[Federal Register Volume 69, Number 236 (Thursday, December 9, 2004)]
[Notices]
[Pages 71456-71459]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E4-3567]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50790; File No. SR-FICC-2004-16]


Self-Regulatory Organizations; Fixed Income Clearing Corporation; 
Order Granting Approval of a Proposed Rule Change Relating to 
Establishment of a Cross-Margining Agreement With The Clearing 
Corporation

December 3, 2004.

I. Introduction

    On August 12, 2004, the Fixed Income Clearing Corporation 
(``FICC'') filed with the Securities and Exchange Commission 
(``Commission'') proposed rule change File No. SR-FICC-2004-16

[[Page 71457]]

pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'').\1\ Notice of the proposed rule change was published in the 
Federal Register on November 1, 2004.\2\ No comment letters were 
received. For the reasons discussed below, the Commission is now 
granting approval of the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Securities Exchange Act Release No. 50594 (October 26, 
2004), 69 FR 63421.
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II. Description

    The proposed rule change establishes a cross-margining arrangement 
between FICC's Government Securities Division (``GSD'') and The 
Clearing Corporation (``TCC'').

(1) Background

    The Government Securities Division of FICC is entering into a new 
cross-margining agreement with TCC. FICC had a cross-margining 
arrangement in place with the Board of Trade Clearing Corporation 
(``BOTCC''), TCC's predecessor, through which certain Chicago Board of 
Trade (``CBOT'') products were cross-margined with certain FICC 
products.\3\ The BOTCC arrangement was terminated on January 2, 2004, 
the date on which BOTCC ceased being the clearing organization for the 
CBOT products that were the subject of the arrangement.\4\ On January 
2, 2004, the Chicago Mercantile Exchange (``CME'') became the clearing 
organization for the CBOT products that are now included in the cross-
margining arrangement that FICC has with the CME.\5\
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    \3\ Securities Exchange Act Release No. 45335 (January 25, 
2002), 67 FR 4768 [File No. SR-GSCC-2001-03].
    \4\ Securities Exchange Act Release No. 49142 (January 28, 
2004), 69 FR 5623 [File No. SR-FICC-2004-02].
    \5\ Securities Exchange Act Release No. 49003 (December 29, 
2003), 69 FR 712 [File No. SR-FICC-2003-10].
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    TCC recently became the clearing organization for EurexUS and has 
approached FICC regarding cross-margining certain U.S. Treasury and 
Agency futures and options on futures products traded on the EurexUS 
futures exchange and cleared by TCC with certain FICC products.\6\
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    \6\ The products traded on the EurexUS futures exchange and 
cleared by TCC are substantially similar to the CBOT products 
originally cleared by BOTCC.
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    FICC is entering into a new cross-margining agreement with TCC 
(``FICC-TCC Agreement'') to cover the EurexUS traded products cleared 
by TCC. Under the FICC-TCC Agreement, the FICC products that will be 
eligible for cross-margining will be Treasury securities that fall into 
the GSD's offset classes A through G, and GCF Repo Treasury securities 
with equivalent remaining maturities, non-mortgage-backed Agency 
securities that fall into the GSD's offset classes e and f, and GCF 
Repo non-mortgage-backed Agency securities with equivalent remaining 
maturities. The TCC products that will be eligible for cross-margining 
will be the EurexUS products, which are Two-Year Treasury Note Futures 
contracts and options thereon, Five-Year Treasury Note Futures 
contracts and options thereon, Ten-Year Treasury Note Futures contracts 
and options thereon, Thirty-Year Treasury Bond Futures contracts and 
options thereon, Five-Year Agency Note Futures contracts and options 
thereon, and Ten-Year Agency Note Futures contracts and options 
thereon, cleared or to be cleared by TCC.\7\
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    \7\ TCC is not currently clearing the Agency futures products. 
However, because it expects to clear Agency futures products in the 
future, FICC has included these products in the proposed rule change 
and the draft agreement. These Agency products are also covered by 
the current cross-margining agreement between FICC and the CME.
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(2) FICC's Cross-Margining Program in General

    In general, cross-margining allows members to optimize their 
capital usage by permitting their clearing organizations to view their 
positions across clearing organizations as a combined portfolio and to 
reduce margin requirements accordingly.\8\ Margin based on the net 
combined risk of correlated positions is based on the cross margining 
arrangement under which FICC and each Participating CO agree to accept 
the correlated positions in lieu of supporting collateral.\9\ All 
eligible positions maintained by a cross-margining participant in its 
account at FICC and in its (or its affiliate's) proprietary account at 
a Participating CO are eligible for cross-margining.\10\
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    \8\ Cross-margining is available to any FICC GSD netting member 
(with the exception of inter-dealer broker netting members) that is 
or that has an affiliate that is a member of a participating 
clearing organization (``Participating CO''). The FICC member (and 
its affiliate, if applicable) sign an agreement under which it (or 
they) agree to be bound by the cross-margining agreement between 
FICC and the Participating CO and which allows FICC or the 
Participating CO to apply the member's (or its affiliate's) margin 
collateral to satisfy any obligation of FICC to the Participating CO 
(or vice versa) that results from a default of the member (or its 
affiliate). Ownership of 50 percent or more of the common stock of 
an entity indicates control of the entity for purposes of the 
definition of ``affiliate.''
    \9\ FICC employs the ``hub-and-spoke'' method of cross-margining 
whereby FICC cross-margins on a multilateral basis (i.e., with more 
than one Participating CO) with FICC as the ``hub.'' Each 
Participating CO enters into a separate cross-margining agreement 
between itself and FICC. No preference is given by FICC to any one 
Participating CO over another.
    \10\ Upon implementation of the new arrangement between FICC and 
TCC, the arrangement will not apply to positions in a customer 
account at TCC that would be subject to the segregation requirements 
of the Commodity Exchange Act. This is also the case under the 
cross-margining arrangement that FICC has in place with the CME.
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    Under the arrangement, FICC and each Participating CO holds and 
manages its own positions and collateral and independently determines 
the amount of margin that it will make available for cross-margining, 
which is referred to as the ``residual margin amount.'' FICC computes 
the amount by which the cross-margining participant's margin 
requirement can be reduced at each clearing organization (i.e., the 
``cross-margining reduction'') by comparing the participant's positions 
and the related margin requirements at FICC against those at each 
Participating CO.\11\ FICC offsets each cross-margining participant's 
residual margin amount at FICC against the offsetting residual margin 
amounts of the participant (or its affiliate) at each Participating CO.
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    \11\ FICC and the Participating COs currently use different 
margin rates to establish margin requirements for their respective 
products. Margin reductions in the cross-margining arrangement are 
always computed based on the lower of the applicable margin rates. 
This methodology results in a potentially lesser benefit to the 
participant but ensures a more conservative result (i.e., more 
collateral held at the clearing organization) for the Participating 
CO and FICC.
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    If the margin that FICC has available for a participant is greater 
than the combined margin submitted by the Participating COs, FICC will 
allocate a portion of its margin equal to the combined margin at the 
Participating COs. If the combined margin submitted by the 
Participating COs is greater than the margin that FICC has available 
for that participant, FICC will first allocate its margin to the 
Participating CO with the most highly correlated positions. If the 
positions are equally correlated, FICC will allocate on a pro rata 
basis based upon the residual margin amount available at each 
Participating CO. FICC and each Participating CO may then reduce the 
amount of collateral that they collect to reflect the offsets between 
the cross-margining participant's positions at FICC and its (or its 
affiliate's) positions at the Participating CO.\12\
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    \12\ FICC and each Participating CO unilaterally have the right 
not to reduce a participant's margin requirement by the cross-
margining reduction or to reduce it by less than the cross-margining 
reduction. However, the clearing organizations may not reduce a 
participant's margin requirement by more than the cross-margining 
reduction.
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    FICC and each Participating CO will guarantee the cross-margining 
participant's (or its affiliate's) performance to each other up to a

[[Page 71458]]

specified maximum amount that relates back to the cross-margining 
reduction and the results of liquidating the member's positions and 
ultimately its collateral. The guaranty represents a contractual 
commitment that each clearing organization has to the other.
    A default by a cross-margining participant will trigger the loss 
sharing provisions of the cross-margining agreement. The loss-sharing 
provisions determine the guaranty payments, if any, that will flow 
between the clearing organizations if the default of the participant 
results in a loss. It should be noted that a declaration of default of 
a cross-margining participant by one of the clearing organizations in 
and of itself will provide grounds for the other clearing organization 
to declare the participant (or its affiliate) in default as well. If 
the guaranty is triggered, the cross-margining participant becomes 
obligated to reimburse the guarantor clearing organization for the 
amount of the guaranty payment, which is called the ``Reimbursement 
Obligation.''
    The cross-margining agreement also provides for the sharing of 
remaining resources beyond the cross-margining arrangement through a 
``cross-guaranty'' provision. This provision reflects the view that 
excess collateral of a defaulting member should remain with the 
clearing organizations, if needed, to cover their losses. Specifically, 
if after guaranty payments, if any, one of the clearing organizations 
has a remaining surplus, and the other has a remaining loss, the 
agreement provides a mechanism for the distribution of that surplus to 
the clearing organization that still has a remaining loss.

(3) Key Changes to the Former Agreement Between FICC and TCC

    (a) The minimum margin factor under the former FICC-BOTCC cross-
margining agreement was 50 percent. FICC and TCC have agreed to a 
minimum margin factor of 25 percent. This is the same minimum margin 
factor used in the current cross-margining arrangement with the 
CME.\13\
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    \13\ The minimum margin factor is the contractually agreed upon 
cap on the amount of the margin reduction that the clearing 
organizations will allow. Should FICC decide to change the minimum 
margin factor, it will submit a proposed rule filing under Section 
19(b) of the Act.
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    (b) The FICC-TCC Agreement provides for inter-offset class cross-
margining whereas the former BOTCC arrangement was limited to intra-
offset class cross-margining. The new agreement is consistent with the 
approach in the existing arrangement between FICC and the CME.
    (c) Appendix B of the FICC-TCC Agreement will include more FICC 
products than did the former BOTCC arrangement. The former BOTCC 
agreement covered FICC offset classes C, E, F, G and f, and offset 
classes E, F, and f were defined more narrowly for purposes of the 
arrangement than they were defined in the GSD's rules. The FICC-TCC 
Agreement includes the GSD's offset classes A through G, GCF Repo 
Treasury securities with equivalent remaining maturities, non-mortgage-
backed Agency securities that fall into the GSD's offset classes e and 
f, and GCF Repo non-mortgage-backed Agency securities with equivalent 
remaining maturities. These offset classes are as broad as they are 
defined in the GSD's rules.
    (d) Appendix B of the FICC-TCC Agreement will also include FICC's 
GCF Repo Treasury and non-mortgage-backed Agency products. FICC is now 
able to margin its GCF Repo Treasury and non-mortgage-backed Agency 
products based upon the specific underlying collateral as opposed to 
the former system of margining these products based upon the longest 
maturity of eligible underlying collateral.\14\ Therefore, these GCF 
Repo products can now be included in the cross-margining arrangement 
because they are being margined at a specific rate based on the actual 
underlying Treasury and Agency collateral. These products are also 
included in the current cross-margining agreement between FICC and the 
CME.
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    \14\ Because of a previous inability to obtain timely data on 
the actual instruments posted in support of GCF Repo positions, up 
until recently the GSD calculated affected members' clearing fund 
requirements based upon the assumption that collateral providers 
have assigned to each generic CUSIP the most volatile (i.e., the 
longest maturity) collateral eligible. The GSD recently developed 
improvements to its margining methodology and is now able to 
identify the specific CUSIP posted.
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    (e) The FICC-TCC Agreement provides that the parties will agree 
from time to time in a separate writing on the disallowance factors 
that will be used in the program. Prior to the implementation date of 
the FICC-TCC cross-margining program, the disallowance factors will be 
tested and agreed to by FICC and TCC in writing.
    (f) The current agreement between FICC and CME provides that in 
order to determine the gain or loss from the liquidation (resulting 
from a default) of the positions that were cross-margined, only the 
proceeds from the side of the market that was offset pursuant to the 
agreement at the last margin cycle will be considered. This approach 
will also be used in the FICC-TCC program to provide consistency in the 
liquidation methods.
    (g) The former FICC-BOTCC agreement provided for a ``Maximization 
Payment'' whereby a clearing organization with a remaining surplus 
after all guaranty payments in relation to cross-margining were made 
(``Aggregate Net Surplus'') to distribute funds to one or more cross-
margining partners with remaining losses. The FICC-TCC Agreement makes 
clear that: (i) the Maximization Payment is also a guaranty payment 
(albeit outside of cross-margining) and (ii) the defaulting member 
would have a reimbursement obligation with respect to such payment 
(``Maximization Reimbursement Obligation''). Should a clearing 
organization become obligated to pay the Maximization Payment, it may 
rely on the defaulting member's collateral to do so.\15\
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    \15\ The guaranty provisions with respect to the Maximization 
Payment Guaranty are identical to the ones in the current cross-
margining agreement between FICC and CME. In order to protect the 
clearing organizations in the event that a court determines that any 
amount of a Maximization Reimbursement Obligation may not be 
recovered by the clearing organization that made a Maximization 
Payment pursuant to a Maximization Payment Guaranty, a provision has 
been added to the FICC-TCC Agreement that provides that the payee 
clearing organization will be expected to return that amount. This 
protective provision is also in the FICC-CME cross-margining 
agreement.
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    (h) A provision has been added to take into account that a 
regulator or other entity having supervisory authority over FICC or TCC 
may direct the clearing organization not to liquidate a defaulting 
member or to partially liquidate such member. In order to prevent the 
affected clearing organization from being penalized under the agreement 
for failing to liquidate or partially liquidating the member in this 
type of situation, the FICC-TCC Agreement provides that the affected 
clearing organization would be deemed to have a cross-margin gain equal 
to the base amount of the guaranty (i.e., cross-margining reduction) or 
a pro rated amount of the base amount of the guaranty in a partial 
liquidation scenario.
    (i) The FICC-TCC Agreement makes clear that the clearing 
organizations have security interests in the ``Aggregate Net Surplus,'' 
a large component of which would be the collateral and proceeds of 
positions of a defaulting member, as security for any reimbursement 
obligation, including any maximization reimbursement obligation, that 
arises on the part of a defaulting member.
    (j) The FICC-TCC Cross Margining Participant Agreement contains

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language to further protect the clearing organizations by making clear 
that the clearing organizations have a security interest in the 
Aggregate Net Surplus and that a participant will have a reimbursement 
obligation in the event that a clearing organization becomes obligated 
to make a maximization payment. Members that wish to participate in the 
FICC-TCC cross-margining program will be required to execute the 
participant agreement to make them subject to the provisions of the 
FICC-TCC Agreement.

(4) Amendment 1 to the FICC-CME Cross-Margining Agreement

    FICC is proposing to amend Appendix A of the cross-margining 
agreement with the CME to add a reference to the FICC-TCC Agreement. In 
Appendix A, the parties set forth the other cross-margining or similar 
arrangements that they have in place and indicate whether such other 
agreements take priority over the FICC-CME Cross-Margining Agreement. 
As stated above, no preference is given by FICC to one Participating CO 
over another.

III. Discussion

    Section 17A(b)(3)(F) of the Act requires among other things that 
the rules of a clearing agency be designed to assure the safeguarding 
of securities and funds in its custody or control or for which it is 
responsible.\16\ The Commission finds that FICC's proposed rule change 
is consistent with this requirement because by continuing its cross-
margin program to include products cleared by TCC, FICC will provide 
its members with the benefits of cross-margining, including greater 
liquidity and more efficient use of collateral, in a manner that is 
consistent with FICC's overall risk management process.
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    \16\ 15 U.S.C. 78q-1(b)(3)(F).
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IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
in particular Section 17A of the Act and the rules and regulations 
thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\17\ that the proposed rule change (File No. SR-FICC-2004-16) be 
and hereby is approved.
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    \17\ 15 U.S.C. 78s(b)(2).

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\18\
Margaret H. McFarland,
Deputy Secretary.
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    \18\ 17 CFR 200.30-3(a)(12).
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 [FR Doc. E4-3567 Filed 12-8-04; 8:45 am]
BILLING CODE 8010-01-P