[Federal Register Volume 69, Number 213 (Thursday, November 4, 2004)]
[Notices]
[Pages 64343-64346]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E4-3006]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50607; File No. SR-FICC-2004-15]


Self-Regulatory Organizations; the Fixed Income Clearing 
Corporation; Notice of Filing of a Proposed Rule Change Relating to 
Trade Submission Requirements and Pre-Netting

October 29, 2004.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on July 30, 2004, The Fixed 
Income Clearing Corporation (``FICC'') filed with the Securities and 
Exchange Commission (``Commission'') the proposed rule change as 
described in

[[Page 64344]]

Items I, II, and III below, which items have been prepared primarily by 
FICC. The Commission is publishing this notice to solicit comments on 
the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    FICC is seeking to amend the rules of its Government Securities 
Division (``GSD'') to broaden its trade submission requirements and to 
prohibit pre-netting activities of certain affiliates of its members.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FICC included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. FICC has prepared summaries, set forth in sections (A), 
(B), and (C) below, of the most significant aspects of such 
statements.\2\
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    \2\ The Commission has modified the text of the summaries 
prepared by FICC.
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(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    Through a recent survey of GSD members and through other means, 
FICC has learned that there is a great deal of Government securities 
activity that is currently being executed or cleared and guaranteed as 
to settlement by affiliates of FICC's netting members, some of which 
are active market participants, and is not being submitted to FICC. 
This currently does not represent a violation of the GSD's rules, which 
require that netting members submit their own eligible trading activity 
but do not address member affiliate trading activity.
    FICC has also determined that its trade submission requirements 
have been ineffective in preventing the ``pre-netting'' of otherwise 
netting-eligible activity by netting members as well as their 
affiliates. In fact, FICC believes that certain members may be 
purposefully funneling eligible transactions through their non-member 
affiliates in order to avoid having to submit these transactions to the 
clearing corporation. Such pre-netting practices, which may take the 
form of ``internalization,'' ``summarization,'' or ``compression,'' 
prevent the submission to the clearing corporation of transactions on a 
trade-by-trade basis.\3\ The GSD's rules currently prohibit certain 
pre-netting practices by requiring that all eligible member-executed 
trades be submitted on a trade-by-trade basis. The proposed rule change 
further expands this requirement and extends it to affiliate trades.
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    \3\ In this regard, it should be noted that on February 28, 
2003, the National Securities Clearing Corporation (``NSCC''), an 
FICC affiliate, issued a paper titled ``Managing Risk in Today's 
Equity Market: A White Paper on New Trade Submission Safeguards,'' 
in which it defined recent trade submission practices that are 
creating risks in the equities market. See http://www.dtcc.com/ThoughtLeadership/index.htm. In the paper, NSCC defined three trade 
submission practices that are some form of pre-netting: (i) 
Compression, which is a technique to combine submissions of data for 
multiple trades to the point where the identity of the party 
actually responsible for the trades is masked; (ii) internalization, 
which is a technique in which trade data on separate correspondents' 
trades completely ``crossed'' on a clearing member's books are not 
reported at all to the clearing corporation; and (iii) 
summarization, which is a technique in which the clearing broker 
nets all trades in a single CUSIP by the same correspondent broker 
into fewer submitted trades.
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    The submission to FICC of eligible activity of each GSD netting 
member and that of its affiliates that are active market participants 
is necessary to preserve the integrity of the netting process and the 
safety and soundness of the overall clearance and settlement process. 
The consequence of a gap in FICC's trade submission requirements is the 
introduction of significant risk issues for FICC and the Government 
securities marketplace as a whole.
    The GSD employs several methods to reduce risk including collateral 
and mark-to-market requirements and various monitoring procedures. 
These methods have been highly successful in protecting the GSD and its 
members from loss. The most powerful risk management tool employed by 
the GSD is its multilateral netting by novation process, which 
eliminates the need to settle the large majority of receive and deliver 
obligations created by the trading activity of members. (For example, 
each business day during the first half of 2004, the netting process 
safely eliminated the settlement risk posed by an average of about 
73,000 government securities transactions worth approximately $1.82 
trillion.) The integrity of this netting process depends upon the 
submission to the GSD of all eligible activity on a trade-by-trade 
basis.
    For this reason, FICC, similar to other registered clearing 
agencies, seeks to prohibit pre-netting activity on the part of 
members.\4\ Indeed, it is the avoidance of ``broker pre-netting'' that 
was a fundamental reason for the formation of the Government Securities 
Clearing Corporation, the predecessor of the GSD, in the 1980s. The 
absence from the GSD's netting and settlement processes of all eligible 
trades of an active market participant that is a GSD netting member or 
an affiliate of a GSD netting member presents systemic risk to the 
marketplace for a number of reasons, including the following:
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    \4\ GSD Rule 11, Netting System, Section 3, Obligation to Submit 
Trades, currently provides that each netting member must submit to 
FICC for comparison and netting data on all of its non-repo trades: 
(including trades executed and settled on the same day and trades 
executed between it or an Executing Firm on whose behalf it is 
acting) with Comparison-Only Members or with other Netting Members 
(or an Executing Firm on whose behalf it or another Member is 
acting) that are eligible for netting pursuant to these Rules. * * * 
If the Corporation determines that a Netting Member has, without 
good cause, violated its obligations pursuant to this Section, such 
Netting Member may be reported to the appropriate regulatory body, 
put on the Watch List pursuant to Rule 4, or subject to an 
additional fee.
    In addition, Rule 5, Comparison System, Section 4, Submission 
Size Alternatives, essentially provides that every non-GCF Repo 
trade must be submitted to FICC ``in the full size and in the exact 
amount in which the trade was executed.''
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1. Counterparty Credit Risk
    Management of the risk of trades that are not submitted to the 
clearing corporation falls to each direct counterparty including ones 
that may have insufficient capital or financial strength and/or 
inadequate internal processes to mitigate such risk. Counterparty risk 
is not managed in a centralized, transparent manner, and the myriad of 
risk protections built into the FICC process that have been supported 
by the industry and have been approved by the Commission are not 
available.
2. Operational Risk
    Eligible trades that are not submitted to FICC introduce 
operational risk, including ``9-11'' type risk, to the extent such 
trades are not submitted to FICC for comparison and guaranteed 
settlement within minutes of execution through the Real-Time Trade 
Matching System. Should a catastrophic event occur after trade 
execution, submission of trade data could be significantly delayed or 
such data even lost. Trade guaranty would also not be obtained 
immediately, if at all, because the trade did not compare.
    It is noteworthy that the GSD now receives approximately ninety-
eight percent of its trade data on a real-time basis. That development 
alone has significantly improved the GSD's ability to timely manage the 
risk arising from the over two trillion dollars of daily activity in 
the Government securities marketplace.

[[Page 64345]]

3. Legal Risk
    Failure of eligible activity to be submitted to FICC increases 
systemic risk to the clearance and settlement system for Government 
securities to the extent that these practices reduce the number of 
trades and provide for clearly enforceable netting rights in the event 
of member insolvency. In an insolvency proceeding of a netting member 
of the GSD under U.S. law, the clearing organization netting provisions 
of the Federal Deposit Insurance Corporation Improvement Act of 1991 
(``FDICIA'') afford clear netting rights to the GSD as a registered 
securities clearing agency. The United States Bankruptcy Code 
(``Code'') and the Federal Deposit Insurance Act (``FDIA''), to the 
extent applicable, also provide a number of protections to registered 
securities clearing agencies such as FICC. Although FDICIA, the Code, 
and the FDIA also provide similar safe harbors protecting netting 
rights with respect to certain securities contracts when not submitted 
to and novated through the GSD and other registered clearing agencies, 
their applicability is highly dependent upon the types of entities 
involved and the nature and adequacy of bilateral documentation.
    Thus, pre-netting activity has the potential to increase risk 
absent the capacity for comprehensive monitoring to ensure that such 
documentation and entities are in fact used throughout the Government 
securities marketplace.
    Furthermore, as a practical matter, to the extent that there are 
any ambiguities in the application of relevant netting or close-out 
rights, FICC would expect that in general a bankruptcy court or other 
insolvency tribunal would be more deferential to close-out and netting 
by a registered securities clearing agency such as FICC than it would 
be to close-out and netting by another market participant.
4. Resolution of Fails Problems
    The failure of netting members to submit eligible trades to FICC 
decreases the ability of FICC to assist in the resolution of fail 
problems. The significant fail problem incurred by the industry over 
the past year with regard to the May 2013 10-Year Note, and similar 
situations that may occur in the future, likely could be mitigated by 
submission of eligible data on behalf of non-member affiliates of GSD 
members by allowing FICC to identify and resolve round robin fail 
scenarios involving these affiliates.
    The failure of FICC to receive all eligible trading activity of an 
active market participant denigrates FICC's vital multilateral netting 
process and leads to systemic risk and to FICC not being in as good a 
position to prevent a market crisis. Given the enormous and growing 
amount of activity in the government securities marketplace and 
resultant huge settlement risks, the proposed trade submission 
requirements and pre-netting prohibitions are the logical next steps 
for enhancing FICC's netting and risk management processes and ensuring 
that FICC can continue to perform its vital risk management role for 
the Government securities marketplace.
    As a result, FICC is proposing to broaden its trade submission 
standards by requiring the submission of data on trades executed or 
cleared and guaranteed as to their settlement by certain affiliates of 
members.\5\ The proposed rule change also makes explicit that these 
affiliate trades must be submitted on a trade-by-trade basis as 
executed. This would advance the goal of having every active Government 
securities market participant which is a GSD netting member, or an 
active affiliate of a GSD netting member, submit or have submitted on 
its behalf its eligible activity to the GSD on a trade-for-trade basis 
for netting, risk management, and guaranteed settlement. It would also 
put the Government securities marketplace on a more equal footing with 
other markets where the presence of exchange and/or regulatory 
confirmation or price transparency requirements effectively mandates 
that all eligible trades be submitted to the clearing corporation.
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    \5\ Trades that the affiliate clears for another entity but does 
not guarantee the settlement of will be excluded from the trade 
submission requirement.
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    Specifically, the proposed rule change would apply to a GSD 
member's non-member affiliates that are registered broker-dealers, 
banks, or futures commission merchants organized in the United States 
(``covered affiliates''). The proposed rule change would require 
members to submit, on a trade-by-trade basis, eligible trades, both 
buy-sells and repos, executed by their covered affiliates with other 
netting members or the other members' covered affiliates. The proposed 
rule change would also require members to submit, on a trade-by-trade 
basis, eligible trades cleared and guaranteed as to their settlement by 
their covered affiliates. The proposed rule change is limited to 
covered affiliates because these are the types of entities that 
comprise the majority of GSD netting members, and the failure to submit 
trades executed by registered broker-dealers, banks, and futures 
commission merchants organized in the United States has given rise to 
the systemic risk concerns discussed above.
    It is important to note that covered affiliates will not be 
required to join FICC as members. As such, FICC is affording members 
and their affiliates the flexibility of choosing to have their trades 
processed by FICC either through direct membership or through a 
correspondent clearing relationship with an affiliate or other entity. 
In addition, the proposed rule filing would exempt the following from 
its coverage, which FICC believes do not raise systemic risk concerns 
of the type described above: (1) An affiliate that engages in de 
minimis eligible activity, which would be defined as less than an 
average of 30 or more eligible trades per business day during any one-
month period within the prior year; (2) trades executed between a 
member and its affiliates or between affiliates of the same member; and 
(3) trades whose submission to FICC would cause the member to violate 
an applicable law, rule, or regulation.
    The proposed rule filing would provide that failure to abide by the 
new trade submission requirements would trigger the disciplinary 
consequences currently in the GSD rules, which can ultimately result in 
termination of membership.\6\
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    \6\ The disciplinary consequences of GSD Rule 48 are being 
referred to explicitly in this rule filing to emphasize to members 
the importance of this proposed rule change and to remind members 
that violations of the GSD's rules, whether of the proposed rule 
upon Commission approval or other GSD rules, may lead to serious 
disciplinary consequences, including termination of membership.
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    FICC believes that the proposed rule change is consistent with the 
requirements of Section 17A of the Act \7\ and the rules and 
regulations thereunder applicable to FICC because the proposed rule 
change will reduce systemic risk in the government securities 
marketplace and therefore facilitate the establishment of a national 
system for the prompt and accurate clearance and settlement of 
securities transactions.
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    \7\ 15 U.S.C. 78q-1.
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    FICC does not believe that the proposed rule change would have any 
impact or impose any burden on competition.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received From Members, Participants, or Others

    Written comments relating to the proposed rule change have not yet 
been

[[Page 64346]]

solicited or received. FICC will notify the Commission of any written 
comments received by FICC.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within thirty five days of the date of publication of this notice 
in the Federal Register or within such longer period (i) as the 
Commission may designate up to ninety days of such date if it finds 
such longer period to be appropriate and publishes its reasons for so 
finding or (ii) as to which the self-regulatory organization consents, 
the Commission will:
    (a) By order approve the proposed rule change or
    (b) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml) or
     Send an e-mail to [email protected]. Please include 
File Number SR-FICC-2004-15 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-FICC-2004-15. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, 
all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Section, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of such filing also will be 
available for inspection and copying at the principal office of FICC 
and on FICC's Web site at www.ficc.com. All comments received will be 
posted without change; the Commission does not edit personal 
identifying information from submissions. You should submit only 
information that you wish to make available publicly. All submissions 
should refer to File Number SR-FICC-2004-15 and should be submitted on 
or before November 26, 2004.
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    \8\ 17 CFR 200.30-3(a)(12).

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\8\
J. Lynn Taylor,
Assistant Secretary.
 [FR Doc. E4-3006 Filed 11-3-04; 8:45 am]
BILLING CODE 8010-01-P