is promulgated 
pursuant to section 7(d), an OTC derivatives dealer remains subject to 
that provision. The final rule continues to provide that the exemption 
from section 7(c), and Regulation T thereunder, does not apply to 
extensions of credit made directly by a registered broker-dealer (other 
than an OTC derivatives dealer) in connection with transactions in 
eligible OTC derivative instruments for which an OTC derivatives dealer 
acts as counterparty.\197\
---------------------------------------------------------------------------

    \195\ 15 U.S.C. 78g(c).
    \196\ 15 U.S.C. 78g(d).
    \197\ OTC derivatives dealers that extend credit in securities 
transactions that are required to be effected through a fully 
regulated broker-dealer, however, may rely on the exemption form 
section 7(c) and Regulation T provided under Rule 36a1-1.
---------------------------------------------------------------------------

    The Commission believes that application of Regulation U in lieu of 
Regulation T is appropriate for the lending that occurs in the OTC 
derivatives market, given the nature of the bilateral financial 
instruments and the relative sophistication of the counterparties. 
Applying Regulation U to extensions of credit by OTC derivatives 
dealers will provide sufficient safeguards, while allowing OTC 
derivatives dealers to extend credit in accordance with their normal 
business practices.\198\
---------------------------------------------------------------------------

    \198\ While the CBOE supported allowing the OTC derivatives 
positions of counterparties carried on the books of OTC derivatives 
dealers to be exempt from Regulation T conditioned on the 
application of Regulation U, it believed that application of 
Regulation U would result in competitive disparities between OTC and 
listed options markets. Accordingly, it requested a similar margin 
treatment for listed options transactions. CBOE Letter, p.3. The 
Commission, however, is not extending a similar margin treatment to 
listed options at this time. The new regulatory framework is 
intended to allow U.S. securities firms to compete more effectively 
in global OTC derivatives markets. Any revisions to the regulatory 
standards for exchange markets would require, among other things, 
careful consideration of the differences between exchange markets 
and OTC derivatives markets.
---------------------------------------------------------------------------

    Because application of Regulation U will promote competition and 
efficiency in the OTC derivatives market and will result in suitable 
margin regulation for OTC derivatives dealers and their counterparties, 
the Commission finds that exempting OTC derivatives dealers from 
Section 7(c) of the Exchange Act is necessary or appropriate in the 
public interest and consistent with the protection of investors. This 
exemption is conditioned on the OTC derivatives dealer's compliance 
with Section 7(d) of the Exchange Act.\199\
---------------------------------------------------------------------------

    \199\ Rule 36a1-1 applies only to extensions of credit by an OTC 
derivatives dealer. Section 7 of the Exchange Act, however, 
continues to apply to persons extending credit to an OTC derivatives 
dealer. Credit extended to an OTC derivatives dealer, like credit 
extended to a fully regulated broker-dealer, however, is excepted 
from section 7 of the Exchange Act if it satisfies the conditions 
for such exceptions contained in section 7.
---------------------------------------------------------------------------

3. Rule 36a1-2; Exemption From SIPA
    Under Rule 36a1-2, OTC derivatives dealers are exempt from the 
provisions of SIPA,\200\ including membership in SIPC. As stated in the 
Proposing Release, the application of SIPA's liquidation provisions to 
an OTC derivatives dealer in bankruptcy could undermine certain 
provisions of the bankruptcy code applicable to the dealer's 
business.\201\ As a result, the potential application of SIPA to OTC 
derivatives dealers would create legal uncertainty about the rights of 
counterparties in transactions with registered OTC derivatives dealers 
in the event of dealer insolvency.\202\ This uncertainty could impair 
the ability of securities firms electing to register as OTC derivatives 
dealers to compete effectively with banks and foreign dealers, which 
are not subject to similar legal uncertainty.
---------------------------------------------------------------------------

    \200\ 15 U.S.C. 78aaa et seq.
    \201\ Proposing Release, Section II.G., 62 FR at 67949-50. The 
bankruptcy code contains certain exceptions to its automatic stay 
provisions that enable a counterparty in a derivatives transaction 
to exercise its rights to liquidate a position (i.e., it preserves a 
counterparty's contractual termination, setoff, and collateral 
foreclosure rights) in the event of the other counterparty's 
insolvency. See, e.g., 11 U.S.C. 362(b)(6), (7), (17); id. at 
sections 555, 556, 559, and 560. Several of these provisions, 
however, may be subject to a stay order under SIPA. See 11 U.S.C. 
555 (contractual right to liquidate a securities contract); id. at 
section 559 (contractual right to liquidate a repurchase agreement).
    \202\ Under the typical relationship where a counterparty 
delivers collateral to an OTC derivatives dealer in order to cover 
its contractual obligations to the dealer, the counterparty and the 
OTC derivatives dealer have a relationship more analogous to a 
debtor-creditor relationship than a fiduciary one. Accordingly, 
these counterparties are not the type of investor intended to be 
protected under SIPA. See Securities Investor Protection Corporation 
v. Executive Services Corp., 423 F. Supp. 94 (S.D.N.Y. 1976), aff'd, 
556 F.2d 98 (2d Cir. 1977).
---------------------------------------------------------------------------

    The commenters addressing this issue generally believed that the 
SIPA exemption was both necessary and appropriate.\203\ In particular, 
Morgan Stanley Dean Witter agreed with the statement in the Proposing 
Release that the exemption was necessary to avoid potential legal 
uncertainty about the rights of counterparties in transactions with 
registered OTC derivatives dealers in the event of dealer 
insolvency.\204\ Two other commenters noted that the exemptive relief 
from SIPA and SIPC membership was critical to the commercial viability 
of an OTC derivatives dealer.\205\
---------------------------------------------------------------------------

    \203\ SIA Letter I, p. 14; DESCO Letter, p. 13; MSDW Letter, p. 
iv.
    \204\ MSDW Letter, p. iv.
    \205\ SIA Letter I, p. 14; DESCO Letter, p. 13.
---------------------------------------------------------------------------

    In response to the comments received, the exemption for OTC 
derivatives dealers from the provisions of SIPA, including from 
membership in SIPC, is being adopted in its proposed form. The purposes 
of SIPA would not be promoted by its application to OTC derivatives 
dealers, and could in fact result in legal uncertainty for OTC 
derivatives dealers' counterparties. As a result, the Commission finds 
that Rule 36a1-2, exempting OTC derivatives dealers from SIPA, is 
necessary or appropriate in the public interest and consistent with the 
protection of investors.\206\
---------------------------------------------------------------------------

    \206\ Section 2 of SIPA states that the provisions of the 
Exchange Act generally apply as if SIPA ``constituted an amendment 
to, and was included as a section of'' the Exchange Act. 15 U.S.C. 
78bbb.
---------------------------------------------------------------------------

E. Rule 11a1-6; Transactions for Certain Accounts of OTC Derivatives 
Dealers

    In response to the Proposing Release's general request for comment 
on whether additional amendments or exemptions would be needed for OTC 
derivatives dealers,\207\ the SIA requested that the Commission clarify 
that an exchange member may execute transactions on a national 
securities exchange for the account of its affiliated OTC derivatives 
dealer without violating Section 11(a)(1) of the Exchange Act.\208\ 
Section 11(a)(1) \209\ makes it unlawful for a member of a national 
securities exchange to effect transactions on that exchange for certain 
accounts, including its own account or the account of an associated 
person of the member.
---------------------------------------------------------------------------

    \207\ Proposing Release, Section III, 62 FR at 67952.
    \208\ SIA Letter II, p. 4.
    \209\15 U.S.C. 78k(a)(1).
---------------------------------------------------------------------------

    This general prohibition, however, is subject to numerous 
exceptions.\210\ Among these is a general exception provided in section 
11(a)(1)(G) \211\ for a member's proprietary transactions where (1) the 
member is primarily engaged in a public securities business (the 
``business mix'' test);\212\ and (2) the transactions ``yield,'' in 
accordance with Commission rules, priority, parity, and

[[Page 59383]]

precedence to transactions for accounts of persons who are not members, 
or associated with members, of the exchange.
---------------------------------------------------------------------------

    \210\ The Commission is also authorized to determine, by rule, 
that additional types of transactions are excepted from the general 
prohibition of section 11(a)(1). See section 11(a)(1)(I) of the 
Exchange Act (15 U.S.C. 78k(a)(1)(I)). In adopting such a rule, the 
Commission must find that such transactions are consistent with the 
purposes of section 11(a), the protection of investors, and the 
maintenance of fair and orderly markets. Id.
    \211\ 15 U.S.C. 78k(a)(1)(G).
    \212\ In order to take advantage of this exception, the member 
must be ``primarily engaged in the business of underwriting and 
distributing securities issued by other persons, selling securities 
to customers, and acting as broker, or any one or more of such 
activities, and whose gross income normally is derived principally 
from such business and related activities.'' 15 U.S.C. 
78k(a)(1)(G)(i).
---------------------------------------------------------------------------

    Rule 11a1-2 under the Exchange Act \213\ generally provides that a 
member may effect a transaction for the account of an associated person 
if the member would have been permitted, under section 11(a) and the 
rules thereunder, to effect the transaction for its own account. The 
rule, however, specifically limits the circumstances in which a member 
may use the rule to rely on section 11(a)(1)(G) for transactions for 
the account of an associated person. In that situation, the associated 
person must independently meet the ``business mix'' test.\214\ Because 
an OTC derivatives dealer will be a newly created entity, it will not 
be able to demonstrate that it meets this test. Thus, the exchange 
member with which it is associated will not be able to rely on section 
11(a)(1)(G) for transactions it effects for the account of the OTC 
derivatives dealer.
---------------------------------------------------------------------------

    \213\ 17 CFR 240.11a1-2.
    \214\ This means that the associated person for whom the member 
is effecting the transaction must have derived, during its preceding 
fiscal year, more than 50% of its gross revenues from one or more of 
the sources specified in Section 11(a)(1)G)(i). See Rule 11a1-2 (17 
CFR 240.11a1-2).
---------------------------------------------------------------------------

    In response to this concern, the Commission is adopting Rule 11a1-
6. This new rule, which is modeled after Rule 11a1-2, will allow a 
fully regulated broker-dealer member to effect a transaction on a 
national securities exchange for the account of an associated person 
that is an OTC derivatives dealer if the member would have been 
permitted to effect the transaction for its own account under section 
11(a) and the rules thereunder, other than Rule 11a1-2. Rule 11a1-6 
permits the fully regulated broker-dealer to rely on the exception 
provided under section 11(a)(i)(G) for transactions it effects for its 
OTC derivatives dealer affiliate even if that affiliate does not meet 
the ``business mix'' test. The fully regulated broker-dealer and the 
OTC derivatives dealer, however, must comply with all other 
requirements of section 11(a). Thus, for example, transactions effected 
by the fully regulated broker-dealer for the account of the OTC 
derivatives dealer must continue to yield priority, parity, and 
precedence to transactions for accounts of persons who are not members, 
or associated with members, of the exchange.
    Although Rule 11a1-6 will allow a fully regulated broker-dealer to 
execute securities transactions on behalf of its OTC derivatives dealer 
affiliate, public customers will continue to receive priority and 
precedence in the execution of their securities orders. Moreover, 
excepting these transactions from the general prohibition of section 
11(a)(1) is consistent with Congressional intent in enacting this 
section. The Commission, therefore, finds that Rule 11a1-6 is 
consistent with the purposes of section 11(a)(1), the protection of 
investors, and the maintenance of fair and orderly markets.

F. Net Capital Requirements for OTC Derivatives Dealers

1. Overview of Amendments to Rule 15c3-1
    The Commission is amending the net capital rule, Rule 15c3-1 under 
the Exchange Act,\215\ as it applies to OTC derivatives dealers. In 
general, the net capital rule requires every registered broker-dealer 
to maintain certain specified minimum levels of net liquid assets, or 
net capital, to enable each firm that falls below the minimum net 
capital requirements to liquidate in an orderly fashion without the 
need for a formal legal proceeding. The rule is designed to protect the 
customers of a broker-dealer from losses that can be incurred upon a 
broker-dealer's failure. The rule prescribes different required minimum 
levels of capital based upon the nature of the broker-dealer's business 
and whether the firm handles customer funds or securities. When 
calculating its net capital, a broker-dealer must reduce its capital by 
certain percentage amounts, or haircuts, on its securities positions. 
The haircuts were designed not only to cover market risk, but also 
other risks faced by the firm, such as credit and liquidity risk.
---------------------------------------------------------------------------

    \215\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    As noted in the Proposing Release, U.S. securities firms generally 
state that firms avoid to the extent feasible booking swaps and other 
types of OTC derivative instruments in the registered broker-dealer 
because of the charges for these transactions under the net capital 
rule./216/ In general, the rule requires a firm to subtract most 
unsecured credits from its net worth when calculating its net capital, 
and limits the hedging allowance against positions if OTC derivatives 
dealers have unsecured credit exposures. The net capital rule's 
treatment of OTC derivatives transactions generally requires broker-
dealers to reserve more capital with respect to these transactions than 
do capital rules governing banks or foreign securities firms.
---------------------------------------------------------------------------

    \216\ See Proposing Release, Section II.E.1., 62 FR at 67946.
---------------------------------------------------------------------------

    The Commission is amending Rule 15c3-1 to provide alternative 
methods for OTC derivatives dealers to calculate capital charges on OTC 
derivatives transactions in several respects. Under Appendix F of Rule 
15c3-1, which is being adopted substantially as proposed, an OTC 
derivatives dealer is permitted to add back to its net worth any 
unsecured credits arising from transactions in eligible OTC derivative 
instruments.\217\ These will include unsecured accrued receivables as 
well as unsecured counterparty exposure in the OTC instruments. 
Appendix F also allows an OTC derivatives dealer to use VAR models to 
compute its market risk charges on proprietary positions instead of 
using the haircut structure under paragraph (c)(2)(vi) of the current 
rule. As mentioned above, the current haircut approach allows more 
limited offsetting among positions than the normal VAR model would 
permit when computing capital charges. Appendix F also allows an OTC 
derivatives dealer to use a less severe regime for credit risk, as 
described below.
---------------------------------------------------------------------------

    \217\ An unsecured receivable from an affiliated entity must be 
deducted to the extent the receivable is not collateralized with 
readily marketable securities.
---------------------------------------------------------------------------

    Currently, some dealers use VAR models as part of their risk 
management systems. These firms use VAR modeling to analyze, control, 
and report the level of market risk from their trading activities. A 
VAR estimate is the loss that is not expected to be exceeded at the 
chosen confidence level for some time period. In practice, VAR models 
aggregate several components of price risk into a single quantitative 
measure of the potential for loss. In addition, VAR is based on a 
number of underlying mathematical assumptions and firm-specific inputs. 
For example, VAR models typically assume normality and that future 
return distributions and correlations can be predicted by past 
returns.\218\
---------------------------------------------------------------------------

    \218\ There is a wide variety of secondary source information 
discussing both the positive and negative aspects of VAR. See 
Philippe Jorion, Value at Risk: The New Benchmark for Controlling 
Market Risk (1996) (explaining how to use VAR to manage market 
risk); JP Morgan, RiskMetrics-Technical Document (1994) (providing a 
detailed description of RiskMetrics, which is JP Morgan's 
proprietary statistical model for quantifying market risk in fixed 
income and equity portfolios); Tanya Styblo Beder, VAR: Seductive 
but Dangerous, Financial Analysts Journal, September-October 1995, 
at 12 (giving an extensive analysis of the different results from 
applying three common VAR methods to three model portfolios); 
Darrell Duffie and Jun Pan, An Overview of Value at Risk, The 
Journal of Derivatives, Spring 1997, at 7 (giving a broad overview 
of VAR models); Darryll Hendricks, Evaluation of Value-at-Risk 
Models Using Historical Data, Federal Reserve Bank of New York 
Economic Policy Review, April 1996, at 39 (examining twelve 
approaches to VAR modeling on portfolios that do not include options 
or other securities with non-linear pricing); and Robert Litterman, 
Hot Spots and Hedges, Goldman Sachs Risk Management Series (1996) 
(giving a detailed analysis on portfolio risk management, including 
how to identify the primary sources of risk and how to reduce these 
risks).

---------------------------------------------------------------------------

[[Page 59384]]

2. Reasons for Allowing OTC Derivatives Dealers To Use Value-at-Risk 
Models
    During the past few years, the Commission has actively participated 
in several international undertakings to gain further experience with 
the use of VAR models to measure market and credit risk. For example, 
through its membership in the International Organization of Securities 
Commissions (``IOSCO''), the Commission has been cooperating with the 
Basle Committee on Banking Supervision (``Basle Committee'') \219\ with 
respect to the use of proprietary VAR models to determine bank capital 
requirements for market risk.\220\
---------------------------------------------------------------------------

    \219\ The Governors of the G-10 countries established the Basle 
Committee in 1974 to provide a forum for ongoing cooperation among 
member countries on banking supervisory matters.
    \220\ In July 1995, IOSCO's Technical Committee issued a paper 
stating that further information and analysis was required before 
the Technical Committee could consider the use of internal models by 
securities firms to set regulatory capital standards for market 
risk. Due to the differences between banks and securities firms, the 
Technical Committee believed that more work was necessary before 
allowing securities firms to use VAR models to establish their 
capital requirements. The Implications for Securities Regulators of 
the Increased Use of Value At Risk Models by Securities Firms, 
Technical Committee of IOSCO, July 1995.
---------------------------------------------------------------------------

    Further, the Board of Governors of the Federal Reserve System, the 
Office of the Comptroller of the Currency, and the Federal Deposit 
Insurance Corporation (collectively, the ``U.S. Banking Agencies'') 
have adopted rules implementing the Capital Accord \221\ for U.S. banks 
and bank holding companies.\222\ Appendix F is generally consistent 
with the U.S. Banking Agencies' rules, and incorporates the qualitative 
and quantitative conditions imposed on banking institutions.
---------------------------------------------------------------------------

    \221\ The Basle Accord, or Capital Accord, is a common 
measurement system and a minimum standard for capital adequacy of 
international banks in the G-10 countries.
    \222\ Federal Reserve System, Docket No. R-0884; Department of 
the Treasury, Office of the Comptroller of the Currency, Docket No. 
96-18; Federal Deposit Insurance Corporation, RIN 3064-AB64 (Sept. 
6, 1996), 61 FR 47358.
---------------------------------------------------------------------------

    By allowing OTC derivatives dealers to use VAR models in 
calculating their net capital requirement, the Commission has an 
opportunity to gain valuable experience with the use of these models by 
entities within its jurisdiction. This experience will enable the 
Commission to reassess its current rules for determining capital 
charges for market risk and determine whether more intensive subjective 
examinations are needed to ensure compliance with Commission 
regulations concerning the use of models.
    The adoption of a more flexible approach for determining capital 
requirements for OTC derivatives dealers is appropriate because of the 
special nature of their business and the additional financial 
responsibility requirements applicable to these firms. The final rule 
requires an OTC derivatives dealer to maintain a minimum of $100 
million in tentative net capital \223\ and at least $20 million in net 
capital. OTC derivatives dealers are prohibited from accepting or 
holding customer funds or securities or generally from owing money or 
securities to customers in connection with securities activities. OTC 
derivatives dealers are, however, allowed to hold counterparty 
collateral or owe money or securities to counterparties, but only as a 
result of contractual commitments. Finally, OTC derivatives dealers are 
required to establish risk management controls pursuant to Rule 15c3-4.
---------------------------------------------------------------------------

    \223\ For an OTC derivatives dealer that elects to compute its 
market risk charges under Appendix F, the term ``tentative net 
capital'' means the net capital of an OTC derivatives dealer before 
deducting charges for market and credit risk as computed pursuant to 
Appendix F and increased by the balance sheet value (including 
counterparty net exposure) resulting from transactions in eligible 
OTC derivative instruments which would otherwise be deducted by 
virtue of paragraph (c)(2)(iv) of Rule 15c3-1.
---------------------------------------------------------------------------

3. Discussion of Net Capital Requirements
    a. Rule 15c3-1(a)(5). Under paragraph (a)(5) of Rule 15c3-1, OTC 
derivatives dealers are required to maintain tentative net capital of 
not less than $100 million and net capital of not less than $20 
million. In the Proposing Release, the Commission requested comment on 
whether the $100 million tentative net capital and $20 million net 
capital requirements would be adequate to ensure against excessive 
leverage and risks other than credit or market risk.\224\ Many 
commenters declined to comment on the minimum required amount.\225\ One 
commenter opposed any minimum tentative net capital requirement because 
other U.S. broker-dealers are not required to maintain minimum 
tentative net capital under the net capital rule, and because it 
believed that U.S. firms, and particularly small-sized, medium-sized, 
and newly established OTC derivatives dealers, would be at a 
competitive disadvantage.\226\
---------------------------------------------------------------------------

    \224\ Proposing Release, Section II.E.3.a., 62 FR at 67947.
    \225\ See Section V.A.1. of the Comment Summary.
    \226\ DESCO Letter, pp. 9-10.
---------------------------------------------------------------------------

    The final rule contains the minimum requirements of $100 million in 
tentative net capital and $20 million in net capital. The minimum 
tentative net capital and net capital requirements are necessary to 
ensure against excessive leverage and risks other than credit or market 
risk, all of which are now factored into the current haircuts. Further, 
while the mathematical assumptions underlying VAR may be useful in 
projecting possible daily trading losses under ``normal'' market 
conditions, VAR may not help firms measure losses that fall outside of 
normal conditions, such as during steep market declines.\227\ 
Accordingly, the minimum capital requirements provide additional 
safeguards to account for possible extraordinary losses or decreases in 
liquidity during times of stress which are not incorporated into VAR 
calculations.
---------------------------------------------------------------------------

    227 Models such as the one specified in Appendix F typically 
measure exposure at the first percentile, and steep market declines 
are, by definition, below the first percentile.
---------------------------------------------------------------------------

    b. Appendix F. Appendix F applies only to an OTC derivatives dealer 
that elects to be subject to the Appendix and has its application to 
use Appendix F approved by the Commission. An OTC derivatives dealer 
that elects to be subject to Appendix F is required to calculate 
specific capital charges for market and credit risk. It is also 
required to maintain a VAR model that meets certain minimum qualitative 
and quantitative requirements described in Appendix F, and it must 
adopt risk management control procedures as provided in Rule 15c3-4.
    i. Application Requirement. An OTC derivatives dealer must be 
authorized by the Commission to compute capital charges for market and 
credit risk pursuant to Appendix F. To request this authorization, an 
OTC derivatives dealer must file an application with the Commission 
describing its VAR model, including whether the firm has developed its 
own model, whether the firm intends to use VAR or alternative methods 
to calculate net capital, and how the qualitative and quantitative 
aspects described in Appendix F are incorporated into the model, and a 
description of its risk management and control procedures.\228\
---------------------------------------------------------------------------

    \228\ See Sections II.F.3.b.iv. and v. below for a description 
of the qualitative and quantitative requirements.
---------------------------------------------------------------------------

    More specifically, the application must include (1) an executive 
summary of information provided in the application; (2) a description 
of the

[[Page 59385]]

statistical models used for pricing OTC derivative instruments and for 
computing VAR, a description of the applicant's controls over those 
models, and a statement regarding whether the firm has developed its 
own internal VAR model; and (3) a description of the policies and 
procedures which the dealer employs in association with its internal 
risk management control systems.\229\ The application must also 
describe any alternative methods that the OTC derivatives dealer 
intends to use to compute its market risk charge for equity 
instruments, and categories of securities having no ready market or 
which are below investment grade. Further, an OTC derivatives dealer 
that wants to use internal credit ratings for counterparties that are 
not rated by a nationally recognized statistical rating organization 
(``NRSRO'' or ``rating organization'') must also include in its 
application a description of its credit rating categories and rating 
procedures.
---------------------------------------------------------------------------

    \229\ See Section II.H.3. below for a description of the risk 
management controls that are required by Rule 15c3-4 (17 CFR 
240.15c3-4)
---------------------------------------------------------------------------

    The Commission is amending Rule 30-3 of the Rules of Practice to 
delegate its authority to approve or deny, in full or in part, 
applications of OTC derivatives dealers to use Appendix F of Rule 15c3-
1 to the Director of the Division of Market Regulation.\230\ A denial 
of an application by the Division would be reviewable by the 
Commission.\231\ The Commission will grant the application and 
authorize the OTC derivatives dealer to compute its net capital under 
Appendix F if the dealer has adopted (1) the internal risk management 
control systems required under Rule 15c3-4; and (2) a VAR model that 
meets the criteria in paragraphs (e)(1) and (e)(2) of Appendix F. All 
application information submitted will be kept confidential, in 
accordance with the rules.
---------------------------------------------------------------------------

    \230\ See Rule 30-3(a)(7)(v) (17 CFR 200.30-3(a)(7)(v)).
    \231\ See Rules 430 and 431 (17 CFR 201.430 and 17 CFR 201.431).
---------------------------------------------------------------------------

    Commenters noted the importance of including provisions for the 
review of risk management practices, policies, and procedures employed 
by OTC derivatives dealers, to assure that they are being executed in 
accordance with their intended purposes.\232\ Accordingly, pursuant to 
the final rule, an OTC derivatives dealer is required to obtain 
authorization from the Commission before it may adopt any material 
changes to its VAR or other models, including changes in the 
qualitative or quantitative aspects of VAR models, before it may 
materially change the categories of non-marketable securities it wishes 
to include in its VAR model, or before it may materially alter its 
internal risk management control systems. If an OTC derivatives dealer 
desires to materially change its VAR model or internal risk management 
control systems, it must file an amended application with the 
Commission describing the changes. The OTC derivatives dealer will be 
authorized by the Commission to implement the proposed changes if the 
Commission determines that the changes meet the compliance standards of 
Rule 15c3-4 and Appendix F, and the amended application complements the 
internal review requirements imposed by those provisions. The final 
rule also clarifies that an OTC derivatives dealer will be in violation 
of the net capital rule if it fails to comply in all material respects 
with the internal risk management control systems under Rule 15c3-4.
---------------------------------------------------------------------------

    \232\ See Comment Letter from the Working Group of the Risk 
Management, OTC Derivative Products, and Capital Committees of the 
Securities Industry Association (``SIA Working Group Letter''), pp. 
1-5.
---------------------------------------------------------------------------

    ii. Market Risk. OTC derivatives dealers electing to apply Appendix 
F pursuant to the final rule must deduct from their net worth a capital 
charge for market risk \233\ that is equal to the sum of its VAR 
charge, alternative charges for equity instruments and non-marketable 
securities, and the charge for residual positions. First, OTC 
derivatives dealers may use the VAR method to calculate capital charges 
for market risk exposure for transactions in eligible OTC derivative 
instruments and other proprietary positions of the OTC derivatives 
dealer. Under the VAR method, a market risk capital charge is equal to 
the VAR of its positions multiplied by a factor specified in Appendix 
F.\234\
---------------------------------------------------------------------------

    \233\ In general, market risk is the risk of adverse price 
movements resulting from a change in market prices, interest rates, 
volatilities, correlations, or other market factors.
    \234\ See Section II.F.3.b.iv. below for a discussion of how an 
OTC derivatives dealer determines the appropriate multiplication 
factor.
---------------------------------------------------------------------------

    Second, an OTC derivatives dealer may use an alternative method of 
computing the market risk capital charge for equity instruments, 
including OTC options. This alternative method may also be used by a 
firm that does not receive Commission authorization to use a VAR model 
for equity instruments. Under the alternative method, an OTC 
derivatives dealer must deduct from its net worth an amount equal to 
the largest theoretical loss calculated in accordance with the 
theoretical pricing model set forth in Appendix A of Rule 15c3-1.\235\ 
The OTC derivatives dealer is permitted to use its own theoretical 
pricing model as long as it contains the minimum pricing factors set 
forth in Appendix A.\236\
---------------------------------------------------------------------------

    \235\ 17 CFR 240.15c3-1a. The Commission recently amended 
Appendix A to include theoretical pricing models. Exchange Act 
Release No. 38248 (Feb. 6, 1997), 62 FR 6474 (Feb. 12, 1997).
    \236\ 17 CFR 240.15c3-1a(b)(1)(B). The minimum pricing factors 
under Appendix A include:
    (1) The current spot price of the underlying asset;
    (2) The exercise price of the option;
    (3) The remaining time until the option's expiration;
    (4) The volatility of the underlying asset;
    (5) Any cash flows associated with ownership of the underlying 
asset that can reasonably be expected to occur during the remaining 
life of the option; and
    (6) The current term structure of interest rates.
---------------------------------------------------------------------------

    Third, an OTC derivatives dealer may not use a VAR model to 
determine a capital charge for any category of securities having no 
ready market or any category of debt securities which are below 
investment grade, or any derivative instrument based on the value of 
these categories of securities, unless the Commission has granted, 
pursuant to paragraph (a)(1) of Appendix F, its application to use its 
VAR model for any such category of securities. However, the dealer may 
apply, pursuant to paragraph (a)(1) of Appendix F, for an alternative 
treatment for any such category of securities, rather than calculate 
the market risk capital charge for such category of securities under 
paragraph (c)(2) (vi) and (vii) of the new capital rule.
    Fourth, to the extent that a position has not been included in the 
calculation of the market risk charge for VAR, or the alternative 
method for equity instruments or for non-marketable securities, the 
market risk charge for the position shall be computed under paragraph 
(c)(2)(vi) of Rule 15c3-1.
    iii. Credit Risk. An OTC derivatives dealer electing to apply 
Appendix F must deduct from its net worth a capital charge for credit 
risk.\237\ This charge has two parts and is computed on a counterparty-
by-counterparty basis. First, for each counterparty with an investment 
or speculative grade rating, an OTC derivatives dealer must take a 
capital charge equal to the net replacement value in the account of the 
counterparty (``net replacement value'') \238\ multiplied by 8%, and

[[Page 59386]]

further multiplied by a counterparty factor. The counterparty factor is 
based on the counterparty's rating by an NRSRO. The counterparty 
factors range from 20% for counterparties that are highly rated to 100% 
for counterparties with ratings among the lowest rating categories. By 
using the ratings of the rating organization as a basis, the 
counterparty factors link the size of the credit risk capital charge to 
the perceived risk that the counterparty may default. A charge of 100% 
of the net replacement value is assessed for counterparties rated below 
speculative grade or that are insolvent, or in bankruptcy, or that have 
senior unsecured long-term debt in default.
---------------------------------------------------------------------------

    \237\ In general, credit risk is the risk that a counterparty 
will fail to perform its obligations to an OTC derivatives dealer.
    \238\ For purposes of calculating credit risk charges, net 
replacement value in the account of a counterparty means the 
aggregate value of all receivables due from that counterparty 
(computed by marking the value of such receivables to market daily), 
including the effect of legally enforceable netting agreements and 
the application of liquid collateral.
---------------------------------------------------------------------------

    The second part of the credit risk charge consists of a 
concentration charge that applies when the net replacement value in the 
account of any one counterparty exceeds 25% of the OTC derivatives 
dealer's tentative net capital. In these situations, the amount of the 
concentration charge is also based on the counterparty's rating by an 
NRSRO. For counterparties that are highly rated, the concentration 
charge equals 5% of the amount of the net replacement value in excess 
of 25% of the OTC derivatives dealer's tentative net capital. The 
concentration charge increases in relation to the OTC derivatives 
dealer's exposure to lower rated counterparties. For example, the 
concentration charge for counterparties with ratings among the lowest 
rating categories would equal 50% of the amount of the net replacement 
value in excess of 25% of the OTC derivatives dealer's tentative net 
capital.
    In the rule as proposed, the credit risk concentration charge 
included a further provision that if the aggregate net replacement 
values of all counterparties exceeded 300% of the OTC derivatives 
dealer's tentative net capital, the OTC derivatives dealer would deduct 
100% of the excess from its net worth. In the Proposing Release, the 
Commission requested comment on whether the 300% threshold for 
determining an overall concentration charge would result in excessive 
concentration risk charges.\239\ Commenters suggested that the charge 
would have to be eliminated in order for the proposal to be 
viable.\240\ The final rule does not contain this further provision.
---------------------------------------------------------------------------

    \239\ Proposing Release, Section II.E.3.b.ii., 62 FR at 67948.
    \240\ See, e.g., SIA Letter I, p. 3; Goldman Sachs Letter, p. 4; 
Salomon Smith Barney Letter, p. 2; MSDW Letter, pp.18-19, iii; 
Merrill Lynch Letter, p. 3.
---------------------------------------------------------------------------

    If a counterparty is not rated by a rating organization, an OTC 
derivatives dealer is permitted to use its own ratings of the 
counterparty to calculate its credit risk charge. In these situations, 
however, the OTC derivatives dealer must demonstrate that its ratings 
categories and due diligence procedures, including procedures for the 
initial analysis and ongoing review of the counterparty (including 
review of the total leverage of the counterparty), are equivalent to 
those used by NRSROs. Several commenters requested that the Commission 
clarify whether the OTC derivatives dealer's demonstration must be on a 
counterparty-by-counterparty basis, and whether an affiliate of the 
dealer could rate non-NRSRO counterparties.\241\ It is anticipated that 
authorization of an OTC derivatives dealer's credit rating methodology 
will occur as a whole rather than as to each counterparty. Further, the 
final rule provides that such ratings may be made by an affiliated bank 
or an affiliated broker-dealer of the OTC derivatives dealer, provided 
that the affiliate's methodology has been authorized by the Commission.
---------------------------------------------------------------------------

    \241\ See letters cited in Section V.A.2.b.i. of the Comment 
Summary.
---------------------------------------------------------------------------

    In the Proposing Release, the Commission requested comment on 
alternatives to relying on the ratings of NRSROs for approximating the 
risk that a counterparty may default.\242\ Several commenters advocated 
the use of internal credit ratings of counterparties instead of or in 
addition to NRSRO ratings to calculate counterparty default risk.\243\ 
Where available, NRSRO ratings are a reliable indicator of the 
perceived risk that a counterparty may default. Therefore, it is only 
in cases where a counterparty is not rated by an NRSRO that an OTC 
derivatives dealer is permitted to use its own ratings of a 
counterparty to calculate the credit risk charge.
---------------------------------------------------------------------------

    \242\ Proposing Release, Section II.E.3.b.ii., 62 FR at 67948.
    \243\ See, e.g., ISDA Letter, p. 4; SIA Letter I, pp. 3-4; 
Salomon Smith Barney Letter, p. 2; MSDW Letter, pp. 15-17; Merrill 
Lynch Letter, p. 4.
---------------------------------------------------------------------------

    Commenters also requested that the Commission allow the use of 
internal VAR models to assess credit risk regulatory capital, instead 
of or in addition to the proposed percentage-based credit risk capital 
charges. While the adoption of the current rule will provide valuable 
experience with the use of VAR models to assess market risk for 
regulatory capital purposes, the Commission has less confidence in the 
use of VAR for credit risk. Therefore, the Commission has determined at 
this time not to allow OTC derivatives dealers to employ credit risk 
VAR modeling in calculating net capital requirements. The Commission, 
however, expects to consider this issue in the future.
    iv. Qualitative Requirements for Value-at-Risk Models. OTC 
derivatives dealers that elect to apply Appendix F are required to have 
VAR models that meet certain minimum qualitative requirements. The 
qualitative requirements address four aspects of an OTC derivatives 
dealer's risk management system. First, an OTC derivatives dealer's VAR 
model must be integrated into, and thus relied upon, in the OTC 
derivatives dealer's daily risk management process. Second, an OTC 
derivatives dealer's policies and procedures must identify and provide 
for appropriate stress tests.\244\ The OTC derivatives dealer's 
policies and procedures must identify the procedures to follow in 
response to the results of the stress tests as well as backtests, and 
the OTC derivatives dealer is required to follow these procedures. 
Third, an OTC derivatives dealer's VAR model and risk management 
systems are required to undergo both periodic reviews that are 
performed by internal audit staff and annual reviews that are conducted 
by an independent public accountant.\245\ Fourth, an OTC derivatives 
dealer is required to conduct backtesting of its VAR model.
---------------------------------------------------------------------------

    \244\ Stress tests are used to evaluate changes in the value of 
a firm's portfolio under extreme market conditions. Stress tests 
must include the core risk factors of: (1) Parallel yield curve 
shifts; (2) changes in the steepness of yield curves; (3) parallel 
yield curve shifts combined with changes in the steepness of yield 
curves; (4) changes in yield volatilities; (5) changes in the value 
of equity indices; (6) changes in equity index volatilities; (7) 
changes in the value of key currencies (relative to the U.S. 
dollar); (8) changes in foreign exchange rate volatilities; and (9) 
changes in swap spreads in at least the G-7 countries plus 
Switzerland. Stress tests should also be designed to reflect the 
composition of the firm's portfolio.
    \245\ The OTC derivatives dealer must discuss the timing and 
nature of the periodic review by internal audit staff as part of the 
application process. See Section II.F.3.b.i. above.
---------------------------------------------------------------------------

    As to the fourth element, the OTC derivatives dealer is required to 
conduct backtesting by comparing each of its most recent 250 business 
days' actual net trading profits or losses with the corresponding daily 
VAR measures. In addition, once each quarter, the OTC derivatives 
dealer must identify the number of exceptions, that is, the number of 
business days for which the actual daily net trading loss, if any, 
exceeds the corresponding daily VAR measure. The number of exceptions 
determines the multiplication factor the

[[Page 59387]]

OTC derivatives dealer will be required to use for the following 
quarter, and which will continue to apply until the next quarter's 
backtesting results are obtained, unless the Commission determines that 
a different adjustment or other action is appropriate. Depending on the 
number of exceptions, the multiplication factors range from three to 
four. Increasing the multiplication factor in response to the number of 
backtesting exceptions increases an OTC derivatives dealer's market 
risk charge, thus requiring an OTC derivatives dealer that uses an 
inappropriate model to increase its net capital reserves. Although the 
multiplication factor increases an OTC derivatives dealer's market risk 
charge and corresponding capital requirement, firms are expected to 
work to improve the reliability of their models rather than set aside 
additional capital for an unreliable model.
    v. Quantitative Requirements for Value-at-Risk Models. Appendix F 
also contains minimum quantitative requirements to address regulatory 
concerns. Because broker-dealers generally use VAR models to measure 
portfolio volatility on a day-to-day basis, the rule imposes certain 
requirements on VAR models to address regulatory capital-related 
concerns where a longer time horizon is appropriate. For example, OTC 
derivatives dealers are required to calculate VAR measures using a 
confidence level with a price change equivalent to a ten-business day 
movement in rates and prices, rather than a one-day price movement that 
is used in many VAR models currently used by firms for internal risk 
management purposes. The final rule also requires a one-year historical 
observation period, and addresses risks to be accounted for in VAR 
measures.

G. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3

    The proposed rules would have excluded from the definition of 
customer, pursuant to Rules 8c-1,\246\ 15c2-1,\247\ and 15c3-3 under 
the Exchange Act,\248\ a counterparty to an OTC derivatives transaction 
that has consented, after receiving appropriate disclosures, to the 
unrestricted use of its collateral by an OTC derivatives dealer. Rules 
8c-1, 15c2-1, 15c3-2,\249\ and 15c3-3 generally restrict a broker-
dealer's use of customer funds and securities to finance its business 
activities.
---------------------------------------------------------------------------

    \246\ 17 CFR 240.8c-1.
    \247\ 17 CFR 240.15c2-1.
    \248\ 17 CFR 240.15c3-3.
    \249\ 17 CFR 240.15c3-2. The Commission did not propose to amend 
Rule 15c3-2 in the Proposing Release. Rule 15c3-2 restricts the use 
by a broker or dealer of funds arising out of any free credit 
balance carried for the account of any customer unless the broker or 
dealer complies with certain notice requirements.
---------------------------------------------------------------------------

    The SIA commented that the proposed exclusions should be expanded 
to include counterparties to permissible cash management, risk 
management, and financing transactions.\250\ In addition, the SIA 
suggested that the Commission clarify that the disclosure requirement 
could be met in any instance in which a counterparty has entered into 
an agreement explicitly authorizing the repledging, rehypothecation, 
substitution, or other disposition of collateral provided by the 
counterparty.\251\ Further, the SIA sought to verify that 
counterparties to transactions effected through a fully regulated 
broker-dealer would not be considered a customer of the OTC derivatives 
dealer for purposes of Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3.\252\
---------------------------------------------------------------------------

    \250\ SIA Letter I, pp. 12-13.
    \251\ SIA Letter I, p. 13.
    \252\ Id.; SIA Letter II, p. 5.
---------------------------------------------------------------------------

    The amendments to Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3 as adopted 
clarify the original intent of the proposal. Further, an OTC 
derivatives dealer that has received collateral from a counterparty 
will not be carrying a free credit balance for the account of a 
customer for the purposes of Rule 15c3-2 if the counterparty is not a 
customer of the dealer pursuant to Rules 8c-1, 15c2-1, and 15c3-3. A 
counterparty that has delivered collateral to an OTC derivatives dealer 
pursuant to a transaction in an eligible OTC derivative instrument or 
pursuant to the OTC derivatives dealer's cash management securities 
activities or ancillary portfolio management securities activities is 
not a customer for purposes of Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3, 
but only if the counterparty has received a prominent written notice 
from the OTC derivatives dealer that, at a minimum, discloses that (1) 
except as otherwise agreed in writing by the OTC derivatives dealer and 
the counterparty, the OTC derivatives dealer may repledge or otherwise 
use the collateral in its business; (2) in the event of the dealer's 
failure, the counterparty will likely be considered an unsecured 
creditor of the dealer as to that collateral; (3) SIPA does not protect 
the counterparty; and (4) the collateral will not be subject to the 
requirements of Rules 8c-1, 15c2-1, 15c3-2, or 15c3-3.

H. Recordkeeping and Reporting

1. Amendments to Rules 17a-3 and 17a-4; Books and Records to be 
Maintained by OTC Derivatives Dealers
    The Proposing Release \253\ stated that OTC derivatives dealers, 
like other registered broker-dealers, are required to comply with the 
books and records requirements of Rules 17a-3 \254\ and 17a-4 \255\ 
under the Exchange Act. Rule 17a-3 would also have been amended to 
require an OTC derivatives dealer to compile a register of all 
derivatives transactions. In addition, Rule 17a-4 would have been 
amended to require OTC derivatives dealers to retain records required 
to be made pursuant to proposed Rules 15c3-4 and 17a-12.\256\
---------------------------------------------------------------------------

    \253\ Proposing Release, Section II.H.1., 62 FR at 67950.
    \254\ 17 CFR 240.17a-3. In general, Rule 17a-3 under the 
Exchange Act requires broker-dealers to make records concerning the 
purchases and sales of securities, receipts and deliveries of 
securities, and receipts and disbursements of cash. In addition, the 
rule requires broker-dealers to make and keep ledgers reflecting 
securities borrowed and securities received, repurchase and reverse 
repurchase agreements, and a record of net capital computations.
    \255\ 17 CFR 240.17a-4. Rule 17a-4 under the Exchange Act 
specifies how long broker-dealers must keep the records required to 
be made under Rule 17a-3 and how long they must keep other records 
made in the normal course of business.
    \256\ See Proposing Release, Section II.H.1., 62 FR at 67950.
---------------------------------------------------------------------------

    The Commission is adopting the amendments to Rules 17a-3 and 17a-4 
as proposed. As several commenters have requested, the rules have been 
clarified to allow the OTC derivatives dealer's books and records to be 
maintained by an affiliated fully regulated broker-dealer. However, the 
OTC derivatives dealer remains responsible for ensuring that its books 
and records are properly maintained in accordance with Rules 17a-3 and 
17a-4.
2. Amendments to Rule 17a-11; Notification Requirements
    In the Proposing Release, the Commission stated that an OTC 
derivatives dealer would be subject to the provisions of Rule 17a-11 
under the Exchange Act,\257\ which requires a

[[Page 59388]]

broker-dealer to report capital and other operational problems to the 
Commission and the broker-dealer's examining authority within specified 
time periods.\258\ In addition, Rule 17a-11 would have been amended to 
take into consideration the new tentative net capital requirements that 
would apply to an OTC derivatives dealer. An OTC derivatives dealer 
would have been required to provide notice to the Commission and to its 
examining authority when its tentative net capital dropped below 120 
percent of its required minimum and when its tentative net capital 
dropped below its required minimum.\259\
---------------------------------------------------------------------------

    \257\ 17 CFR 240.17a-11. Under Rule 17a-11, if a broker-dealer's 
net capital falls below the required minimum level, the broker-
dealer must provide both the Commission and the broker-dealer's DEA 
with notice of such deficiency. A broker-dealer is also required to 
give same-day notice if it fails to make and keep current its books 
and records pursuant to Rules 17a-3 and 17a-4, and to submit a 
report within 48 hours detailing the steps it is taking to correct 
the problem. In addition, Rule 17a-11 requires a broker-dealer to 
give notice when it discovers any material inadequacy in its system 
of internal controls, or is notified of this inadequacy by its 
independent public accountant. In these instances, the broker-dealer 
is required to submit a report detailing steps being taken to 
correct the inadequacy.
    \258\ Proposing Release, Section II.H.2., 62 FR at 67950.
    \259\ Under proposed Rule 15b9-2, an OTC derivatives dealer 
would have been required to enter into an agreement with the 
examining authority for one or more of its registered broker-dealer 
affiliates. Under this agreement, the examining authority would have 
agreed to conduct a review of the activities of the OTC derivatives 
dealer. See supra note 181 and accompanying text.
---------------------------------------------------------------------------

    The Commission did not receive any comments that addressed the 
proposed amendments to Rule 17a-11. However, as discussed in Section 
II.D.1. above, the Commission is not requiring an OTC derivatives 
dealer to enter into an agreement with the examining authority for one 
of its registered broker-dealer affiliates that would require the 
examining authority to conduct a review of the activities of the OTC 
derivatives dealer. Therefore, the adopted amendments to Rule 17a-11 
require an OTC derivatives dealer to provide the required notices only 
to the Commission. With respect to tentative net capital, an OTC 
derivatives dealer is required to provide notice to the Commission when 
its tentative net capital drops below 120 percent of its required 
minimum and when its tentative net capital drops below its required 
minimum. The Commission is also amending Rule 17a-11 to require an OTC 
derivatives dealer to notify the Commission of backtesting exceptions 
identified pursuant to Appendix F of Rule 15c3-1.
3. Rule 15c3-4; Internal Risk Management Control Systems for OTC 
Derivatives Dealers
    Pursuant to proposed Rule 15c3-4, an OTC derivatives dealer would 
have been required to establish a system of internal controls for 
monitoring and managing risks associated with its business activities. 
More specifically, proposed Rule 15c3-4 would have established the 
basic elements for the design, implementation, and review of an OTC 
derivatives dealer's risk management control system. The proposed rule 
would have required an OTC derivatives dealer to assess a number of 
aspects about its business environment when creating its risk 
management control system. For example, an OTC derivatives dealer would 
have been required to consider the sophistication and experience of 
relevant trading, risk management, and internal audit personnel, as 
well as the management philosophy and culture of the firm. In addition, 
proposed Rule 15c3-4 would have required certain elements be included 
in an OTC derivatives dealer's internal control systems. For example, 
the proposed rule would have required the unit at the firm responsible 
for monitoring risks to be separate from and senior to the trading 
units whose activity created the risks.
    The SIA Working Group commented \260\ that an OTC derivatives 
dealer's internal risk management control system should specifically 
address operational risk,\261\ market risk,\262\ credit risk,\263\ 
liquidity risk,\264\ and legal risk.\265\ In response to the comment, 
the Commission has revised Rule 15c3-4 to clarify the specific risks to 
be addressed by the OTC derivatives dealer's system of internal risk 
management controls. In particular, Rule 15c3-4 requires that an OTC 
derivatives dealer's system of internal risk management controls 
specifically address market risk, credit risk, leverage risk, liquidity 
risk, legal risk, and operational risk.
---------------------------------------------------------------------------

    \260\ SIA Working Group Letter, p. 1.
    \261\ Operational risk encompasses the risk of loss due to the 
breakdown of controls within the firm including, but not limited to, 
unidentified limit excesses, unauthorized trading, fraud in trading 
or in back office functions, inexperienced personnel, and unstable 
and easily accessed computer systems.
    \262\ Market risk involes the risk that prices or rates will 
adversely change due to economic forces. Such risks include adverse 
effects of movements in equity and interest rate markets, currency 
exchange rates, and commodity prices. Market risk can also include 
the risks associated with the cost of borrowing securities, dividend 
risk, and correlation risk.
    \263\ Credit risk comprises risk of loss resulting from 
counterparty default on loans, swaps, options, and other similar 
financial instruments during settlement.
    \264\ Liquidity risk includes the risk that a firm will not be 
able to unwind or hedge a position.
    \265\ Legal risk arises from possible risk of loss due to an 
uneforceable contract or an ultra vires act of a counterparty.
---------------------------------------------------------------------------

    Rule 15c3-4 has also been revised to require that an OTC 
derivatives dealer's written guidelines include the dealer's procedures 
to prevent it from engaging in any securities transaction that is not 
permitted under Rule 15a-1 or from improperly relying on certain 
exceptions set forth in Rule 15a-1 (including procedures to determine 
whether a counterparty is acting in the capacity of principal or 
agent).\266\ Under Rule 15c3-4, the dealer's management must also 
periodically review the dealer's business activities for consistency 
with risk management guidelines. The rule has been revised to require 
management, as part of this process, to review whether procedures are 
in place to prevent the dealer from engaging in impermissible 
securities transactions and from improperly relying on the exceptions 
contained in Rule 15a-1.\267\
---------------------------------------------------------------------------

    \266\ See Rule 15c3-4(c)(5)(xiii) and (xiv) (17 CFR 240.15c3-
4(c)(5)(xiii) and (xiv)). See also Rule 15a-1 (17 CFR 240.15a-1) and 
Section II.C.1. above, discussing revisions to proposed Rule 15a-1.
    \267\ See rule 15c3-4(d)(8) and (9) (17 CFR 240.15c3-4(d)(8) and 
(9)).
---------------------------------------------------------------------------

4. Rule 17a-12; Reports to be Made by OTC Derivatives Dealers
    Proposed Rule 17a-12 would have required an OTC derivatives dealer 
to file quarterly Financial Operational Combined Uniform Single Reports 
(``FOCUS'' reports),\268\ and to include with its filing the enhanced 
reporting information and evaluation of risks in relation to capital 
provisions of the Framework for Voluntary Oversight of the Derivatives 
Policy Group (``DPG'').\269\ Proposed Rule 17a-12 would also have 
required an OTC derivatives dealer to file annually its audited 
financial statements, a corresponding audit report, and three 
supplemental audit reports regarding (1) material inadequacies and 
reportable conditions; (2) derivatives pricing and modeling procedures; 
and (3) compliance with internal risk management controls. The proposed 
rule would have established guidelines for the content and form of the 
annual report, accountant qualifications, the process for designating 
an accountant, and audit objectives. For example, among other things, 
the annual audit report would have been required to include a statement 
of financial condition, a statement of income, a statement of cash 
flows, a statement of

[[Page 59389]]

changes in owners' equity, and a statement of changes in subordinated 
liabilities.
---------------------------------------------------------------------------

    \268\ Form X-17A-5 (17 CFR 249.617).
    \269\ See Framework for Voluntary Oversight, Derivatives Policy 
Group (Mar. 1995). The firms comprising the DPG consist of the six 
U.S. broker-dealers with the largest OTC derivatives affiliates. 
This group was organized to respond to the public policy interests 
of Congress, federal agencies, and others in the OTC derivatives 
activities of unregulated affiliates of SEC-registered broker-
dealers and CFTC-registered futures commission merchants. The 
Framework for Voluntary Oversight specifies certain information that 
the members of the DPG have voluntarily agreed to submit regarding 
their OTC derivatives activities and establishes certain internal 
control principles that group members should follow.
---------------------------------------------------------------------------

    The SIA requested clarification as to the scope of the auditor's 
report regarding inventory pricing and modeling procedures.\270\ More 
specifically, the SIA sought clarification that the objective of the 
review of the inventory pricing and modeling procedures was to confirm 
that (1) the pricing and modeling procedures relied upon by the OTC 
derivatives dealer conform to the procedures submitted to the 
Commission as part of its OTC derivatives dealer application; and (2) 
the procedures comply with the qualitative and quantitative standards 
set forth in proposed Rule 15c3-1f.\271\ Further clarification was 
sought by the SIA and other commenters as to whether an OTC derivatives 
dealer would be required to file its FOCUS report monthly or quarterly 
and whether an OTC derivatives dealer would be required to comply with 
Rule 17a-5 under the Exchange Act.\272\
---------------------------------------------------------------------------

    \270\ SIA Letter I, p. 4.
    \271\ Id.
    \272\ 17 CFR 240.17a-5. See Section V.D.4.a. of the Comment 
Summary.
---------------------------------------------------------------------------

    Rule 17a-12 has been amended to clarify the scope of the auditor's 
report on inventory pricing and modeling procedures. The rule requires 
that, at a minimum, the accountant's report on inventory pricing and 
modeling procedures confirm that (1) the pricing and modeling 
procedures relied upon by the OTC derivatives dealer conform to the 
procedures submitted to the Commission as part of its OTC derivatives 
dealer application; and (2) the procedures comply with the qualitative 
and quantitative standards set forth in Rule 15c3-1f. This does not 
imply any lessening of the auditor's normal role in the audit of the 
financial statements of the OTC derivatives dealer. Finally, the rule 
provides that an OTC derivatives dealer must file its FOCUS report 
quarterly, unless otherwise directed by the Commission, and amends Rule 
17a-5 to clarify that an OTC derivatives dealer may comply with Rule 
17a-5 by complying with the provisions of Rule 17a-12.
5. Amendments to Form X-17A-5
    Proposed Rule 17a-12 would have required that certain conforming 
changes be made to Rule 249.617 to require OTC derivatives dealers to 
file the appropriate parts of Form X-17A-5, commonly known as the FOCUS 
report. These changes would have provided for the appropriate 
disclosure of the business activities of OTC derivatives dealers and 
the risks associated with those activities.
    Under the proposed amendments to Form X-17A-5, the net capital 
computation worksheet would have been revised to reflect the proposed 
net capital requirements for OTC derivatives dealers. Other changes 
would have included revising the statement of financial condition and 
the statement of income, and eliminating the customer reserve 
computation and commission income line items. OTC derivatives dealers 
would also have been required to include certain new information in the 
quarterly FOCUS filing. This information would include credit 
concentration information, together with a geographic breakdown and a 
counterparty breakdown as described in the DPG Framework for Voluntary 
Oversight. OTC derivatives dealers would also have been required to 
provide, where applicable, a detailed summary of all long and short 
securities and commodities positions, including all OTC derivatives 
contracts. The SIA suggested several minor changes to the proposed 
amendments to Form X-17A-5.\273\ For example, these suggestions 
included expanding the scope of covered OTC instruments to include all 
relevant sources of, or offsets to, market risk in an OTC derivatives 
dealer's portfolio. The SIA's suggestions have been incorporated into 
the amendments to Form X-17A-5, as adopted.
---------------------------------------------------------------------------

    \273\ SIA Letter I, pp. 16-17.
---------------------------------------------------------------------------

III. Costs and Benefits of the Rules and Rule Amendments

    The rules and rule amendments adopted by the Commission today 
create a limited regulatory scheme for dealers active in the OTC 
derivatives market and allow U.S. securities firms to establish 
separately capitalized OTC derivatives dealer affiliates. OTC 
derivatives dealers may act as dealers in eligible OTC derivative 
instruments, which include both securities and non-securities OTC 
derivative instruments. Registration as an OTC derivatives dealer is 
optional and is an alternative to registration as a fully regulated 
broker-dealer or to conducting a more limited OTC derivatives business 
through an unregistered affiliate.
    Under the limited regulatory scheme, an OTC derivatives dealer is 
able to conduct its business more efficiently and at lower cost than if 
it were a fully regulated broker-dealer. This is, in fact, because an 
OTC derivatives dealer is subject to specifically tailored capital, 
margin, and other broker-dealer regulatory requirements. With respect 
to margin in particular, OTC derivatives dealers are exempted from the 
margin requirements of Section 7(c) of the Exchange Act and Regulation 
T thereunder, provided that they comply with Section 7(d) of the 
Exchange Act and the requirements of Regulation U. Regulation U 
generally allows OTC derivatives dealers to extend credit on OTC 
derivative instruments on more flexible terms than Regulation T.
    While registered OTC derivatives dealers will benefit from the new 
regulatory scheme, regulators and financial markets will also benefit 
if an unregistered derivatives dealer elects to register as an OTC 
derivatives dealer. Net capital requirements and other financial 
responsibility requirements imposed on registered OTC derivatives 
dealers help to protect against excessive leverage and business risk, 
and provide a cushion of capital against market declines and other 
risks. In addition, Commission oversight authority, including reporting 
and notice requirements, enable the Commission to monitor the financial 
and operational condition and securities activities of OTC derivatives 
dealers. Moreover, because an OTC derivatives dealer must adopt certain 
internal risk management controls that promote financial 
responsibility, the risk that significant losses by a single firm could 
undermine the securities markets as a whole is reduced.

A. Comments and Survey

    In the Proposing Release, the Commission requested comment on the 
costs and benefits associated with the proposed rules and rule 
amendments.\274\ More specifically, the Commission requested comment on 
the one-time costs of any modifications to accounting, information 
management, and recordkeeping systems required to implement the 
proposed rules and rule amendments, as well as on the continuing costs 
arising from compliance with the proposed rules and rule amendments. 
The Commission also requested comment on the benefits from the modified 
capital, margin, and other regulatory requirements. Commenters 
indicated that the new regulatory structure would result in lower 
capital requirements and would allow them to compete more effectively 
with banks and foreign dealers.\275\ However, the Commission did not 
receive any specific cost or benefit data in response to the Proposing 
Release.
---------------------------------------------------------------------------

    \274\ Proposing Release, Section IV., 62 FR at 67952.
    \275\ See Section VI. of the Comment Summary.
---------------------------------------------------------------------------

    In an effort to obtain more specific information on the potential 
costs and

[[Page 59390]]

benefits of operating as an OTC derivatives dealer, Commission staff 
asked broker-dealers to provide more specific estimates of the costs 
and benefits of moving OTC derivatives business to, and conducting 
business in the form of, an OTC derivatives dealer. Five firms that 
believed OTC derivative dealer registration would be cost effective 
provided cost information, and requested confidential treatment of the 
data provided to the Commission.\276\ Most firms responding expected 
significant benefits from registering as an OTC derivatives dealer 
because of regulatory capital savings, increased capital efficiency, 
and efficiencies resulting from business consolidation. These benefits 
generally outweighed increased one-time and continuing operating costs 
associated with combining activities currently conducted in a 
registered broker-dealer with activities conducted in other 
unregistered entities. The firms that responded to the survey also 
stated that the margin requirements applicable to OTC derivatives 
dealers are beneficial in instances where the less stringent Regulation 
U applies to transactions instead of Regulation T, but costly to the 
extent Regulation U applies to offshore business not previously subject 
to either U.S. margin requirement.
---------------------------------------------------------------------------

    \276\ Two additional firms submitted responses to the survey, 
but these responses are not reflected in this analysis. One firm 
provided limited cost information that was excluded because the firm 
indicated that, due to the small size of its OTC derivatives 
business, it is not likely to register as an OTC derivatives dealer. 
A second firm's response was excluded because it gave qualitative, 
rather than quantitative, information. A summary of the responses to 
the survey has been placed in Public Reference File No. S7-30-97 and 
is available for inspection in the Commission's Public Reference 
Room.
---------------------------------------------------------------------------

    Responses to the survey varied in terms of length and detail. Some 
were more qualitative than quantitative. At times respondents combined 
categories, making comparability and averaging more difficult. Where 
possible, estimated costs and benefits are provided below.

B. Benefits

1. Regulatory Capital Effects
    Most firms responding to the survey identified regulatory capital 
effects as the most significant benefit resulting from operation as an 
OTC derivatives dealer. By applying Appendix F instead of taking 
traditional haircuts under paragraph (c)(2)(vi) of Rule 15c3-1, OTC 
derivatives dealers will be required to reserve less regulatory capital 
than they would if this business was conducted on the books of their 
fully regulated broker-dealer affiliates.\277\ The five firms that 
provided estimated regulatory capital savings figures estimated an 
aggregate difference in net capital requirements of $1.25 billion if 
they registered as OTC derivatives dealers. Additionally, assuming that 
these firms would otherwise conduct their derivatives business through 
a fully regulated broker-dealer, the staff estimated that their reduced 
capital requirements would yield an aggregate annual benefit for the 
use of this capital of approximately $138 million.\278\
---------------------------------------------------------------------------

    \277\ Many of these firms may currently conduct their OTC 
derivatives business in unregistered or offshore affiliates not 
subject to regulatory net capital requirements.
    \278\ The total annual benefit was computed by multiplying the 
regulatory capital savings of $1.25 billion by 11%, which is the 
average of three estimated incremental rates of return provided by 
three responding firms.
---------------------------------------------------------------------------

2. Operational Cost Savings
    The firms surveyed generally predicted that they would not 
experience significant operational savings from operating as an OTC 
derivatives dealer. They predicted, but did not quantify, potential 
operational benefits from the consolidation of businesses into one 
entity. These benefits include:
     Streamlined transaction processing if all OTC derivatives 
activity were consolidated into one entity;
     Consolidated netting of counterparty credit exposures, and 
margining of counterparty net balances; and
     Consolidated transaction documentation by counterparty.
3. Decreased Margin Requirements
    Most firms stated that the modified margin requirements would not 
be a significant benefit of registering as an OTC derivatives dealer, 
and did not quantify this benefit. The firms noted that margin 
requirements under Regulation U would be more flexible when extending 
credit than Regulation T, which applies to broker-dealers. They also 
noted, however, that with respect to business previously conducted 
offshore, which was not subject to Federal Reserve Board margin 
requirements, complying with Regulation U would increase the cost of 
doing business.

C. Costs

1. Costs of Combining Activities Into One Operation
    A firm electing to register as an OTC derivatives dealer would 
incur costs to combine activities currently conducted in a registered 
broker-dealer with activities conducted in other unregistered entities. 
It also would incur continuing costs to comply with the applicable 
rules and rule amendments. Respondents to the survey identified, but 
did not uniformly quantify, the costs associated with operating as an 
OTC derivatives dealer. These costs include:

     Forming and registering as an OTC derivatives dealer;
     Adjusting risk management practices to conform with 
Rules 15c3-1 and 15c3-4;
     Enhancing and developing VAR and credit risk systems;
     Complying with minimum capital requirements;
     Making and retaining required books and records;
     Preparing and submitting FOCUS reports and annual 
audited financial statements;
     Responding to examination requests;
     Developing systems for compliance with the margin 
requirements of Regulation U;
     Subjecting offshore activities to Regulation U; and
     Hiring compliance personnel.

    Five firms responding to the survey estimated that their annual 
operating costs would increase by at least $36 million in the aggregate 
to conduct business as an OTC derivatives dealer. Respondents' 
individual estimates of increased costs ranged from $900,000 to $26 
million per year. However, they stated that the increases in operating 
costs were far outweighed by estimated positive regulatory capital 
effects. Although survey results were not uniformly comparable, 
estimates of some specific operational costs follow.
2. Registration as an OTC Derivatives Dealer
    One firm estimated that the cost of registering an entity as an OTC 
derivatives dealer would be as high as $50,000. This firm noted that 
set-up and registration costs would likely decrease for later 
registrants, after the process becomes standardized.
3. Risk Management Adjustments
    One firm did not consider the costs of further developing its VAR 
and other statistical risk models to be attributable to the OTC 
derivatives dealer specifically, because such development would be 
required in any event. This firm and another firm each estimated the 
cost of conforming their VAR model to the regulatory requirements to be 
approximately $200,000. A third firm estimated the cost of obtaining 
risk management systems and procedures that meet the regulatory 
requirements to be at least $250,000. One firm stated that the 
additional cost of compensating model-related personnel would be 
approximately $650,000 per year.

[[Page 59391]]

4. Books and Records Requirements
    Apart from a likely increase in outside auditor fees, firms 
generally stated that the cost of compliance with books and records and 
reporting requirements were not significant. One firm estimated that 
the cost of systems changes necessary to create and maintain OTC 
derivatives dealer books and records, as well as the cost of necessary 
compliance personnel would be $500,000 in the first year. A second firm 
estimated that the cost of compensating additional regulatory 
compliance staff would be approximately $75,000 per year. A third firm 
expected increased costs of $400,000 per year for audit and related 
services, and for hiring additional personnel in the areas of 
compliance, operations, and reporting.
5. Regulatory Reporting
    One firm estimated that the cost for an OTC derivatives dealer to 
prepare the required regulatory reports would be approximately $38,000 
per year. This firm also estimated that internal and external auditor 
fees would be $100,000 per year. Another firm estimated the cost of 
preparation for regulatory examinations as $75,000 per year.
6. Regulation U Margin Requirements
    One firm estimated the cost of maintaining OTC derivative dealer 
margin to be approximately $75,000. The Commission has also considered 
whether systemic risk would be created by permitting OTC derivatives 
dealers to comply with the reduced margin requirements of Regulation U 
as opposed to Regulation T. Although the collection of less margin in 
some transactions may increase risk for OTC derivatives dealers, the 
systemic risk is no greater for OTC derivatives dealers than for their 
banking competitors. Further, this risk is offset in part by financial 
responsibility safeguards applicable to OTC derivatives dealers, such 
as the minimum capital requirements in Rule 15c3-1 and the internal 
risk management control systems required by Rule 15c3-4.

D. Conclusion

    Based on the survey results and its own analysis, the Commission 
believes that the rules and rule amendments adopted today provide firms 
that are active in the OTC derivatives market with a cost effective 
alternative to conducting this business through a fully regulated 
broker-dealer. In addition, it is important to note that registration 
as an OTC derivatives dealer is optional. Thus, a firm can perform its 
own cost and benefit analysis to determine whether registration as an 
OTC derivatives dealer is an appropriate alternative for that firm.

IV. Efficiency, Competition, and Capital Formation

    Section 23(a)(2) of the Exchange Act\279\ requires the Commission, 
in adopting Exchange Act rules, to consider the impact any such rule 
would have on competition and to not adopt a rule that would impose a 
burden on competition not necessary or appropriate in furthering the 
purposes of the Exchange Act. Furthermore, section 3(f) of the Exchange 
Act\280\ provides that whenever the Commission is engaged in rulemaking 
and is required to consider or determine whether an action is necessary 
or appropriate in the public interest, the Commission shall consider, 
in addition to the protection of investors, whether the action will 
promote efficiency, competition, and capital formation. The Commission 
has considered the rules and rule amendments in light of the standards 
cited in sections 23(a)(2) and 3(f) of the Exchange Act.
---------------------------------------------------------------------------

    \279\ 15 U.S.C. 78w(a)(2).
    \280\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    In the Proposing Release, the Commission requested comment on the 
effect of the proposed rules and rule amendments on competition, 
efficiency, and capital formation.\281\ Commenters generally indicated 
that the reduced capital, margin, and other regulatory requirements 
would allow an OTC derivatives dealer to compete more effectively with 
banks and foreign dealers. However, commenters did not provide detailed 
information or analysis on the limited regulatory scheme's effect on 
competition, efficiency, or capital formation.\282\
---------------------------------------------------------------------------

    \281\ Proposing Release, Sections IV. and V., 62 FR at 67952-53.
    \282\ See Section VI. of the Comment Summary.
---------------------------------------------------------------------------

    The rules and rule amendments adopted by the Commission today 
increase the ability of certain highly capitalized broker-dealers to 
compete effectively in global securities markets by removing 
substantial regulatory and economic barriers. Because registration as 
an OTC derivatives dealers is optional and is an alternative to 
registration as a fully regulated broker-dealer or to conducting a more 
limited OTC derivatives business in an unregistered entity, a firm can 
make its own analysis of the competitive advantages of being registered 
as an OTC derivatives dealer.
    Major dealers in the OTC derivatives market are generally large, 
highly capitalized banks and securities firms. One commenter opposed 
any minimum tentative net capital requirement, arguing that other U.S. 
broker-dealers are not required to maintain minimum tentative net 
capital under the net capital rule, and that U.S. firms, and 
particularly small-sized, medium-sized, and newly established OTC 
derivatives dealers, would be at a competitive disadvantage.\283\ It is 
likely that smaller firms in the OTC derivatives business will not be 
able to register as OTC derivatives dealers because they cannot satisfy 
the minimum capital requirements. This will not prevent competition, 
however, because these smaller firms may continue to conduct their OTC 
derivatives business outside of the OTC derivatives dealer regulatory 
structure, although they will not receive the benefits of the new 
rules. Further, reducing minimum capital requirements would not be 
consistent with investor protection.
---------------------------------------------------------------------------

    \283\ DESCO Leter, pp. 9-10.
---------------------------------------------------------------------------

    The minimum capital requirements imposed on OTC derivatives dealers 
are necessary to help protect against excessive leverage and the risks 
associated with conducting an OTC derivatives business, and to provide 
a cushion of capital against severe market disturbances. It would not 
be appropriate, for example, to require less capital from less active 
OTC derivatives dealers. Firms of all sizes face risks, such as legal 
risk, liquidity risk, and operational risk, which are not typically 
incorporated into VAR calculations. Further, VAR may not measure losses 
that fall outside of normal conditions, such as during steep market 
declines. The minimum capital requirements provide additional 
safeguards to account for possible extraordinary losses or decreases in 
liquidity during times of market stress.
    Two commenters suggested that the Commission address certain 
competitive disparities that they argued exist between exchange-traded 
products and seemingly similar products available in the OTC 
derivatives market.\284\ The rules adopted today are only designed to 
address competitive disparities between market participants within the 
OTC derivatives market. They are not intended to address actual or 
perceived competitive disparities between OTC products and any other 
product or service.
---------------------------------------------------------------------------

    \284\ CBOE Letter, pp. 1-2; Comment Letter from the Chicago 
Mercantile Exchange, p. 2.
---------------------------------------------------------------------------

    The rules and rule amendments promote market efficiency and capital 
formation. The limited regulatory scheme provides U.S. broker-dealers 
with an optional alternative to conducting OTC derivatives

[[Page 59392]]

transactions through fully regulated broker-dealers, but does not 
create significant impediments to competition. As a result of the new 
regulatory structure, the Commission will be better able to monitor the 
financial and operational activities of OTC derivatives dealers. 
Finally, minimum capital requirements will provide a cushion against 
severe market disturbances, thus reducing the risk that a single firm 
will experience significant losses and trigger such losses by other 
market participants.

V. Summary of Final Regulatory Flexibility Analysis

    A Final Regulatory Flexibility Analysis (``FRFA'') regarding the 
rules and rule amendments under the Exchange Act that tailor capital, 
margin, and other broker-dealer regulatory requirements to the 
activities of OTC derivatives dealers has been prepared in accordance 
with 5 U.S.C. 604. The FRFA notes that registration as an OTC 
derivatives dealer is optional, and therefore will not impose any 
reporting requirements for those entities choosing not to become 
registered as OTC derivatives dealers. Those entities choosing to 
register as OTC derivatives dealers under the new regulatory system 
will be subject to the reporting requirements applicable to broker-
dealers under the Exchange Act.

A. Need for the Rules and Rule Amendments

    As discussed more fully in the FRFA, the rules and rule amendments 
are intended to give U.S. securities firms an opportunity to conduct 
business in a vehicle subject to modified regulation appropriate to OTC 
derivatives markets, and thereby to improve the efficiency and 
competitiveness of U.S. securities firms participating in global OTC 
derivatives markets. These improvements will be realized through a 
limited regulatory structure that is expected to impose fewer costs on 
firms conducting an OTC derivatives business than would be imposed 
under the Commission's current rules. In particular, the application of 
revised capital requirements and an exemption from the margin 
requirements of Regulation T should make it feasible for firms to 
conduct a business involving both securities and non-securities OTC 
derivative instruments within the United States. Commenters generally 
commended the Commission for its efforts to improve competition and 
efficiency.

B. Small Entities Subject to the Rules

    These rules and rule amendments will not significantly affect a 
substantial number of small entities, as defined in the Commission's 
rules.\285\ At the time of the Proposing Release, a broker-dealer 
(including any person that would be an OTC derivatives dealer) 
generally would be considered a small entity if (1) it had total 
capital (net worth plus subordinated liabilities) of less than $500,000 
on the date in the prior fiscal year as of which its audited financial 
statements were prepared pursuant to Rule 17a-5(d) or, if not required 
to file such statements, a broker-dealer that had total capital (net 
worth plus subordinated liabilities) of less than $500,000 on the last 
day of the preceding fiscal year (or in the time that it has been in 
business, if shorter); and (2) it is not affiliated with any person 
(other than a natural person) that is not a small business or small 
organization.\286\
---------------------------------------------------------------------------

    \285\ On June 24, 1998, several months after the Proposing 
Release was published, the Commission amended its definitions of 
small entities. See Exchange Act Release No. 40122 (June 24, 1998), 
63 FR 35508 (June 30, 1998). The Commission's revised definition 
applicable to broker-dealers, effective as of July 30, 1998, 
maintains the capital standard set forth in the prior version, but 
also expands the affiliation standard applicable to broker-dealers. 
See Rule 0-10 under the Exchange Act (17 CFR 240.0-10). Although the 
FRFA analyzes the rules and rule amendments under the previous 
definition, the analysis applies equally under the Commission's new 
definition.
    \286\ Rule 0-10 (17 CFR 240.0-10).
---------------------------------------------------------------------------

    The Commission requested comment with respect to the Initial 
Regulatory Flexibility Analysis (``IRFA'') that was prepared when the 
new regulatory regime was proposed. The Commission did not receive any 
comments specifically concerning the IRFA. However, some of the 
commenters addressed aspects of the rules that could potentially affect 
small businesses. These comments are discussed below.
    Under the amendments to Rule 15c3-1, OTC derivatives dealers are 
required to maintain at least $100 million in tentative net capital and 
at least $20 million in net capital. Based on these minimum capital 
requirements, the FRFA notes that no OTC derivatives dealer would be 
considered a small entity. Major dealers in OTC derivatives markets 
tend to be the largest, highest-capitalized banks and securities firms. 
The capital requirements for OTC derivatives dealers have been tailored 
to this market and are necessary to ensure against excessive leverage 
and the risks associated with conducting an OTC derivatives business, 
as well as to provide for a cushion of capital against severe market 
disturbances.
    Registration as an OTC derivatives dealer is optional. The rules 
and rule amendments do not require any broker-dealer to use this 
alternative. Instead, all broker-dealers may consider whether, given 
the nature of their business or any other relevant considerations, they 
want to register as an OTC derivatives dealer. Accordingly, the rules 
and rule amendments do not impose any additional costs on any entity, 
including any small business, currently engaging in the business of 
effecting transactions in OTC derivative instruments.
    The rules and rule amendments guard against excessive leverage and 
the risk associated with conducting an OTC derivatives business, and 
provide a cushion of capital against severe market disturbances. In 
order to do so, the final rules require that an OTC derivatives dealer 
maintain $100 million in tentative net capital and $20 million in net 
capital. Lesser net capital requirements for small entities seeking to 
register as OTC derivatives dealers likely would not afford sufficient 
protection against these risks.
    Given the level of these net capital requirements, the Commission 
is not aware of any small business or small organizations, as defined 
in Rule 0-10, that could operate as OTC derivatives dealers under the 
rule. In any event, the Commission is not aware of any small business 
or small organizations, as defined in Rule 0-10, that currently are 
active as dealers in OTC derivatives markets. In the Proposing Release, 
the Commission specifically requested comment on whether there were 
small entities that act as dealers in OTC derivatives, and what effect, 
if any, the proposed rules and rule amendments would have on their 
activities. No small entities, as defined in Rule 0-10 under the 
Exchange Act, submitted comments addressing this issue. Only one 
commenter, which is not a small entity under the Commission's rules, 
addressed the impact of the rules on small entities that might wish to 
take advantage of the new regulatory regime, noting that the $100 
million tentative net capital requirement could have anti-competitive 
consequences for small-and medium-sized firms and newer entrants to the 
OTC derivatives business.
    The final rules and rule amendments contain no limitations on the 
ability of small entities to participate as counterparties in OTC 
derivatives transactions with registered OTC derivatives dealers. Under 
proposed Rule 3b-14, the term ``permissible derivatives counterparty'' 
would have included a range of financial institutions, corporations, 
and other institutional entities with whom OTC

[[Page 59393]]

derivatives dealers would have been permitted to enter into OTC 
derivatives transactions. Like OTC derivatives dealers, these 
institutional counterparties are frequently large, well-capitalized 
entities. Nevertheless, the proposed definition may have also included 
potential counterparties that would be considered small entities for 
purposes of the Regulatory Flexibility Act (``RFA'').\287\
---------------------------------------------------------------------------

    \287\ 5 U.S.C. 601 et seq.
---------------------------------------------------------------------------

    The Commission specifically requested comment regarding the 
participation of these classes of persons in OTC derivatives markets, 
whether any of them would be considered small entities, and what 
effect, if any, the proposed rules and rule amendments would have on 
their activities. The Commission also specifically requested comment 
from small entities that would not be able to satisfy the definition of 
permissible derivatives counterparty and, therefore, would not be 
eligible to engage in transactions with OTC derivatives dealers. No 
comments from small entities addressing this issue were received. 
Numerous comments, however, were received regarding the proposed 
definition of ``eligible derivatives counterparty.''
    The majority of commenters on this issue suggested that a broad 
range of persons should be able to act as permissible derivatives 
counterparties, and believed that the definition should be expanded, at 
a minimum, to include natural persons having at least $5 million in 
total assets as proposed. Other commenters raised concerns that the 
proposed group of permissible derivatives counterparties could include 
unsophisticated persons who would need the protections provided by the 
securities sales practice requirements.
    In response to commenters' concerns, and in light of the 
protections afforded through requiring intermediation of securities 
transactions, the final rules do not limit the persons with whom an OTC 
derivatives dealer may engage in transactions. Thus, to the extent that 
a small entity could act as a counterparty to an OTC derivatives 
transaction prior to the adoption of this new regulatory regime, it may 
still act as a counterparty to an OTC derivatives dealer under the new 
rules and rule amendments. Nothing in these rules, therefore, affects 
the ability of a small entity to participate in an OTC derivatives 
transaction. Other provisions of the rules that require broker-dealer 
intermediation will help assure protection of small entities.

C. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    Because no small entity would be eligible to meet the requirements 
of an OTC derivatives dealer, there is no compliance requirement for 
small entities. The adopting release details the cost, benefits, and 
compliance requirements for non-small entities that elect to register 
as OTC derivatives dealers.
    As explained in the FRFA, none of the recordkeeping, reporting, or 
other compliance requirements under the rules and rule amendments are 
expected to apply directly to counterparties that enter into 
transactions with OTC derivatives dealers. No small entities commented 
on this aspect of the proposal, and no commenters addressed the costs, 
if any, on small entities that acted as counterparties to OTC 
derivatives transactions with OTC derivatives dealers. Nevertheless, 
the ability of an OTC derivatives dealer to consolidate its OTC 
derivatives activities into a single entity under the new regulatory 
regime with lower capital and margin requirements could result in lower 
transactional costs to counterparties, including small entities.

D. Alternatives To Minimize Effect on Small Entities

    As discussed further in the FRFA, the Commission has considered 
alternatives to the rules and rule amendments that would minimize the 
effects of the rules on small entities, but would still accomplish the 
stated objectives of improving the efficiency and competitiveness of 
U.S. securities firms participating in global OTC derivatives markets, 
and make it feasible for these firms to conduct a business involving 
securities and non-securities OTC derivative instruments within the 
United States. Several of these alternatives were considered but 
rejected, while other alternatives were taken into account in the final 
rules. The final rules and rule amendments meet the Commission's stated 
goals by tailoring capital, margin, and other regulatory requirements 
to the activities of OTC derivatives dealers, while still providing 
sufficient protections.
    Registration as an OTC derivatives dealer is an alternative to 
registration as a fully regulated broker-dealer, and is optional. The 
Commission is not imposing any additional costs on any entity, 
including any small businesses, currently engaging in the business of 
effecting transactions in OTC derivative instruments, which could 
remain subject to full regulation. The proposed capital requirements, 
in particular, provide OTC derivatives dealers with significant 
alternatives for computing risk charges. Thus, firms choosing to 
register as OTC derivatives dealers may individually tailor the 
methodology they will employ to calculate their net capital on an on-
going basis, subject to Commission staff authorization. This 
flexibility should enable firms to keep costs of compliance as low as 
possible.
    The final rules and rule amendments guard against excessive 
leverage and the risks associated with conducting an OTC derivatives 
business, and provide a cushion of capital against severe market 
disturbances. In order to do so, the final rules require that an OTC 
derivatives dealer maintain $100 million in tentative net capital and 
$20 million in net capital. Lesser net capital requirements for small 
entities seeking to register as OTC derivatives dealers would not 
afford sufficient protection against these risks, and this alternative 
was therefore rejected. Similarly, additional exemptions from specific 
broker-dealer regulations under the Exchange Act for small businesses 
engaging in an OTC derivatives business, if there are any, would not be 
warranted. Moreover, the Commission is not aware of any small 
businesses that are currently engaged as dealers in OTC derivative 
instruments.
    Counterparties are expected to benefit from the final rules and 
rule amendments by being able to engage in transactions in both 
securities and non-securities OTC derivative instruments with a class 
of registered dealers subject to Commission oversight. To the extent 
that a small entity could act as a counterparty to an OTC derivatives 
transaction prior to adoption of the new regulatory regime, it would 
still be able to act in that capacity after adoption of the new rules 
and rule amendments. Nothing in the Commission's optional regulatory 
regime for OTC derivatives dealers affects a counterparty's ability to 
enter into an OTC derivatives transaction with an OTC derivatives 
dealer. A copy of the FRFA may be obtained by contacting Laura S. 
Pruitt, Special Counsel, Division of Market Regulation, Securities and 
Exchange Commission, 450 Fifth Street, NW., Mail Stop 10-1, Washington, 
DC 20549, (202) 942-0073.

VI. Paperwork Reduction Act

    As set forth in the Proposing Release, Rules 15c3-4, 17a-12, 
Appendix F to Rule 15c3-1, and the amendments to Rule 17a-3 contain 
collections of information within the meaning of the Paperwork 
Reduction Act of 1995

[[Page 59394]]

(``PRA'').\288\ Accordingly, the collection of information requirements 
contained in the rules and rule amendments were submitted to the Office 
of Management and Budget (``OMB'') for review and were approved by OMB 
which assigned the following control numbers: Rule 15c3-4, control 
number 3235-0497; Rule 17a-12, control number 3235-0498; Appendix F to 
Rule 15c3-1, control number 3235-0496; and amendments to Rule 17a-3, 
control number 3235-0033. The collections of information are in 
accordance with Section 3507 of the PRA.\289\
---------------------------------------------------------------------------

    \288\ 44 U.S.C. 3501 et seq.
    \289\ 44 U.S.C. 3507.
---------------------------------------------------------------------------

    The collection of information obligations imposed by the rules and 
rule amendments are mandatory. However, it is important to note that 
registration as an OTC derivatives dealer is optional. The information 
collected, retained, and/or filed pursuant to the rules and rule 
amendments will be kept confidential to the extent permitted by the 
Freedom of Information Act (5 U.S.C. 552 et seq.). An agency may not 
conduct or sponsor, and a person is not required to comply with, a 
collection of information unless it displays a currently valid OMB 
control number.
    The collections of information are necessary for persons to obtain 
certain benefits or to comply with certain requirements. As described 
in the Proposing Release, the rules and rule amendments to which the 
collections of information are related implement a limited regulatory 
system under the Exchange Act for OTC derivatives dealers. Under this 
limited regulatory system, OTC derivatives dealers are permitted to 
engage in dealing activities with respect to certain types of 
securities and non-securities OTC derivatives instruments, and to issue 
and reacquire their issued securities, without being required to comply 
with the full range of capital, margin, and other regulatory 
requirements applicable to other regulated broker-dealers.
    The Proposing Release solicited comments on the proposed 
collections of information. No comments were received that addressed 
the PRA submission. However, the Commission did receive comments on 
other aspects of the proposal. After carefully considering the comments 
received, the Commission is retaining its collection of information 
burden estimate. Thus the descriptions and estimated burdens of the 
collection of information requirements have not changed, and are set 
forth in the Proposing Release.

VII. Statutory Authority

    The Commission is amending Title 17, Chapter II of the Code of 
Federal Regulations pursuant to the Securities Exchange Act of 1934 (15 
U.S.C. 78a et seq.) (particularly sections 3(b), 11(a), 15(a), 15(b), 
15(c), 17(a), 23, and 36 thereof (15 U.S.C. 78c(b), 78k(a), 78o(a), 
78o(b), 78o(c), 78q(a), 78w, and 78mm)).

Text of Rules and Rule Amendments

List of Subjects

17 CFR Part 200

    Administrative practice and procedure, Authority delegations 
(Government agencies).

17 CFR Parts 240 and 249

    Broker-dealers, Reporting and recordkeeping requirements, 
Securities.

    For the reasons set forth in the preamble, Title 17, Chapter II of 
the Code of Federal Regulations is amended as set forth below.

PART 200--ORGANIZATION; CONDUCT AND ETHICS; AND INFORMATION AND 
REQUESTS

    1. The authority citation for Part 200 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77s, 78d-1, 78d-2, 78w, 78ll(d), 78mm, 79t, 
77sss, 80a-37, 80b-11, unless otherwise noted.
* * * * *
    2. Section 200.30-3 is amended by removing the period after 
paragraph (a)(7)(iv) and in its place adding ``; and'' and by adding 
paragraphs (a)(7)(v), (a)(64), (a)(65) and (a)(66) to read as follows:


Sec. 200.30-3  Delegation of authority to Director of Division of 
Market Regulation.

* * * * *
    (a) * * *
    (7) * * *
    (v) To review applications of OTC derivatives dealers filed 
pursuant to Appendix F of Sec. 240.15c3-1f of this chapter, and to 
grant or deny such applications in full or in part.
* * * * *
    (64) Pursuant to Sec. 240.15a-1(b)(1) of this chapter, to issue 
orders identifying other permissible securities activities in which an 
OTC derivatives dealer may engage.
    (65) Pursuant to Sec. 240.15a-1(b)(2) of this chapter, to issue 
orders determining that a class of fungible instruments that are 
standardized as to their material economic terms is within the scope of 
eligible OTC derivative instrument.
    (66) Pursuant to Sec. 240.17a-12 of this chapter:
    (i) To authorize the issuance of orders requiring OTC derivatives 
dealers to file, pursuant to Sec. 240.17a-12(a)(ii) of this chapter, 
monthly, or at such times as shall be specified, Part IIB of Form X-
17A-5 (Sec. 249.617 of this chapter) and such other financial and 
operational information as shall be specified.
    (ii) Pursuant to Sec. 240.17a-12(n) of this chapter, to consider 
applications by OTC derivatives dealers for exemptions from, and 
extensions of time within which to file, reports required by 
Sec. 240.17a-12 of this chapter, and to grant or deny such 
applications.
* * * * *

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    3. The authority citation for part 240 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 
78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 
80b-11, unless otherwise noted.
* * * * *
    4. By adding Secs. 240.3b-12 through 240.3b-15 to read as follows:


Sec. 240.3b-12  Definition of OTC derivatives dealer.

    The term OTC derivatives dealer means any dealer that is affiliated 
with a registered broker or dealer (other than an OTC derivatives 
dealer), and whose securities activities:
    (a) Are limited to:
    (1) Engaging in dealer activities in eligible OTC derivative 
instruments that are securities;
    (2) Issuing and reacquiring securities that are issued by the 
dealer, including warrants on securities, hybrid securities, and 
structured notes;
    (3) Engaging in cash management securities activities;
    (4) Engaging in ancillary portfolio management securities 
activities; and
    (5) Engaging in such other securities activities that the 
Commission designates by order pursuant to Sec. 240.15a-1(b)(1); and
    (b) Consist primarily of the activities described in paragraphs 
(a)(1), (a)(2), and (a)(3) of this section; and
    (c) Do not consist of any other securities activities, including 
engaging in any transaction in any security that is not an eligible OTC 
derivative instrument, except as permitted under paragraphs (a)(3), 
(a)(4), and (a)(5) of this section.
    (d) For purposes of this section, the term hybrid security means a 
security that incorporates payment features economically similar to 
options,

[[Page 59395]]

forwards, futures, swap agreements, or collars involving currencies, 
interest or other rates, commodities, securities, indices, quantitative 
measures, or other financial or economic interests or property of any 
kind, or any payment or delivery that is dependent on the occurrence or 
nonoccurrence of any event associated with a potential financial, 
economic, or commercial consequence (or any combination, permutation, 
or derivative of such contract or underlying interest).


Sec. 240.3b-13  Definition of eligible OTC derivative instrument.

    (a) Except as otherwise provided in paragraph (b) of this section, 
the term eligible OTC derivative instrument means any contract, 
agreement, or transaction that:
    (1) Provides, in whole or in part, on a firm or contingent basis, 
for the purchase or sale of, or is based on the value of, or any 
interest in, one or more commodities, securities, currencies, interest 
or other rates, indices, quantitative measures, or other financial or 
economic interests or property of any kind; or
    (2) Involves any payment or delivery that is dependent on the 
occurrence or nonoccurrence of any event associated with a potential 
financial, economic, or commercial consequence; or
    (3) Involves any combination or permutation of any contract, 
agreement, or transaction or underlying interest, property, or event 
described in paragraphs (a)(1) or (a)(2) of this section.
    (b) The term eligible OTC derivative instrument does not include 
any contract, agreement, or transaction that:
    (1) Provides for the purchase or sale of a security, on a firm 
basis, unless:
    (i) The settlement date for such purchase or sale occurs at least 
one year following the trade date or, in the case of an eligible 
forward contract, at least four months following the trade date; or
    (ii) The material economic features of the contract, agreement, or 
transaction consist primarily of features of a type described in 
paragraph (a) of this section other than the provision for the purchase 
or sale of a security on a firm basis; or
    (2) Provides, in whole or in part, on a firm or contingent basis, 
for the purchase or sale of, or is based on the value of, or any 
interest in, any security (or group or index of securities), and is:
    (i) Listed on, or traded on or through, a national securities 
exchange or registered national securities association, or facility or 
market thereof; or
    (ii) Except as otherwise determined by the Commission by order 
pursuant to Sec. 240.15a-1(b)(2), one of a class of fungible 
instruments that are standardized as to their material economic terms.
    (c) The Commission may issue an order pursuant to Sec. 240.15a-
1(b)(3) clarifying whether certain contracts, agreements, or 
transactions are within the scope of eligible OTC derivative 
instrument.
    (d) For purposes of this section, the term eligible forward 
contract means a forward contract that provides for the purchase or 
sale of a security other than a government security, provided that, if 
such contract provides for the purchase or sale of margin stock (as 
defined in Regulation U of the Regulations of the Board of Governors of 
the Federal Reserve System, 12 CFR Part 221), such contract either:
    (1) Provides for the purchase or sale of such stock by the issuer 
thereof (or an affiliate that is not a bank or a broker or dealer); or
    (2) Provides for the transfer of transaction collateral in an 
amount that would satisfy the requirements, if any, that would be 
applicable assuming the OTC derivatives dealer party to such 
transaction were not eligible for the exemption from Regulation T of 
the Regulations of the Board of Governors of the Federal Reserve 
System, 12 CFR part 220, set forth in Sec. 240.36a1-1.


Sec. 240.3b-14  Definition of cash management securities activities.

    The term cash management securities activities means securities 
activities that are limited to transactions involving:
    (a) Any taking possession of, and any subsequent sale or 
disposition of, collateral provided by a counterparty, or any 
acquisition of, and any subsequent sale or disposition of, collateral 
to be provided to a counterparty, in connection with any securities 
activities of the dealer permitted under Sec. 240.15a-1 or any non-
securities activities of the dealer that involve eligible OTC 
derivative instruments or other financial instruments;
    (b) Cash management, in connection with any securities activities 
of the dealer permitted under Sec. 240.15a-1 or any non-securities 
activities of the dealer that involve eligible OTC derivative 
instruments or other financial instruments; or
    (c) Financing of positions of the dealer acquired in connection 
with any securities activities of the dealer permitted under 
Sec. 240.15a-1 or any non-securities activities that involve eligible 
OTC derivative instruments or other financial instruments.


Sec. 240.3b-15  Definition of ancillary portfolio management securities 
activities.

    (a) The term ancillary portfolio management securities activities 
means securities activities that:
    (1) Are limited to transactions in connection with:
    (i) Dealer activities in eligible OTC derivative instruments;
    (ii) The issuance of securities by the dealer; or
    (iii) Such other securities activities that the Commission 
designates by order pursuant to Sec. 240.15a-1(b)(1); and
    (2) Are conducted for the purpose of reducing the market or credit 
risk of the dealer or consist of incidental trading activities for 
portfolio management purposes; and
    (3) Are limited to risk exposures within the market, credit, 
leverage, and liquidity risk parameters set forth in:
    (i) The trading authorizations granted to the associated person (or 
to the supervisor of such associated person) who executes a particular 
transaction for, or on behalf of, the dealer; and
    (ii) The written guidelines approved by the governing body of the 
dealer and included in the internal risk management control system for 
the dealer pursuant to Sec. 240.15c3-4; and
    (4) Are conducted solely by one or more associated persons of the 
dealer who perform substantial duties for, or on behalf of, the dealer 
in connection with its dealer activities in eligible OTC derivative 
instruments.
    (b) The Commission may issue an order pursuant to Sec. 240.15a-
1(b)(4) clarifying whether certain securities activities are within the 
scope of ancillary portfolio management securities activities.
    5. Section 240.8c-1 is amended by revising paragraph (b)(1) to read 
as follows:


Sec. 240.8c-1  Hypothecation of customers' securities.

* * * * *
    (b) * * *
    (1) The term customer shall not include any general or special 
partner or any director or officer of such member, broker or dealer, or 
any participant, as such, in any joint, group or syndicate account with 
such member, broker or dealer or with any partner, officer or director 
thereof. The term also shall not include any counterparty who has 
delivered collateral to an OTC derivatives dealer pursuant to a 
transaction in an eligible OTC derivative instrument, or pursuant to 
the OTC derivatives dealer's cash management securities activities or 
ancillary portfolio management securities activities, and who has 
received a prominent written

[[Page 59396]]

notice from the OTC derivatives dealer that:
    (i) Except as otherwise agreed in writing by the OTC derivatives 
dealer and the counterparty, the dealer may repledge or otherwise use 
the collateral in its business;
    (ii) In the event of the OTC derivatives dealer's failure, the 
counterparty will likely be considered an unsecured creditor of the 
dealer as to that collateral;
    (iii) The Securities Investor Protection Act of 1970 (15 U.S.C. 
78aaa through 78lll) does not protect the counterparty; and
    (iv) The collateral will not be subject to the requirements of 
Sec. 240.8c-1, Sec. 240.15c2-1, Sec. 240.15c3-2, or Sec. 240.15c3-3;
* * * * *
    6. By adding Sec. 240.11a1-6 to read as follows:


Sec. 240.11a1-6  Transactions for certain accounts of OTC derivatives 
dealers.

    A transaction effected by a member of a national securities 
exchange for the account of an OTC derivatives dealer that is an 
associated person of that member shall be deemed to be of a kind that 
is consistent with the purposes of section 11(a)(1) of the Act (15 
U.S.C. 78k(a)(1)), the protection of investors, and the maintenance of 
fair and orderly markets if, assuming such transaction were for the 
account of a member, the member would have been permitted, under 
section 11(a) of the Act and the other rules thereunder (with the 
exception of Sec. 240.11a1-2), to effect the transaction.
    7. By adding Sec. 240.15a-1 under the undesignated section heading 
``Exemption of Certain OTC Derivatives Dealers'' to read as follows:


Sec. 240.15a-1  Securities activities of OTC derivatives dealers.

    Preliminary Note: OTC derivatives dealers are a special class of 
broker-dealers that are exempt from certain broker-dealer 
requirements, including membership in a self-regulatory organization 
(Sec. 240.15b9-2), regular broker-dealer margin rules 
(Sec. 240.36a1-1), and application of the Securities Investor 
Protection Act of 1970 (Sec. 240.36a1-2). OTC derivative dealers are 
subject to special requirements, including limitations on the scope 
of their securities activities (Sec. 240.15a-1), specified internal 
risk management control systems (Sec. 240.15c3-4), recordkeeping 
obligations (Sec. 240.17a-3(a)(10)), and reporting responsibilities 
(Sec. 240.17a-12). They are also subject to alternative net capital 
treatment (Sec. 240.15c3-1(a)(5)). This rule 15a-1 uses a number of 
defined terms in setting forth the securities activities in which an 
OTC derivatives dealer may engage: ``OTC derivatives dealer,'' 
``eligible OTC derivative instrument,'' ``cash management securities 
activities,'' and ``ancillary portfolio management securities 
activities.'' These terms are defined under Rules 3b-12 through 3b-
15 (Sec. 240.3b-12 through Sec. 240.3b-15).

    (a) The securities activities of an OTC derivatives dealer shall:
    (1) Be limited to:
    (i) Engaging in dealer activities in eligible OTC derivative 
instruments that are securities;
    (ii) Issuing and reacquiring securities that are issued by the 
dealer, including warrants on securities, hybrid securities, and 
structured notes;
    (iii) Engaging in cash management securities activities;
    (iv) Engaging in ancillary portfolio management securities 
activities; and
    (v) Engaging in such other securities activities that the 
Commission designates by order pursuant to paragraph (b)(1) of this 
section; and
    (2) Consist primarily of the activities described in paragraphs 
(a)(1)(i), (a)(1)(ii), and (a)(1)(iii) of this section; and
    (3) Not consist of any other securities activities, including 
engaging in any transaction in any security that is not an eligible OTC 
derivative instrument, except as permitted under paragraphs 
(a)(1)(iii), (a)(1)(iv), and (a)(1)(v) of this section.
    (b) The Commission, by order, entered upon its own initiative or 
after considering an application for exemptive relief, may clarify or 
expand the scope of eligible OTC derivative instruments and the scope 
of permissible securities activities of an OTC derivatives dealer. Such 
orders may:
    (1) Identify other permissible securities activities;
    (2) Determine that a class of fungible instruments that are 
standardized as to their material economic terms is within the scope of 
eligible OTC derivative instrument;
    (3) Clarify whether certain contracts, agreements, or transactions 
are within the scope of eligible OTC derivative instrument; or
    (4) Clarify whether certain securities activities are within the 
scope of ancillary portfolio management securities activities.
    (c) To the extent an OTC derivatives dealer engages in any 
securities transaction pursuant to paragraphs (a)(1)(i) through 
(a)(1)(v) of this section, such transaction shall be effected through a 
registered broker or dealer (other than an OTC derivatives dealer) 
that, in the case of any securities transaction pursuant to paragraphs 
(a)(1)(i), or (a)(1)(iii) through (a)(1)(v) of this section, is an 
affiliate of the OTC derivatives dealer, except that this paragraph (c) 
shall not apply if:
    (1) The counterparty to the transaction with the OTC derivatives 
dealer is acting as principal and is:
    (i) A registered broker or dealer;
    (ii) A bank acting in a dealer capacity, as permitted by U.S. law;
    (iii) A foreign broker or dealer; or
    (iv) An affiliate of the OTC derivatives dealer; or
    (2) The OTC derivatives dealer is engaging in an ancillary 
portfolio management securities activity, and the transaction is in a 
foreign security, and a registered broker or dealer, a bank, or a 
foreign broker or dealer is acting as agent for the OTC derivatives 
dealer.
    (d) To the extent an OTC derivatives dealer induces or attempts to 
induce any counterparty to enter into any securities transaction 
pursuant to paragraphs (a)(1)(i) through (a)(1)(v) of this section, any 
communication or contact with the counterparty concerning the 
transaction (other than clerical and ministerial activities conducted 
by an associated person of the OTC derivatives dealer) shall be 
conducted by one or more registered persons that, in the case of any 
securities transaction pursuant to paragraphs (a)(1)(i), or (a)(1)(iii) 
through (a)(1)(v) of this section, is associated with an affiliate of 
the OTC derivatives dealer, except that this paragraph (d) shall not 
apply if the counterparty to the transaction with the OTC derivatives 
dealer is:
    (1) A registered broker or dealer;
    (2) A bank acting in a dealer capacity, as permitted by U.S. law;
    (3) A foreign broker or dealer; or
    (4) An affiliate of the OTC derivatives dealer.
    (e) For purposes of this section, the term hybrid security means a 
security that incorporates payment features economically similar to 
options, forwards, futures, swap agreements, or collars involving 
currencies, interest or other rates, commodities, securities, indices, 
quantitative measures, or other financial or economic interests or 
property of any kind, or any payment or delivery that is dependent on 
the occurrence or nonoccurrence of any event associated with a 
potential financial, economic, or commercial consequence (or any 
combination, permutation, or derivative of such contract or underlying 
interest).
    (f) For purposes of this section, the term affiliate means any 
organization (whether incorporated or unincorporated) that directly or 
indirectly controls, is controlled by, or is under common control with, 
the OTC derivatives dealer.

[[Page 59397]]

    (g) For purposes of this section, the term foreign broker or dealer 
means any person not resident in the United States (including any U.S. 
person engaged in business as a broker or dealer entirely outside the 
United States, except as otherwise permitted by Sec. 240.15a-6) that is 
not an office or branch of, or a natural person associated with, a 
registered broker or dealer, whose securities activities, if conducted 
in the United States, would be described by the definition of 
``broker'' in section 3(a)(4) of the Act (15 U.S.C. 78c(a)(4)) or 
``dealer'' in section 3(a)(5) of the Act (15 U.S.C. 78c(a)(5)).
    (h) For purposes of this section, the term foreign security means 
any security (including a depositary share issued by a United States 
bank, provided that the depositary share is initially offered and sold 
outside the United States in accordance with Regulation S (17 CFR 
230.901 through 230.904)) issued by a person not organized or 
incorporated under the laws of the United States, provided the 
transaction that involves such security is not effected on a national 
securities exchange or on a market operated by a registered national 
securities association; or a debt security (including a convertible 
debt security) issued by an issuer organized or incorporated under the 
laws of the United States that is initially offered and sold outside 
the United States in accordance with Regulation S (17 CFR 230.901 
through 230.904).
    (i) For purposes of this section, the term registered person is:
    (A) A natural person who is associated with a registered broker or 
dealer and is registered or approved under the rules of a self-
regulatory organization of which such broker or dealer is a member; or
    (B) If the counterparty to the transaction with the OTC derivatives 
dealer is a resident of a jurisdiction other than the United States, a 
natural person who is not resident in the United States and is 
associated with a broker or dealer that is registered or licensed by a 
foreign financial regulatory authority in the jurisdiction in which 
such counterparty is resident or in which such natural person is 
located, in accordance with applicable legal requirements, if any.
    8. Section 240.15b1-1 is amended to revise paragraph (a) to read as 
follows:


Sec. 240.15b1-1  Application for registration of brokers or dealers.

    (a) An application for registration of a broker or dealer that is 
filed pursuant to section 15(b) of the Act (15 U.S.C. 78o(b)) shall be 
filed on Form BD (Sec. 249.501 of this chapter) in accordance with the 
instructions to the form. A broker or dealer that is an OTC derivatives 
dealer shall indicate where appropriate on Form BD that the type of 
business in which it is engaged is that of acting as an OTC derivatives 
dealer.
* * * * *
    9. By adding Sec. 240.15b9-2 to read as follows:


Sec. 240.15b9-2  Exemption from SRO membership for OTC derivatives 
dealers.

    An OTC derivatives dealer, as defined in Sec. 240.3b-12, shall be 
exempt from any requirement under section 15(b)(8) of the Act (15 
U.S.C. 78o(b)(8)) to become a member of a registered national 
securities association.
    10. Section 240.15c2-1 is amended to revise paragraph (b)(1) to 
read as follows:


Sec. 240.15c2-1  Hypothecation of customers' securities.

* * * * *
    (b) * * *
    (1) The term customer shall not include any general or special 
partner or any director or officer of such broker or dealer, or any 
participant, as such, in any joint, group or syndicate account with 
such broker or dealer or with any partner, officer or director thereof. 
The term also shall not include a counterparty who has delivered 
collateral to an OTC derivatives dealer pursuant to a transaction in an 
eligible OTC derivative instrument, or pursuant to the OTC derivatives 
dealer's cash management securities activities or ancillary portfolio 
management securities activities, and who has received a prominent 
written notice from the OTC derivatives dealer that:
    (i) Except as otherwise agreed in writing by the OTC derivatives 
dealer and the counterparty, the dealer may repledge or otherwise use 
the collateral in its business;
    (ii) In the event of the OTC derivatives dealer's failure, the 
counterparty will likely be considered an unsecured creditor of the 
dealer as to that collateral;
    (iii) The Securities Investor Protection Act of 1970 (15 U.S.C 
78aaa through 78lll) does not protect the counterparty; and
    (iv) The collateral will not be subject to the requirements of 
Sec. 240.8c-1, Sec. 240.15c2-1, Sec. 240.15c3-2, or Sec. 240.15c3-3;
* * * * *
    11. Section 240.15c2-5 is amended by adding paragraph (d) to read 
as follows:


Sec. 240.15c2-5  Disclosure and other requirements when extending or 
arranging credit in certain transactions.

* * * * *
    (d) This section shall not apply to a transaction involving the 
extension of credit by an OTC derivatives dealer, as defined in 
Sec. 240.3b-12, if the transaction is exempt from the provisions of 
Section 7(c) of the Act (15 U.S.C. 78g(c)) pursuant to Sec.  240.36a1-
1.
    12. Section 240.15c3-1 is amended to add a sentence following the 
first sentence in the introductory text of paragraph (a); adding 
paragraphs (a)(5) and (c)(15) to read as follows:


Sec. 240.15c3-1  Net capital requirements for brokers or dealers.

    (a) * * * In lieu of applying paragraphs (a)(1) and (a)(2) of this 
section, an OTC derivatives dealer shall maintain net capital pursuant 
to paragraph (a)(5) of this section. * * *
    (5) In accordance with Appendix F to this section (Sec. 240.15c3-
1f), the Commission may grant an application by an OTC derivatives 
dealer when calculating net capital to use the market risk standards of 
Appendix F as to some or all of its positions in lieu of the provisions 
of paragraph (c)(2)(vi) of this section and the credit risk standards 
of Appendix F to its receivables (including counterparty net exposure) 
arising from transactions in eligible OTC derivative instruments in 
lieu of the requirements of paragraph (c)(2)(iv) of this section. An 
OTC derivatives dealer shall at all times maintain tentative net 
capital of not less than $100 million and net capital of not less than 
$20 million.
* * * * *
    (c) * * *
    (15) The term tentative net capital shall mean the net capital of a 
broker or dealer before deducting the securities haircuts computed 
pursuant to paragraph (c)(2)(vi) of this section and the charges on 
inventory computed pursuant to Appendix B to this section 
(Sec. 240.15c3-1b). However, for purposes of paragraph (a)(5) of this 
section, the term tentative net capital means the net capital of an OTC 
derivatives dealer before deducting the charges for market and credit 
risk as computed pursuant to Appendix F to this section (Sec. 240.15c3-
1f) or paragraph (c)(2)(vi) of this section, if applicable, and 
increased by the balance sheet value (including counterparty net 
exposure) resulting from transactions in eligible OTC derivative 
instruments which would otherwise be deducted by virtue of paragraph 
(c)(2)(iv) of this section.
* * * * *
    13. By adding Sec. 240.15c3-1f to read as follows:

[[Page 59398]]

Sec. 240.15c3-1f  Optional Market and Credit Risk Requirements for OTC 
Derivatives Dealers (Appendix F to 17 CFR 240.15c3-1)

Application Requirements

    (a) An OTC derivatives dealer may apply to the Commission for 
authorization to compute capital charges for market and credit risk 
pursuant to this Appendix F in lieu of computing securities haircuts 
pursuant to Sec. 240.15c3-1(c)(2)(vi).
    (1) An OTC derivatives dealer's application shall contain the 
following information:
    (i) Executive summary. An OTC derivatives dealer shall include in 
its application an Executive Summary of information provided to the 
Commission.
    (ii) Description of methods for computing market risk charges. An 
OTC derivatives dealer shall provide a description of all statistical 
models used for pricing OTC derivative instruments and for computing 
value-at-risk (``VAR''), a description of the applicant's controls over 
those models, and a statement regarding whether the firm has developed 
its own internal VAR models. If the OTC derivatives dealer's VAR model 
incorporates empirical correlations across risk categories, the dealer 
shall describe its process for measuring correlations and describe the 
qualitative and quantitative aspects of the model which at a minimum 
must adhere to the criteria set forth in paragraph (e) of this Appendix 
F. The application shall further state whether the OTC derivatives 
dealer intends to use an alternative method for computing its market 
risk charge for equity instruments and, if applicable, a description of 
how its own theoretical pricing model contains the minimum pricing 
factors set forth in Appendix A (Sec. 240.15c3-1a). The application 
shall also describe any category of securities having no ready market 
or any category of debt securities which are below investment grade for 
which the OTC derivatives dealer wishes to use its VAR model to 
calculate its market risk charge or for which it wishes to use an 
alternative method for computing this charge and a description of how 
those charges would be determined.
    (iii) Internal risk management control systems. An OTC derivatives 
dealer shall provide a comprehensive description of its internal risk 
management control systems and how those systems adhere to the 
requirements set forth in Sec. 240.15c3-4(a) through (d).
    (2) The Commission may approve the application after reviewing the 
application to determine whether the OTC derivatives dealer:
    (i) Has adopted internal risk management control systems that meet 
the requirements set forth in Sec. 240.15c3-4; and
    (ii) Has adopted a VAR model that meets the requirements set forth 
in paragraphs (e)(1) and (e)(2) of this Appendix F.
    (3) If the OTC derivatives dealer materially amends its VAR model 
or internal risk management control systems as described in its 
application, including any material change in the categories of non-
marketable securities that it wishes to include in its VAR model, the 
dealer shall file an application describing the changes which must be 
approved by the Commission before the changes may be implemented. After 
reviewing the application for changes to the dealer's VAR model or 
internal risk management control systems to determine whether, with the 
changes, the OTC derivatives dealer's VAR model and internal risk 
management control systems would meet the requirements set forth in 
this Appendix F and Sec. 240.15c3-4, the Commission may approve the 
application.
    (4) The applications provided for in this paragraph (a) shall be 
considered filed when received at the Commission's principal office in 
Washington, DC. All applications filed pursuant to this paragraph (a) 
shall be deemed to be confidential.

Compliance With Sec. 240.15c3-4

    (b) An OTC derivatives dealer must be in compliance in all material 
respects with Sec. 240.15c3-4 regarding its internal risk management 
control systems in order to be in compliance with Sec. 240.15c3-1.

Market Risk

    (c) An OTC derivatives dealer electing to apply this Appendix F 
shall compute a capital charge for market risk which shall be the 
aggregate of the charges computed below:
    (1) Value-at-Risk. An OTC derivatives dealer shall deduct from net 
worth an amount for market risk for eligible OTC derivative instruments 
and other positions in its proprietary or other accounts equal to the 
VAR of these positions obtained from its proprietary VAR model, 
multiplied by the appropriate multiplication factor in paragraph 
(e)(1)(iv)(C) of this Appendix F. The OTC derivatives dealer may not 
elect to calculate its capital charges under this paragraph (c)(1) 
until its application to use the VAR model has been approved by the 
Commission.
    (2) Alternative method for equities. An OTC derivatives dealer may 
elect to use this alternative method to calculate its market risk for 
equity instruments, including OTC options, upon approval by the 
Commission on application by the dealer. Under this alternative method, 
the deduction for market risk must be the amount computed pursuant to 
Appendix A to Rule 15c3-1
(Sec. 240.15c3-1a). In this computation, the OTC derivatives dealer may 
use its own theoretical pricing model provided that it contains the 
minimum pricing factors set forth in Appendix A.
    (3) Non-marketable securities. An OTC derivatives dealer may not 
use a VAR model to determine a capital charge for any category of 
securities having no ready market or any category of debt securities 
which are below investment grade or any derivative instrument based on 
the value of these categories of securities, unless the Commission has 
granted, pursuant to paragraph (a)(1) of this Appendix F, its 
application to use its VAR model for any such category of securities. 
The dealer in any event may apply, pursuant to paragraph (a)(1) of this 
Appendix F, for an alternative treatment for any such category of 
securities, rather than calculate the market risk capital charge for 
such category of securities under Sec. 240.15c3-1(c)(2)(vi) and (vii).
    (4) Residual positions. To the extent that a position has not been 
included in the calculation of the market risk charge in paragraphs 
(c)(1) through (c)(3) of this section, the market risk charge for the 
position shall be computed under Sec. 240.15c3-1(c)(2)(vi).

Credit Risk

    (d) The capital charge for credit risk arising from an OTC 
derivatives dealer's transactions in eligible OTC derivative 
instruments shall be:
    (1) The net replacement value in the account of a counterparty 
(including the effect of legally enforceable netting agreements and the 
application of liquid collateral) that is insolvent, or in bankruptcy, 
or that has senior unsecured long-term debt in default;
    (2) As to a counterparty not otherwise described in paragraph 
(d)(1) of this section, the net replacement value in the account of the 
counterparty (including the effect of legally enforceable netting 
agreements and the application of liquid collateral) multiplied by 8%, 
and further multiplied by the counterparty factor. The counterparty 
factors are:
    (i) 20% for counterparties with ratings for senior unsecured long-
term debt or commercial paper in the two highest rating categories by a 
nationally

[[Page 59399]]

recognized statistical rating organization (``NRSRO'');
    (ii) 50% for counterparties with ratings for senior unsecured long-
term debt in the third and fourth highest ratings categories by an 
NRSRO; and
    (iii) 100% for counterparties with ratings for senior unsecured 
long-term debt below the four highest rating categories; and
    (3) A concentration charge where the net replacement value in the 
account of any one counterparty (other than a counterparty described in 
paragraph (d)(1) of this section) exceeds 25% of the OTC derivatives 
dealer's tentative net capital, calculated as follows:
    (i) For counterparties with ratings for senior unsecured long-term 
debt or commercial paper in the two highest rating categories by an 
NRSRO, 5% of the amount of the net replacement value in excess of 25% 
of the OTC derivatives dealer's tentative net capital;
    (ii) For counterparties with ratings for senior unsecured long-term 
debt in the third and fourth highest rating categories by an NRSRO, 20% 
of the amount of the net replacement value in excess of 25% of the OTC 
derivatives dealer's tentative net capital; and
    (iii) For counterparties with ratings for senior unsecured long-
term debt below the four highest rating categories, 50% of the amount 
of the net replacement value in excess of 25% of the OTC derivatives 
dealer's tentative net capital.
    (4) Counterparties that are not rated by an NRSRO may be rated by 
the OTC derivatives dealer, or by an affiliated bank or affiliated 
broker-dealer of the OTC derivatives dealer, upon approval by the 
Commission on application by the OTC derivatives dealer. After 
reviewing the application to determine whether the credit rating 
procedures and rating categories are equivalent to those used by NRSROs 
and that such ratings are current, the Commission may approve the 
application. The OTC derivatives dealer must make and keep current a 
record of the basis for the credit rating for each counterparty. The 
record must be preserved for a period of not less than three years, the 
first two years in an easily accessible place.

VAR Models

    (e) An OTC derivatives dealer's VAR model must meet the following 
qualitative and quantitative requirements:
    (1) Qualitative requirements. An OTC derivatives dealerapplying 
this Appendix F must have a VAR model that meets the following minimum 
qualitative requirements:
    (i) The OTC derivatives dealer's VAR model must be integrated into 
the firm's daily risk management process;
    (ii) The OTC derivatives dealer must conduct appropriate stress 
tests of the VAR model, and develop appropriate procedures to follow in 
response to the results of such tests;
    (iii) The OTC derivatives dealer must conduct periodic reviews 
(which may be performed by internal audit staff) of its VAR model. The 
OTC derivatives dealer's VAR model also must be subject to annual 
reviews conducted by independent public accountants; and
    (iv) The OTC derivatives dealer must conduct backtesting of the VAR 
model pursuant to the following procedures:
    (A) Beginning one year after the OTC derivatives dealer begins 
using its VAR model to calculate its net capital, the OTC derivatives 
dealer must conduct backtesting by comparing each of its most recent 
250 business days' actual net trading profit or loss with the 
corresponding daily VAR measures generated for determining market risk 
capital charges and calibrated to a one-day holding period and a 99 
percent, one-tailed confidence level;
    (B) Once each quarter, the OTC derivatives dealer must identify the 
number of exceptions, that is, the number of business days for which 
the actual daily net trading loss, if any, exceeded the corresponding 
daily VAR measure; and
    (C) An OTC derivatives dealer must use the multiplication factor 
indicated in Table 1 of this Appendix F in determining its capital 
charge for market risk until it obtains the next quarter's backtesting 
results, unless the Commission determines that a different adjustment 
or other action is appropriate.

     Table 5.--Multiplication Factor Based on Results of Backtesting
------------------------------------------------------------------------
                                                          Multiplication
                  Number of exceptions                        factor
------------------------------------------------------------------------
 4 or fewer.............................................         3.00
 5......................................................         3.40
 6......................................................         3.50
 7......................................................         3.65
 8......................................................         3.75
 9......................................................         3.85
10 or more..............................................         4.00
------------------------------------------------------------------------

    (2) Quantitative requirements. An OTC derivatives dealer applying 
this Appendix F must have a VAR model that meets the following minimum 
quantitative requirements:
    (i) The VAR measures must be calculated on a daily basis using a 99 
percent, one-tailed confidence level with a price change equivalent to 
a ten-business day movement in rates and prices;
    (ii) The effective historical observation period for VAR measures 
must be at least one year, and the weighted average time lag of the 
individual observations cannot be less than six months. Historical data 
sets must be updated at least every three months and reassessed 
whenever market prices or volatilities are subject to large changes;
    (iii) The VAR measures must include the risks arising from the non-
linear price characteristics of options positions and the sensitivity 
of the market value of the positions to changes in the volatility of 
the underlying rates or prices. An OTC derivatives dealer must measure 
the volatility of options positions by different maturities;
    (iv) The VAR measures may incorporate empirical correlations within 
and across risk categories, provided that the OTC derivatives dealer 
has described its process for measuring correlations in its application 
to apply this Appendix F and the Commission has approved its 
application. In the event that the VAR measures do not incorporate 
empirical correlations across risk categories, the OTC derivatives 
dealer must add the separate VAR measures for the four major risk 
categories in paragraph (e)(2)(v) of this Appendix F to determine its 
aggregate VAR measure; and
    (v) The OTC derivatives dealer's VAR model must use risk factors 
sufficient to measure the market risk inherent in all covered 
positions. The risk factors must address, at a minimum, the following 
major risk categories: interest rate risk, equity price risk, foreign 
exchange rate risk, and commodity price risk. For material exposures in 
the major currencies and markets, modeling techniques must capture, at 
a minimum, spread risk and must incorporate enough segments of the 
yield curve to capture differences in volatility and less-than-perfect 
correlation of rates along the yield curve. An OTC derivatives dealer 
must provide the Commission with evidence that the OTC derivatives 
dealer's VAR model takes account of specific risk in positions, 
including specific equity risk, if the OTC derivatives dealer intends 
to utilize its VAR model to compute capital charges for equity price 
risk.
    14. Section 240.15c3-3 is amended to revise paragraph (a)(1) to 
read as follows, and in paragraph (h) to revise the phrase 
``Sec. 240.17a-5,'' to read ``Secs. 240.17a-5 or 240.17a-12,''.

[[Page 59400]]

Sec. 240.15c3-3  Customer protection--reserves and custody of 
securities.

    (a) * * *
    (1) The term customer shall mean any person from whom or on whose 
behalf a broker or dealer has received or acquired or holds funds or 
securities for the account of that person. The term shall not include a 
broker or dealer, a municipal securities dealer, or a government 
securities broker or government securities dealer. The term shall, 
however, include another broker or dealer to the extent that broker or 
dealer maintains an omnibus account for the account of customers with 
the broker or dealer in compliance with Regulation T (12 CFR 220.1 
through 220.19). The term shall not include a general partner or 
director or principal officer of the broker or dealer or any other 
person to the extent that person has a claim for property or funds 
which by contract, agreement or understanding, or by operation of law, 
is part of the capital of the broker or dealer or is subordinated to 
the claims of creditors of the broker or dealer. The term also shall 
not include a counterparty who has delivered collateral to an OTC 
derivatives dealer pursuant to a transaction in an eligible OTC 
derivative instrument, or pursuant to the OTC derivatives dealer's cash 
management securities activities or ancillary portfolio management 
securities activities, and who has received a prominent written notice 
from the OTC derivatives dealer that:
    (i) Except as otherwise agreed in writing by the OTC derivatives 
dealer and the counterparty, the dealer may repledge or otherwise use 
the collateral in its business;
    (ii) In the event of the OTC derivatives dealer's failure, the 
counterparty will likely be considered an unsecured creditor of the 
dealer as to that collateral;
    (iii) The Securities Investor Protection Act of 1970 (15 U.S.C. 
78aaa et seq.) does not protect the counterparty; and
    (iv) The collateral will not be subject to the requirements of 
Sec. 240.8c-1, Sec. 240.15c2-1, Sec. 240.15c3-2, or Sec. 240.15c3-3;
* * * * *
    15. By adding Sec. 240.15c3-4 to read as follows:


Sec. 240.15c3-4  Internal risk management control systems for OTC 
derivatives dealers.

    (a) An OTC derivatives dealer shall establish, document, and 
maintain a system of internal risk management controls to assist it in 
managing the risks associated with its business activities, including 
market, credit, leverage, liquidity, legal, and operational risks.
    (b) An OTC derivatives dealer shall consider the following when 
adopting its internal control system guidelines, policies, and 
procedures:
    (1) The ownership and governance structure of the OTC derivatives 
dealer;
    (2) The composition of the governing body of the OTC derivatives 
dealer;
    (3) The management philosophy of the OTC derivatives dealer;
    (4) The scope and nature of established risk management guidelines;
    (5) The scope and nature of the permissible OTC derivatives 
activities;
    (6) The sophistication and experience of relevant trading, risk 
management, and internal audit personnel;
    (7) The sophistication and functionality of information and 
reporting systems; and
    (8) The scope and frequency of monitoring, reporting, and auditing 
activities.
    (c) An OTC derivatives dealer's internal risk management control 
system shall include the following elements:
    (1) A risk control unit that reports directly to senior management 
and is independent from business trading units;
    (2) Separation of duties between personnel responsible for entering 
into a transaction and those responsible for recording the transaction 
in the books and records of the OTC derivatives dealer;
    (3) Periodic reviews (which may be performed by internal audit 
staff) and annual reviews (which must be conducted by independent 
certified public accountants) of the OTC derivatives dealer's risk 
management systems;
    (4) Definitions of risk, risk monitoring, and risk management; and
    (5) Written guidelines, approved by the OTC derivatives dealer's 
governing body, that include and discuss the following:
    (i) The OTC derivatives dealer's consideration of the elements in 
paragraph (b) of this section;
    (ii) The scope, and the procedures for determining the scope, of 
authorized activities or any nonquantitative limitation on the scope of 
authorized activities;
    (iii) Quantitative guidelines for managing the OTC derivatives 
dealer's overall risk exposure;
    (iv) The type, scope, and frequency of reporting by management on 
risk exposures;
    (v) The procedures for and the timing of the governing body's 
periodic review of the risk monitoring and risk management written 
guidelines, systems, and processes;
    (vi) The process for monitoring risk independent of the business or 
trading units whose activities create the risks being monitored;
    (vii) The performance of the risk management function by persons 
independent from or senior to the business or trading units whose 
activities create the risks;
    (viii) The authority and resources of the groups or persons 
performing the risk monitoring and risk management functions;
    (ix) The appropriate response by management when internal risk 
management guidelines have been exceeded;
    (x) The procedures to monitor and address the risk that an OTC 
derivatives transaction contract will be unenforceable;
    (xi) The procedures requiring the documentation of the principal 
terms of OTC derivatives transactions and other relevant information 
regarding such transactions;
    (xii) The procedures authorizing specified employees to commit the 
OTC derivatives dealer to particular types of transactions;
    (xiii) The procedures to prevent the OTC derivatives dealer from 
engaging in any securities transaction that is not permitted under 
Sec. 240.15a-1; and
    (xiv) The procedures to prevent the OTC derivatives dealer from 
improperly relying on the exceptions to Sec. 240.15a-1(c) and 
Sec. 240.15a-1(d), including the procedures to determine whether a 
counterparty is acting in the capacity of principal or agent.
    (d) Management must periodically review, in accordance with written 
procedures, the OTC derivatives dealer's business activities for 
consistency with risk management guidelines including that:
    (1) Risks arising from the OTC derivatives dealer's OTC derivatives 
activities are consistent with prescribed guidelines;
    (2) Risk exposure guidelines for each business unit are appropriate 
for the business unit;
    (3) The data necessary to conduct the risk monitoring and risk 
management function as well as the valuation process over the OTC 
derivatives dealer's portfolio of products is accessible on a timely 
basis and information systems are available to capture, monitor, 
analyze, and report relevant data;
    (4) Procedures are in place to enable management to take action 
when internal risk management guidelines have been exceeded;

[[Page 59401]]

    (5) Procedures are in place to monitor and address the risk that an 
OTC derivatives transaction contract will be unenforceable;
    (6) Procedures are in place to identify and address any 
deficiencies in the operating systems and to contain the extent of 
losses arising from unidentified deficiencies;
    (7) Procedures are in place to authorize specified employees to 
commit the OTC derivatives dealer to particular types of transactions, 
to specify any quantitative limits on such authority, and to provide 
for the oversight of their exercise of such authority;
    (8) Procedures are in place to prevent the OTC derivatives dealer 
from engaging in any securities transaction that is not permitted under 
Sec. 240.15a-1;
    (9) Procedures are in place to prevent the OTC derivatives dealer 
from improperly relying on the exceptions to Sec. 240.15a-1(c) and 
Sec. 240.15a-1(d), including procedures to determine whether a 
counterparty is acting in the capacity of principal or agent;
    (10) Procedures are in place to provide for adequate documentation 
of the principal terms of OTC derivatives transactions and other 
relevant information regarding such transactions;
    (11) Personnel resources with appropriate expertise are committed 
to implementing the risk monitoring and risk management systems and 
processes; and
    (12) Procedures are in place for the periodic internal and external 
review of the risk monitoring and risk management functions.
    16. Amend Sec. 240.17a-3, in paragraph (a)(4)(vi) by revising the 
phrase ``Rule 17a-13 and Rule 17a-5 hereunder'' to read ``Sec. 240.17a-
5, Sec. 240.17a-12, and Sec. 240.17a-13'' and by adding a sentence to 
the end of paragraph (a)(10) to read as follows:


Sec. 240.17a-3  Records to be made by certain exchange members, 
brokers, and dealers.

    (a) * * *
    (10) * * * An OTC derivatives dealer shall also keep a record of 
all eligible OTC derivative instruments as defined in Sec.  240.3b-13 
in which the OTC derivatives dealer has any direct or indirect interest 
or which it has written or guaranteed, containing, at a minimum, an 
identification of the security or other instrument, the number of units 
involved, and the identity of the counterparty.
* * * * *
    17. Amend Sec. 240.17a-4 in paragraph (b)(8) introductory text by 
revising the phrase ``Part IIA'' to read ``Part IIA or Part IIB'' and 
by revising the phrase ``Sec. 240.17a-5(i)(xv)'' to read 
``Sec. 240.17a-5(d) and Sec. 240.17a-12(b)''; in paragraph (b)(8)(xv) 
by revising the phrase ``Sec. 240.17a-5'' to read ``Sec. 240.17a-5 and 
Sec.  240.17a-12''; by adding paragraph (b)(10) to read as follows:


Sec. 240.17a-4  Records to be preserved by certain exchange members, 
brokers and dealers.

* * * * *
    (b) * * *
    (10) The records required to be made pursuant to Sec. 240.15c3-4 
and the results of the periodic reviews conducted pursuant to 
Sec. 240.15c3-4(d).
* * * * *
    18. Amend Sec. 240.17a-5 by adding paragraph (o) to read as 
follows:


Sec. 240.17a-5  Reports to be made by certain brokers and dealers.

* * * * *
    (o) Compliance with Sec. 240.17a-12. An OTC derivatives dealer may 
comply with Sec. 240.17a-5 by complying with the provisions of 
Sec. 240.17a-12.
    19. Amend Sec. 240.17a-11 by redesignating paragraph (b) as 
paragraph (b)(1) and by adding paragraph (b)(2) to read as follows; in 
paragraph (c) introductory text by revising the phrase ``(c)(1), (c)(2) 
or (c)(3)'' to read ``(c)(1), (c)(2), (c)(3) or (c)(4)''; by revising 
paragraph (c)(3) and by adding paragraph (c)(4) to read as follows; in 
paragraph (e) introductory text by adding the phrase ``or Sec. 240.17a-
12(f)(2)'' after the phrase ``240.17a-5(h)(2)'' and by adding the 
phrase ``or Sec.  240.17a-12(e)(2)'' after the phrase ``240.17a-5(g)''; 
and in paragraph (h) by revising the phrase ``Sec. 240.15c3-3(i) and 
Sec.  240.17a-5(h)(2)'' to read ``Sec. 240.15c3-3(i), Sec. 240.17a-
5(h)(2), and Sec. 240.17a-12(f)(2)''.


Sec. 240.17a-11  Notification provisions for brokers and dealers.

* * * * *
    (b) * * *
    (2) In addition to the requirements of paragraph (b)(1) of this 
section, an OTC derivatives dealer shall also provide notice if its 
tentative net capital falls below the minimum amount required pursuant 
to Sec. 240.15c3-1. The notice shall specify the OTC derivatives 
dealer's net capital and tentative net capital requirements, and its 
current amount of net capital and tentative net capital.
    (c) * * *
    (3) If a computation made by a broker or dealer pursuant to 
Sec. 240.15c3-1 shows that its total net capital is less than 120 
percent of the broker's or dealer's required minimum net capital, or if 
a computation made by an OTC derivatives dealer pursuant to 
Sec. 240.15c3-1 shows that its total tentative net capital is less than 
120 percent of the dealer's required minimum tentative net capital.
    (4) The occurrence of the fourth and each subsequent backtesting 
exception under Sec. 240.15c3-1f(e)(1)(iv) during any 250 business day 
measurement period.
* * * * *
    20. By adding Sec. 240.17a-12 to read as follows:


Sec. 240.17a-12  Reports to be made by certain OTC derivatives dealers.

    (a) Filing of quarterly reports. (1) This paragraph (a) shall apply 
to every OTC derivatives dealer registered pursuant to Section 15 of 
the Act (15 U.S.C. 78o).
    (i) Every OTC derivatives dealer shall file Part IIB of Form X-17A-
5 (Sec. 249.617 of this chapter) within 17 business days after the end 
of each calendar quarter and within 17 business days after the date 
selected for the annual audit of financial statements where said date 
is other than the end of the calendar quarter.
    (ii) Upon receiving from the Commission written notice that 
additional reporting is required, an OTC derivatives dealer shall file 
monthly, or at such times as shall be specified, Part IIB of Form X-
17A-5 (Sec. 249.617 of this chapter) and such other financial or 
operational information as shall be required by the Commission.
    (2) The reports provided for in this paragraph (a) shall be 
considered filed when received at the Commission's principal office in 
Washington, DC. All reports filed pursuant to this paragraph (a) shall 
be deemed to be confidential.
    (3) Upon written application by an OTC derivatives dealer to the 
Commission, the Commission may extend the time for filing the 
information required by this paragraph (a). The written application 
shall be filed with the Commission at its principal office in 
Washington DC.
    (b) Annual filing of audited financial statements. (1)(i) Every OTC 
derivatives dealer registered pursuant to Section 15 of the Act (15 
U.S.C. 78o) shall file annually, on a calendar or fiscal year basis, a 
report which shall be audited by a certified public accountant. Reports 
filed pursuant to this paragraph (b) shall be as of the same fixed or 
determinable date each year, unless a change is approved in writing by 
the Commission.
    (ii) An OTC derivatives dealer succeeding to and continuing the 
business of another OTC derivatives dealer need not file a report under 
this paragraph (b) as of a date in the fiscal or calendar year in which 
the succession occurs if the predecessor

[[Page 59402]]

OTC derivatives dealer has filed a report in compliance with this 
paragraph (b) as of a date in such fiscal or calendar year.
    (2) The annual audit report shall contain a Statement of Financial 
Condition (in a format and on a basis which is consistent with the 
total reported on the Statement of Financial Condition contained in 
Form X-17A-5 (Sec. 249.617 of this chapter), Part IIB, a Statement of 
Income, a Statement of Cash Flows, a Statement of Changes in 
Stockholders' or Partners' or Sole Proprietor's Equity, and a Statement 
of Changes in Liabilities Subordinated to Claims of General Creditors. 
Such statements shall be in a format which is consistent with such 
statements as contained in Form X-17A-5 (Sec. 249.617 of this chapter), 
Part IIB. If the Statement of Financial Condition filed in accordance 
with instructions to Form X-17A-5 (Sec. 249.617 of this chapter), Part 
IIB, is not consolidated, a summary of financial data for subsidiaries 
not consolidated in the Part IIB Statement of Financial Condition as 
filed by the OTC derivatives dealer shall be included in the notes to 
the consolidated statement of financial condition reported on by the 
certified public accountant. The summary financial data shall include 
the assets, liabilities, and net worth or stockholders' equity of the 
unconsolidated subsidiaries.
    (3) Supporting schedules shall include, from Part IIB of Form X-
17A-5 (Sec. 249.617 of this chapter), a Computation of Net Capital 
under Sec. 240.15c3-1.
    (4) A reconciliation, including appropriate explanations, of the 
Computation of Net Capital under Sec. 240.15c3-1 contained in the audit 
report with the broker's or dealer's corresponding unaudited most 
recent Part IIB filing shall be filed with the report when material 
differences exist. If no material differences exist, a statement so 
indicating shall be filed.
    (5) The annual audit report shall be filed not more than sixty days 
after the date of the financial statements.
    (6) Two copies of the annual audit report shall be filed at the 
Commission's principal office in Washington, DC.
    (c) Nature and form of reports. The financial statements filed 
pursuant to paragraph (b) of this section shall be prepared and filed 
in accordance with the following requirements:
    (1) An audit shall be conducted by a certified public accountant 
who shall be in fact independent as defined in paragraph (f) of this 
section, and it shall give an opinion covering the statements filed 
pursuant to paragraph (b) of this section.
    (2) Attached to the report shall be an oath or affirmation that, to 
the best knowledge and belief of the person making such oath or 
affirmation, the financial statements and schedules are true and 
correct and neither the OTC derivatives dealer, nor any partner, 
officer, or director, as the case may be, has any significant interest 
in any counterparty or in any account classified solely as that of a 
counterparty. The oath or affirmation shall be made before a person 
duly authorized to administer such oaths or affirmations. If the OTC 
derivatives dealer is a sole proprietorship, the oath or affirmation 
shall be made by the proprietor; if a partnership, by a general 
partner; or if a corporation, by a duly authorized officer.
    (3) All of the statements filed pursuant to paragraph (b) of this 
section shall be confidential except that they shall be available for 
use by any official or employee of the United States or by any other 
person to whom the Commission authorizes disclosure of such information 
as being in the public interest.
    (d) Qualification of accountants. The Commission will not recognize 
any person as a certified public accountant who is not duly registered 
and in good standing as such under the laws of the State of his 
principal office.
    (e) Designation of accountant. (1) Every OTC derivatives dealer 
shall file no later than December 10 of each year with the Commission's 
principal office in Washington, DC a statement indicating the existence 
of an agreement, dated no later than December 1 of that year, with a 
certified public accountant covering a contractual commitment to 
conduct the OTC derivatives dealer's annual audit during the following 
calendar year.
    (2) If the agreement is of a continuing nature, providing for 
successive yearly audits, no further filing is required. If the 
agreement is for a single audit, or if the continuing agreement 
previously filed has been terminated or amended, a new statement must 
be filed by the required date.
    (3) The statement shall be headed ``Notice pursuant to Sec.  
240.17a-12(e)'' and shall contain the following information:
    (i) Name, address, telephone number, and registration number of the 
OTC derivatives dealer;
    (ii) Name, address, and telephone number of the certified public 
accounting firm; and
    (iii) The audit date of the OTC derivatives dealer for the year 
covered by the agreement.
    (4) Notwithstanding the date of filing specified in paragraph 
(e)(1) of this section, every OTC derivatives dealer shall file the 
notice provided for in paragraph (e) of this section within 30 days 
following the effective date of registration as an OTC derivatives 
dealer.
    (f) Independence of accountant. A certified public accountant shall 
be independent in accordance with the provisions of Sec. 210.2-01(b) 
and (c) of this chapter.
    (g) Replacement of accountant. (1) An OTC derivatives dealer shall 
file a notice that must be received by the Commission's principal 
office in Washington, DC not more than 15 business days after:
    (i) The OTC derivatives dealer has notified the certified public 
accountant whose opinion covered the most recent financial statements 
filed under paragraph (b) of this section that the certified public 
accountant's services will not be utilized in future engagements; or
    (ii) The OTC derivatives dealer has notified a certified public 
accountant who was engaged to give an opinion covering the financial 
statements to be filed under paragraph (b) of this section that the 
engagement has been terminated; or
    (iii) A certified public accountant has notified the OTC 
derivatives dealer that it will not continue under an engagement or 
give an opinion covering the financial statements to be filed under 
paragraph (b) of this section; or
    (iv) A new certified public accountant has been engaged to give an 
opinion covering the financial statements to be filed under paragraph 
(b) of this section without any notice of termination having been given 
to or by the previously engaged certified public accountant.
    (2) Such notice shall state the date of notification of the 
termination of the engagement of the former certified public accountant 
or the engagement of the new certified public accountant, as 
applicable, and the details of any disagreements existing during the 24 
months (or the period of the engagement, if less) preceding such 
termination or new engagement relating to any matter of accounting 
principles or practices, financial statement disclosure, auditing scope 
or procedure, or compliance with applicable rules of the Commission, 
which disagreements, if not resolved to the satisfaction of the former 
certified public accountant, would have caused the former certified 
public accountant to make reference to them in connection with the 
report on the subject matter of the disagreements.

[[Page 59403]]

The disagreements required to be reported in response to the preceding 
sentence include both those resolved to the former certified public 
accountant's satisfaction and those not resolved to the former 
certified public accountant's satisfaction. Disagreements contemplated 
by this section are those that occur at the decision-making level 
(i.e., between principal financial officers of the OTC derivatives 
dealer and personnel of the certified public accounting firm 
responsible for rendering its report). The notice shall also state 
whether the certified public accountant's report on the financial 
statements for any of the past two years contained an adverse opinion 
or a disclaimer of opinion or was qualified as to uncertainties, audit 
scope, or accounting principles, and describe the nature of each such 
adverse opinion, disclaimer of opinion, or qualification. The OTC 
derivatives dealer shall also request the former certified public 
accountant to furnish the OTC derivatives dealer with a letter 
addressed to the Commission stating whether the former certified public 
accountant agrees with the statements contained in the notice of the 
OTC derivatives dealer and, if not, stating the respects in which the 
former certified public accountant does not agree. The OTC derivatives 
dealer shall file three copies of the notice and the certified public 
accountant's letter, one copy of which shall be manually signed by the 
sole proprietor, or a general partner or a duly authorized corporate 
officer, as appropriate, and by the certified public accountant.
    (h) Audit objectives. (1) The audit shall be made in accordance 
with U.S. Generally Accepted Auditing Standards and shall include a 
review of the accounting system, the internal accounting controls, and 
procedures for safeguarding securities including appropriate tests 
thereof for the period since the date of the prior audited financial 
statements. The audit shall include all procedures necessary under the 
circumstances to enable the certified public accountant to express an 
opinion on the statement of financial condition, results of operations, 
cash flows, and the Computation of Net Capital under Sec. 240.15c3-1. 
The scope of the audit and review of the accounting system, the 
internal accounting controls, and procedures for safeguarding 
securities shall be sufficient to provide reasonable assurance that any 
material inadequacies existing at the date of the examination in the 
following are disclosed:
    (i) The accounting system;
    (ii) The internal accounting controls; and
    (iii) The procedures for safeguarding securities.
    (2) A material inadequacy in the accounting system, internal 
accounting controls, procedures for safeguarding securities, and 
practices and procedures referred to in paragraph (h) (1) of this 
section that must be reported under these audit objectives includes any 
condition which has contributed substantially to or, if appropriate 
corrective action is not taken, could reasonably be expected to:
    (i) Inhibit an OTC derivatives dealer from promptly completing 
securities transactions or promptly discharging its responsibilities to 
counterparties, other brokers and dealers, or creditors;
    (ii) Result in material financial loss;
    (iii) Result in material misstatements of the OTC derivatives 
dealer's financial statements; or
    (iv) Result in violations of the Commission's recordkeeping or 
financial responsibility rules to an extent that could reasonably be 
expected to result in the conditions described in paragraphs (h)(2)(i), 
(ii), or (iii) of this section.
    (i) Extent and timing of audit procedures. (1) The extent and 
timing of audit procedures are matters for the certified public 
accountant to determine on the basis of its review and evaluation of 
existing internal controls and other audit procedures performed in 
accordance with U.S. Generally Accepted Auditing Standards and the 
audit objectives set forth in paragraph (h) of this section.
    (2) If, during the course of the audit or interim work, the 
certified public accountant determines that any material inadequacies 
exist in the accounting system, internal accounting controls, 
procedures for safeguarding securities, or as otherwise defined in 
paragraph (h)(2) of this section, then the certified public accountant 
shall call it to the attention of the chief financial officer of the 
OTC derivatives dealer, who shall inform the Commission by telegraphic 
or facsimile notice within 24 hours thereafter as set forth in 
Sec. 240.17a-11(e) and (g). The OTC derivatives dealer shall also 
furnish the certified public accountant with a copy of said notice to 
the Commission by telegram or facsimile within the same 24 hour period. 
If the certified public accountant fails to receive such notice from 
the OTC derivatives dealer within that 24 hour period, or if the 
certified public accountant disagrees with the statements contained in 
the notice of the OTC derivatives dealer, the certified public 
accountant shall inform the Commission by report of material inadequacy 
within 24 hours thereafter as set forth in Sec. 240.17a-11(g). Such 
report from the certified public accountant shall, if the OTC 
derivatives dealer failed to file a notice, describe any material 
inadequacies found to exist. If the OTC derivatives dealer filed a 
notice, the certified public accountant shall file a report detailing 
the aspects, if any, of the OTC derivatives dealer's notice with which 
the certified public accountant does not agree.
    (j) Accountant's report, general provisions.--(1) Technical 
requirements. The certified public accountant's report shall be dated; 
be signed manually; indicate the city and state where issued; and 
identify without detailed enumeration the financial statements and 
schedules covered by the report.
    (2) Representations as to the audit. The certified public 
accountant's report shall state that the audit was made in accordance 
with U.S. Generally Accepted Auditing Standards; state whether the 
certified public accountant reviewed the procedures followed for 
safeguarding securities; and designate any auditing procedures deemed 
necessary by the certified public accountant under the circumstances of 
the particular case that have been omitted, and the reason for their 
omission. Nothing in this section shall be construed to imply authority 
for the omission of any procedure which certified public accountants 
would ordinarily employ in the course of an audit made for the purpose 
of expressing the opinions required under this section.
    (3) Opinion to be expressed. The certified public accountant's 
report shall state clearly the opinion of the certified public 
accountant:
    (i) In respect of the financial statements and schedules covered by 
the report and the accounting principles and practices reflected 
therein; and
    (ii) As to the consistency of the application of the accounting 
principles, or as to any changes in such principles which have a 
material effect on the financial statements.
    (4) Exceptions. Any matters to which the certified public 
accountant takes exception shall be clearly identified, explained, and, 
to the extent practicable, the effect of each such exception on the 
related financial statements shall be provided.
    (5) Definitions. For the purpose of this section, the terms audit 
(or examination), accountant's report, and certified shall have the 
meanings given in Sec. 210.1-02 of this chapter.

[[Page 59404]]

    (k) Accountant's report on material inadequacies and reportable 
conditions. The OTC derivatives dealer shall file concurrently with the 
annual audit report a supplemental report by the certified public 
accountant describing any material inadequacies or any matter that 
would be deemed to be a reportable condition under U.S. Generally 
Accepted Auditing Standards that are unresolved as of the date of the 
certified public accountant's report. The report shall also describe 
any material inadequacies found to have existed since the date of the 
previous audit. The supplemental report shall indicate any corrective 
action taken or proposed by the OTC derivatives dealer with regard to 
any identified material inadequacies or reportable conditions. If the 
audit did not disclose any material inadequacies or reportable 
conditions, the supplemental report shall so state.
    (l) Accountant's report on management controls. The OTC derivatives 
dealer shall file concurrently with the annual audit report a 
supplemental report by the certified public accountant indicating the 
certified public accountant's opinion on the OTC derivatives dealer's 
compliance with its internal risk management controls. The procedures 
are to be performed and the report is to be prepared in accordance with 
U.S. Generally Accepted Auditing Standards.
    (m) Accountant's report on inventory pricing and modeling. (1) The 
OTC derivatives dealer shall file concurrently with the annual audit 
report a supplemental report by the certified public accountant 
indicating the results of the certified public accountant's review of 
the broker's or dealer's inventory pricing and modeling procedures. 
This review shall be conducted in accordance with procedures agreed to 
by the OTC derivatives dealer and by the certified public accountant 
conducting the review. The purpose of the review is to confirm that the 
pricing and modeling procedures relied upon by the OTC derivatives 
dealer conform to the procedures submitted to the Commission as part of 
its OTC derivatives dealer application, and that the procedures comply 
with the qualitative and quantitative standards set forth in 
Sec. 240.15c3-1f.
    (2) The agreed-upon procedures are to be performed and the report 
is to be prepared in accordance with U.S. Generally Accepted 
Attestation Standards.
    (3) Every OTC derivatives dealer shall file prior to the 
commencement of the initial review, the procedures to be performed 
pursuant to paragraph (m)(1) of this section with the Commission's 
principal office in Washington, DC. Prior to the commencement of each 
subsequent review, every OTC derivatives dealer shall file with the 
Commission's principal office in Washington, DC notice of changes in 
the agreed-upon procedures.
    (n) Extensions and exemptions. Upon the written request of the OTC 
derivatives dealer, or on its own motion, the Commission may grant an 
extension of time or an exemption from any of the requirements of this 
section either unconditionally or on specified terms and conditions.
    (o) Notification of change of fiscal year. (1) In the event any OTC 
derivatives dealer finds it necessary to change its fiscal year, it 
must file a notice of such change with the Commission's principal 
office in Washington, DC.
    (2) Such notice shall contain a detailed explanation of the reasons 
for the change. Any change in the filing period for the audit report 
must be approved by the Commission.
    (p) Filing requirements. For purposes of filing requirements as 
described in Sec. 240.17a-12, these filings shall be deemed to have 
been accomplished upon receipt at the Commission's principal office in 
Washington, DC.
    21. By adding Secs. 240.36a1-1 and 240.36a1-2 to read as follows:


Sec. 240.36a1-1  Exemptionfrom Section 7 for OTC derivatives dealers.

    Preliminary Note: OTC derivatives dealers are a special class of 
broker-dealers that are exempt from certain broker-dealer 
requirements, including membership in a self-regulatory organization 
(Sec. 240.15b9-2), regular broker-dealer margin rules 
(Sec. 240.36a1-1), and application of the Securities Investor 
Protection Act of 1970 (Sec. 240.36a1-2). OTC derivative dealers are 
subject to special requirements, including limitations on the scope 
of their securities activities (Sec. 240.15a-1), specified internal 
risk management control systems (Sec. 240.15c3-4), recordkeeping 
obligations (Sec. 240.17a-3(a)(10)), and reporting responsibilities 
(Sec. 240.17a-12). They are also subject to alternative net capital 
treatment (Sec. 240.15c3-1(a)(5)).

    (a) Except as otherwise provided in paragraph (b) of this section, 
transactions involving the extension of credit by an OTC derivatives 
dealer shall be exempt from the provisions of section 7(c) of the Act 
(15 U.S.C. 78g(c)), provided that the OTC derivatives dealer complies 
with Section 7(d) of the Act (15 U.S.C. 78g(d)).
    (b) The exemption provided under paragraph (a) of this section 
shall not apply to extensions of credit made directly by a registered 
broker or dealer (other than an OTC derivatives dealer) in connection 
with transactions in eligible OTC derivative instruments for which an 
OTC derivatives dealer acts as counterparty.


Sec. 240.36a1-2  Exemption from SIPA for OTC derivatives dealers.

    Preliminary Note: OTC derivatives dealers are a special class of 
broker-dealers that are exempt from certain broker-dealer 
requirements, including membership in a self-regulatory organization 
(Sec. 240.15b9-2), regular broker-dealer margin rules 
(Sec. 240.36a1-1), and application of the Securities Investor 
Protection Act of 1970 (Sec. 240.36a1-2). OTC derivative dealers are 
subject to special requirements, including limitations on the scope 
of their securities activities (Sec. 240.15a-1), specified internal 
risk management control systems (Sec. 240.15c3-4), recordkeeping 
obligations (Sec. 240.17a-3(a)(10)), and reporting responsibilities 
(Sec. 240.17a-12). They are also subject to alternative net capital 
treatment (Sec. 240.15c3-1(a)(5)).

    OTC derivatives dealers, as defined in Sec. 240.3b-12, shall be 
exempt from the provisions of the Securities Investor Protection Act of 
1970 (15 U.S.C. 78aaa through 78lll).

PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934

    22. The authority citation for part 249 continues to read in part 
as follows:

    Authority: 15 U.S.C. 78a, et seq., unless otherwise noted;
* * * * *


Sec. 249.617  [Amended]

    23. Section 249.617 is amended by revising the phrase ``and 
Sec. 240.17a-11'' in the section heading to read ``, Sec. 240.17a-11, 
and Sec. 240.17a-12''; and by revising the phrase ``and Sec. 240.17a-
11'' to read ``, Sec. 240.17a-11, and Sec. 240.17a-12''.
    24. Form X-17A-5 (referenced in Sec. 249.617) is amended by adding 
section IIB to read as follows:

    Note: Form X-17A-5 does not, and the amendments will not, appear 
in the Code of Federal Regulations. Part IIB of Form X-17A-5 is 
attached as Appendix A to this document.

    Dated: October 23, 1998.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.

Appendix A

    Note: the text of Appendix A does not appear in the Code of 
Federal Regulations.

General Instructions

    The FOCUS Report (Form X-17A-511B) constitutes the basic financial 
and operational report required of OTC derivatives dealers. Much of the

[[Page 59405]]

information required by the FOCUS report is the same or similar to the 
information required to be reported by broker-dealers required to file 
Form X-17A-5 Part II. Consequently, for those items that appear on both 
forms, the instructions for X-17A-5 Part II are to be followed when 
completing Form X-17A-5 Part IIB. The following instructions apply to 
new information requests and to items appearing on both forms that have 
been altered to better reflect an OTC derivatives dealers's unique 
business.

Computation of Net Capital and Required Net Capital

(Under 15c3-1 Appendix F)

Tentative Net Capital

    For purposes of paragraph (a)(5) of Rule 15c3-1 of this chapter 
(Sec. 240.15c3-1), the term ``tentative net capital'' mean the net 
capital of an OTC derivatives dealer before deducting the charges for 
market and credit risk as computed pursuant to Appendix F and increased 
by the balance sheet value (including counterparty net exposure) 
resulting from transactions in eligible OTC derivative instruments 
which would otherwise be deducted by virtue of paragraph (c)(2)(iv) of 
Rule 15c3-1.

Market Risk Exposure

    The capital requirement for an OTC derivatives dealer electing to 
apply Appendix F of Rule 240.15c3-1 is computed as follows:
    (1) Value-at-Risk. An OTC derivatives dealer shall deduct from net 
worth an amount for market risk exposure for eligible OTC derivatives 
transactions and other positions in its proprietary or other accounts 
equal to the value at risk (``VAR'') of these positions obtained from 
its proprietary VAR model, multiplied by the appropriate multiplication 
factor. See paragraph (e)(1)(v)(C) of Appendix F for more information 
on the multiplication factor. The proprietary model used to calculate 
the capital requirement for market risk must be approved by the 
Commission prior to its use.
    (2) Alternative Method for Equities. An OTC derivatives dealer may 
choose to use the Alternative Method to calculate market risk for 
equity instruments, including OTC options. An OTC derivatives dealer 
also may use this alternative method if the Commission does not approve 
the OTC derivatives dealer's use of VAR models for equity instruments. 
Under the alternative method, the deduction for market risk will be an 
amount equal to the largest theoretical loss calculated in accordance 
with the theoretical pricing model set forth in Appendix A of 
Sec. 240.15c3-1. The OTC derivatives dealer may use its own theoretical 
pricing model as long as it contains the minimum pricing factors set 
forth in Appendix A.
    (3) Non-Marketable Securities. An OTC derivatives dealer may not 
use a VAR model a determine a capital charge for any category of 
securities having no ready market or any category of debt securities 
which are below investment grade, or any derivative instrument based on 
the value of these categories of securities, unless the Commission has 
granted, pursuant to paragraph (a)(1) of Appendix F, its application to 
use its VAR model for any such category of securities. The dealer in 
any event may apply, pursuant to paragraph (a)(1) of Appendix F, for an 
alternative treatment for any such category of securities, rather than 
calculate the market risk capital charge for such category of 
securities under paragraphs (c)(2)(vi) and (vii) of Sec. 240.15c3-1.
    (4) Residual Positions. To the extent that a position has not been 
included in the calculation of the market risk charge in subparagraph 
(1) through (3) of this paragraph, the market risk charge for the 
position shall be computed under paragraph (c)(2)(vi) of Sec. 240.15c3-
1.

Credit Risk Exposure

    The capital requirement for credit risk arising from an OTC 
derivatives dealer's eligible OTC derivatives transactions consists of 
a counterparty charge and a concentration charge. The counterparty 
charge is computed as follows:
    (1) The net replacement value for each counterparty (including the 
effect of legally enforceable netting agreements and the application of 
liquid collateral) multiplied by 8% multiplied by the counterparty 
factor. The counterparty factors are 20% for entities with ratings for 
senior unsecured long term debt or commercial paper in the two highest 
rating categories by a nationally recognized statistical rating 
organization (``NRSRO''); 50% for entities with ratings of senior 
unsecured long term debt in the third and fourth highest ratings 
categories by and NRSRO; and 100% for entities with ratings for senior 
unsecured long term debt below the highest rating categories.
    (2) The net replacement value for each counterparty (including the 
effect of legally enforceable netting agreements and the application of 
liquid collateral) that is insolvent, or in bankruptcy, or that has 
senior unsecured long-term debt in default.
    The concentration charge is computed as follows: where the net 
replacement value in the account of any one counterparty exceeds 25% of 
the OTC derivatives dealer's tentative net capital, deduct the 
following amounts: for couterparties with ratings for senior unsecured 
long-term debt or commercial paper in the two highest rating categories 
by an NRSRO, 5% of the amount of the net replacement value in excess of 
25% of the OTC derivatives dealer's tentative net capital; for 
counterparties with ranting for senior unsecured long-term debt in the 
third and fourth highest rating categories by an NRSRO, 20% of the 
amount of the net replacement value in excess of 25% of the OTC 
derivates dealer's tentative net capital; and for counterparties with 
ratings for senior unsecured long-term debt below the four highest 
rating categories, 50% of the amount of the net replacement value in 
excess of 25% of the OTC derivatives dealer's tentative net capital.

Aggregate Securities and OTC Derivatives Positions

    Provide information for each affiliated broker-dealer in a separate 
column, or complete a separate schedule for each affiliated broker-
dealer. In the event a separate listing of a position, financial 
instrument or otherwise is required pursuant to any of the provisions 
Sec. 240.17h-1T, the dealer should indicate as such in the appropriate 
section of this schedule. Where appropriate, indicate long and short 
positions separately.

Paperwork Reduction Act Disclosure

    Part IIB of Form X-17A-5 requires an OTC derivatives dealer to file 
with the Commission certain financial and operational information. The 
form is designed to enable the Commission to ascertain the nature and 
scope of a dealer's over-the-counter derivatives activity and to 
monitor the dealer's financial condition and risk exposure.
    It is estimated that an OTC derivatives dealer will spend 
approximately 20 hours completing Part IIB of Form X-17A-5. Any member 
of the public may direct to the Commission any comments concerning the 
accuracy of this burden estimate and any suggestions for reducing this 
burden.
    The information collected pursuant to Part IIB of Form X-17A-5 will 
be kept confidential.
    This collection of information has been reviewed by the Office of 
Management and Budget (OMB) in accordance with the clearance 
requirements of 44 U.S.C. 3507. This collection of information has been 
assigned Control Number 3235-0498 by OMB.

[[Page 59406]]

    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a 
currently valid number. Section 17(a) of the Securities Exchange Act of 
1934 authorizes the Commission to collect the information on this Form 
from registrants. See U.S.C. 78q.

BILLING CODE 8010-01-W

[[Page 59407]]

       
    [GRAPHIC] [TIFF OMITTED] TR03NO98.000
    
 
[[Page 59408]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.001

 

[[Page 59409]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.002

 

[[Page 59410]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.003

 

[[Page 59411]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.004

 

[[Page 59412]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.005

 

[[Page 59413]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.006

 

[[Page 59414]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.007

 

[[Page 59415]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.008

 

[[Page 59416]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.009

 

[[Page 59417]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.010

 

[[Page 59418]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.011

 

[[Page 59419]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.012

 

[[Page 59420]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.013

 

[[Page 59421]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.014

 

[[Page 59422]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.015

 

[[Page 59423]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.016

 

[[Page 59424]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.017

 

[[Page 59425]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.018

 

[[Page 59426]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.019

 

[[Page 59427]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.020

 

[[Page 59428]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.021

 

[[Page 59429]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.022

 

[[Page 59430]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.023

 

[[Page 59431]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.024

 

[[Page 59432]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.025

 

[[Page 59433]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.026

 

[[Page 59434]]

[GRAPHIC] [TIFF OMITTED] TR03NO98.027


[FR Doc. 98-29007 Filed 11-2-98; 8:45 am]
BILLING CODE 8010-01-C