[Federal Register Volume 70, Number 124 (Wednesday, June 29, 2005)]
[Notices]
[Pages 37450-37455]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-3381]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-51908; File No. SR-FICC-2004-15]


Self-Regulatory Organizations; Fixed Income Clearing Corporation; 
Order Granting Approval of a Proposed Rule Change Relating to Trade 
Submission Requirements and Pre-Netting

 June 22, 2005.

I. Introduction

    On July 30, 2004, the Fixed Income Clearing Corporation (``FICC'') 
filed with the Securities and Exchange Commission (``Commission'') 
proposed rule change SR-FICC-2004-15 pursuant to section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'').\1\ Notice of the 
proposal was published in the Federal Register on November 4, 2004.\2\ 
Eleven comment letters were received.\3\ FICC amended the proposed rule 
change on March 4, 2005. Notice of the amended proposed rule change was 
published in the Federal Register on March 18, 2005.\4\ No comments 
were received on the amendment. On June 22, 2005, FICC further amended 
the proposed rule change to clarify the rule language regarding de 
minimus trades. Republication of the notice was not necessary because 
the June 22 amendment made only a technical change to the proposed rule 
change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Securities Exchange Act Release No. 50607 (October 29, 
2004), 69 FR 64343.
    \3\ Scott Gordon, Chief Executive Officer, Rosenthal Collins 
Group, LLC (November 26, 2004); Stephen Merkel, Executive Managing 
Director and General Counsel, Cantor Fitzgerald Securities (November 
26, 2004); Scott Gordon, Chief Executive Officer, Rosenthal Collins 
Group, LLC (November 29, 2004); John P. Murphy, Managing Director of 
Operations, Hilliard Farber & Co., Inc. (December 15, 2004); Ronald 
A. Purpora, Chief Executive Officer, ICAP North American Securities, 
Garban LLC (December 17, 2004); Robert F. Gartland, Managing 
Director, Morgan Stanley & Co. Incorporated (December 23, 2004); 
Frank Tripodi, Managing Director & CFO, TD Securities (USA) LLC 
(December 17, 2004); David Cassan, Countrywide Securities Corp. 
(January 4, 2004); Jeffrey F. Ingber, General Manager, Fixed Income 
Clearing Corporation (January 14, 2005); Emil Assentato, President, 
Tradition Asiel Securities, Inc. (February 17, 2005); Eric L. 
Foster, Vice President and Associate General Counsel, The Bond 
Market Association (February 28, 2005).
    \4\ Securities Exchange Act Release No. 51365 (March 14, 2005), 
70 FR 13222.
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    For the reasons discussed below, the Commission is granting 
approval of the proposed rule change.

II. Description

    Through a recent survey of FICC's Government Securities Division 
(``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 trading activity of members' affiliates.
    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 FICC of transactions on a trade-by-trade 
basis.\5\ The GSD's rules currently prohibit certain pre-netting 
practices by requiring that all eligible trades executed by its netting 
members be submitted on a trade-by-trade basis. The proposed rule 
change expands this requirement to extend it to affiliate trades.
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    \5\ 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.'' 
(http://www.dtcc.com/ThoughtLeadership/whitepapers/managingrisk.pdf). In the paper, which defined recent trade 
submission practices that are creating risks in the equities market, 
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 Government Securities clearance and 
settlement process. The consequence of a gap in FICC's trade submission 
requirements raises 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 netting members' need to settle the large majority of 
receive and deliver obligations created by in trading activities. (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

[[Page 37451]]

process depends upon the submission to the GSD of all eligible activity 
on a trade-by-trade basis.
    For this reason, FICC, seeks to prohibit pre-netting activity on 
the part of members. Indeed, it is the avoidance of ``broker pre-
netting'' that was a fundamental reason for the formation in the 1980s 
of the Government Securities Clearing Corporation, the predecessor of 
the GSD. 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:

1. Counterparty Credit Risk

    Management of the risk of trades that are not submitted to FICC 
becomes the responsibility of each direct counterparty, including ones 
that may have insufficient capital or financial strength and/or 
inadequate internal processes to mitigate such risk. Counterparty 
credit risk is therefore 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 employed.

2. Operational Risk

    Eligible trades that are not submitted to FICC introduce 
operational risk, including ``9-11'' type risk, because such trades are 
not submitted to FICC for comparison and guaranteed settlement within 
minutes of execution through FICC's Real-Time Trade Matching (``RTTM'') 
System. Should a catastrophic event occur after trade execution, 
submission of netted trade data could be significantly delayed or even 
lost. Trade guaranty would also not be obtained.
    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.

3. Legal Risk

    Members' failure to submit eligible activity to FICC increases 
systemic risk to the clearance and settlement system for Government 
securities by reducing the number of trades without providing 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 (``Bankruptcy 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 Bankruptcy 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 the bilateral documentation. Thus, pre-
netting activity has the potential to increase risk absent each trading 
entity's capacity for comprehensive monitoring to ensure that the 
proper documentation is 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 clearing agency such as FICC than it would be to close-
out and netting by nother market participants.

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 with 
regard to the May 2013 10-Year Note likely could have been mitigated by 
submission of eligible data on behalf of non-member affiliates of GSD 
members. With submission, FICC could have identified and resolved fail 
situations 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 causes FICC to not be in as good a position to prevent 
future market crises. Given the enormous and growing amount of activity 
in the government securities marketplace and the 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 for ensuring that FICC can 
continue to perform its vital risk management role for the Government 
securities marketplace.
    As a result, FICC is broadening 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.\6\ 
The proposed rule change also makes explicit that these affiliate 
trades must be submitted on a trade-by-trade basis as executed. This 
should advance the goal of having every active Government securities 
market participant which is a GSD netting member or is 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 regulatory confirmation or price 
transparency requirements effectively mandates that all eligible trades 
be submitted to the clearing corporation.
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    \6\ 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 applies 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 requires 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 with 
other netting members' covered affiliates. The proposed rule change 
also requires 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 because 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 with another 
entity. In addition, the proposed rule filing exempts the following 
trades from its

[[Page 37452]]

coverage: (1) An affiliate that engages in de minimis eligible 
activity, which is defined as less than an average of 30 trades per 
business day per month within the prior twelve-month period; (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.\7\
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    \7\ FICC believes that exclusion of these trades from the 
submission requirement's coverage does not raise the systemic risk 
concerns described above.
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    The proposed rule filing provides that failure to abide by the new 
trade submission requirements will trigger the disciplinary 
consequences currently in the GSD rules, which can ultimately result in 
termination of membership.\8\
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    \8\ The disciplinary consequences of GSD Rule 48 are being 
referred to explicitly to emphasize to members the importance of 
this rule and to remind members that violations of the GSD's rules 
may lead to serious disciplinary consequences, including termination 
of membership.
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III. Amendment

    As originally filed the proposed rule change would have required 
GSD members of FICC to submit trades that were executed or whose 
settlement was cleared and guaranteed by affiliates of GSD members 
registered as U.S. broker-dealers, banks, or futures commission 
merchants. Because the proposed rule defined a covered affiliate as an 
entity organized in the U.S., it would not have applied to trades 
executed by non-U.S. affiliates of GSD members. FICC has stated to the 
Commission its belief that most of the pre-netting activity is 
occurring with domestic affiliates and therefore there is no reason to 
apply the rule to foreign affiliates. Furthermore, FICC did not want to 
adopt a rule where compliance or enforcement would be difficult.
    After discussion with the staffs of the Commission and other 
regulatory entities, FICC amended the proposed rule change to require 
netting members to report to FICC trades of their non-U.S. affiliates. 
The trades will be reported to FICC on an annual basis in the format 
and within the timeframe specified by guidelines to be issued by FICC. 
The reporting requirement will not apply to ``foreign affiliate 
trades'' of a foreign affiliate where the foreign affiliate has 
executed less than an average of 30 ``foreign affiliate trades'' per 
business day per month within the prior twelve-month period.
    The amendment adds definitions of ``foreign affiliate'' and 
``foreign affiliate trade'' to GSD's rules. A ``foreign affiliate'' is 
defined as an affiliate of a netting member that is not itself a 
netting member and is a foreign person. A ``foreign affiliate trade'' 
is defined as a trade executed by a ``foreign affiliate'' of a netting 
member that satisfies the following criteria: (i) the trade is eligible 
for netting pursuant to GSD's rules and (ii) the trade is executed with 
another netting member, with a covered affiliate, or with a ``foreign 
affiliate'' of another netting member. ``Foreign affiliate trade'' does 
not include a trade that is executed between a member and its affiliate 
or between affiliates of the same member. For purposes of this 
definition, the term ``executed'' includes trades that are cleared and 
guaranteed as to their settlement by the foreign affiliate.

IV. Comments

    The Commission received eleven comment letters to the proposed rule 
change. Cantor Fitzgerald Securities (``Cantor'') and Rosenthal Collins 
Group, LLC (``RCG'') wrote letters opposing the proposed rule 
change.\9\ FICC submitted a letter responding to those letters.\10\ 
Additionally, the Bond Market Association submitted a comment letter 
supporting the proposed rule change but making two recommendations 
regarding the compliance costs of the proposed rule change and 
regarding foreign affiliates.\11\ The remaining comment letters were 
submitted by FICC netting members that are in favor of the proposed 
rule change.\12\
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    \9\ Scott Gordon, Chief Executive Officer, Rosenthal Collins 
Group, LLC (November 26, 2004); Stephen Merkel, Executive Managing 
Director and General Counsel, Cantor Fitzgerald Securities (November 
26, 2004); Scott Gordon, Chief Executive Officer, Rosenthal Collins 
Group, LLC (November 29, 2004).
    \10\ Jeffrey F. Ingber, General Manager, Fixed Income Clearing 
Corporation (January 14, 2005).
    \11\ Eric L. Foster, Vice President and Associate General 
Counsel, The Bond Market Association (February 28, 2005).
    \12\ John P. Murphy, Managing Director of Operations, Hilliard 
Farber & Co., Inc. (December 8, 2004); Ronald A. Purpora, Chief 
Executive Officer, ICAP North American Securities, Garban LLC 
(December 17, 2004); Robert F. Gartland, Managing Director, Morgan 
Stanley & Co. Incorporated (December 23, 2004); Frank Tripodi, 
Managing Director & CFO, TD Securities (USA) LLC (December 17, 
2004); David Cassan, Countrywide Securities Corp. (January 4, 2004); 
and Emil Assentato, President, Tradition Asiel Securities, Inc. 
(February 17, 2005).
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    Cantor and RCG are each netting members of FICC. RCG has a wholly-
owned subsidiary, Rosenthal Global Securities, LLC (``RGS''), which is 
not a member of FICC. RGS is a registered broker-dealer that engages in 
proprietary trading of fixed income securities with various 
institutional counterparties, including Cantor. RCG had been submitting 
RGS's trades to FICC on a trade-by-trade basis, but in October 2003 RCG 
began submitting only a net settlement balance to FICC. It was this 
activity that first brought the affiliate pre-netting issue to FICC's 
attention. However, Cantor and RCG each claim that many of FICC's 
members engage in affiliate pre-netting. Cantor's comment letter 
contained most of the substantive arguments opposing the proposed rule 
change. RCG submitted two comment letters to the Commission stating 
that it substantially agrees with the analysis and positions set forth 
in Cantor's comment letter.
    Cantor and RCG argue that FICC's proposal is anticompetitive and 
that the proposal is not balanced by any benefit such as FICC's claim 
that the proposed rule change will reduce systemic risk in the 
Government securities marketplace. They argue that FICC, as the only 
registered clearing agency that provides clearance and settlement 
services for Government securities, has an economic monopoly and that 
it is using this monopoly to require additional trade submissions in 
order to raise its revenue from trade submission fees.
    Cantor also addresses each of the specific risks FICC listed in its 
rule filing (i.e., counterparty credit risk, operational risk, legal 
risk, and resolutions of fails risk) and disagrees with FICC's 
assertion that the proposed rule change would reduce any of these 
risks.

1. Counterparty Credit Risk

    Cantor and RCG disagree with FICC's claim that the proposal will 
reduce counterparty credit risk. They argue that pre-netting is not per 
se a risky activity. They claim that netting is a risk reducing 
measure, whether done or not done by a clearing agency, and that in 
this circumstance the parties doing the netting are highly regulated 
entities (i.e., banks, futures commission merchants, and broker-
dealers) that are required to conform to certain capital and risk 
management standards and that have developed sophisticated risk 
management techniques. Accordingly, Cantor and RCG argue that these 
entities can net their trades prior to submission to a clearing agency 
without adding risk to the marketplace.
    Cantor and RCG further argue that if the purpose of the proposed 
rule change is to reduce risk, FICC would not have excluded non-U.S. 
affiliates from the proposed rule. They claim that compared to U.S. 
affiliates non-U.S. affiliates present the same or greater level risk 
to the marketplace. Cantor claims that a significant portion of 
government securities are held by foreign entities (43.7% of U.S. 
government securities other than savings bonds) and that cross-border

[[Page 37453]]

transactions raise a number of complex issues.

2. Operational Risk

    Cantor does not agree with FICC's assertion that the submission of 
affiliate trades to FICC on a trade-by-trade basis will reduce 
operational risk. In the event of operational difficulties in the 
government securities clearance and settlement system, participants in 
the government securities markets in all likelihood would be adversely 
impacted whether or not a transaction was submitted to FICC. Although 
submitting trades in real-time to FICC's RTTM System reduces the risk 
of trade data being lost, it does not follow that transactions 
submitted to FICC somehow reduce operational risk.

3. Legal Risk

    Cantor disagrees with FICC's assertion that market participants 
will have more legal protections in an insolvency proceeding if the 
trade is submitted to a registered clearing agency. Cantor argues that 
there are sufficient legal protections in place to protect market 
participants in the event of an insolvency, with special treatment 
under several applicable laws for protecting non-defaulting financial 
institutions upon their repo counterparty's insolvency.

4. Resolution of Fails Problem

    Cantor argues that submission of affiliate trades will not make it 
more likely for FICC to identify round-robin chains as FICC claims. 
Many market participants are still excluded from FICC's system, 
including institutional investors which represent most of the buy-side 
of the government securities market.
    Finally, Cantor and RCG claim that the proposed rule change may 
actually increase systemic risk because it will result in higher fees 
that will prevent small firms from joining or maintaining membership in 
FICC. As a result, more transactions will be settled outside of FICC. 
Cantor also claims that the proposed rule change will affect FICC 
members disparately because some of FICC's members trade often with 
affiliates, some not at all, and others trade with foreign affiliates, 
which are exempt from the proposed rule.
    In response to the comment letters from Cantor and RCG, FICC in its 
comment letter reiterates the reasoning that it laid out in its filing 
that the proposed rule change would significantly reduce the systemic 
risk in the government securities clearance and settlement process. 
FICC disputes Cantor's and RCG's claim that FICC is proposing the rule 
as a way to collect additional fees by noting that it is owned and 
governed by its members and pays substantial rebates to its members. 
Additionally, FICC states that it recently amended its netting fees in 
recognition of the proliferation of large volume/small dollar trading 
and to provide cost savings to those firms that engage in this type of 
trading.\13\
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    \13\ Securities Exchange Act Release No. 50806 (December 7, 
2004), 69 FR 72237 (December 13, 2004) [File No. SR-FICC-2004-21].
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    FICC responds to Cantor's comments regarding foreign affiliates by 
stating that the rule filing was designed to encompass those entities 
(i.e., banks, futures commission merchants, and broker-dealers) that 
make up the large majority of its membership. It excluded non-U.S. 
affiliates from the proposed rule because of the limited ability of 
domestic FICC members to submit the activity of their non-U.S. 
affiliates. FICC also states that there are potential regulatory and 
other legal barriers under foreign law to the application of FICC's 
rules to non-U.S. affiliates. However, as discussed previously, FICC 
has amended the proposed rule change to require disclosure from its 
members regarding foreign affiliate pre-netting following discussion 
with the Commission.
    Finally, FICC addresses the claim that the proposed rule change 
would create an unfair burden on competition by stating that any burden 
on competition that the proposal could be regarded as imposing is not 
unreasonable or inappropriate in light of the substantial benefits that 
submission of affiliate trades will yield.
    The Bond Market Association (``BMA''), an industry group that 
represents securities firms and banks that underwrite, distribute, and 
trade in fixed income securities, submitted a comment letter in support 
of the proposed rule change but made two comments regarding the cost of 
compliance for FICC's members and the exclusion of foreign affiliates 
from the scope of the proposed rule. In its comment letter, the BMA 
notes the value of FICC as a centralized and automated system for 
clearing and settling trades, comparison and netting services for its 
members, and a credit risk reduction and containment system for its 
members. It states that FICC plays an important role in increasing 
efficiency and reducing risk in the Government securities markets and 
that practices designed to deliberately delay and reduce submission of 
trades to FICC should be discouraged. Accordingly, because the proposed 
rule change should increase the number of transactions that are 
compared, novated, and settled by FICC everyday, the BMA recommends 
that the Commission approve the proposed rule change.
    However, the BMA has two concerns regarding the proposed rule 
change. First, the BMA is concerned of the costs to FICC's members of 
the implementation of the proposed rule change. The BMA believes that a 
new trade submission requirement for covered affiliates will require 
its members to develop, test, and implement new systems for submitting 
transactions by covered affiliates. The BMA requested that FICC 
evaluate the costs and benefits of the proposed rule change and assist 
its members in the implementation of compliance with the new rule.
    Second, the BMA noted that the proposed rule change would have a 
disparate impact on FICC's members because it will not apply to foreign 
affiliates of FICC members. The BMA notes that as drafted the rule 
proposal will apply to the U.S. branch of a foreign bank but not to the 
foreign branch of a U.S. bank. The BMA recommends that FICC consider 
excluding any entity, including U.S. banks' foreign branches, that is 
domiciled (instead of ``organized'') outside of the U.S. The BMA also 
recommends that FICC review the de minimus transaction exclusion to 
ensure that the proposed level is appropriate.
    The Commission received seven comment letters from FICC netting 
members in favor of the proposed rule change. These commenters 
highlight the importance of FICC's netting and risk management 
processes and state that the proposed rule change should help to 
preserve the integrity of these processes by reducing systemic risk. 
Several commenters note that pre-netting gives FICC members the 
opportunity to ``cherry-pick'' among their covered affiliate trades and 
to submit only the riskiest of those trades to FICC for clearance and 
settlement. One commenter states that if the proposed rule change is 
not approved other FICC netting members will be driven by competitive 
forces to lower costs to their customers by also engaging in pre-
netting with non-member affiliates. This would further harm FICC's 
netting and risk management processes and also the Government 
securities marketplace.

V. Discussion

    After carefully considering the proposed rule change as amended and 
all of the written comments received, the Commission has determined 
that the

[[Page 37454]]

proposed rule change meets the requirements of Section 17A(b)(3)(F) of 
the Act. That section provides that the rules of a clearing agency be 
designed to promote the prompt and accurate clearance and settlement of 
securities transactions and to assure the safeguarding of securities 
and funds which are in the clearing agency's control or for which it is 
responsible. FICC has long recognized that pre-netting of trades by its 
members affects the operation of its netting system and, accordingly, 
FICC's Rules expressly require netting members to submit all eligible 
trades with another FICC netting member to FICC. The proposed rule 
change extends this requirement to netting between FICC members and 
their covered affiliates. For the following reasons, the Commission 
finds that the proposed rule change prohibiting pre-netting between 
FICC members and covered affiliates meets the requirements of Section 
17A. Additionally, in consideration of the comments from Cantor and RCG 
regarding competition, the Commission finds that the proposed rule 
change will not impose any burden on competition that is not necessary 
or appropriate in furtherance of the purposes of the Act in accordance 
with section 17A(b)(3)(I).
    Section 3(a)(23)(A) of the Act defines a clearing agency as any 
person who, among other things, acts as an intermediary to reduce the 
number of settlements of securities transactions.\14\ section 17A(b)(1) 
of the Act requires that an entity performing the functions of a 
clearing agency must register as a clearing agency with the 
Commission.\15\ Although netting of affiliates trades alone may not 
require an entity to register as a clearing agency with the Commission, 
netting is clearly contemplated by the Act as an operation central to 
clearing. In general, the Commission feels that a proposed rule change 
that is designed to require netting to be provided by a registered 
clearing agency is designed to further the purposes of section 17A of 
the Act. In this case in particular, FICC's ability to perform the 
netting function for Government securities is well-established. A rule 
that is designed to bring additional securities transactions into its 
netting system is clearly designed to promote the prompt and accurate 
clearance and settlement of those transactions and to preserve the 
safety and soundness of the national clearance and settlement system.
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    \14\ 15 U.S.C. 78c(a)(23)(A).
    \15\ 15 U.S.C. 78q-1(b)(1).
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    Cantor and RCG have argued that netting may occur outside of a 
clearing agency without presenting any additional risks to the clearing 
agency or to its members and that while FICC as a registered clearing 
agency is the appropriate party to provide a multilateral netting 
service it should not be able to prohibit its members from netting 
trades on a bilateral basis with their non-member affiliates. Netting 
may be a risk-reducing measure outside of a clearing agency, but here 
FICC has shown that it is important for it to prohibit its members from 
pre-netting in order for FICC to maintain the effective operation of 
its netting service.
    FICC has represented to the Commission that its netting system may 
fail to operate effectively if its members may delay trade submission 
or cherry-pick among their trades by pre-netting some trades prior to 
submission to FICC. The Commission finds persuasive FICC's argument 
that FICC's netting and risk management services are compromised if it 
receives some but not all of the trade data it needs to effectively 
perform its netting function. Accordingly, the Commission finds that it 
is appropriate for FICC to prohibit its members from engaging in pre-
netting with covered affiliates before submitting their trades to FICC.
    The proposed rule change is also designed to alleviate the risks 
pre-netting presents to the marketplace which FICC describes in its 
filing as counterparty credit risk, operational risk, legal risk, and 
fails risk. The Commission is particularly concerned about the risks 
that counterparties will be unable to settle their obligations or that 
trade data will be lost in the event of a market crisis. The proposed 
rule change, by requiring trade information to be submitted to FICC on 
a trade-by-trade basis and, in particular, through FICC's RTTM system, 
will substantially reduce the risk that trades between FICC's members 
will not settle. Cantor and RCG have argued that requiring trades 
between members and covered affiliates to be netted within FICC's 
netting system will not reduce counterparty credit risk or operational 
risk and that FICC's members are regulated entities that can 
appropriately manage these risks. Despite these arguments, FICC's 
netting process and risk management processes are highly sophisticated 
and specialized services that are subject to Commission oversight. 
Accordingly, because the proposed rule change should bring more member 
trades into FICC's netting system, the Commission finds that it is 
designed to promote prompt and accurate clearance and settlement of 
securities transactions and to assure the safeguarding of securities 
and funds which are in FICC's control or for which it is responsible.
    Cantor and the BMA have commented that the proposed rule change 
will result in disparate treatment of FICC's members because it does 
not apply to trades with foreign affiliates of FICC's members. Section 
17(b)(3)(F) provides that the rules of a clearing agency shall not 
permit unfair discrimination among participants in the use of the 
clearing agency. Cantor has essentially argued that FICC is 
discriminating against its smaller, domestic members by proposing that 
the rule apply only to domestic affiliates. Cantor also argues that 
FICC is using the proposed rule change to generate additional fees from 
its smaller members while allowing its larger, more favored members, to 
continue to engage in the pre-netting of trades. FICC has denied this 
and states that it is not requiring the submission of trades by foreign 
affiliates because of potential regulatory barriers and because it does 
not believe that those entities are engaging in substantial amounts of 
pre-netting activities.
    As discussed in the previous section, FICC amended the proposed 
rule change to require disclosure by its members of their pre-netting 
with foreign affiliates. The Commission feels that the amendment 
requiring disclosure of trades with foreign affiliates is an 
appropriate measure at this time. If FICC learns through these 
disclosures that its members are engaging in substantial amounts of 
affiliate pre-netting with their foreign affiliates, the Commission 
expects FICC to take appropriate steps to similarly address such 
activities. Accordingly, because FICC has acted at this time 
appropriately to address the foreign affiliate pre-netting issue, the 
Commission finds that the proposed rule change would not permit unfair 
discrimination among FICC's participants as prohibited by section 
17A(b)(3)(F).
    Cantor and RCG have also argued that the Commission should not 
approve the proposed rule change because it imposes a burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Act. The Commission is not persuaded by Cantor's claim that the 
proposed rule change will result in an undue burden on competition. We 
find it unlikely that the proposed rule change will force some FICC 
members to discontinue their membership in FICC. First the Commission 
does not believe the increased fee implications of the proposed rule 
change are as significant as Cantor alleges. As noted by FICC in its 
filing and in its comment letter, it operates as a not-for-profit 
corporation

[[Page 37455]]

that matches fees to costs and pays rebates to its members. 
Furthermore, Cantor and RCG were the only parties to submit negative 
comments on the proposed rule change. The Commission did not receive 
comments from any FICC members or potential FICC members, other than 
from Cantor and RCG, stating that the proposed rule change would make 
it too expensive for them to remain or to become a member of FICC. 
Accordingly, for the reasons discussed above, the Commission finds that 
the proposed rule change is consistent with section 17A(b)(3)(I) of the 
Act in that it does not impose a burden on competition not necessary or 
appropriate in furtherance of the purposes of the Act.

VI. 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 with the requirements of Section 17A of the Act and the 
rules and regulations thereunder applicable.
    It is therefore ordered, pursuant to section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-FICC-2004-15) be and hereby 
is approved.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. E5-3381 Filed 6-28-05; 8:45 am]
BILLING CODE 8010-01-P