[Federal Register Volume 77, Number 226 (Friday, November 23, 2012)]
[Proposed Rules]
[Pages 70214-70354]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-26164]



[[Page 70213]]

Vol. 77

Friday,

No. 226

November 23, 2012

Part II





Securities and Exchange Commission





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17 CFR Part 240





Capital, Margin, and Segregation Requirements for Security-Based Swap 
Dealers and Major Security-Based Swap Participants and Capital 
Requirements for Broker-Dealers; Proposed Rule

  Federal Register / Vol. 77 , No. 226 / Friday, November 23, 2012 / 
Proposed Rules  

[[Page 70214]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-68071; File No. S7-08-12]
RIN 3235-AL12


Capital, Margin, and Segregation Requirements for Security-Based 
Swap Dealers and Major Security-Based Swap Participants and Capital 
Requirements for Broker-Dealers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: In accordance with the Dodd-Frank Wall Street Reform and 
Consumer Protection Act of 2010 (``Dodd-Frank Act''), the Securities 
and Exchange Commission (``Commission''), pursuant to the Securities 
Exchange Act of 1934 (``Exchange Act''), is proposing capital and 
margin requirements for security-based swap dealers (``SBSDs'') and 
major security-based swap participants (``MSBSPs''), segregation 
requirements for SBSDs, and notification requirements with respect to 
segregation for SBSDs and MSBSPs. The Commission also is proposing to 
increase the minimum net capital requirements for broker-dealers 
permitted to use the alternative internal model-based method for 
computing net capital (``ANC broker-dealers'').

DATES: Comments should be received on or before January 22, 2013.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an email to [email protected]. Please include 
File Number S7-08-12 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-08-12. This file number 
should be included on the subject line if email 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/proposed.shtml). Comments also are available for Web site viewing and 
printing in the Commission's Public Reference Room, 100 F Street, NE., 
Washington, DC 20549, on official business days between the hours of 10 
a.m. and 3 p.m. 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 
publicly available.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate 
Director, at (202) 551-5525; Thomas K. McGowan, Deputy Associate 
Director, at (202) 551-5521; Randall W. Roy, Assistant Director, at 
(202) 551-5522; Mark M. Attar, Branch Chief, at (202) 551-5889; Sheila 
Dombal Swartz, Special Counsel, at (202) 551-5545; Valentina M. Deng, 
Attorney, at (202) 551-5778; or Teen I. Sheng, Attorney, at 202-551-
5511, Division of Trading and Markets, Securities and Exchange 
Commission, 100 F Street, NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background
II. Proposed Rules and Rule Amendments
    A. Capital
    1. Introduction
    2. Proposed Capital Rules for Nonbank SBSDs
    a. Computing Required Minimum Net Capital
    i. Stand-alone SBSDs Not Using Internal Models
    ii. Broker-Dealer SBSDs Not Using Internal Models
    iii. Stand-alone SBSDs Using Internal Models
    iv. Broker-Dealer SBSDs Using Internal Models and ANC Broker-
Dealers
    b. Computing Net Capital
    i. The Net Liquid Assets Test
    ii. Standardized Haircuts for Security-Based Swaps
    iii. VaR Models
    iv. Credit Risk Charges
    v. Capital Charge In Lieu of Margin Collateral
    vi. Treatment of Swaps
    c. Risk Management
    d. Funding Liquidity Stress Test Requirement
    e. Other Rule 15c3-1 Provisions Incorporated into Rule 18a-1
    i. Debt-Equity Ratio Requirements
    ii. Capital Withdrawal Requirements
    iii. Appendix C
    iv. Appendix D
    3. Proposed Capital Rules for Nonbank MSBSPs
    B. Margin
    1. Introduction
    2. Proposed Margin Requirements for Nonbank SBSDs and Nonbank 
MSBSPs
    a. Scope of Rule 18a-3
    b. Daily Calculations
    i. Nonbank SBSDs
    ii. Nonbank MSBSPs
    c. Account Equity Requirements
    i. Nonbank SBSDs
    ii. Nonbank MSBSPs
    d. $100,000 Minimum Transfer Amount
    e. Risk Monitoring and Procedures
    3. Specific Request for Comment to Limit the Use of Collateral
    C. Segregation
    1. Background
    2. Proposed Rule 18a-4
    a. Possession and Control of Excess Securities Collateral
    b. Security-Based Swap Customer Reserve Account
    c. Special Provisions for Non-cleared Security-Based Swap 
Counterparties
III. General Request for Comment
IV. Paperwork Reduction Act
    A. Summary of Collections of Information Under the Proposed 
Rules and Rule Amendments
    1. Proposed Rule 18a-1 and Amendments to Rule 15c3-1
    2. Proposed Rule 18a-2
    3. Proposed Rule 18a-3
    4. Proposed Rule 18a-4
    B. Proposed Use of Information
    C. Respondents
    D. Total Initial and Annual Recordkeeping and Reporting Burden
    1. Proposed Rule 18a-1 and Amendments to Rule 15c3-1
    2. Proposed Rule 18a-2
    3. Proposed Rule 18a-3
    4. Proposed Rule 18a-4
    E. Collection Of Information Is Mandatory
    F. Confidentiality
    G. Retention Period For Recordkeeping Requirements
    H. Request For Comment
V. Economic Analysis
    A. Baseline Of Economic Analysis
    1. Overview of the OTC Derivatives Markets--Baseline for 
Proposed Rules 18a-1 through 18a-4
    2. Baseline for Amendments to Rule 15c3-1
    B. Analysis of the Proposals and Alternatives
    1. Overview--The Proposed Financial Responsibility Program
    a. Nonbank SBSDs
    b. Nonbank MSBSPs
    2. The Proposed Capital Rules
    a. Nonbank SBSDs and ANC Broker-dealers
    i. Minimum Capital Requirements
    ii. Standardized Haircuts
    iii. Capital Charge in Lieu of Margin Collateral
    iv. Credit Risk Charge
    v. Funding Liquidity Stress Test Requirement
    vi. Risk Management Procedures
    b. Capital Requirements for MSBSPs
    c. Consideration of Burden on Competition, and Promotion of 
Efficiency, Competition, and Capital Formation
    3. The Proposed Margin Rule--Rule 18a-3

[[Page 70215]]

    a. Calculation of Margin Amount
    b. Account Equity Requirements
    i. Commercial end users
    ii. SBSDs--Alternatives A and B
    c. Margin Requirements for Nonbank-MSBSPs
    d. Consideration of Burden on Competition, and Promotion of 
Efficiency, Competition, and Capital Formation
    4. Proposed Segregation Rule--Rule 18a-4
    a. Consideration of Burden on Competition, and Promotion of 
Efficiency, Competition, and Capital Formation
    C. Implementation Considerations
    D. General Request for Comment
VI. Regulatory Flexibility Act Certification
VII. Statutory Basis and Text of the Proposed Amendments

I. Background

    On July 21, 2010, President Obama signed the Dodd-Frank Act into 
law.\1\ Title VII of the Dodd-Frank Act (``Title VII'') established a 
new regulatory framework for OTC derivatives.\2\ In this regard, Title 
VII was enacted, among other reasons, to reduce risk, increase 
transparency, and promote market integrity within the financial system 
by, among other things: (i) Providing for the registration and 
regulation of SBSDs and MSBSPs; (ii) imposing clearing and trade 
execution requirements on standardized derivative products; (iii) 
creating recordkeeping and real-time reporting regimes; and (iv) 
enhancing the Commission's rulemaking and enforcement authorities with 
respect to all registered entities and intermediaries subject to the 
Commission's oversight.\3\
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    \1\ See Public Law 111-203, 124 Stat. 1376 (2010).
    \2\ Pursuant to section 701 of the Dodd-Frank Act, Title VII may 
be cited as the ``Wall Street Transparency and Accountability Act of 
2010.'' See Public Law 111-203 Sec.  701. The Dodd-Frank Act assigns 
responsibility for the oversight of the U.S. OTC derivatives markets 
to the Commission, the Commodity Futures Trading Commission 
(``CFTC''), and certain ``prudential regulators,'' discussed below. 
The Commission has oversight authority with respect to a security-
based swap as defined in section 3(a)(68) of the Exchange Act (15 
U.S.C. 78c(a)(68)), including to implement a registration and 
oversight program for a security-based swap dealer as defined in 
section 3(a)(71) of the Exchange Act (15 U.S.C. 78c(a)(71)) and a 
major security-based swap participant as defined in section 3(a)(67) 
of the Exchange Act (15 U.S.C. 78c(a)(67)). The CFTC has oversight 
authority with respect to a swap as defined in section 1(a)(47) of 
the Commodity Exchange Act (``CEA'') (7 U.S.C. 1(a)(47)), including 
to implement a registration and oversight program for a swap dealer 
as defined in section 1(a)(49) of the CEA (7 U.S.C. 1(a)(49)) and a 
major swap participant as defined in section 1(a)(33) of the CEA (7 
U.S.C. 1(a)(33)). The Commission and the CFTC jointly have adopted 
rules to further define, among other things, those terms and the 
terms swap, security-based swap, swap dealer, major swap 
participant, security-based swap dealer, and major security-based 
swap participant. See Further Definition of ``Swap,'' ``Security-
Based Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps; 
Security-Based Swap Agreement Recordkeeping, Exchange Act Release 
No. 64372 (Apr. 29, 2011), 76 FR 29818 (May 23, 2011) (``Product 
Definitions Proposing Release''); Further Definition of ``Swap,'' 
``Security-Based Swap,'' and ``Security-Based Swap Agreement''; 
Mixed Swaps; Security-Based Swap Agreement Recordkeeping, Exchange 
Act Release No. 67453 (July 18, 2012), 77 FR 48208 (Aug. 13, 2012) 
(Joint final rule with the CFTC) (``Product Definitions Adopting 
Release''); Further Definition of ``Swap Dealer,'' ``Security-Based 
Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based 
Swap Participant'' and ``Eligible Contract Participant'', Exchange 
Act Release No. 63452 (Dec. 7, 2010), 75 FR 80174 (Dec. 21, 2010) 
(Joint proposal with the CFTC) (``Entity Definitions Proposing 
Release''); and Further Definition of ``Swap Dealer,'' ``Security-
Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-
Based Swap Participant'' and ``Eligible Contract Participant'', 
Exchange Act Release No. 66868 (Apr. 27, 2012), 77 FR 30596 (May 23, 
2012) (Joint final rule with the CFTC) (``Entity Definitions 
Adopting Release'').
    \3\ See Public Law 111-203 Sec. Sec.  701-774.
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    Section 764 of the Dodd-Frank Act added section 15F to the Exchange 
Act.\4\ Section 15F(e)(1)(B) of the Exchange Act provides that the 
Commission shall prescribe capital and margin requirements for SBSDs 
and nonbank MSBSPs that do not have a prudential regulator 
(respectively, ``nonbank SBSDs'' and ``nonbank MSBSPs'').\5\ Section 
763 of the Dodd-Frank Act added section 3E to the Exchange Act.\6\ 
Section 3E provides the Commission with authority to establish 
segregation requirements for SBSDs and MSBSPs.\7\
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    \4\ See id. Sec.  764; 15 U.S.C. 78o-10.
    \5\ See 15 U.S.C. 78o-10(e)(1)(B). Specifically, section 
15F(e)(1)(B) of the Exchange Act provides that each registered SBSD 
and MSBSP for which there is not a prudential regulator shall meet 
such minimum capital requirements and minimum initial and variation 
margin requirements as the Commission shall by rule or regulation 
prescribe. The term ``prudential regulator'' is defined in section 
1(a)(39) of the CEA (7 U.S.C. 1(a)(39)) and that definition is 
incorporated by reference in section 3(a)(74) of the Exchange Act 
(15 U.S.C. 78c(a)(74)). Pursuant to the definition, the Board of 
Governors of the Federal Reserve System (``Federal Reserve''), the 
Office of the Comptroller of the Currency (``OCC''), the Federal 
Deposit Insurance Corporation (``FDIC''), the Farm Credit 
Administration, or the Federal Housing Finance Agency (collectively, 
the ``prudential regulators'') is the ``prudential regulator'' of an 
SBSD, MSBSP, swap participant, or major swap participant if the 
entity is directly supervised by that agency.
    \6\ See Public Law 111-203 Sec.  763; 15 U.S.C. 78c-5.
    \7\ See 15 U.S.C. 78c-5(a)-(g). Section 3E of the Exchange Act 
does not distinguish between bank and nonbank SBSDs and bank and 
nonbank MSBSPs, and, consequently, provides the Commission with the 
authority to establish segregation requirements for SBSDs and 
MSBSPs, whether or not they have a prudential regulator. Id.
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    Section 4s(e)(1)(B) of the CEA provides that the CFTC shall 
prescribe capital and margin requirements for swap dealers and major 
swap participants for which there is not a prudential regulator 
(``nonbank swap dealers'' and ``nonbank swap participants'').\8\ 
Section 15F(e)(1)(A) of the Exchange Act provides that the prudential 
regulators shall prescribe capital and margin requirements for bank 
SBSDs and bank MSBSPs, and section 4s(e)(1)(A) of the CEA provides that 
the prudential regulators shall prescribe capital and margin 
requirements for swap dealers and major swap participants for which 
there is a prudential regulator (``bank swap dealers'' and ``bank swap 
participants'').\9\ The prudential regulators have proposed capital and 
margin requirements for bank swap dealers, bank SBSDs, bank swap 
participants, and bank MSBSPs.\10\ The CFTC has proposed capital and 
margin requirements for nonbank swap dealers and nonbank major swap 
participants.\11\ The CFTC also has adopted segregation requirements 
for cleared swaps and proposed segregation requirements for non-cleared 
swaps.\12\
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    \8\ See 7 U.S.C. 6s(e)(1)(B).
    \9\ See 15 U.S.C. 78o-10(e)(1)(A); 7 U.S.C. 6s(e)(1)(A).
    \10\ See Margin and Capital Requirements for Covered Swap 
Entities, 76 FR 27564 (May 11, 2011) (``Prudential Regulator Margin 
and Capital Proposing Release''). The prudential regulators, as part 
of their proposed margin requirements for non-cleared security-based 
swaps, proposed a segregation requirement for collateral received as 
margin. Id.
    \11\ See Capital Requirements of Swap Dealers and Major Swap 
Participants, 76 FR 27802 (May 12, 2011) (``CFTC Capital Proposing 
Release''); Margin Requirements for Uncleared Swaps for Swap Dealers 
and Major Swap Participants, 76 FR 23732 (Apr. 28, 2011) (``CFTC 
Margin Proposing Release''). The CFTC reopened the comment period 
for the CFTC Margin Proposing Release to allow interested parties to 
comment on the CFTC proposed rules in light of the proposals 
discussed in the international consultative paper. See Margin 
Requirements for Uncleared Swaps for Swap Dealers and Major Swap 
Participants, 77 FR 41109 (July 12, 2012).
    \12\ See Protection of Cleared Swaps Customer Contracts and 
Collateral; Conforming Amendments to the Commodity Broker Bankruptcy 
Provisions, 77 FR 6336 (Feb. 7, 2012) and Protection of Collateral 
of Counterparties to Non-cleared Swaps; Treatment of Securities in a 
Portfolio Margining Account in a Commodity Broker Bankruptcy, 75 FR 
75432 (Dec. 3, 2010).
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    Pursuant to sections 763 and 764 of the Dodd-Frank Act, the 
Commission is proposing to amend Rule 15c3-1 and Rule 15c3-3 and 
propose new Rules 18a-1 (including appendices to Rule 18a-1), 18a-2, 
18a-3, and 18a-4 (including an exhibit to Rule 18a-4).\13\ The proposed 
amendments and new rules would establish capital and margin 
requirements for nonbank SBSDs, including broker-dealers that are 
registered as SBSDs (``broker-dealer SBSDs''), and nonbank MSBSPs. They 
also would establish segregation requirements for SBSDs and 
notification requirements with respect to segregation for SBSDs and 
MSBSPs.
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    \13\ See 17 CFR 240.15c3-1; 17 CFR 240.15c3-3.
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    Further, the proposals also would increase the minimum net capital

[[Page 70216]]

requirements and establish liquidity requirements for ANC broker-
dealers.\14\ An ANC broker-dealer is a broker-dealer that has been 
approved by the Commission to use internal value-at-risk (``VaR'') 
models to determine market risk charges for proprietary securities and 
derivatives positions and to take a credit risk charge in lieu of a 
100% charge for unsecured receivables related to OTC derivatives 
transactions (hereinafter, collectively ``internal models''). The 
proposed amendments applicable to ANC broker-dealers are designed to 
account for their large size, the scale of their custodial activities, 
and the potential substantial leverage they may take on if they become 
more active in the security-based swap markets under the Dodd-Frank Act 
reforms, which, among other things, require dealers in security-based 
swaps to register with the Commission.\15\ Finally, some of the 
proposed amendments to Rule 15c3-1 would apply to broker-dealers that 
are not registered as SBSDs. These proposed amendments are designed to 
maintain a consistent capital treatment for security-based swaps and 
swaps under Rule 15c3-1 and proposed new Rule 18a-1.
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    \14\ See 17 CFR 240.15c3-1(a)(7); 17 CFR 240.15c3-1e.
    \15\ See, e.g., 15 U.S.C. 78o-10(a)(1) (``It shall be unlawful 
for any person to act as a security-based swap dealer unless the 
person is registered as a security-based swap dealer with the 
Commission.'').
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    As discussed in detail below, the proposals for capital, margin, 
and segregation requirements for SBSDs and MSBSPs are based in large 
part on existing capital, margin, and segregation requirements for 
broker-dealers (``broker-dealer financial responsibility 
requirements'').\16\ The broker-dealer financial responsibility 
requirements served as the model for the proposals because the 
financial markets in which SBSDs and MSBSPs are expected to operate are 
similar to the financial markets in which broker-dealers operate. In 
addition, as discussed below, the objectives of the broker-dealer 
financial responsibility requirements are similar to the objectives 
underlying the proposals. Moreover, the broker-dealer financial 
responsibility requirements have existed for many years and have 
facilitated the prudent operation of broker-dealers.\17\ Consequently, 
they provide a reasonable template for building a financial 
responsibility program for SBSDs and MSBSPs. Furthermore, it is 
expected that some nonbank SBSDs also will register as broker-dealers 
in order to be able to offer customers a broader range of services than 
a nonbank SBSD not registered as a broker-dealer (``stand-alone SBSD'') 
would be permitted to engage in. Therefore, establishing consistent 
financial responsibility requirements would avoid potential competitive 
disparities between stand-alone SBSDs and broker-dealer SBSDs.
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    \16\ See infra section II.A.1. of this release (describing 
generally the broker-dealer capital standards); section II.B.1. of 
this release (describing generally the broker-dealer margin 
standards); section II.C.1. of this release (describing generally 
the broker-dealer segregation requirements).
    \17\ For example, one of the objectives of the broker-dealer 
financial responsibility requirements is to protect customers from 
the consequences of the financial failure of a broker-dealer in 
terms of safeguarding customer securities and funds held by the 
broker-dealer. It should be noted that the Securities Investor 
Protection Corporation (``SIPC''), since its inception in 1971, has 
initiated customer protection proceedings for only 324 broker-
dealers, which is less than 1% of the approximately 39,200 broker-
dealers that have been members of SIPC during that timeframe. From 
1971 through December 31, 2011, approximately 1% of the $117.5 
billion of cash and securities distributed for accounts of customers 
came from the SIPC fund rather than debtors' estates. See SIPC, 
Annual Report 2011, available at http://www.sipc.org/Portals/0/PDF/2011_Annual_Report.pdf (``SIPC 2011 Annual Report'').
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    However, the Commission recognizes that there may be other 
approaches to establishing financial responsibility requirements that 
may be appropriate--including, for example, applying a standard based 
on the international capital standard for banks (``Basel Standard'') 
\18\ in the case of entities that are part of a bank holding company, 
as has been proposed by the CFTC.\19\ In general, the bank capital 
model requires the holding of specified levels of capital as a 
percentage of ``risk weighted assets.'' \20\ It does not require 
generally a full capital deduction for unsecured receivables, given 
that banks, as lending entities, are in the business of extending 
credit to a range of counterparties.
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    \18\ The Basel Standard was developed by the Basel Committee on 
Banking Supervision of the Bank for International Settlements 
(``BCBS''). More information about the Basel Standard is available 
at the Web site of the Bank for International Settlements (``BIS'') 
at http://www.bis.org/bcbs/index.htm.
    \19\ CFTC Capital Proposing Release, 76 FR 27802.
    \20\ The prudential regulators also have proposed capital rules 
that would require a covered swap entity to comply with the 
regulatory capital rules already made applicable to that covered 
swap entity as part of its prudential regulatory regime. Prudential 
Regulator Margin and Capital Proposing Release, 76 FR at 27568. The 
prudential regulators note that they have ``had risk-based capital 
rules in place for banks to address over-the-counter derivatives 
since 1989 when the banking agencies implemented their risk-based 
capital adequacy standards * * * based on the first Basel Accord.'' 
Id.
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    This approach could promote a consistent view and management of 
capital within a bank holding company structure. The Commission is not 
proposing this approach, however, both because of the distinctions 
between bank and nonbank dealer business models and access to backstop 
liquidity, as well as uncertainties as to how a bank capital standard 
would in practice affect valuations and the conduct of business in a 
nonbank entity; but the Commission is specifically seeking comment on 
this approach. In addition, detailed comment is requested below on 
alternative financial responsibility frameworks that could serve as a 
model for establishing financial responsibility requirements for SBSDs 
and MSBSPs.
    The minimum financial and customer protection requirements proposed 
today--like other financial tests that market participants use in the 
ordinary course of business to manage risk or to comply with applicable 
regulations--incorporate many specific numerical thresholds, limits, 
deductions, and ratios.\21\ The Commission recognizes that each such 
quantitative requirement could be read by some to imply a definitive 
conclusion based on quantitative analysis of that requirement and its 
alternatives.
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    \21\ For example, the proposed capital requirements would 
include in the formula that determines minimum net capital an amount 
generally equal to 8% of the amount of margin that nonbank SBSDs 
would be required to collect from counterparties. Similarly, the 
capital and margin proposals, in setting ``haircut'' requirements to 
reflect market risk for certain types of security-based swaps, 
propose to use a numerical grid that establishes specific deductions 
depending on spread and tenor, among other factors.
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    The Commission notes in this regard that the specific quantitative 
requirements included in this proposal have not been derived directly 
from econometric or mathematical models, nor has the Commission 
performed a detailed quantitative analysis of the likely economic 
consequences of the specific quantitative requirements being included 
in this proposal. As discussed in the economic analysis below, there 
are a number of challenges presented in conducting such a quantitative 
analysis in a robust fashion. Accordingly, the selection of a 
particular quantitative requirement proposed below reflects a 
qualitative assessment by the Commission regarding the appropriate 
financial standard for an identified issue. In making such assessments 
and in turn selecting proposed quantitative requirements, the 
Commission has drawn from its experiences in regulating broker-dealers 
and has frequently looked to comparable quantitative elements in the 
existing broker-dealer financial responsibility regime (e.g., the 
current capital charges in the existing broker-dealer net capital rule) 
or, where appropriate, the existing or proposed regulations of the 
prudential regulators,

[[Page 70217]]

FINRA, or the CFTC with respect to similar activities. For example, the 
Commission may propose using a specified haircut percentage (e.g., 15%, 
as opposed to a percentage that is higher or lower) because it 
believes, based on its experience regulating markets, that such 
percentage should be sufficient to cover a severe market movement. The 
Commission has used these comparable quantitative requirements as a 
reasonable starting point for purposes of the various proposals 
because, as noted above, there are substantial similarities between the 
proposed rules and those other regimes in terms of the relevant 
markets, entities, and regulatory objectives, and because many nonbank 
SBSDs may also be subject to the existing broker-dealer financial 
responsibility requirements.
    The Commission invites comment, including relevant data and 
analysis, regarding all aspects of the various quantitative 
requirements reflected in the proposed rules. In particular, data and 
comment from market participants and other interested parties regarding 
the likely effect of each proposed quantitative requirement, the effect 
of such requirements in the aggregate, and potential alternative 
requirements will be particularly useful to the Commission in 
evaluating modifications to the proposals. Commenters are also 
requested to describe in detail any econometric or mathematical models 
or economic analyses of data, to the extent they exist, that they 
believe would be relevant for evaluating or modifying any quantitative 
provisions contained in the proposals.
    The Commission staff consulted with the prudential regulators and 
the CFTC in drafting the proposals discussed in this release.\22\ In 
addition, the proposals of the prudential regulators and the CFTC were 
considered in developing the Commission's proposed capital, margin, and 
segregation requirements for SBSDs and MSBSPs. The Commission's 
proposals differ in some respects from proposals of the prudential 
regulators and the CFTC, and such differences are described below in 
connection with the relevant proposals. While some differences are 
based on differences in the activities of securities firms, banks, and 
commodities firms, or differences in the products at issue, other 
differences may reflect an alternative approach to balancing the 
relevant policy choices and considerations. Where these differences 
exist, comment is sought on the advantages and disadvantages of each 
proposal and whether a given proposal is appropriate based on 
differences in the business models of the types of entities that would 
be subject to the respective proposal, the risks of these entities, and 
any other factors commenters believe relevant.\23\
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    \22\ See 15 U.S.C. 78o-10(e)(3)(D)(i) (``The prudential 
regulators, the [CFTC], and the [Commission] shall periodically (but 
not less frequently than annually) consult on the minimum capital 
requirements and minimum initial and variation margin 
requirements.'').
    \23\ See 15 U.S.C. 78o-10(e)(3)(D)(ii) (providing that the 
prudential regulators, the CFTC, and the Commission ``shall, to the 
maximum extent practicable establish and maintain comparable minimum 
capital requirements and minimum initial and variation margin 
requirements, including the use of noncash collateral,'' for SBSDs 
and swap dealers).
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    The capital, margin, and segregation requirements ultimately 
adopted, like other requirements established under the Dodd-Frank Act, 
could have a substantial impact on international commerce and the 
relative competitive position of intermediaries operating in various, 
or multiple, jurisdictions. In particular, intermediaries operating in 
the U.S. and in other jurisdictions could be advantaged or 
disadvantaged if corresponding requirements are not established in 
other jurisdictions or if the Commission's rules are substantially more 
or less stringent than corresponding requirements in other 
jurisdictions. This could, among other potential impacts, affect the 
ability of intermediaries and other market participants based in the 
U.S. to participate in non-U.S. markets, the ability of non-U.S.-based 
intermediaries and other market participants to participate in U.S. 
markets, and whether and how international firms make use of global 
``booking entities'' to centralize risks related to security-based 
swaps. These issues have been the focus of numerous comments to the 
Commission and other regulators, Congressional inquiries, and other 
public dialogue.\24\
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    \24\ See, e.g., letter from Senator Tim Johnson, Chairman of the 
U.S. Senate Committee on Banking, Housing, and Urban Affairs, and 
Congressman Barney Frank, Ranking Member of the U.S. House Committee 
on Financial Services, to the CFTC, Commission, Federal Reserve, and 
FDIC (Oct. 4, 2011), available at http://www.sec.gov/comments/s7-25-11/s72511-34.pdf (``Given the global nature of this market, U.S. 
regulators should avoid creating opportunities for international 
regulatory arbitrage that could increase systemic risk and reduce 
the competitiveness of U.S. firms abroad''); letter from Barclays 
Bank PLC, BNP Paribas S.A., Credit Suisse AG, Deutsche Bank AG, 
HSBC, Nomura Securities International, Inc., Rabobank Nederland, 
Royal Bank of Canada, The Royal Bank of Scotland Group PLC, Societe 
Generale, The Toronto-Dominion Bank, and UBS AG, to the CFTC, 
Commission, and Federal Reserve (Feb. 17, 2011), available at http://www.sec.gov/comments/s7-39-10/s73910-25.pdf (``[T]he home country 
regulator has the greatest interest in and is in the best position 
to protect a foreign bank swap dealer under its primary supervision 
by setting appropriate margin requirements or functionally 
equivalent capital charges for non-cleared swaps''); letter from 
Carlos Tavares, Vice-Chairman of European Securities and Markets 
Authority, to the Commission (Jan. 17, 2011), available at http://www.sec.gov/comments/s7-35-10/s73510-19.pdf (``if the foreign 
supervision were not taken into account * * * a foreign [entity 
would] be subject to multiple regimes * * * [which would be] very 
challenging for regulated entities and would significantly raise the 
costs for both the industry and supervisors''); BCBS, Board of the 
International Organization of Securities Commissions (``IOCSO''), 
Consultative Document, Margin Requirements for Non-centrally-cleared 
Derivatives (July 2012), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD387.pdf (consultative document seeking comment on 
margin requirements for non-centrally-cleared derivatives).
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    The potential international implications of the proposed capital, 
margin, and segregation requirements warrant further consideration. 
However, consistent with the Commission's general approach with respect 
to its other proposals under Title VII, these implications are 
recognized here but not fully addressed. Instead, the Commission 
intends to publish a comprehensive release seeking public comment on 
the full spectrum of issues relating to the application of Title VII to 
cross-border security-based swap transactions and non-U.S. persons that 
act in capacities regulated under the Dodd-Frank Act. This approach 
will provide market participants, foreign regulators, and other 
interested parties with an opportunity to consider, as an integrated 
whole, the proposed approach to the cross-border application of Title 
VII, including capital, margin, and segregation requirements.

II. Proposed Rules and Rule Amendments

A. Capital

1. Introduction
    Section 15F(e)(1)(B) of the Exchange Act requires that the 
Commission prescribe capital requirements for nonbank SBSDs and nonbank 
MSBSPs.\25\ The Commission also has concurrent authority under section 
15(c)(3) of the Exchange Act to prescribe capital requirements for 
broker-dealers.\26\ The existing broker-dealer capital requirements are 
contained in

[[Page 70218]]

Rule 15c3-1,\27\ including seven appendices to Rule 15c3-1.\28\ The 
minimum capital requirements for stand-alone SBSDs would be contained 
in proposed new Rule 18a-1,\29\ and the minimum capital requirements 
for broker-dealer SBSDs would be contained in Rule 15c3-1, as proposed 
to be amended. Proposed Rule 18a-1 would be structured similarly to 
Rule 15c3-1 and would contain many provisions that correspond to those 
in Rule 15c3-1.\30\
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    \25\ 15 U.S.C. 78o-10(e)(1)(B).
    \26\ 15 U.S.C. 78o(c)(3). Section 771 of the Dodd-Frank Act 
states that unless otherwise provided by its terms, its provisions 
relating to the regulation of the security-based swap markets do not 
divest any appropriate Federal banking agency, the Commission, the 
CFTC, or any other Federal or State agency, of any authority derived 
from any other provision of applicable law. See Public Law 111-203 
Sec.  771. In addition, section 15F(e)(3)(B) of the Exchange Act 
provides that nothing in section 15F ``shall limit, or be construed 
to limit, the authority'' of the Commission ``to set financial 
responsibility rules for a broker or dealer * * * in accordance with 
Section 15(c)(3).'' 15 U.S.C. 78o-8(e)(3)(B).
    \27\ 17 CFR 240.15c3-1.
    \28\ 17 CFR 240.15c3-1a (Options); 17 CFR 240.15c3-1b 
(Adjustments to net worth and aggregate indebtedness for certain 
commodities transactions); 17 CFR 240.15c3-1c (Consolidated 
computations of net capital and aggregate indebtedness for certain 
subsidiaries and affiliates); 17 CFR 240.15c3-1d (Satisfactory 
subordination agreements); 17 CFR 240.15c3-1e (Deductions for market 
and credit risk for certain brokers or dealers); 17 CFR 240.15c3-1f 
(Optional market and credit risk requirements for OTC derivatives 
dealers); 17 CFR 240.15c3-1g (Conditions for ultimate holding 
companies of certain brokers or dealers).
    \29\ See proposed new Rule 18a-1.
    \30\ For example, proposed new Rule 18a-1 would include four 
appendices: Appendix A (proposed new Rule 18a-1a); Appendix B 
(proposed new Rule18a-1b); Appendix C (proposed new Rule 18a-1c); 
and Appendix D (proposed new Rule 18a-1d). The appendices would 
correspond to the following appendices to Rule 15c3-1: Appendix A 
(Options) (17 CFR 240.15c3-1a); Appendix B (Adjustments to net worth 
and aggregate indebtedness for certain commodities transactions) (17 
CFR 240.15c3-1b); Appendix C (Consolidated computations of net 
capital and aggregate indebtedness for certain subsidiaries and 
affiliates) (17 CFR 240.15c3-1c); and Appendix D (Satisfactory 
subordination agreements) (17 CFR 240.15c3-1d).
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    As described above, the capital and other financial responsibility 
requirements for broker-dealers generally provide a reasonable template 
for crafting the corresponding requirements for nonbank SBSDs. For 
example, among other considerations, the objectives of capital 
standards for both types of entities are similar. Rule 15c3-1, 
described in detail below, is a net liquid assets test that is designed 
to require a broker-dealer to maintain sufficient liquid assets to meet 
all obligations to customers and counterparties and have adequate 
additional resources to wind-down its business in an orderly manner 
without the need for a formal proceeding if it fails financially.\31\ 
In turn, the objective of the proposed capital standards for nonbank 
SBSDs is to protect customer assets and mitigate the consequences of a 
firm failure, while allowing these firms the flexibility in how they 
conduct a security-based swaps business.
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    \31\ See Net Capital Rule, Exchange Act Release No. 38248 (Feb. 
6, 1997), 62 FR 6474 (Feb. 12, 1997) (``Rule 15c3-1 requires 
registered broker-dealers to maintain sufficient liquid assets to 
enable those firms that fall below the minimum net capital 
requirements to liquidate in an orderly fashion without the need for 
a formal proceeding.''). As indicated, the goal of the rule is to 
require a broker-dealer to hold sufficient liquid net capital to 
meet all obligations to creditors, except for creditors who agree to 
subordinate their claims to all other creditors. As discussed in 
more detail below, Rule 15c3-1d (Appendix D to Rule 15c3-1) sets 
forth minimum requirements for a subordinated loan agreement. See 17 
CFR 240.15c3-1d. Typically, affiliates of the broker-dealer (e.g., 
the firm's holding company) or individual owners of the broker-
dealer make subordinated loans to the broker-dealer. If the broker-
dealer fails financially and is liquidated, the obligations of the 
broker-dealer to all other creditors would need to be paid in full 
before the obligations of the broker-dealer to a subordinated lender 
are paid.
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    In addition, the Dodd-Frank Act divided responsibility for SBSDs by 
providing the prudential regulators with authority to prescribe the 
capital and margin requirements for bank SBSDs and the Commission with 
authority to prescribe capital and margin requirements for nonbank 
SBSDs.\32\ This division also suggests it may be appropriate to model 
the capital requirements for nonbank SBSDs on the capital standards for 
broker-dealers, while the capital requirements for bank SBSDs are 
modeled on capital standards for banks (as reflected in the proposal by 
the prudential regulators).\33\ Certain operational, policy, and legal 
differences appear to support this distinction between nonbank SBSDs 
and bank SBSDs. First, based on the Commission staff's understanding of 
the activities of nonbank dealers in over-the counter (``OTC'') 
derivatives, nonbank SBSDs are expected to engage in a securities 
business with respect to security-based swaps that is more similar to 
the dealer activities of broker-dealers than to the activities of 
banks; indeed, some broker-dealers likely will be registered as nonbank 
SBSDs.\34\ Second, existing capital standards for banks and broker-
dealers reflect, in part, differences in their funding models and 
access to certain types of financial support, and those same 
differences also will exist between bank SBSDs and nonbank SBSDs. For 
example, banks obtain funding through customer deposits and can obtain 
liquidity through the Federal Reserve's discount window, whereas 
broker-dealers do not--and nonbank SBSDs will not--have access to these 
sources of funding and liquidity. Third, Rule 15c3-1 currently contains 
provisions designed to address dealing in OTC derivatives by broker-
dealers and, therefore, to some extent already can accommodate this 
type of activity (although, as discussed below, proposed amendments to 
Rule 15c3-1 would be designed to more specifically address the risks of 
security-based swaps and the potential for increased involvement of 
broker-dealers in the security-based swaps markets).\35\
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    \32\ See 15 U.S.C. 78o-10, in general; 15 U.S.C. 78o-
10(e)(2)(A)-(B), in particular.
    \33\ The prudential regulators have proposed capital 
requirements for bank SBSDs and bank swap dealers that are based on 
the capital requirements for banks. See Prudential Regulator Margin 
and Capital Proposing Release, 76 FR at 27582.
    \34\ Id.
    \35\ See 17 CFR 240.15c3-1f and 17 CFR 240.15c3-1e. See also 
Alternative Net Capital Requirements for Broker-Dealers That Are 
Part of Consolidated Supervised Entities, Exchange Act Release No. 
49830 (June 8, 2004), 69 FR 34428 (June 21, 2004) (``Alternative Net 
Capital Requirements Adopting Release''); OTC Derivatives Dealers, 
Exchange Act Release No. 40594 (Oct. 23, 1998), 63 FR 59362 (Nov. 3, 
1998).
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    For these reasons, the proposed capital standard for nonbank SBSDs 
is a net liquid assets test modeled on the broker-dealer capital 
standard in Rule 15c3-1.\36\ However, the Commission

[[Page 70219]]

recognizes that there may be alternative approaches to financial 
responsibility requirements that may be appropriate.\37\ Accordingly, 
in the requests for comment below on the various capital standards, 
commenters are encouraged: (1) To consider alternative approaches to 
capital for nonbank SBSDs generally; (2) for nonbank SBSDs that are 
broker-dealers, to identify what, if any, specific amendments to Rule 
15c3-1 and its appendices they believe would not be appropriate for 
broker-dealers; and (3) for stand-alone SBSDs, to identify what, if 
any, specific provisions in proposed new Rule 18a-1 and its appendices 
(including those modeled on provisions in Rule 15c3-1 and its 
appendices) they believe would not be appropriate for stand-alone 
SBSDs.
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    \36\ As noted above, the prudential regulators similarly 
proposed capital standards for bank SBSDs based on the capital 
standards for banks. See Prudential Regulator Margin and Capital 
Proposing Release 76 FR 27564. The CFTC has proposed three different 
capital standards for nonbank swap dealers. First, a futures 
commission merchant (``FCM'') that is registered as a swap dealer 
would be subject to the CFTC's net capital rule for FCMs, which is 
similar to the Commission's net capital rule for broker-dealers in 
that it imposes a net liquid assets test. See CFTC Capital Proposing 
Release, 76 FR 27802. Second, a swap dealer that is not an FCM and 
not affiliated with a U.S. bank holding company would be subject to 
a ``tangible net equity'' capital standard (the CFTC proposal 
defines tangible net equity as equity determined under U.S. 
generally accepted accounting principles (``GAAP''), and excludes 
goodwill and other intangible assets). Third, a swap dealer that is 
not an FCM and is affiliated with a U.S. bank holding company would 
be subject to the capital standard that applies to U.S. banking 
institutions. Id. The proposed capital standard for nonbank SBSDs 
would not make such distinctions and, therefore, all nonbank SBSDs 
would be subject to the net liquid assets test embodied in Rule 
15c3-1 (i.e., regardless of whether they are registered as broker-
dealers or affiliates of U.S. bank holding companies). The CFTC 
proposed a tangible net equity requirement for certain swap dealers 
to address the probability that commercial entities (e.g., entities 
engaged in agricultural or energy businesses) may need to register 
as swap dealers and that imposing a net liquid assets test could 
require them to engage in significant corporate restructuring and 
potentially cause undue costs because their equity is comprised of 
physical and other non-current assets. Differences between the swaps 
markets and the security-based swaps markets may make a single 
capital standard more workable for nonbank SBSDs. The swaps market 
is significantly larger than the security-based swaps market and has 
many more active participants that are commercial entities. See BIS, 
OTC Derivatives Market Activity in the Second Half of 2010, Monetary 
and Economic Department, (May 2011), available at http://www.bis.org/publ/otc_hy1105.pdf. It is expected that financial 
institutions will comprise a large segment of the security-based 
swaps market as is currently the case and that these entities are 
more likely to have affiliates dedicated to OTC derivatives trading 
and affiliates that are broker-dealers registered with the 
Commission. See infra section V.A. of this release (providing an 
overview of the security-based swaps markets). Consequently, these 
affiliates--because their capital structures are geared towards 
securities trading or because they already are broker-dealers--would 
be able to more readily adhere to a net liquid assets test. In 
addition, many broker-dealers currently are affiliates within bank 
holding companies. Consequently, these broker-dealers are subject to 
Rule 15c3-1, while their bank affiliates are subject to bank capital 
standards.
    \37\ CFTC Capital Proposing Release, 76 FR 27802.
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    The capital standard in Rule 15c3-1--that serves as a model for the 
proposed capital standard for nonbank SBSDs--is a net liquid assets 
test. This standard is designed to promote liquidity; the rule allows a 
broker-dealer to engage in activities that are part of conducting a 
securities business (e.g., taking securities into inventory) but in a 
manner that places the firm in the position of holding at all times 
more than one dollar of highly liquid assets for each dollar of 
unsubordinated liabilities (e.g., money owed to customers, 
counterparties, and creditors).\38\ For example, Rule 15c3-1 allows 
securities positions to count as allowable net capital, subject to 
standardized or internal model-based haircuts.\39\ The rule, however, 
does not permit most unsecured receivables to count as allowable net 
capital.\40\ This aspect of the rule severely limits the ability of 
broker-dealers to engage in activities, such as unsecured lending, that 
generate unsecured receivables. The rule also does not permit fixed 
assets or other illiquid assets to count as allowable net capital, 
which creates disincentives for broker-dealers to own real estate and 
other fixed assets that cannot be readily converted into cash. For 
these reasons, Rule 15c3-1 incentivizes broker-dealers to confine their 
business activities and devote capital to activities such as 
underwriting, market making, and advising on and facilitating customer 
securities transactions.
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    \38\ See, e.g., Interpretation Guide to Net Capital Computation 
for Brokers and Dealers, Exchange Act Release No. 8024 (Jan. 18, 
1967), 32 FR 856 (Jan. 25, 1967) (``Rule 15c3-1 (17 CFR 240.15c3-1) 
was adopted to provide safeguards for public investors by setting 
standards of financial responsibility to be met by brokers and 
dealers. The basic concept of the rule is liquidity; its object 
being to require a broker-dealer to have at all times sufficient 
liquid assets to cover his current indebtedness.'') (footnotes 
omitted); Net Capital Treatment of Securities Positions, Obligations 
and Transactions in Suspended Securities, Exchange Act Release No. 
10209 (June 8, 1973), 38 FR 16774 (June 26, 1973) (Commission 
release of a letter from the Division of Market Regulation) (``The 
purpose of the net capital rule is to require a broker or dealer to 
have at all times sufficient liquid assets to cover its current 
indebtedness. The need for liquidity has long been recognized as 
vital to the public interest and for the protection of investors and 
is predicated on the belief that accounts are not opened and 
maintained with broker-dealers in anticipation of relying upon suit, 
judgment and execution to collect claims but rather on a reasonable 
demand one can liquidate his cash or securities positions.''); Net 
Capital Requirements for Brokers and Dealers, Exchange Act Release 
No. 15426 (Dec. 21, 1978), 44 FR 1754 (Jan. 8, 1979) (``The rule 
requires brokers or dealers to have sufficient cash or liquid assets 
to protect the cash or securities positions carried in their 
customers' accounts. The thrust of the rule is to insure that a 
broker or dealer has sufficient liquid assets to cover current 
indebtedness.''); Net Capital Requirements for Brokers and Dealers, 
Exchange Act Release No. 26402 (Dec. 28, 1989), 54 FR 315 (Jan. 5, 
1989) (``The rule's design is that broker-dealers maintain liquid 
assets in sufficient amounts to enable them to satisfy promptly 
their liabilities. The rule accomplishes this by requiring broker-
dealers to maintain liquid assets in excess of their liabilities to 
protect against potential market and credit risks.'') (footnote 
omitted).
    \39\ See 17 CFR 240.15c3-1(c)(2)(vi); 17 CFR 240.15c3-1e; 17 CFR 
240.15c3-1f.
    \40\ See 17 CFR 240.15c3-1(c)(2)(iv).
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    Rule 15c3-1 requires broker-dealers to maintain a minimum level of 
net capital (meaning highly liquid capital) at all times.\41\ The rule 
requires that a broker-dealer perform two calculations: (1) A 
computation of the minimum amount of net capital the broker-dealer must 
maintain; \42\ and (2) a computation of the amount of net capital the 
broker-dealer is maintaining.\43\ The minimum net capital requirement 
is the greater of a fixed-dollar amount specified in the rule and an 
amount determined by applying one of two financial ratios: the 15-to-1 
aggregate indebtedness to net capital ratio or the 2% of aggregate 
debit items ratio.\44\
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    \41\ See 17 CFR 240.15c3-1.
    \42\ See 17 CFR 240.15c3-1(a).
    \43\ See 17 CFR 240.15c3-1(c)(2). The computation of net capital 
is based on the definition of net capital in paragraph (c)(2) of 
Rule 15c3-1. Id.
    \44\ See 17 CFR 240.15c3-1(a).
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    In computing net capital, the broker-dealer must, among other 
things, make certain adjustments to net worth such as deducting 
illiquid assets and taking other capital charges and adding qualifying 
subordinated loans.\45\ The amount remaining after these deductions is 
defined as ``tentative net capital.'' \46\ The final step in computing 
net capital is to take prescribed percentage deductions (``standardized 
haircuts'') from the mark-to-market value of the proprietary positions 
(e.g., securities, money market instruments, and commodities) that are 
included in its tentative net capital.\47\ The standardized haircuts 
are designed to account for the market risk inherent in these positions 
and to create a buffer of liquidity to protect against other risks 
associated with the securities business.\48\ ANC broker-dealers and a 
type of limited purpose broker-dealer that deals solely in OTC 
derivatives (``OTC derivative dealers'') are permitted, with Commission 
approval, to calculate net capital using internal models as the basis 
for taking market risk and credit risk charges in lieu of the 
standardized haircuts for classes of positions for which they have been 
approved to use models.\49\ Rule 15c3-1 imposes substantially higher 
minimum capital requirements for ANC broker-dealers and OTC derivatives 
dealers, as compared to other types of broker-dealers, because, among 
other reasons, the use of internal models to compute net capital can 
substantially reduce the deductions for securities and money market 
positions as compared with the standardized haircuts.\50\ Consequently, 
the higher minimum capital requirements are designed to account for 
risks that may not be addressed by the internal models. A broker-dealer 
must ensure that its net capital exceeds

[[Page 70220]]

its minimum net capital requirement at all times.\51\
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    \45\ See 17 CFR 240.15c3-1(c)(2)(i)-(xiii).
    \46\ See 17 CFR 240.15c3-1(c)(15).
    \47\ See 17 CFR 240.15c3-1(c)(2)(vi).
    \48\ See, e.g., Uniform Net Capital Rule, Exchange Act Release 
No. 13635 (June 16, 1977), 42 FR 31778 (June 23, 1977) (``[Haircuts] 
are intended to enable net capital computations to reflect the 
market risk inherent in the positioning of the particular types of 
securities enumerated in [the rule]''); Net Capital Rule, Exchange 
Act Release No. 22532 (Oct. 15, 1985), 50 FR 42961 (Oct. 23, 1985) 
(``These percentage deductions, or `haircuts', take into account 
elements of market and credit risk that the broker-dealer is exposed 
to when holding a particular position.''); Net Capital Rule, 
Exchange Act Release No. 39455 (Dec. 17, 1997), 62 FR 67996 (Dec. 
30, 1997) (``Reducing the value of securities owned by broker-
dealers for net capital purposes provides a capital cushion against 
adverse market movements and other risks faced by the firms, 
including liquidity and operational risks.'') (footnote omitted).
    \49\ See 17 CFR 240.15c3-1(a)(5) and (a)(7); 17 CFR 240.15c3-1e; 
17 CFR 240.15c3-1f. As part of the application to use internal 
models, an entity seeking to become an ANC broker-dealer or an OTC 
derivatives dealer must identify the types of positions it intends 
to include in its model calculation. See 17 CFR 240.15c3-
3e(a)(1)(iii); 17 CFR 240.15c3-1f(a)(1)(ii). After approval, an ANC 
broker-dealer and OTC derivatives dealer must obtain Commission 
approval to make a material change to the model, including a change 
to the types of positions included in the model. See 17 CFR 
240.15c3-1e(a)(8); 17 CFR 240.15c3-f(a)(3).
    \50\ See 17 CFR 240.15c3-1(a)(5) and (a)(7).
    \51\ 17 CFR 240.15c3-1(a).
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    A different capital standard than the net liquid assets test is 
proposed for nonbank MSBSPs. As discussed in more detail below, 
proposed Rule 18a-2 would require nonbank MSBSPs to maintain positive 
tangible net worth.\52\ The Commission preliminarily believes that a 
tangible net worth standard--as opposed to the net liquid assets test--
is more workable for nonbank MSBSPs because these entities may engage 
in a diverse range of business activities different from, and broader 
than, the securities activities conducted by broker-dealers or SBSDs 
(and, to the extent they did not, they likely would be required to 
register as an SBSD and/or broker-dealer).\53\ Consequently, requiring 
nonbank MSBSPs to adhere to a capital standard based on a net liquid 
assets test could restrict these entities from engaging in commercial 
activities that are part of their core business models. For example, 
some of these entities may engage in manufacturing and supply 
activities that generate large amounts of unsecured receivables and 
require substantial fixed assets.\54\ Accordingly, as discussed below, 
proposed Rule 18a-2 is not modeled on Rule 15c3-1 because of the 
expected differences between nonbank SBSDs and broker-dealers, on the 
one hand, and the entities that may register as nonbank MSBSPs, on the 
other hand.
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    \52\ See proposed new Rule 18a-2.
    \53\ An entity will need to register with the Commission as an 
MSBSP and, consequently, be subject to proposed new Rule 18a-2 if it 
falls within the definition of major security-based swap participant 
in section 3(a)(67) of the Exchange Act (15 U.S.C. 78c(a)(67)) as 
further defined by the Commission by rule. See Entity Definitions 
Adopting Release, 77 FR 30596.
    \54\ See CFTC Capital Proposing Release, 76 FR at 27807 
(proposing a tangible net equity test for major swap participants 
that are not part of bank holding companies noting that although 
these firms ``may have significant amounts of balance sheet equity, 
it may also be the case that significant portions of their equity is 
comprised of physical and other noncurrent assets, which would 
preclude the firms from meeting FCM capital requirements without 
engaging in significant corporate restructuring and incurring 
potentially undue costs.'').
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Request for Comment
    The Commission generally requests comment on the proposals to 
impose a net liquid assets test capital standard for nonbank SBSDs and 
a tangible net worth standard for nonbank MSBSPs. In addition, the 
Commission requests comment, including empirical data in support of 
comments, in response to the following questions:
    1. Will the entities that register as nonbank SBSDs engage in a 
securities business with respect to security-based swaps that is 
similar to the securities business conducted by broker-dealers? If not, 
describe how the securities activities of nonbank SBSDs will differ 
from the securities activities of broker-dealers.
    2. Will some broker-dealers register as nonbank SBSDs? If so, which 
types of broker-dealers and which types of activities do these broker-
dealers currently engage in?
    3. Should there be different capital standards for nonbank SBSDs 
depending on whether they are registered as broker-dealers or 
affiliated with bank holding companies, or not registered as broker-
dealers and not affiliated with bank holding companies? If so, explain 
why. If not, explain why not. For example, should stand-alone SBSDs be 
subject to a tangible net worth standard or, if affiliated with a bank 
holding company, the bank capital standard? Would different standards 
create competitive advantages? If so, explain why. If different capital 
standards would be appropriate, explain the appropriate capital 
standard that should apply to each of these classes of nonbank SBSDs.
    4. Generally, is there a level of capital under which 
counterparties will not transact with a dealer in OTC derivatives 
because the counterparty credit risk is too great? If so, identify that 
level of capital.
    5. Will stand-alone SBSDs seek to effect transactions in securities 
OTC derivatives products other than security-based swaps, such as OTC 
options, that would necessitate registration as a broker-dealer? If so, 
would registering as a limited purpose broker-dealer under the 
provisions applicable to OTC derivatives dealers provide a workable 
alternative to registering as a full-service broker-dealer? For 
example, would there be conflicts between the proposed capital, margin, 
and segregation requirements for SBSDs and the existing requirements 
for OTC derivatives dealers? If so, identify the conflicts.
    6. Should the requirements for OTC derivatives dealers be amended 
(by exemptive relief or otherwise) to accommodate firms that want to 
deal in security-based swaps? If so, explain how the requirements 
should be amended and why.
    7. Should the Commission exempt nonbank SBSDs engaged in activities 
with respect to securities OTC derivatives products other than 
security-based swaps from any requirements applicable to OTC 
derivatives dealers? Please identify which requirements and explain 
why.
    8. As discussed below, the proposed minimum net capital 
requirements would differ substantially for stand-alone SBSDs that are 
approved to use models in computing net capital (i.e., a $20 million 
fixed-dollar minimum net capital requirement and $100 million tentative 
net capital requirement) compared to broker-dealer SBSDs approved to 
use models (i.e., a $1 billion fixed-dollar minimum net capital 
requirement and $5 billion tentative net capital requirement). In 
general, because the definition of ``security-based swap dealer'' in 
the Dodd-Frank Act does not include acting as a broker or agent in 
security-based swaps, entities engaging in brokerage activities with 
respect to security-based swaps could be required to register as 
broker-dealers. To the extent these broker-dealer SBSDs wanted to use 
models to compute net capital, they would be subject to the higher 
minimum net capital requirements. Accordingly, in order to avoid being 
subject to higher minimum net capital requirements applicable to 
broker-dealer SBSDs approved to use models to compute net capital, a 
stand-alone SBSD may need to limit the activity it could conduct on 
behalf of customers so that it does not fall within the definition of a 
``broker'' under the Exchange Act and, thereby, need to register as a 
broker-dealer. Commenters are requested to address this issue, 
including any potential changes to the proposed capital requirements 
for stand-alone SBSDs and broker-dealer SBSDs discussed below. For 
example, should broker-dealer SBSDs approved to use internal models to 
compute net capital and that register as broker-dealers only in order 
to conduct brokerage activities with respect to security-based swaps, 
and that do not conduct a general business in securities with 
customers, be subject to the minimum net capital requirements 
applicable to stand-alone SBSDs approved to use internal models? If so, 
explain why. If not, explain why not. If different capital standards 
would be appropriate, explain the appropriate capital standard that 
should apply to this class of broker-dealer SBSDs and whether any 
limitations should apply, including with respect to the types of broker 
activities in which the nonbank SBSD may engage in order to qualify for 
a particular capital treatment. Alternatively, or in addition, should 
the Commission allow OTC derivatives dealers (which are subject to a 
$20 million fixed-dollar minimum net capital requirement and $100 
million tentative net capital requirement) to be dually registered as 
nonbank SBSDs and/or amend the rules for OTC derivatives dealers to 
conduct a broader range of activities than are currently

[[Page 70221]]

permitted? If the Commission took this action, should it also remove 
the exemption for OTC derivatives dealers from membership in a self-
regulatory organization (``SRO'')?
    9. Describe the types of entities that may need to register as 
MSBSPs and how the activities that these entities engage in would 
impact the entity's capital position.
    10. Should nonbank MSBSPs be subject to a net liquid assets test 
capital standard (in contrast to a tangible net worth test)? If so, 
explain why. If not, explain why not.
2. Proposed Capital Rules for Nonbank SBSDs
    As discussed in detail below, proposed new Rule 18a-1 would 
prescribe capital requirements for stand-alone SBSDs and amendments to 
Rule 15c3-1 would prescribe capital requirements for broker-dealer 
SBSDs. Proposed new Rule 18a-1 would require a stand-alone SBSD to 
compute net capital using standardized haircuts prescribed in the rule 
(including standardized haircuts specifically for security-based swaps 
and swaps) or, alternatively, with Commission approval, to use internal 
models for positions for which the stand-alone SBSD has been approved 
to use internal models. Under the proposed amendments to Rule 15c3-1, a 
broker-dealer SBSD would be required to use the existing standardized 
haircuts in the rule plus proposed new additional standardized haircuts 
specifically for security-based swaps and swaps. A broker-dealer SBSD 
that seeks to compute net capital using internal models would need to 
apply to the Commission for approval to operate as an ANC broker-
dealer. A nonbank SBSD permitted to use internal models to compute net 
capital (whether a stand-alone SBSD subject to proposed new Rule 18a-1 
or an ANC broker-dealer subject to Rule 15c3-1, as amended) would need 
to comply with additional requirements as compared to a nonbank SBSD 
that is not approved to use internal models. This would be consistent 
with the existing requirements in Rule 15c3-1, which impose additional 
requirements on ANC broker-dealers and OTC derivatives dealers as 
compared with other broker-dealers.\55\ Finally, the amendments to Rule 
15c3-1 would apply to broker-dealers that are not registered as SBSDs 
to the extent they hold positions in security-based swaps and swaps.
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    \55\ See, e.g., 17 CFR 240.15c3-1(a)(5) and (a)(7); 17 CFR 
240.15c3-1e; 17 CFR 240.15c3-1f; 17 CFR 240.15c3-4.
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a. Computing Required Minimum Net Capital
    Rule 15c3-1 prescribes the minimum net capital requirement for a 
broker-dealer as the greater of a fixed-dollar amount specified in the 
rule and an amount determined by applying one of two financial ratios: 
the 15-to-1 aggregate indebtedness to net capital ratio or the 2% of 
aggregate debit items ratio.\56\ The proposed capital requirements for 
nonbank SBSDs would use a similar framework. Under the proposals, there 
would be different minimum net capital requirements for stand-alone 
SBSDs that are not approved to use internal models, broker-dealer SBSDs 
that are not approved to use internal models, stand-alone SBSDs that 
are approved to use internal models, and broker-dealer SBSDs that are 
approved to use internal models (i.e., ANC broker-dealers). The 
following table provides a summary of the proposed minimum net capital 
requirements, which are discussed in the following sections.
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    \56\ See 17 CFR 240.15c3-1(a).
    [GRAPHIC] [TIFF OMITTED] TP23NO12.000
    
i. Stand-alone SBSDs Not Using Internal Models

    A stand-alone SBSD would be subject to the capital requirements set 
forth in proposed new Rule 18a-1. Under this proposed new rule, a 
stand-alone SBSD that is not approved to use internal models to compute 
haircuts would be required to maintain minimum net capital of not less 
than the greater of $20 million or 8% of the firm's risk margin amount 
(``8% margin factor'').\57\ The term risk margin amount would be 
defined as the sum of: (1) The greater of the total margin required to 
be delivered by the nonbank SBSD with respect to security-based swap 
transactions cleared for security-based swap customers at a clearing 
agency or the amount of the deductions that would apply to the cleared 
security-based swap positions of the security-based swap customers 
pursuant to paragraph (c)(1)(vi) of Rule 18a-1; and (2) the total 
margin amount calculated by the stand-alone SBSD with respect to non-
cleared security-based swaps pursuant to proposed new Rule 18a-3.\58\ 
Accordingly, to determine its minimum net capital requirement, a stand-
alone SBSD would need to calculate the amount equal to the 8% margin 
factor.\59\ The firm's minimum net capital requirement would be the 
greater of $20 million or the amount equal to the 8% margin factor.\60\
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    \57\ See paragraph (a)(1) of proposed new Rule 18a-1. The 
rationales for these minimum requirements are discussed below.
    \58\ See paragraph (c)(6) of proposed new Rule 18a-1. The 
components of the risk margin amount are discussed in detail below.
    \59\ See paragraphs (a)(1) and (c)(6) of proposed new Rule 18a-
1.
    \60\ See paragraph (a)(1) of proposed new Rule 18a-1.
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    The proposed $20 million fixed-dollar minimum requirement would be 
the same as the fixed-dollar minimum

[[Page 70222]]

requirement applicable to OTC derivatives dealers and already familiar 
to existing market participants.\61\ OTC derivatives dealers are 
limited purpose broker-dealers that are authorized to trade in certain 
derivatives, including security-based swaps, and to use internal models 
to calculate net capital. They are required to maintain minimum 
tentative net capital of $100 million and minimum net capital of $20 
million.\62\ These current fixed-dollar minimums have been the minimum 
capital standards for OTC derivative dealers for over a decade, and are 
substantially lower than the fixed-dollar minimums in Rule 15c3-1 
currently applicable to ANC broker-dealers, which use internal models 
to calculate net capital.\63\ In addition, available data regarding the 
current population of broker-dealers suggests that these minimums would 
not prevent new entrants in the security-based swap market.\64\ To 
date, there have been no indications that these minimums are not 
adequately meeting the objective of requiring OTC derivatives dealers 
to maintain sufficient levels of regulatory capital to account for the 
risks inherent in their activities.
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    \61\ See 17 CFR 240.15c3-1(a)(5). The CFTC proposed a $20 
million fixed-dollar minimum net capital requirement for FCMs that 
are registered as swap dealers, regardless of whether the firm is 
approved to use internal models to compute regulatory capital. See 
CFTC Capital Proposing Release, 76 FR 27802.
    Further, the CFTC proposed a $20 million fixed-dollar ``tangible 
net equity'' minimum requirement for swap dealers and major swap 
participants that are not FCMs and are not affiliated with a U.S. 
bank holding company. Finally, the CFTC proposed a $20 million 
fixed-dollar Tier 1 capital minimum requirement for swap dealers and 
major swap participants that are not FCMs and are affiliated with a 
U.S. bank holding company (the term ``Tier 1 capital'' refers to the 
regulatory capital requirement for U.S. banking institutions). Id.
    \62\ See 17 CFR 240.15c3-1(a)(5). When adopting the capital 
requirements for OTC derivatives dealers, the Commission stated 
``[t]he 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. 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.'' See OTC 
Derivatives Dealers, 63 FR 59362.
    \63\ Paragraph (a)(7) of Rule 15c3-1 currently requires that ANC 
broker-dealers at all times maintain tentative net capital of not 
less than $1 billion and net capital of not less than $500 million. 
17 CFR 240.15c3-1(a)(7).
    \64\ See infra section V.B.2.a.i. of this release (economic 
analysis discussion based on year-end 2011 data showing that 
approximately 270 broker-dealers maintain net capital of $20 million 
or more).
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    At the same time, the proposed $20 million fixed-dollar minimum 
requirement for stand-alone SBSDs that do not use internal models to 
calculate net capital would be substantially higher than the fixed-
dollar minimums in Rule 15c3-1 currently applicable to broker-dealers 
that do not use internal models (i.e., that are not ANC broker-dealers 
or OTC derivatives dealers).\65\ Under the proposals, stand-alone SBSDs 
that do not use models would not be able to avail themselves of such 
minimums and would be subject to the same $20 million minimum net 
capital requirement as OTC derivatives dealers, even though they would 
not be using models like such derivatives dealers. In other words, the 
same minimum net capital requirement will apply to stand-alone SBSDs 
regardless of whether or not they use models.
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    \65\ For example, a broker-dealer that carries customer accounts 
has a fixed-dollar minimum requirement of $250,000; a broker-dealer 
that does not carry customer accounts but engages in proprietary 
securities trading (defined as more than ten trades a year) has a 
fixed-dollar minimum requirement of $100,000; and a broker-dealer 
that does not carry accounts for customers or otherwise does not 
receive or hold securities and cash for customers, and does not 
engage in proprietary trading activities, has a fixed-dollar minimum 
requirement of $5,000. See 17 CFR 240.15c3-1(a)(2).
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    This level of minimum capital may be appropriate because of the 
nature of the business of a stand-alone SBSD and the differences from 
the business of a broker-dealer or OTC derivatives dealer. Generally, 
OTC derivatives, such as security-based swaps, are contracts between a 
dealer and its counterparty. Consequently, the counterparty's ability 
to collect amounts owed to it under the contract depends on the 
financial wherewithal of the dealer. In contrast, the returns on 
financial instruments held by a broker-dealer for an investor (other 
than a derivative issued by the broker-dealer) are not linked to the 
financial wherewithal of the broker-dealer holding the instrument for 
the customer. Accordingly, if a stand-alone SBSD fails, the 
counterparty may not be able to liquidate the contract or replace the 
contract with a new counterparty without incurring a loss on the 
position. The entities that will register and operate as nonbank SBSDs 
should be sufficiently capitalized to minimize the risk that they 
cannot meet their obligations to counterparties, particularly given 
that the counterparties will not be limited to other dealers but will 
include customers and other counterparties as well.
    In addition, stand-alone SBSDs will not be subject to the same 
limitations that apply to OTC derivative dealers in effecting 
transactions with customers and engaging in dealing activities.\66\ 
Therefore, the failure of a stand-alone SBSD could have a broader 
adverse impact on a larger number of market participants, including 
customers and counterparties.\67\ The proposed capital requirements for 
this group of firms, in part, are meant to account for this potential 
broader impact on market participants.\68\
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    \66\ See 17 CFR 240.3b-12; 17 CFR 240.15a-1. Rule 3b-12, 
defining the term OTC derivatives dealer, provides, among other 
things, 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 the rule) 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 (17 CFR 240.3b-14)); (4) 
engaging in ancillary portfolio management securities activities (as 
defined in the rule); and (5) engaging in such other securities 
activities that the Commission designates by order. See 17 CFR 
240.3b-12. Rule 15a-1, governing the securities activities of OTC 
derivatives dealers, provides that an OTC derivatives dealer must 
effect transactions in OTC derivatives with most types of 
counterparties through an affiliated Commission-registered broker-
dealer that is not an OTC derivatives dealer. See 17 CFR 240.15a-1.
    \67\ The proposal is consistent with the CFTC's proposed capital 
requirements for nonbank swap dealers, which impose $20 million 
fixed-dollar minimum requirements regardless of whether the firm is 
approved to use internal models to compute regulatory capital. See 
CFTC Capital Proposing Release, 76 FR 27802.
    \68\ As discussed above, stand-alone SBSDs would be subject to a 
minimum ratio amount based on the 8% margin factor. OTC derivatives 
dealers are not subject to a minimum ratio amount.
---------------------------------------------------------------------------

    Consequently, stand-alone SBSDs that do not use internal models 
would be subject to the same $20 million fixed-dollar minimum net 
capital requirement that applies to OTC derivatives dealers. The same 
firms would not, however, be subject to a minimum tentative net capital 
requirement, which is applied to firms that use internal models to 
account for risks that may not be fully captured by the models.\69\
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    \69\ OTC derivatives dealers are subject to a $100 million 
minimum tentative net capital requirement. ANC broker-dealers are 
currently subject to a $1 billion minimum tentative net capital 
requirement. The minimum tentative net capital requirements are 
designed to address risks that may not be captured when using 
internal models rather than standardized haircuts to compute net 
capital. See OTC Derivatives Dealers, 63 FR at 59384; Alternative 
Net Capital Requirements for Broker-Dealers That Are Part of 
Consolidated Supervised Entities; Proposed Rule, Exchange Act 
Release No. 48690 (Oct. 24, 2003), 68 FR 62872, 62875 (Nov. 6, 2003) 
(``We expect that net capital charges will be reduced for broker-
dealers that use the proposed alternative net capital computation. 
The present haircut structure is designed so that firms will have a 
sufficient capital base to account for, in addition to market and 
credit risk, other types of risk, such as operational risk, leverage 
risk, and liquidity risk. Raising the minimum tentative net capital 
requirement to $1 billion and net capital requirement to $500 
million is one way to ensure that firms that use the alternative 
capital computation maintain sufficient capital reserves to account 
for these other risks. In addition, based on our experience, firms 
must have this scale of operations in order to have developed 
internal risk management control systems necessary to support 
reliable VaR computations.'').

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[[Page 70223]]

    The proposed 8% margin factor would be part of determining the 
stand-alone SBSD's minimum net capital requirement. As noted above, the 
stand-alone SBSD would determine this amount by adding:
     The greater of the total margin required to be delivered 
by the stand-alone SBSD with respect to security-based swap 
transactions cleared for security-based swap customers at a clearing 
agency or the amount of the deductions that would apply to the cleared 
security-based swap positions of the security-based swap customers 
pursuant to paragraph (c)(1)(vi) of Rule 18a-1; \70\ and
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    \70\ See paragraph (c)(6) of proposed new Rule 18a-1. As 
discussed below in section II.B. of this release, nonbank SBSDs will 
be subject to margin requirements imposed by clearing agencies 
pursuant to which nonbank SBSDs will be required to collect 
collateral from customers relating to the customers' cleared 
security-based swap transactions. The amount of collateral required 
to be collected as a result of customers' cleared security-based 
swap transactions would be used to determine the first component of 
the risk margin amount. This amount would be added to the second 
component of the risk margin amount relating to non-cleared 
security-based swaps and that amount would be multiplied by 8% to 
determine the 8% margin factor. However, if the margin requirements 
of the clearing agencies require the stand-alone SBSD to collect 
total collateral in an amount that is less than the deductions the 
firm would apply to the customers' cleared security-based swap 
positions under proposed new Rule 18a-1, the stand-alone SBSD would 
need to add the amount of the deductions to the second component of 
the risk margin amount relating to non-cleared security-based swaps 
and multiply that amount by 8% to determine the 8% margin factor.
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     The total margin amount calculated by the stand-alone SBSD 
with respect to non-cleared security-based swaps pursuant to paragraph 
(c)(1)(i)(B) of proposed new Rule 18a-3.\71\
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    \71\ See paragraph (c)(6) of proposed new Rule 18a-1. As 
discussed below in section II.B. of this release, proposed new Rule 
18a-3 would establish margin requirements for nonbank SBSDs with 
respect to non-cleared security-based swaps. See proposed new Rule 
18a-3. The proposed rule would define the term margin to mean the 
amount of positive equity in an account of a counterparty. See 
paragraph (b)(5) of proposed new Rule 18a-3. Under the proposed 
rule, a nonbank SBSD would be required to calculate daily a margin 
amount for the account of each counterparty to a non-cleared 
security-based swap. See paragraph (c)(1)(i)(B) of proposed new Rule 
18a-3. These calculations of counterparty margin amounts for the 
purposes of proposed new Rule 18a-3 would be used to determine the 
component of the risk margin amount relating to non-cleared 
security-based swaps. This amount would be added to the first 
component relating to cleared security-based swaps, and the total 
amount would be multiplied by 8% to determine the 8% margin factor.
---------------------------------------------------------------------------

    The total of these two amounts--i.e., the risk margin amount--would 
be multiplied by 8% to determine the amount of the 8% margin factor, 
which, if greater than the $20 million fixed-dollar amount, would be 
the stand-alone SBSD's minimum net capital requirement.\72\ This 
proposed 8% margin factor ratio requirement is similar to an existing 
requirement in the CFTC's net capital rule for FCMs.\73\ Further, the 
CFTC has proposed a similar requirement for swap dealers and major swap 
participants registered as FCMs.\74\ Under the CFTC's proposal, an FCM 
would be required to maintain adjusted net capital that is equal to or 
greater than 8% of the risk margin required for customer and non-
customer exchange-traded futures and swaps positions that are cleared 
by a derivatives clearing organization (``DCO'').\75\ The CFTC's 
proposed 8% of margin, or risk-based capital rule, ``is intended to 
require FCMs to maintain a minimum level of capital that is associated 
with the level of risk associated with the customer positions that the 
FCM carries.'' \76\ Based on Commission staff experience with dually-
registered broker-dealer/FCMs, the Commission preliminarily believes 
that the 8% margin factor would serve as a reasonable measure to ensure 
that a firm's minimum capital requirement increases or decreases in 
tandem with the level of risk arising from customer futures 
transactions. Consequently, the 8% margin factor is being proposed to 
provide a similar adjustable minimum net capital requirement for 
nonbank SBSDs with respect to their security-based swap activity.\77\
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    \72\ See paragraphs (a)(1) and (c)(6) of proposed new Rule 18a-
1.
    \73\ See 17 CFR 1.17(a)(1)(i)(B). See also Minimum Financial and 
Related Reporting Requirements for Futures Commission Merchants and 
Introducing Brokers, 69 FR 49784 (Aug. 12, 2004). The CFTC proposed 
the 8% risk margin requirement to establish a margin-based capital 
computation identical to the margin-based minimum net capital 
computation that several futures self-regulatory organizations, 
including one derivatives clearing organization, adopted for their 
respective member-FCMs. Id. at note 16.
    \74\ See CFTC Capital Proposing Release, 76 FR 27802. The 8% 
risk margin calculation under the CFTC's proposal relates to cleared 
swaps or futures transactions, whereas the 8% margin factor proposed 
in new Rule 18a-1 would be based on cleared and non-cleared 
security-based swaps. As discussed below, the proposed minimum net 
capital requirement is based on a nonbank SBSD's cleared and non-
cleared security-based swap activity in order to account for the 
risks of both types of positions.
    \75\ See CFTC Capital Proposing Release, 76 FR 27802.
    \76\ Id. at 27807.
    \77\ As discussed below in section II.A.2.b.iv. of this release, 
an 8% multiplier is used for purposes of calculating credit risk 
charges under Appendix E to Rule 15c3-1. While this is a different 
calculation than the proposed 8% margin factor, using an 8% 
multiplier for purposes of computing regulatory capital requirements 
is an international standard. See Alternative Net Capital 
Requirements Adopting Release, 69 FR 34428, note 42 (describing the 
8% multiplier in Appendix E to Rule 15c3-1 as being ``consistent 
with the calculation of credit risk in the OTC derivatives dealers 
rules and with the Basel Standard'' and as being ``designed to 
dampen leverage to help ensure that the firm maintains a safe level 
of capital.'').
---------------------------------------------------------------------------

    Under the proposed rule, nonbank SBSDs--including stand-alone SBSDs 
that are not approved to use internal models to calculate net capital--
would be subject to a minimum net capital requirement that increases in 
tandem with an increase in the risks associated with nonbank SBSD's 
security-based swap activities.\78\ Without the 8% margin factor, the 
minimum net capital requirement for a nonbank SBSD would be the same 
(i.e., $20 million) regardless of the volume, size, and risk of its 
outstanding security-based swap transactions.
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    \78\ As discussed below in sections II.A.2.a.ii., II.A.2.a.iii., 
and II.A.2.a.iv. of this release, the 8% margin factor would be used 
to compute the minimum net capital requirement for all nonbank 
SBSDs.
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    The amount computed under the 8% margin factor generally would 
increase as the stand-alone SBSD increased the volume, size, and risk 
of its security-based swap transactions. Specifically, the proposed 
definition of the term risk margin amount is designed to link the 
stand-alone SBSD's minimum net capital requirement to its cleared and 
non-cleared security-based swap activity. For example, the definition 
in proposed new Rule 18a-1 provides that, for cleared security-based 
swaps, the amount is the greater of the margin required to be collected 
or the amount of the deductions that would apply pursuant to proposed 
new Rule 18a-1 (i.e., the amount of the deductions using standardized 
haircuts).\79\ The margin requirement for cleared security-based swap 
positions generally should increase with the volume, size, and risk of 
the positions as would the amount of the standardized haircuts 
applicable to the positions. Further, the ``greater of'' provision is 
designed to ensure that the 8% margin factor requirement is based on, 
at a minimum, the standardized haircuts as these provide a uniform 
approach for all cleared security-based

[[Page 70224]]

swaps, whereas margin requirements for cleared security-based swaps 
will vary over time and across different clearing agencies.
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    \79\ For a stand-alone SBSD approved to use internal models and 
an ANC broker-dealer, it would be the amount of the deductions 
determined using a VaR model, except for types of positions for 
which the firm has not been approved to use a VaR model.
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    As proposed, the 8% margin factor is determined using the greater 
of required margin or standardized haircuts with respect to cleared 
security-based swaps plus the margin amount for non-cleared security-
based swaps calculated under proposed new Rule 18a-3.\80\ Thus, the 8% 
margin factor would be based on a stand-alone SBSD's activity in both 
cleared and non-cleared security-based swaps. As noted above, the goal 
of the provision is to require the stand-alone SBSD to increase its net 
capital in tandem with an increase in the risk of its security-based 
swap transactions. The proposal does not limit the computation to only 
cleared security-based swaps, as proposed by the CFTC, because such a 
limitation would allow the stand-alone SBSD to increase the amount of 
its non-cleared security-based swaps positions without a corresponding 
increase in net capital. This could create greater risk to the stand-
alone SBSD's customers because--as discussed above--their ability to 
collect amounts owing on security-based swaps depends on the ability of 
the stand-alone SBSD to meets its obligations.
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    \80\ Proposed new Rule 18a-3 would require a nonbank SBSD to 
calculate daily a margin amount for the account of each counterparty 
to a non-cleared security-based swap. See paragraph (c)(1)(i)(B) of 
proposed new Rule 18a-3. As discussed below in section II.B. of this 
release, a nonbank SBSD would be required to perform this 
calculation even though proposed new Rule 18a-3 would not require 
the nonbank SBSD to collect collateral from all counterparties to 
collateralize the margin amount. For example, the Commission is 
proposing that collateral need not be collected from commercial end 
users. Nonetheless, the calculation of the margin amount for 
purposes of proposed new Rule 18a-3 would determine the non-cleared 
security-based swap component of the risk margin amount regardless 
of whether the nonbank SBSD would be required to collect collateral 
from the counterparty to collateralize the margin amount. In other 
words, the amount of the risk margin amount would be based on the 
calculation required by proposed new Rule 18a-3 for all 
counterparties to non-cleared security-based swaps and not on 
whether the stand-alone SBSD would be required to collect collateral 
from a counterparty to collateralize the margin amount. As discussed 
in section II.B. of this release, this is designed to ensure that 
the risk margin amount is based on all non-cleared security-based 
swap activity of the stand-alone SBSD and not just on security-based 
swap activity that would require the firm to collect collateral.
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Request for Comment
    The Commission generally requests comment on the proposed minimum 
net capital requirements in proposed new Rule 18a-1 for stand-alone 
SBSDs that are not approved to use internal models to compute net 
capital. In addition, the Commission requests comment, including 
empirical data in support of comments, in response to the following 
questions:
    1. Is the proposed $20 million minimum net capital requirement for 
stand-alone SBSDs not using internal models appropriate? If not, 
explain why not. What minimum amount would be more appropriate? For 
example, should the minimum fixed-dollar amount be greater than $20 
million to account for the broader range of activities that stand-alone 
SBSDs will be able to engage in as compared with OTC derivatives 
dealers? If so, explain why. If it should be a greater amount, how much 
greater should it be (e.g., $30 million, $50 million, $100 million, or 
some other amount)? Alternatively, should the minimum fixed-dollar 
amount be less than $20 million because these firms will not be using 
internal models to compute net capital? If so, explain why. If it 
should be a lower amount, how much lower (e.g., $15 million, $10 
million, $5 million, or some other amount)? If a greater or lesser 
alternative amount is recommended, explain why it would be more 
appropriate for broker-dealer SBSDs that are not approved to use 
internal models.
    2. Is the proposed definition of risk margin amount appropriate? If 
not, explain why and suggest modifications to the definition. For 
example, are there modifications that could make the definition more 
accurately reflect the nonbank SBSD's risk exposure from dealing in 
security-based swaps? If so, describe the modifications and explain why 
they would achieve this result.
    3. Is the component of the risk margin amount definition addressing 
margin delivered for cleared swaps appropriate? If not, explain why 
not. Would the definition be more appropriate if this component was 
dropped so that the first prong of the definition only incorporated the 
haircuts for cleared security-based swaps?
    4. Should the proposed definition of risk margin amount only 
address cleared security-based swaps, consistent with the CFTC's 
proposal? If so, explain why, including how the risk of non-cleared 
security-based swap activities could be addressed through other 
measures.
    5. Is the component of the risk margin amount definition addressing 
margin collected for non-cleared security-based swaps appropriate? If 
not, explain why not.
    6. Is the 8% margin factor an appropriate metric for determining a 
nonbank SBSD's minimum net capital requirement in terms of increasing a 
nonbank SBSD's minimum net capital requirement as the risk of its 
security-based swap activities increases? If not, explain why not. For 
example, should the percentage be greater than 8% (e.g., 10%, 12%, or 
some other percentage)? If so, identify the percentage and explain why 
it would be preferable. Should the percentage be less than 8% (e.g., 
6%, 4%, or some other percentage)? If so, identify the percentage and 
explain why it would be preferable.
    7. Should the 8% multiplier be tiered as the amount of the risk 
margin amount increases? If so, explain why. For example, should the 
multiplier decrease from 8% to 6% for the amount of the risk margin 
amount that exceeds a certain threshold, such as $1 billion or $5 
billion? If so, explain why. Should the amount of the multiplier 
increase from 8% to 10% for the amount of the risk margin amount that 
exceeds a certain threshold such as $1 billion or $5 billion? If so, 
explain why.
    8. Should the 8% margin factor be an adjustable ratio (e.g., 
increase to 10% or decrease to 6%)? For example, should the multiplier 
adjust periodically if certain conditions occur? If so, explain the 
conditions under which the 8% multiplier would adjust upward or 
downward and why having an adjustable ratio would be appropriate.
    9. Would the 8% margin factor be a sufficient minimum net capital 
requirement without the $20 million fixed-dollar minimum? If so, 
explain why.
    10. Are there metrics other than a fixed-dollar minimum and the 8% 
margin factor for calculating required minimum capital that would more 
appropriately reflect the risk of nonbank SBSDs? If so, identify them 
and explain why they would be preferable. For example, instead of an 
absolute fixed-dollar minimum, should the minimum net capital 
requirement be linked to a scalable metric such as the size of the 
nonbank SBSD or the amount of the deductions taken by the nonbank SBSD 
when computing net capital? For any scalable minimum net capital 
requirements identified, explain how the computation would work in 
practice and how the minimum requirement would address the same 
objectives of a fixed-dollar minimum.
    11. Would the 8% margin factor address the risk of extremely large 
nonbank SBSDs? If not, explain why not. For example, if the customer 
margin requirements for cleared and non-cleared security-based swaps 
carried by the nonbank SBSD were low because the positions were hedged 
or otherwise not high risk, the 8% margin

[[Page 70225]]

factor may not increase in tandem with the level of the nonbank SBSD's 
security-based swap activity. In this case, would the 8% margin factor 
adequately address the risk of the nonbank SBSD, particularly if it 
carried substantial security-based swap positions? If not, explain why 
not. Would the 8% margin factor be necessary for small nonbank SBSDs? 
If not, explain why not.
    12. Would the 8% margin factor provide an appropriate and workable 
restraint on the amount of leverage incurred by stand-alone SBSDs not 
using internal models because the amount of minimum net capital would 
increase as the risk margin amount increases? If not, explain why not. 
Is there another measure that would more accurately and effectively 
address the leverage risk of these firms? If so, identify the measure 
and explain why it would be more accurate and effective.
    13. Should the 8% margin factor be applied to margin related to 
cleared and non-cleared swap transactions in addition to security-based 
swap transactions? For example, the provision could require that 8% of 
the margin required for cleared and non-cleared swaps be added to the 
8% of margin required for cleared and non-cleared security-based swaps 
in determining the minimum net capital requirement. Would this be a 
workable approach to address the fact that the CFTC's proposed 8% 
margin requirement would not apply to swap dealers that are not 
registered as FCMs and, with respect to dually-registered FCM swap 
dealers, it would apply only to cleared swaps? Including swaps in the 
8% margin factor calculation would provide for equal treatment of 
security-based swaps and swaps in determining a minimum net capital 
requirement. Would this be a workable approach? If so, explain why. If 
not, explain why not.
    14. Would the 8% margin factor be practical as applied to a 
portfolio margin account that contains security-based swaps and swaps? 
If so, explain why. If not, explain why not.
    15. What will be the practical impacts of the 8% margin factor? For 
example, what will be the effect on transaction costs, liquidity in 
security-based swaps, availability of capital to support security-based 
swap transactions generally and/or for non-security-based swap-related 
uses, use of security-based swaps for hedging purposes, risk management 
at SBSDs, the costs for potential new SBSDs to participate in the 
security-based swap markets, etc.? How would these impacts increase or 
decrease if the 8% margin factor were set at a higher or lower 
percentage?
ii. Broker-Dealer SBSDs Not Using Internal Models
    A broker-dealer that registers as an SBSD would continue to be 
subject to the capital requirements in Rule 15c3-1, as proposed to be 
amended to account for security-based swap activities. Proposed 
amendments to paragraph (a) of Rule 15c3-1 would establish minimum net 
capital requirements for a broker-dealer SBSD that is not approved to 
use internal models to compute net capital.\81\ Under these proposed 
amendments, the broker-dealer SBSD would be subject to the same $20 
million fixed-dollar minimum net capital requirement as a stand-alone 
SBSD that does not use internal models.\82\ As discussed above in 
section II.A.2.a.i. of this release, the proposed $20 million fixed-
dollar minimum would be consistent with the current fixed-dollar 
minimum that applies to OTC derivatives dealers, which has been used as 
a minimum capital standard for OTC derivative dealers for over a 
decade.
---------------------------------------------------------------------------

    \81\ See proposed new paragraph (a)(10) of Rule 15c3-1.
    \82\ Id.
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    In addition, a broker-dealer SBSD that does not use internal models 
would be required to use the 8% margin factor to compute its minimum 
net capital amount. As discussed above in section II.A.2.a.i. of this 
release, the 8% margin factor is designed to adjust the broker-dealer 
SBSD's minimum net capital requirement in tandem with the risk 
associated with the broker-dealer SBSD's security-based swap activity. 
Without the 8% margin factor, the minimum net capital requirement for a 
broker-dealer SBSD would be the same (i.e., $20 million) regardless of 
the number, size, and risk of its outstanding security-based swap 
transactions. Consequently, the proposed rule would include the 8% 
margin factor in order to increase the broker-dealer SBSD's net capital 
requirement as the risk of its security-based swap activities 
increases.
    Moreover, the broker-dealer SBSD--as a broker-dealer--would be 
subject to the existing financial ratio requirements in Rule 15c3-1 
and, therefore, would need to include the applicable financial ratio 
amount when determining the firm's minimum net capital requirement.\83\ 
A broker-dealer's minimum net capital requirement is the greater of the 
applicable fixed-dollar amount and one of two alternative financial 
ratios. The first financial ratio requirement provides that a broker-
dealer must not permit its aggregate indebtedness to all other persons 
to exceed 1500% of its net capital (i.e., a 15-to-1 aggregate 
indebtedness to net capital requirement).\84\ This is the default 
financial ratio requirement that all broker-dealers must apply unless 
they affirmatively elect to be subject to the second financial ratio 
requirement by notifying their designated examining authority of the 
election.\85\ The second financial ratio requirement provides that a 
broker-dealer must not permit its net capital to be less than 2% of 
aggregate debit items (i.e., customer-related obligations to the 
broker-dealer).\86\
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    \83\ See 17 CFR 240.15c3-1(a)(1); proposed new paragraph 
(a)(10)(i) of Rule 15c3-1. Currently, all broker-dealers, including 
the ANC broker-dealers, are subject either to the aggregate 
indebtedness standard or the aggregate debit items (alternative 
standard) financial ratio requirements.
    \84\ See 17 CFR 240.15c3-1(a)(1)(i). Stated another way, the 
broker-dealer must maintain, at a minimum, an amount of net capital 
equal to 1/15th (or 6.67%) of its aggregate indebtedness. This 
financial ratio generally is used by smaller broker-dealers that do 
not hold customer securities and cash.
    \85\ See 17 CFR 240.15c3-1(a)(1)(i)-(ii).
    \86\ See 17 CFR 240.15c3-1(a)(1)(ii). Customer debit items--
computed pursuant to Rule 15c3-3--consist of, among other things, 
margin loans to customers and securities borrowed by the broker-
dealer to effectuate deliveries of securities sold short by 
customers. See 17 CFR 240.15c3-3; 17 CFR 240.15c3-3a. This ratio 
generally is used by larger broker-dealers that hold customer 
securities and cash.
---------------------------------------------------------------------------

    The proposed amendments to Rule 15c3-1 would provide that a broker-
dealer SBSD that is not approved to use internal models would be 
required to maintain a minimum net capital level of not less than the 
greater of: (1) $20 million or (2) the financial ratio amount required 
pursuant to paragraph (a)(1) of Rule 15c3-1 plus the 8% margin 
factor.\87\ Thus, the proposed minimum net capital requirement for a 
broker-dealer SBSD would incorporate the requirement in Rule 15c3-1 
that a broker-dealer maintain the greater of a fixed-dollar amount or 
one of the two financial ratio amounts, as applicable.\88\ The 
financial ratio requirements in Rule 15c3-1 are designed to link the 
broker-dealer's minimum net capital requirement to the level of its 
securities activities. For example, the aggregate debit ratio 
requirement is designed for broker-dealers that carry customer 
securities and cash.\89\ This provision increases the minimum net 
capital requirement for these broker-dealers as they increase their 
debit items by engaging in margin lending and facilitating of customer 
short-sale

[[Page 70226]]

transactions.\90\ The proposal to combine the Rule 15c3-1 financial 
ratios with the 8% margin factor in a broker-dealer SBSD's computation 
of its minimum net capital requirement is designed to require the 
broker-dealer SBSD to maintain a capital cushion to support its 
traditional securities activities (e.g., margin lending) and its 
security-based swap activities.
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    \87\ See proposed new paragraph (a)(10)(i) of Rule 15c3-1.
    \88\ Id.
    \89\ See Net Capital Requirements for Brokers and Dealers, 
Exchange Act Release No. 17208 (Oct. 9, 1980), 45 FR 69915 (Oct. 22, 
1980).
    \90\ See 17 CFR 240.15c3-1(a)(1)(ii); 17 CFR 240.15c3-3a.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposed minimum 
net capital requirements for broker-dealer SBSDs that are not approved 
to use internal models. Commenters are referred to the general 
questions above in section II.A.2.a.i. of this release about the 8% 
margin factor as applied broadly to nonbank SBSDs. In addition, the 
Commission requests comment, including empirical data in support of 
comments, in response to the following questions:
    1. Is the proposed $20 million minimum net capital requirement 
appropriate for broker-dealer SBSDs that are not approved to use 
internal models? If not, explain why not. What minimum amount would be 
more appropriate? For example, should the minimum fixed-dollar amount 
be greater than $20 million to account for the broader range of 
activities that broker-dealer SBSDs will be able to engage in (e.g., 
traditional securities activities such as margin lending), as compared 
with stand-alone SBSDs and OTC derivatives dealers? If it should be a 
greater amount, how much greater should it be (e.g., $30 million, $50 
million, $100 million, or some other amount)? Alternatively, should the 
minimum fixed-dollar amount be less than $20 million because these 
firms will not be using internal models to compute net capital? If it 
should be a lower amount, how much lower (e.g., $15 million, $10 
million, $5 million or some other amount)? If a greater or lesser 
alternative amount is recommended, explain why it would be preferable 
for broker-dealer SBSDs that are not approved to use internal models.
    2. Is combining the 8% margin factor requirement with the 
applicable Rule 15c3-1 financial ratio requirement an appropriate way 
to determine a minimum net capital requirement for broker-dealer SBSDs 
that are not approved to use internal models? If not, explain why not.
    3. Would the 8% margin factor combined with the Rule 15c3-1 
financial ratio provide an appropriate and workable restraint on the 
amount of leverage incurred by broker-dealer SBSDs not using internal 
models? If not, explain why not. Is there another measure that would 
more accurately and effectively address the leverage risk of these 
firms? If so, identify the measure and explain why it would be more 
accurate and effective.
iii. Stand-Alone SBSDs Using Internal Models
    As discussed above, a stand-alone SBSD would be subject to the 
capital requirements in proposed new Rule 18a-1.\91\ Rule 18a-1 would 
permit stand-alone SBSDs to apply to use internal models to compute net 
capital.\92\ In terms of minimum capital requirements, a stand-alone 
SBSD that has been approved to use internal models would be required to 
maintain: (1) a minimum tentative net capital level of not less than 
$100 million; and (2) a minimum net capital level of not less than the 
greater of $20 million or the 8% margin factor.\93\ The proposed 
minimum net capital requirement for stand-alone SBSDs using internal 
models (i.e., the greater of $20 million or the 8% margin factor) is 
the same as the proposed minimum net capital requirement for stand-
alone SBSDs and broker-dealer SBSDs not using internal models (though 
the latter would need to incorporate the Rule 15c3-1 financial ratio 
requirement into their minimum net capital computations).
---------------------------------------------------------------------------

    \91\ See proposed new Rule 18a-1.
    \92\ See paragraphs (a)(2) and (d) of proposed new Rule 18a-1; 
the discussion below in section II.A.2.b.iii. of this release.
    \93\ See paragraph (a)(2) of proposed Rule 18a-1. As discussed 
above in section II.A.2.a.i. of this release, the 8% margin factor 
is designed to adjust the stand-alone SBSD's minimum net capital 
requirement in tandem with the risk associated with the broker-
dealer firm's security-based swap activity.
---------------------------------------------------------------------------

    A stand-alone SBSD approved to use internal models also would be 
subject to a minimum tentative net capital requirement of $100 
million.\94\ This proposed minimum tentative net capital requirement 
would be consistent with the current minimum tentative net capital 
requirement applicable to OTC derivatives dealers.\95\ A minimum 
tentative net capital requirement is designed to operate as a 
prudential control on the use of internal models for regulatory capital 
purposes.\96\ Tentative net capital is the amount of net capital 
maintained by a broker-dealer before applying the standardized haircuts 
or using internal models to determine deductions on the mark-to-market 
value of proprietary positions to arrive at the broker-dealer's amount 
of net capital.\97\ OTC derivatives dealers, therefore, compute 
tentative net capital before using internal VaR models to take the 
market risk deductions. The minimum tentative net capital requirement 
is designed to account for the fact that VaR models, while more risk 
sensitive than standardized haircuts, tend to substantially reduce the 
amount of the deductions to tentative net capital in comparison to the 
standardized haircuts because the models recognize more offsets between 
related positions (i.e., positions that show historical correlations) 
than the standardized haircuts.\98\ In addition, VaR models may

[[Page 70227]]

not capture all risks and, therefore, having a minimum tentative net 
capital requirement (i.e., one that is not derived using the VaR model) 
is designed to require that capital be sufficient to withstand events 
that the model may not take into account (e.g., extraordinary losses or 
decreases in liquidity during times of stress that are not incorporated 
into VaR calculations).\99\ Consequently, the proposed $100 million 
minimum tentative net capital requirement is designed to provide a 
sufficient liquid capital cushion for stand-alone SBSDs that use 
models, just as it has done in practice for entities registered as OTC 
derivatives dealers.\100\
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    \94\ See paragraph (a)(2) of proposed new Rule 18a-1.
    \95\ Both ANC broker-dealers and OTC derivatives dealers--
entities that use internal models--are subject to a minimum 
tentative net capital requirement. See 17 CFR 240.15c3-1(a)(5) and 
(a)(7).
    \96\ OTC Derivatives Dealers, 63 FR at 59384 (``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. 
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.''). See also Alternative Net Capital Requirements 
Adopting Release, 69 FR at 34431 (``The current haircut structure 
[use of the standardized haircuts] seeks to ensure that broker-
dealers maintain a sufficient capital base to account for 
operational, leverage, and liquidity risk, in addition to market and 
credit risk. We expect that use of the alternative net capital 
computation [internal models] will reduce deductions for market and 
credit risk substantially for broker-dealers that use that method. 
Moreover, inclusion in net capital of unsecured receivables and 
securities that do not have a ready market under the current net 
capital rule will reduce the liquidity standards of Rule 15c3-1. 
Thus, the alternative method of computing net capital and, in 
particular, its requirements that broker-dealers using the 
alternative method of computing [sic] maintain minimum tentative net 
capital of at least $1 billion, maintain net capital of at least 
$500 million, notify the Commission that same day if their tentative 
net capital falls below $5 billion, and comply with Rule 15c3-4 are 
intended to provide broker-dealers with sufficient capital reserves 
to account for market, credit, operational, and other risks.'') 
(Text in brackets added).
    \97\ See 17 CFR 240.15c3-1(c)(10).
    \98\ See OTC Derivatives Dealers, 63 FR 53962. See Net Capital 
Rule, Exchange Act Release No. 39456 (Dec. 17, 1997), 62 FR 68011 
(Dec. 30, 1997) (concept release considering the extent to which 
statistical models should be used in setting the capital 
requirements for a broker-dealer's proprietary positions) (``For 
example, the current method of calculating net capital by deducting 
fixed percentages from the market value of securities can allow only 
limited types of hedges without becoming unreasonably complicated. 
Accordingly, the net capital rule recognizes only certain specified 
hedging activities, and the Rule does not account for historical 
correlations between foreign securities and U.S. securities or 
between equity securities and debt securities. By failing to 
recognize offsets from these correlations between and within asset 
classes, the fixed percentage haircut method may cause firms with 
large, diverse portfolios to reserve capital that actually 
overcompensates for market risk.'' Id. ``The primary advantage of 
incorporating models into the net capital rule is that a firm would 
be able to recognize, to a greater extent, the correlations and 
hedges in its securities portfolio and have a comparatively smaller 
capital charge for market risk.'').
    \99\ See OTC Derivatives Dealers, 63 FR 59362; Alternative Net 
Capital Requirements Adopting Release, 69 FR 34428. Further, the 
deductions to tentative net capital taken by nonbank SBSDs and 
broker-dealers are intended to create a pool of new liquid assets 
that can be used for any risk assumed by the firm and not only 
market risk. A tentative net capital requirement also serves as a 
capital buffer for these other risks to offset the narrower type of 
risk intended to be covered by calculating net capital using 
internal models.
    \100\ OTC Derivatives Dealers, 63 FR 59362.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposed capital 
requirements for stand-alone SBSDs using internal models. Commenters 
are referred to the general questions above in section II.A.2.a.i. of 
this release about the 8% margin factor as applied broadly to nonbank 
SBSDs. In addition, the Commission requests comment, including 
empirical data in support of comments, in response to the following 
questions:
    1. Is the proposed minimum net capital requirement of $20 million 
appropriate for stand-alone SBSDs that are approved to use internal 
models, in comparison to OTC derivatives dealers which are more limited 
by the activities they are permitted to conduct (such as being 
prohibited from effecting transactions with customers)? If not, explain 
why not. What minimum amount would be more appropriate? For example, 
should the minimum fixed-dollar amount be greater than $20 million to 
account for the use of internal models? If it should be a greater 
amount, how much greater should it be (e.g., $30 million, $50 million, 
$100 million, or some other amount)? Alternatively, should the minimum 
fixed-dollar amount be less than $20 million? If it should be a lower 
amount, how much lower (e.g., $15 million, $10 million, $5 million or 
some other amount)? If a greater or lesser alternative amount is 
recommended, explain why it would be more appropriate for stand-alone 
SBSDs that are approved to use internal models.
    2. Is it necessary to impose a minimum tentative net capital 
requirement for stand-alone SBSDs using internal models to capture 
additional risks not incorporated into VaR models (consistent with 
those tentative minimum met capital requirements imposed on OTC 
derivatives dealers)? If not, why not?
    3. Is the proposed amount of the minimum tentative net capital 
level of $100 million for stand-alone SBSDs using internal models 
appropriate? If not, explain why not. For example, should the minimum 
tentative net capital amount be greater than $100 million to account 
for the use of internal models? If it should be a greater amount, how 
much greater should it be (e.g., $150 million, $200 million, $250 
million, or some other amount)? Should it be a lesser amount (e.g., $75 
million, $50 million, or some other amount)? If a greater or lesser 
alternative amount is recommended, explain why it would be more 
appropriate for stand-alone SBSDs that are approved to use internal 
models.
    4. Are there metrics other than a fixed-dollar minimum tentative 
net capital requirement that would more appropriately reflect the risk 
of nonbank SBSDs? If so, identify them and explain why they would be 
preferable. For example, instead of an absolute fixed-dollar minimum 
tentative net capital requirement, should the minimum tentative net 
capital requirement be linked to a scalable metric such as the size of 
a nonbank SBSD? For any scalable minimum tentative net capital 
requirements identified, explain how the computation would work in 
practice and how the minimum requirement would address the same 
objectives of a fixed-dollar minimum. Would the 8% margin factor 
provide an appropriate and workable restraint on the amount of leverage 
incurred by stand-alone SBSDs that are approved to use internal models? 
Is there another measure that would more accurately and effectively 
address the leverage risk of these firms? If so, identify the measure 
and explain why it would be more accurate and effective.
iv. Broker-Dealer SBSDs Using Internal Models and ANC Broker-Dealers
    Under the current requirements of Rule 15c3-1, a broker-dealer that 
seeks to use internal models to compute net capital must apply to the 
Commission to become an ANC broker-dealer.\101\ If the application is 
granted, the ANC broker-dealer is able to take less than 100% 
deductions for unsecured receivables from OTC derivatives 
counterparties (non-ANC broker-dealers must deduct these receivables in 
full) and can use VaR models in lieu of the standardized haircuts to 
take deductions on their proprietary positions in securities and money 
market instruments to the extent the firm has been approved to use an 
internal model for the type of position.\102\ It is expected that some 
broker-dealer SBSDs would seek to use internal models to compute net 
capital--as have some broker-dealers--by applying to become ANC broker-
dealers. Broker-dealer SBSDs using internal models would be subject to 
the existing provisions and proposed amendments to those provisions 
currently applicable to ANC broker-dealers.
---------------------------------------------------------------------------

    \101\ See 17 CFR 240.15c3-1e.
    \102\ Id.
---------------------------------------------------------------------------

    Under the proposed amendments, the current net capital requirements 
for ANC broker-dealers in Rule 15c3-1 would be enhanced to account for 
the firms' large size, the scale of their custodial activities, and the 
potential that they may become substantially more active in the 
security-based swap markets under the Dodd-Frank Act's OTC derivatives 
reforms. As discussed in more detail below, the proposed enhancements 
would include increasing the minimum tentative net capital and minimum 
net capital requirements; increasing the ``early warning'' notice 
threshold; narrowing the types of unsecured receivables for which ANC 
broker-dealers may take a credit risk charge in lieu of a 100% 
deduction; and requiring ANC broker-dealers to comply with a new 
liquidity requirement.\103\
---------------------------------------------------------------------------

    \103\ See proposed amendments to 17 CFR 240.15c3-1; 17 CFR 
240.15c3-1e.
---------------------------------------------------------------------------

    Currently, an ANC broker-dealer must maintain minimum tentative net 
capital of at least $1 billion and minimum net capital of at least $500 
million.\104\ In addition, an ANC broker-dealer must provide the 
Commission with an ``early warning'' notice when its tentative net 
capital falls below $5 billion.\105\ These relatively high minimum 
capital requirements (as compared with the requirements for other types 
of broker-

[[Page 70228]]

dealers) reflect the substantial and diverse range of business 
activities engaged in by ANC broker-dealers and their importance as 
intermediaries in the securities markets.\106\ Further, the heightened 
capital requirements reflect the fact that, as noted above, VaR models 
are more risk sensitive but also may not capture all risks and 
generally permit substantially reduced deductions to tentative net 
capital as compared to the standardized haircuts.\107\
---------------------------------------------------------------------------

    \104\ See 17 CFR 240.15c3-1(a)(7)(i).
    \105\ See 17 CFR 240.15c3-1(a)(7)(ii).
    \106\ For example, based on data from broker-dealer FOCUS 
Reports, the six ANC broker-dealers collectively hold in excess of 
one trillion dollars' worth of customer securities. Under Rule 17a-5 
(17 CFR 240.17a-5), broker-dealers must file periodic reports on 
Form X-17A-5 (Financial and Operational Combined Uniform Single 
Reports, ``FOCUS Reports''). Unless an exception applies, the 
Commission's rules deem all reports filed under Rule 17a-5 
confidential. 17 CFR 240.17a-5(a)(3). The FOCUS Report requires, 
among other financial information, a balance sheet, income 
statement, and net capital and customer reserve computations. The 
FOCUS Report data used in this release is year-end 2011 FOCUS Report 
data.
    \107\ See Alternative Net Capital Requirements Adopting Release, 
69 FR 34428.
---------------------------------------------------------------------------

    The proposals to strengthen the requirements for ANC broker-dealers 
are made in response to issues that arose during the 2008 financial 
crisis, recognizing the large size of these firms, and the scale of 
their custodial responsibilities. The proposals also are based on the 
Commission staff's experience supervising the ANC broker-dealers. The 
financial crisis demonstrated the risks to financial firms when market 
conditions are stressed and how the failure of a large firm can 
accelerate the further deterioration of market conditions.\108\ The 
proposals are designed to bolster the ANC broker-dealer net capital 
rules to ensure that these firms continue to maintain sufficient 
capital reserves to account for market, credit, operational, and other 
risks.\109\ While the rationale for these enhancements exists 
irrespective of whether the ANC broker-dealers ultimately register as 
SBSDs, the proposed increased capital requirements also are designed to 
account for increased security-based swap activities by these firms. 
FOCUS Report data and the Commission staff's supervision of the ANC 
broker-dealers indicate that these firms currently do not engage in a 
substantial business in security-based swaps.\110\ It is expected, 
however, that they may increase their security-based swap activities 
after the Dodd-Frank Act's OTC derivatives reforms are implemented and 
become effective because security-based swap activities will need to be 
conducted in regulated entities.\111\ Consequently, financial 
institutions that currently deal in security-based swaps will need to 
register as an SBSD or register one or more affiliates as an SBSD. To 
the extent they want to offer securities products and services beyond 
those related to security-based swaps, they also will need to be 
registered as broker-dealers. Using an existing broker-dealer--
particularly an ANC broker-dealer that already is capitalized and has 
risk management systems and personnel in place--could provide 
efficiencies that create incentives to register the same entity as a 
nonbank SBSD.
---------------------------------------------------------------------------

    \108\ See, e.g., World Economic Outlook: Crisis and Recovery, 
International Monetary Fund (``IMF'') (Apr. 2009), available at 
http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf.
    \109\ See Alternative Net Capital Requirements Adopting Release, 
69 FR 34428.
    \110\ The ANC broker-dealers are subject to ongoing Commission 
staff supervision, which includes monthly meetings with senior staff 
of the ANC broker-dealers. This supervision program provides the 
Commission with information about the current practices of the ANC 
broker-dealers.
    \111\ This expectation is based on information gathered as part 
of the ANC broker-dealer supervision program.
---------------------------------------------------------------------------

    Under the proposed amendments to Rule 15c3-1, ANC broker-dealers 
would be required to maintain: (1) Tentative net capital of not less 
than $5 billion; and (2) net capital of not less than the greater of $1 
billion or the financial ratio amount required pursuant to paragraph 
(a)(1) of Rule 15c3-1 plus the 8% margin factor.\112\ FOCUS Report data 
indicates that the six current ANC broker-dealers report capital levels 
in excess of these proposed increased minimum requirements. While 
raising the tentative net capital requirement under Rule 15c3-1 from $1 
billion to $5 billion would be a significant increase, the existing 
``early warning'' notice requirement for ANC broker-dealers is $5 
billion.\113\ This $5 billion ``early warning'' threshold acts as a de 
facto minimum tentative net capital requirement since ANC broker-
dealers seek to maintain sufficient levels of tentative net capital to 
avoid the necessity of providing this regulatory notice. Accordingly, 
the objective in raising the minimum capital requirements for ANC 
broker-dealers is not to require the six existing ANC broker-dealers to 
increase their current capital levels (as they already maintain 
tentative net capital in excess of $5 billion).\114\ Rather, the goal 
is to establish new higher minimum requirements designed to ensure that 
the ANC broker-dealers continue to maintain high capital levels and 
that any new ANC broker-dealer entrants maintain capital levels 
commensurate with their peers.
---------------------------------------------------------------------------

    \112\ See proposed amendments to paragraph (a)(7)(i) of Rule 
15c3-1.
    \113\ See 17 CFR 240.15c3-1(a)(7)(i).
    \114\ The ANC broker-dealers report to the Commission staff, as 
part of the ANC broker-dealer supervision program, levels of 
tentative net capital that generally are well in excess of $6 
billion, which, as discussed below, is the proposed new ``early 
warning'' threshold for ANC broker-dealers.
---------------------------------------------------------------------------

    As indicated above, the proposed amendments to Rule 15c3-1 would 
require an ANC broker-dealer to incorporate the 8% margin factor into 
its net capital calculation.\115\ Consequently, an ANC broker-dealer 
would be required at all times to maintain tentative net capital of not 
less than $5 billion and net capital of not less than the greater of $1 
billion or the sum of the ratio requirement under paragraph (a)(1) of 
Rule 15c3-1 and eight percent (8%) of the risk margin amount for 
security-based swaps carried by the ANC broker-dealer.\116\
---------------------------------------------------------------------------

    \115\ See proposed amendments to paragraph (a)(7)(i) of Rule 
15c3-1. As discussed above in section II.A.2.a.i. of this release, 
the 8% margin factor is designed to adjust the firm's minimum net 
capital requirement in tandem with the risk associated with the 
broker-dealer firm's security-based swap activity.
    \116\ See proposed amendments to paragraph (a)(7)(i) of Rule 
15c3-1.
---------------------------------------------------------------------------

    Under the proposal, an ANC broker-dealer would be required to 
provide early warning notification to the Commission if its tentative 
net capital fell below $6 billion.\117\ The purpose of an ``early 
warning'' notice requirement is to require a broker-dealer to provide 
notice when its level of regulatory capital falls to a level that 
approaches its required minimum capital requirement but is sufficiently 
above the minimum that the Commission and SROs can increase their 
monitoring of the firm before the minimum is breached. The proposed 
increase in the minimum tentative net capital requirement to $5 billion 
necessitates a corresponding increase in the ``early warning'' 
threshold to an amount above $5 billion. Existing early warning 
thresholds for OTC derivatives dealers include a requirement to provide 
notice when the firm's tentative net capital falls below an amount that 
is 120% of the firm's required minimum tentative net capital 
amount.\118\ The proposed new ``early warning'' threshold for ANC 
broker-dealers of $6 billion in tentative net capital is modeled on 
this requirement and is equal in percentage terms (120%) to the amount 
that the early warning level exceeds the minimum tentative net capital

[[Page 70229]]

requirement for OTC derivatives dealers.
---------------------------------------------------------------------------

    \117\ See proposed amendments to paragraph (a)(7)(ii) of Rule 
15c3-1. As noted above, the ANC broker-dealers report to the 
Commission staff tentative net capital levels that generally are 
well in excess of $6 billion.
    \118\ See 17 CFR 240.17a-11(c)(3).
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    The rules applicable to ANC broker-dealers provide that the 
Commission may impose additional conditions on an ANC broker-dealer 
under certain circumstances.\119\ In particular, paragraph (e) of 
Appendix E to Rule 15c3-1 establishes a non-exclusive list of 
circumstances under which the Commission may restrict the business of 
an ANC broker-dealer, including when the firm's tentative net capital 
falls below the early warning threshold.\120\ In this event, the 
Commission--if it finds it is necessary or appropriate in the public 
interest or for the protection of investors--may impose additional 
conditions on the firm, including requiring the firm to submit to the 
Commission a plan to increase its tentative net capital (to an amount 
above the early warning level).\121\ Additional restrictions could 
include restricting the ANC broker-dealer's business on a product-
specific, category-specific, or general basis; requiring the firm to 
file more frequent reports with the Commission; modifying the firm's 
internal risk management controls or procedures; requiring the firm to 
compute deductions for market and credit risk using standardized 
haircuts; or imposing any other additional conditions, if the 
Commission finds that imposition of other conditions is necessary or 
appropriate in the public interest or for the protection of 
investors.\122\
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    \119\ See 17 CFR 240.15c3-1e(e)(1).
    \120\ Id.
    \121\ Id. See also Alternative Net Capital Requirements Adopting 
Release, 69 FR 34428.
    \122\ See 17 CFR 240.15c3-1e(e).
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Request for Comment
    The Commission generally requests comment on the proposed minimum 
capital requirements for ANC broker-dealers. Commenters are referred to 
the general questions above in section II.A.2.a.i. of this release 
about the 8% margin factor as applied broadly to nonbank SBSDs. In 
addition, the Commission requests comment, including empirical data in 
support of comments, in response to the following questions:
    1. Is the proposed increased minimum net capital requirement from 
$500 million to $1 billion for ANC broker-dealers appropriate? If not, 
explain why not. What minimum amount would be preferable? For example, 
should the minimum fixed-dollar amount be greater than $1 billion to 
account for the large size of these firms and the scale of their 
custodial activities? If so, explain why. If it should be a greater 
amount, how much greater should it be (e.g., $1.5 billion, $2 billion, 
$3 billion, or some other amount)? Alternatively, should the minimum 
fixed-dollar amount be less than $1 billion? If so, explain why. If it 
should be a lower amount, how much lower (e.g., $950 million, $900 
million, $850 million, $800 million, $750 million, or some other 
amount)? If a greater or lesser alternative amount is recommended, 
explain why it would be preferable.
    2. Is the proposed increase in the minimum tentative net capital 
level for ANC broker-dealers appropriate? If not, explain why not. For 
example, should the minimum tentative net capital amount be greater 
than $5 billion to account for the use of internal models and the large 
size of these firms and the scale of their custodial activities? If it 
should be a greater amount, how much greater should it be (e.g., $6 
billion, $8 billion, $10 billion, or some other amount)? Should it be 
lesser amount (e.g., $4 billion, $3 billion, $2 billion or some other 
amount)? If a greater or lesser alternative amount is recommended, 
explain why it would be preferable.
    3. Is the proposed increase in the early warning threshold from $5 
billion to $6 billion for ANC broker-dealers appropriate? If not, 
explain why not. For example, should the minimum tentative net capital 
amount be greater than $6 billion, given that the current early warning 
threshold ($5 billion) is five times the current tentative net capital 
requirement ($1 billion)? If the early warning level should be a 
greater amount, how much greater should it be (e.g., $8 billion, $10 
billion, $12 billion, $20 billion, $25 billion, or some other amount)? 
Should it be lesser amount (e.g., $5.8 billion, 5.5 billion, or some 
other amount)? If a greater or lesser alternative amount is 
recommended, explain why it would be preferable.
    4. Is it appropriate to require broker-dealer SBSDs to become ANC 
broker-dealers in order to use internal models? For example, would it 
be appropriate to permit broker-dealer SBSDs to use internal models but 
subject them to lesser minimum capital requirements than the ANC 
broker-dealers? If so, explain why. In addition, provide suggested 
alternative minimum capital requirements.
    5. Is combining the 8% margin factor requirement with the 
applicable Rule 15c3-1 financial ratio requirement an appropriate way 
to determine a minimum net capital requirement for ANC broker-dealers? 
If not, explain why not.
    6. Would the 8% margin factor provide an appropriate and workable 
restraint on the amount of leverage incurred by ANC broker-dealers? If 
not, explain why not. Is there another measure that would more 
accurately and effectively address the leverage risk of these firms? If 
so, identify the measure and explain why it would be more accurate and 
effective.
Additional Request for Comment on VaR-Based Capital Charges
    On June 7, 2012, the OCC, the FDIC, and the Federal Reserve 
(collectively, the ``Banking Agencies'') approved a joint final rule 
(``Final Rule'') regarding market risk capital rules.\123\ Certain 
portions of the Final Rule relate to the use of financial models for 
regulatory capital purposes. Generally, the Banking Agencies stated 
that the Final Rule is designed to ``better capture positions for which 
the market risk capital rules are appropriate; to reduce 
procyclicality; enhance the rules' sensitivity to risks that are not 
adequately captured under current methodologies; and increase 
transparency through enhanced disclosures.'' The effective date for the 
Final Rule is January 1, 2013.
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    \123\ Risk Based Capital Guidelines: Market Risk, Federal 
Reserve, FDIC, OCC, 77 FR 53059 (Aug. 30, 2012).
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    Under the Final Rule, the capital charge for market risk is the sum 
of: (1) Its VaR-based capital requirement; (2) its stressed VaR-based 
capital requirement; (3) any specific risk add-ons; (4) any incremental 
risk capital requirement; (5) any comprehensive risk capital 
requirement; and (6) any capital requirement for de minimis exposures. 
Generally, the qualitative and quantitative requirements for the 
Banking Agencies' VaR-based capital requirement are similar to the VaR-
based capital requirements for ANC broker-dealers, OTC derivatives 
dealers, and, as proposed, for nonbank SBSDs approved to use internal 
models.
    The Banking Agencies' stressed VaR-based capital requirement is a 
new requirement that banks calculate a VaR measure with model inputs 
calibrated to reflect historical data from a continuous 12-month period 
that reflects a period of significant financial stress appropriate to 
the bank's current portfolio. The stressed VaR requirement is designed 
to address concerns that the Banking Agencies' existing VaR-based 
measure, due to inherent limitations, proved inadequate in producing 
capital requirements appropriate to the level of losses incurred at 
many banks during the financial crisis and to mitigate

[[Page 70230]]

procyclicality in the existing market risk capital requirement for 
banks.
    The Final Rule also specifies modeling standards for specific risk 
and eliminates the current option for a bank to model some but not all 
material aspects of specific risk for an individual portfolio of debt 
or equity positions. To address concerns about the ability to model 
specific risk of securitization products, the Final Rule would require 
a bank to calculate an additional capital charge ``add-on'' for certain 
securitization positions that are not correlation trading positions.
    Further, under the Final Rule, a bank that measures the specific 
risk of a portfolio of debt positions using internal models is required 
to calculate an incremental risk measure for those positions using an 
internal model (an incremental risk model). Generally, incremental risk 
consists of the risk of default and credit migration risk of a 
position. Under the Final Rule, an internal model used to calculate 
capital charges for incremental risk must measure incremental risk over 
a one-year time horizon and at a one-tail, 99.9% confidence level, 
either under the assumption of a constant level of risk, or under the 
assumption of constant positions.
    A bank may measure all material price risk of one or more 
portfolios of correlation trading positions using a comprehensive risk 
model. Among the requirements for using a comprehensive risk model is 
that the model measure comprehensive risk consistent with a one-year 
time horizon and at a one-tail, 99.9% confidence level, under the 
assumption of either a constant level of risk or constant positions.
    The Commission seeks comment on whether the Final Rule adopted by 
the Banking Agencies for calculating market risk capital requirements 
should be required for ANC broker-dealers, OTC derivatives dealers, and 
nonbank SBSDs that have approval to use internal models for regulatory 
capital purposes, and, if so, which aspects of the proposed rules of 
the Banking Agencies would be appropriate in this context.
b. Computing Net Capital
i. The Net Liquid Assets Test
    The net liquid assets test embodied in Rule 15c3-1 is being 
proposed as the regulatory capital standard for all nonbank SBSDs 
(i.e., stand-alone SBSDs and broker-dealer SBSDs) because these firms, 
as previously noted, are expected to engage in a securities business 
with respect to security-based swaps that is similar to the dealer 
activities of broker-dealers and because some broker-dealers likely 
will be registered as nonbank SBSDs. In addition, Rule 15c3-1 currently 
contains provisions designed to address dealing in OTC derivatives by 
broker-dealers.\124\ Furthermore, Rule 15c3-1 has been the capital 
standard for broker-dealers since 1975 and, generally, it has promoted 
the maintenance of prudent levels of capital. As discussed in section 
II.A.1. of this release, the net liquid assets test is designed to 
promote liquidity; the rule allows a broker-dealer to engage in 
activities that are part of conducting a securities business (e.g., 
taking securities into inventory) but in a manner that places the firm 
in the position of holding at all times more than one dollar of highly 
liquid assets for each dollar of unsubordinated liabilities (e.g., 
money owed to customers, counterparties, and creditors). Consequently, 
under the proposed rules, this standard--the net liquid assets test--
would be applied to all categories of nonbank SBSDs. The objective is 
to require the nonbank SBSD to maintain sufficient liquidity so that if 
it fails financially it can meet all unsubordinated obligations to 
customers and counterparties and have adequate resources to wind-down 
in an orderly manner without the need for a formal proceeding.
---------------------------------------------------------------------------

    \124\ See 17 CFR 240.15c3-1e; 17 CFR 240.15c3-1f.
---------------------------------------------------------------------------

    The net liquid assets test is imposed through the mechanics of how 
a broker-dealer is required to compute net capital pursuant to Rule 
15c3-1. These requirements are set forth in paragraph (c)(2) of Rule 
15c3-1, which defines the term ``net capital.'' \125\ The first step is 
to compute the broker-dealer's net worth under GAAP.\126\ Next, the 
broker-dealer must make certain adjustments to its net worth to 
calculate net capital.\127\ These adjustments are designed to leave the 
firm in a position where each dollar of unsubordinated liabilities is 
matched by more than a dollar of highly liquid assets.\128\ There are 
thirteen categories of net worth adjustments required by the rule.\129\ 
The most significant adjustments are briefly discussed below.
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    \125\ See 17 CFR 240.15c3-1(c)(2).
    \126\ See id. See also, e.g., Computation of Net Capital on 
FOCUS Report Part II, available at http://sec.gov/about/forms/formx-17a-5_2.pdf. Net worth is to be computed in accordance with GAAP. 
See Interpretation Rule 15c3-1(c)(2)/01 by the Financial Industry 
Regulatory Authority (``FINRA''), available at http://www.finra.org/web/groups/industry/@ip/@reg/@rules/documents/interpretationsfor/p037763.pdf.
    \127\ See 17 CFR 240.15c3-1(c)(2).
    \128\ See, e.g., Net Capital Requirements for Brokers and 
Dealers, 54 FR at 315 (``The [net capital] rule's design is that 
broker-dealers maintain liquid assets in sufficient amounts to 
enable them to satisfy promptly their liabilities. The rule 
accomplishes this by requiring broker-dealers to maintain liquid 
assets in excess of their liabilities to protect against potential 
market and credit risks.'') (footnote omitted).
    \129\ See 17 CFR 240.15c3-1(c)(2)(i)-(xiii).
---------------------------------------------------------------------------

    The first adjustment permits the broker-dealer to add back to net 
worth liabilities that are subordinated to all other creditors pursuant 
to a loan agreement that meets requirements set forth in Appendix D to 
the net capital rule.\130\ Appendix D prescribes a number of 
requirements for a loan to qualify for the ``add-back'' treatment.\131\ 
For example, the loan agreement must provide that the broker-dealer 
cannot re-pay the loan at term if doing so would reduce its net capital 
to certain levels above the minimum requirement.\132\
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    \130\ See 17 CFR 240.15c3-1(c)(2)(ii); 17 CFR 240.15c3-1d.
    \131\ See 17 CFR 240.15c3-1d(b).
    \132\ See 17 CFR 240.15c3-1d(b)(8). The restriction on 
repayment, if triggered, makes the subordinated loan take on the 
characteristics of permanent capital in that the loan cannot be 
repaid until such time as the conditions preventing repayment no 
longer exist. Other requirements for the subordinated loan include 
that the agreement shall: (1) Have a term of at least one year; (2) 
effectively subordinate any right of the lender to receive any 
payment (a defined term) with respect thereto, together with accrued 
interest or compensation, to the prior payment or provision for 
payment in full of all claims of all present and future creditors of 
the broker-dealer arising out of any matter occurring prior to the 
date on which the related payment obligation (a defined term) 
matures; and (3) provide that the cash proceeds thereof shall be 
used and dealt with by the broker-dealer as part of its capital and 
shall be subject to the risks of the broker-dealer's business. 17 
CFR 240.15c3-1d(b)(1), (3), and (4).
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    The second adjustment to net worth is that the broker-dealer must 
add unrealized gains and deduct unrealized losses in the firm's 
accounts, mark-to-market all long and short positions in listed 
options, securities, and commodities as well as add back certain 
deferred tax liabilities.\133\
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    \133\ See 17 CFR 240.15c3-1(c)(2)(i).
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    The third adjustment is that the broker-dealer must deduct from net 
worth any asset that is not readily convertible into cash.\134\ This 
means the broker-dealer must deduct the following types of assets 
(among others): real estate; furniture and fixtures; exchange 
memberships; prepaid rent, insurance and other expenses; goodwill; and 
most unsecured receivables.\135\ An additional adjustment is that the 
broker-dealer must deduct 100% of the carrying value of securities for 
which there is no ``ready market'' or which cannot be publicly offered 
or sold because of statutory, regulatory, or contractual arrangements 
or other restrictions.\136\

[[Page 70231]]

After making these and other adjustments and taking charges required 
under Appendix B to Rule 15c3-1,\137\ the broker-dealer is left with an 
amount of adjusted net worth that is defined in the rule as ``tentative 
net capital.'' \138\
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    \134\ See 17 CFR 240.15c3-1(c)(2)(iv).
    \135\ Id.
    \136\ See 17 CFR 240.15c3-1(c)(2)(vii). Rule 15c3-1 defines 
ready market to include a recognized established securities market 
in which there exists independent bona fide offers to buy and sell 
so that a price reasonably related to the last sales price or 
current bona fide competitive bid and offer quotations can be 
determined for a particular security almost instantaneously and 
where payment will be received in settlement of a sale at such price 
within a relatively short time conforming to trade custom. See 17 
CFR 240.15c3-1(c)(11). The rule also provides that a ready market 
will be deemed to exist where the securities have been accepted as 
collateral for a loan by a bank as defined in section 3(a)(6) of the 
Exchange Act and where the broker-dealer demonstrates to its 
designated examining authority that such securities adequately 
secure such loans. Id. The rule further provides that indebtedness 
will be deemed to be adequately secured when the excess of the 
market value of the collateral over the amount of the indebtedness 
is sufficient to make the loan acceptable as a fully secured loan to 
banks regularly making secured loans to broker-dealers. See 17 CFR 
240.15c3-1(c)(5).
    \137\ 17 CFR 240.15c3-1b.
    \138\ See 17 CFR 240.15c3-1(c)(15). Tentative net capital--net 
worth after the adjustments--is the amount by which highly liquid 
assets plus subordinated debt of the broker-dealer exceeds total 
liabilities. See 17 CFR 240.15c3-1(c)(15). Hence, the adjustments to 
net worth required by Rule 15c3-1 impose the net liquid assets test.
---------------------------------------------------------------------------

    As discussed in more detail below, the final step in the process of 
computing net capital is to take deductions from tentative net capital 
to account for the market risk inherent in the proprietary positions of 
the broker-dealer and to create a buffer of extra liquidity to protect 
against other risks associated with the securities business.\139\ Most 
broker-dealers use the standardized haircuts prescribed in Rule 15c3-1 
to determine the amount of the deductions they must take from tentative 
net capital. ANC broker-dealers and OTC derivatives dealers may use 
internal VaR models to determine the amount of the deductions for 
positions for which they have been approved to use VaR models.\140\ For 
all other types of positions, they must use standardized haircuts. The 
standardized haircuts prescribe deductions in amounts that are based on 
the type of security or money market instrument and, in the case of 
certain debt instruments, the time-to-maturity of the bond.\141\ Under 
the VaR model approach, the amount of the deductions is based on an 
estimate of the maximum potential loss the portfolio of securities 
would be expected to incur over a fixed time period at a certain 
probability level.
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    \139\ See, e.g., Uniform Net Capital Rule, 42 FR 31778 
(``[Haircuts] are intended to enable net capital computations to 
reflect the market risk inherent in the positioning of the 
particular types of securities enumerated in [the rule]''); Net 
Capital Rule, 50 FR 42961 (``These percentage deductions, or 
`haircuts', take into account elements of market and credit risk 
that the broker-dealer is exposed to when holding a particular 
position.''); Net Capital Rule, 62 FR 67996 (``Reducing the value of 
securities owned by broker-dealers for net capital purposes provides 
a capital cushion against adverse market movements and other risks 
faced by the firms, including liquidity and operational risks.'') 
(footnote omitted).
    \140\ See 17 CFR 240.15c3-1e; 17 CFR 240.15c3-1f.
    \141\ See 17 CFR 240.15c3-1(c)(2)(vi).
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    In order to comply with the proposed net liquid assets test capital 
standard for nonbank SBSDs, broker-dealer SBSDs would be required to 
comply with the existing provisions of Rule 15c3-1 and proposed 
amendments to the rule designed to account for security-based swap 
activities. Consequently, a broker-dealer SBSD would compute its net 
capital pursuant to the provisions described above. Stand-alone SBSDs 
would be subject to the net liquid assets test capital standard through 
application of proposed new Rule 18a-1.\142\ The mechanics of computing 
net capital in Rule 18a-1 would be the same as the existing mechanics 
for computing net capital in Rule 15c3-1.\143\
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    \142\ See proposed new Rule 18a-1.
    \143\ Compare 17 CFR 240.15c3-1(c)(2), with paragraph (c)(1) of 
proposed new Rule 18a-1.
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ii. Standardized Haircuts for Security-Based Swaps
    As discussed above, Rule 15c3-1 provides two alternative approaches 
for taking the deductions to tentative net capital to compute net 
capital: standardized haircuts and internal VaR models.\144\ ANC 
broker-dealers and OTC derivatives dealers are permitted to use 
internal VaR models to take deductions for types of positions for which 
they have been approved to use the models. For all other types of 
positions, they must use the standardized haircuts. Broker-dealers that 
are not ANC broker-dealers or OTC derivatives dealers must use the 
standardized haircuts for all positions. The same approach is being 
proposed for nonbank SBSDs.\145\ Under this proposal, a nonbank SBSD 
would be required to apply standardized haircuts to its proprietary 
positions unless the Commission approves the firm to use internal 
models for those positions.
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    \144\ See 17 CFR 240.15c3-1(a)(5), (a)(7), and (c)(2)(vi). See 
also 17 CFR 240.15c3-1e; 17 CFR 240.15c3-1f.
    \145\ See section II.A.1. of this release.
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    Nonbank SBSDs would be required to apply the standardized haircuts 
currently set forth in Rule 15c3-1 for securities positions for which 
they have not been approved to use internal models.\146\ The 
standardized haircuts in Rule 15c3-1 prescribe differing deduction 
amounts for a variety of classes of securities, including, for example: 
securities guaranteed as to principal or interest by the government of 
the United States (``U.S. government securities''); \147\ certain 
municipal securities; \148\ Canadian debt obligations; \149\ certain 
types of mutual funds; \150\ certain types of commercial paper, bankers 
acceptances, and certificates of deposit; \151\ certain nonconvertible 
debt securities; \152\ certain convertible debt securities; \153\

[[Page 70232]]

certain cumulative, nonconvertible preferred stock; \154\ and certain 
options.\155\ The rule also contains catchall provisions to account for 
securities that are not included in these specific classes of 
securities.\156\ Generally, the catchall provisions impose higher 
deductions than the deductions in the specifically identified classes 
of securities.\157\ Further, as discussed above in section II.A.2.b.i. 
of this release, if a security does not have a ``ready market,'' it is 
subject to the 100% deduction from net worth.\158\
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    \146\ See 17 CFR 240.15c3-1(c)(2)(vi); paragraph (c)(1)(vi) of 
proposed new Rule 18a-1. As proposed, paragraph (c)(1)(vi) of 
proposed new Rule 18a-1 would incorporate by reference the 
standardized haircuts in paragraph (c)(2)(vi) of Rule 15c3-1 rather 
than repeat them in the rule text.
    \147\ See 17 CFR 240.15c3-1(c)(2)(vi)(A).
    \148\ See 17 CFR 240.15c3-1(c)(2)(vi)(B). To qualify for the 
deductions under this paragraph, the municipal security cannot be 
traded flat or in default as to principal or interest (a bond is 
traded flat if it is sold or traded without accrued interest). Id. A 
municipal security that does not meet this condition would be 
subject to the deductions prescribed in the catchall provisions 
discussed below in the paragraph accompanying this footnote or the 
100% deduction to net worth for securities that do not have a ready 
market discussed above in section II.A.2.b.i. of this release. See 
17 CFR 240.15c3-1(c)(2)(iv), (c)(2)(vi)(J), and (c)(2)(vi)(K).
    \149\ See 17 CFR 240.15c3-1(c)(2)(vi)(C).
    \150\ See 17 CFR 240.15c3-1(c)(2)(vi)(D).
    \151\ See 17 CFR 240.15c3-1(c)(2)(vi)(E). To qualify for the 
deductions under this paragraph, the instrument must have a fixed 
rate of interest or be sold at a discount and be rated in one of the 
three highest categories by at least two nationally recognized 
statistical rating organizations (``NRSROs''). Id. If the instrument 
does not meet these conditions, it is subject to the deductions 
prescribed in the catchall provisions discussed below in the 
paragraph accompanying this footnote or the 100% deduction to net 
worth for securities that do not have a ready market discussed above 
in section II.A.2.b.i. of this release. See 17 CFR 240.15c3-
1(c)(2)(iv), (c)(2)(vi)(J), and (c)(2)(vi)(K). Pursuant to section 
939A of the Dodd-Frank Act, the Commission has proposed substituting 
the NRSRO-rating requirement in this provision and other provisions 
of Rule 15c3-1 with a different standard of creditworthiness. See 
Public Law 111-203 Sec.  939A and Removal of Certain References to 
Credit Ratings Under the Securities Exchange Act of 1934, Exchange 
Act Release No. 64352 (Apr. 27, 2011), 76 FR 26550 (May 6, 2011) 
(``Reference Removal Release'').
    \152\ See 17 CFR 240.15c3-1(c)(2)(vi)(F). To qualify for the 
deductions under this paragraph, a nonconvertible debt security must 
have a fixed interest rate and a fixed maturity date, not be traded 
flat or in default as to principal or interest, and be rated in one 
of the four highest rating categories by at least two NRSROs. Id. If 
the nonconvertible debt security does not meet these conditions it 
is subject to the deductions prescribed in the catchall provisions 
discussed below in the paragraph accompanying this footnote or the 
100% deduction to net worth for securities that do not have a ready 
market discussed above in section II.A.2.b.i. of this release. See 
17 CFR 240.15c3-1(c)(2)(iv), (c)(2)(vi)(J), and (c)(2)(vi)(K). 
Pursuant to section 939A of the Dodd-Frank Act, the Commission has 
proposed substituting the NRSRO-rating requirement in this provision 
with a different standard of creditworthiness. See Public Law 111-
203 Sec.  939A; Reference Removal Release, 76 FR 26550.
    \153\ See 17 CFR 240.15c3-1(c)(2)(vi)(G).
    \154\ See 17 CFR 240.15c3-1(c)(2)(vi)(H). To qualify for the 
deductions under this paragraph, a nonconvertible preferred stock 
must rank prior to all other classes of stock of the same issuer, be 
rated in one of the four highest rating categories by at least two 
NRSROs, and not be in arrears as to dividends. Id. If the 
nonconvertible preferred stock does not meet these conditions, it is 
subject to the deductions prescribed in the catchall provisions 
discussed below in the paragraph accompanying this footnote or the 
100% deduction to net worth for securities that do not have a ready 
market discussed above. See 17 CFR 240.15c3-1(c)(2)(iv), 
(c)(2)(vi)(J), and (c)(2)(vi)(K). Pursuant to section 939A of the 
Dodd-Frank Act, the Commission has proposed substituting the NRSRO-
rating requirement in this provision with a different standard of 
creditworthiness. See Public Law 111-203 Sec.  939A; Reference 
Removal Release, 76 FR 26550.
    \155\ See 17 CFR 240.15c3-1(c)(2)(vi); 17 CFR 240.15c3-1a.
    \156\ See 17 CFR 240.15c3-1(c)(2)(vi)(J)-(K).
    \157\ Compare 17 CFR 240.15c3-1(c)(2)(vi)(A)-(H), with 17 CFR 
240.15c3-1(c)(2)(vi)(J)-(K).
    \158\ See 17 CFR 240.15c3-1(c)(2)(vii).
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    Security-based swaps currently are not an identified class of 
securities in Rule 15c3-1.\159\ The proposed amendments to Rule 15c3-1 
and proposed new Rule 18a-1 would establish standardized deductions for 
security-based swaps that would apply to broker-dealers registered as 
nonbank SBSDs and broker-dealers that are not registered as SBSDs (in 
the case of Rule 15c3-1), and to stand-alone SBSDs (in the case of Rule 
18a-1).\160\ Some broker-dealers may engage in a de minimis amount of 
security-based swap activity, which would allow them to take advantage 
of an exemption from the definition of ``security-based swap dealer'' 
and not require them to register as SBSDs.\161\ Rule 15c3-1 currently 
requires broker-dealers to take haircuts on their proprietary security-
based swap positions as they must for all proprietary positions. 
Because there are no specific standardized haircuts for security-based 
swaps, a broker-dealer currently is required to apply a deduction based 
on the existing provisions (e.g., the catchall provisions). For certain 
types of OTC derivatives, the deduction is the notional amount of the 
derivative multiplied by the deduction that would apply to the 
underlying instrument referenced by the derivative.\162\
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    \159\ See 17 CFR 240.15c3-1(c)(2)(vi).
    \160\ See proposed new paragraph (c)(2)(vi)(O) of Rule 15c3-1; 
paragraph (c)(1)(vi) of proposed new Rule 18a-1.
    \161\ See section 3(a)(71) of the Exchange Act (15 U.S.C. 
78c(a)(71)) (defining the term security-based swap dealer); Entity 
Definitions Adopting Release, 77 FR 30596; Registration of Security-
Based Swap Dealers and Major Security-Based Swap Participants, 
Exchange Act Release No. 65543 (Oct. 12, 2011), 76 FR 65784 (Oct. 
24, 2011) (``SBSD Registration Proposing Release'').
    \162\ See Net Capital Rule, Exchange Act Release No. 32256 (May 
6, 1993), 58 FR 27486, 27490 (May 10, 1993).
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    The proposals would establish two separate sets of standardized 
haircuts for security-based swaps: one applicable to security-based 
swaps that are credit default swaps and one applicable to other 
security-based swaps.\163\
---------------------------------------------------------------------------

    \163\ See proposed new paragraph (c)(2)(vi)(O) of Rule 15c3-1; 
paragraph (c)(1)(vi) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

Credit Default Swaps
    The proposed standardized haircuts for cleared and uncleared 
security-based swaps that are credit default swaps (``CDS security-
based swaps'') are designed to account for the unique attributes of 
these positions.\164\ A CDS security-based swap is an instrument in 
which the ``protection buyer'' makes a series of payments to the 
``protection seller'' and, in return, the ``protection seller'' is 
obligated to make a payment to the ``protection buyer'' if a credit 
event occurs with respect to one or more entities referenced in the 
contract or with respect to certain types of obligations of the entity 
or entities referenced in the contract.\165\ The credit events that can 
trigger a payment obligation of the protection seller on a CDS 
security-based swap referencing a corporate entity typically include 
the bankruptcy of the entity or entities referenced in the contract and 
the non-payment of interest and/or principal on one or more of 
specified type(s) of obligations issued by the entity or entities 
referenced in the contract.\166\ In the case of a CDS security-based 
swap that references an asset-backed security, the credit events may 
include a principal write-down, a failure to pay interest, and an 
interest shortfall.\167\ CDS security-based swaps referencing both 
asset-backed securities and corporate entities can include other 
standardized and customized credit events.
---------------------------------------------------------------------------

    \164\ See section 3(a)(68) of the Exchange Act (15 U.S.C. 
78c(a)(68)) (defining the term security-based swap) and Product 
Definitions Adopting Release, 77 FR 48207 (Joint Commission and CFTC 
release adopting interpretative guidance and rules to, among other 
things, further define the types of credit default swaps that would 
meet the definition of security-based swap).
    \165\ See Product Definitions Adopting Release, 77 FR 48207. See 
also The Credit Default Swap Market--Report, IOSCO FR05/12 (June 
2012) available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD385.pdf.
    \166\ See Product Definitions Adopting Release, 77 FR at 48267.
    \167\ Id. at 48267, note 682.
---------------------------------------------------------------------------

    In addition to the entity or asset-backed security to which they 
reference, CDS security-based swaps are defined by the amount of 
protection purchased (the notional amount) and the tenor of the 
contract (e.g., 1, 3, 5, 7, or 10 years). For example, a protection 
buyer can enter into a credit default swap referencing XYZ Company with 
a notional amount of $10 million and a tenor of five years. If XYZ 
Company suffers a credit event (as defined in the contract) during the 
five-year period before the contract expires, the protection seller 
must pay the protection buyer $10 million less the then-current market 
value of $10 million of obligations issued or guaranteed by XYZ 
Company.\168\ To receive this protection, the protection buyer must pay 
the protection seller periodic (typically quarterly) payments over the 
five-year term of the contract and possibly an additional upfront 
amount. The cumulative amount of annual payments can be expressed as a 
``spread'' in basis points.\169\ The spread at which a CDS security-
based swap trades is based on the market's estimation of the risk that 
XYZ Company will suffer a credit event (as defined in the contract) 
that triggers the credit seller's payment obligation as

[[Page 70233]]

well as the market's assessment of the size of that payment. The 
greater the estimated risk that a credit event will occur (or the 
greater the expected payment contingent upon a credit event occurring), 
the higher the spread (i.e., the cost of buying the protection).
---------------------------------------------------------------------------

    \168\ While most CDS security-based swaps currently use a 
standardized ``Auction Settlement'' mechanism to determine the 
amount of payment due from a protection seller to the protection 
buyer after the occurrence of a credit event, in some contracts the 
protection buyer is required to deliver obligations issued or 
guaranteed by the entity referenced in the contract to the 
protection seller. The protection seller can use the value of those 
obligations to offset the payment to the protection buyer.
    \169\ Most CDS security-based swaps currently trade with 
contractually standardized fixed rates (100 basis points or 500 
basis points for standard North American corporate CDS security-
based swaps). Buyers and sellers of protection agree on upfront 
payments to adjust the value of the contract from the contractual 
fixed rate to the rate which reflects the credit risks perceived by 
the market. For example, if the market spread for a one-year CDS 
security-based swap on XYZ Company is 200 basis points per annum and 
the notional amount is $10 million, a CDS security-based swap with a 
standardized 100-basis points fixed rate would have quarterly 
payments of $25,000 (for $100,000 in annual payments) and an upfront 
payment of approximately $100,000. See http://www.cdsmodel.com/cdsmodel/ for documentation on the standard model to convert an 
upfront payment on a CDS security-based swap to a spread (or vice-
versa) and https://www.theice.com/cds/Calculator.shtml for an 
implementation of the standard model.
---------------------------------------------------------------------------

    The proposed standardized haircuts for CDS security-based swaps 
would be based on a ``maturity grid'' approach.\170\ Rule 15c3-1 
currently uses maturity grids to prescribe standardized haircuts for 
various classes of debt instruments.\171\ The grids impose a sliding 
scale of haircuts with the largest deductions applying to bonds with 
the longest period of time-to-maturity.\172\ The grids also permit 
broker-dealers to completely or partially net long and short positions 
in these classes of debt instruments when the maturities of long and 
short positions are in the same category, subcategory, or, in some 
cases, between certain adjacent categories.\173\ The permitted netting 
allows the broker-dealer to reduce its required deductions.\174\
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    \170\ See proposed new paragraph (c)(2)(vi)(O)(1) of Rule 15c3-
1; paragraph (c)(1)(vi)(A) of proposed new Rule 18a-1.
    \171\ See 17 CFR 240.15c3-1(c)(2)(vi)(A), (B), (C), (E), and 
(G). See also FINRA Rule 4240 (which prescribes margin requirements 
for CDS security-based swaps and includes a maturity-grid approach), 
available in the FINRA Manual at http://www.finra.org; Notice of 
Filing and Order Granting Accelerated Approval of Proposed Rule 
Change, as Modified by Amendment No. 1, to Implement an Interim 
Pilot Program with Respect to Margin Requirements for Certain 
Transactions in Credit Default Swaps, Exchange Act Release No. 59955 
(May 22, 2009), 74 FR 25586 (May 28, 2009) (File No. SR-FINRA 2009-
012); Notice of Filing and Order Granting Accelerated Approval of 
Proposed Rule Change to Extend the Implementation of FINRA Rule 4240 
(Margin Requirements for Credit Default Swaps), Exchange Act Release 
No. 66528 (Mar. 7, 2012) (File No. SR-FINRA-2012-014) (extending 
interim pilot program until July 17, 2012); Notice of Filing and 
Immediate Effectiveness of Proposed Rule Change to Extend the 
Implementation of FINRA Rule 4240 (Margin Requirements for Credit 
Default Swaps), Exchange Act Release No. 67449 (July 17, 2012) 
(extending interim pilot program until July 17, 2013).
    \172\ Id. For example, the grid for certain nonconvertible debt 
securities has nine maturity categories (this class of debt 
instrument includes corporate debt and asset-backed securities). See 
17 CFR 240.15c3-1(c)(2)(vi)(F)(1). Each category prescribes a 
different deduction and the amounts of the deductions increase as 
the maturity increases. Id. The following table shows the maturity 
categories and corresponding deductions for these securities:
    Time to Maturity and Deduction
    Less than 1 year--2.0%
    1 year but less than 2 years--3.0%
    2 years but less than 3 years--5.0%
    3 years but less than 5 years--6.0%
    5 years but less than 10 years--7.0%
    10 years but less than 15 years--7.5%
    15 years but less than 20 years--8.0%
    20 years but less than 25 years--8.5%
    25 years or more--9%
    \173\ See 17 CFR 240.15c3-1(c)(2)(vi)(A), (B), (C), (E), and 
(G).
    \174\ Netting would be permitted under the proposed rule for 
cleared and non-cleared CDS because the CDS will have the same 
underlying reference obligation and similar time to maturity and 
spread factors.
---------------------------------------------------------------------------

    The proposed grid for CDS security-based swaps would prescribe the 
applicable deduction based on two variables: the length of time to 
maturity of the CDS security-based swap contract and the amount of the 
current offered basis point spread on the CDS security-based swap.\175\ 
As discussed above, the maturity grids for debt instruments in Rule 
15c3-1 require increased capital charges as maturity increases. 
Similarly, the vertical axis of the proposed grid for CDS security-
based swaps (presented in the first column of the grid) would contain 
nine maturity categories ranging from 12 months or less (the smallest 
deduction) to 121 months and longer (the largest deduction).\176\ The 
horizontal axis in the proposed maturity grid (presented in the top row 
of the grid) would contain six spread categories ranging from 100 basis 
points or less (the smallest deduction) to 700 basis points and above 
(the largest deduction).\177\ Similar to the current ``haircut'' grids 
under Rule 15c3-1, the proposed grid for CDS security-based swaps is 
designed to be risk sensitive by specifying a range of maturity and 
spread buckets.
---------------------------------------------------------------------------

    \175\ See proposed new paragraph (c)(2)(vi)(O)(1)(i) of Rule 
15c3-1; paragraph (c)(1)(vi)(A)(1) of proposed new Rule 18a-1. The 
current offered spread would be the spread on the CDS security-based 
swap offered by the market at the time of the net capital 
computation and not the spread specified under the terms of the 
contract.
    \176\ See proposed new paragraph (c)(2)(vi)(O)(1)(i) of Rule 
15c3-1; paragraph (c)(1)(vi)(A)(1) of proposed new Rule 18a-1.
    \177\ Id.
---------------------------------------------------------------------------

    The number of maturity and spread categories in the proposed grid 
for CDS security-based swaps is based on Commission staff experience 
with the maturity grids for other securities in Rule 15c3-1 and, in 
part, on FINRA Rule 4240.\178\ While FINRA Rule 4240 is one reference 
point, the maturity grid it specifies does not appear to have been 
widely used by market participants, in part because a significant 
amount of business in the current CDS security-based swap market is 
conducted by entities that are not members of FINRA.\179\ Accordingly, 
the proposed grid draws largely on Commission staff experience and 
reasoned judgments about the appropriate specifications, and, as 
detailed below, the Commission requests comment and empirical data as 
to whether these specifications or others appropriately reflect the 
unique attributes of CDS security-based swaps.
---------------------------------------------------------------------------

    \178\ See Notice of Filing and Order Granting Accelerated 
Approval of Proposed Rule Change to Amend FINRA Rule 4240 (Margin 
Requirements for Credit Default Swaps), Exchange Act Release No. 
66527 (Mar. 7, 2012) (File No. SR-FINRA-2012-015) (in which FINRA 
amended the maturity grid in Rule 4240 in the interest of regulatory 
clarity and efficiency, and based upon FINRA's experience in the 
administration of the rule).
    \179\ Broker-dealers historically have not participated in a 
significant way in security-based swap trading, in part, because the 
Exchange Act has not previously defined security-based swaps as 
``securities'' and, therefore, they have not been required to be 
traded through registered broker-dealers. Existing broker-dealer 
capital requirements, however, make it relatively costly to conduct 
these activities in broker-dealers, as discussed in section II.A.2. 
of this release. As a result, security-based swap activities, 
including CDS transactions, currently are generally concentrated in 
entities that are affiliated with the parent companies of broker-
dealers, but not in broker-dealers themselves.
---------------------------------------------------------------------------

    The horizontal ``spread'' axis is designed to address the specific 
credit risk associated with the obligor or obligation referenced in the 
contract. As noted above, the spread increases as the protection 
seller's estimation of the likelihood of a credit event occurring 
increases. Therefore, the net capital deduction--which is designed to 
address the risk inherent in the instrument--should increase as the 
spread increases. Combining the two components (maturity and spread) in 
the grid results in the smallest deduction (1% of notional) required 
for a short CDS security-based swap with a maturity of 12 months or 
less and a spread of 100 basis points or below and the largest 
deduction (50% of notional) required for a short CDS security-based 
swap with a maturity of 121 months or longer and a spread of 700 basis 
points or more. The deduction for an un-hedged short position in a CDS 
security-based swap (i.e., when the nonbank SBSD is the seller of 
protection) would be the applicable percentage specified in the grid. 
The deduction for an un-hedged long position in a CDS security-based 
swap (i.e., when the nonbank SBSD is the buyer of protection) would be 
50% of the applicable deduction in the grid.\180\
---------------------------------------------------------------------------

    \180\ See proposed new paragraph (c)(2)(vi)(O)(1)(ii) of Rule 
15c3-1; paragraph (c)(1)(vi)(A)(2) of proposed new Rule 18a-1. The 
approach of taking 100% of the applicable deduction for short 
positions in CDS security-based swaps and 50% for long positions in 
CDS security-based swaps is consistent with FINRA Rule 4240 and is 
designed to account for the greater risk inherent in short CDS 
security-based swaps.
---------------------------------------------------------------------------

    The proposed deduction requirements for CDS security-based swaps 
would permit a nonbank SBSD to net long and short positions where the 
credit default swaps reference the same entity (in the case of CDS 
securities-based swaps referencing a corporate entity) or

[[Page 70234]]

obligation (in the case of CDS securities-based swaps referencing an 
asset-backed security), reference the same credit events that would 
trigger payment by the seller of protection, reference the same basket 
of obligations that would determine the amount of payment by the seller 
of protection upon the occurrence of a credit event, and are in the 
same or adjacent maturity and spread categories (as long as the long 
and short positions each have maturities within three months of the 
other maturity category).\181\ In this case, the nonbank SBSD would 
need to take the specified percentage deduction only on the notional 
amount of the excess long or short position.\182\
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    \181\ See proposed new paragraph (c)(2)(vi)(O)(1)(iii)(A) of 
Rule 15c3-1; paragraph (c)(1)(vi)(A)(3)(i) of proposed new Rule 18a-
1.
    \182\ Id. For example, assume the nonbank SBSD is short 
protection on $10 million in notional CDS security-based swaps on 
XYZ Company with a 4.25-year (51-month) maturity that trades at a 
290 basis point spread and long protection on $8 million in notional 
CDS security-based swaps on XYZ Company with a 5.25-year (63-month) 
maturity that trades at a 310 basis point spread. Rather than take 
the deductions on the short protection $10 million position and the 
long protection $8 million position individually, the nonbank SBSD 
would take a deduction on the excess short position of $2 million 
($10 million short protection position minus the $8 million long 
protection position) of 5-year maturity CDS security-based swaps 
trading at a 290 basis point spread.
---------------------------------------------------------------------------

    A reduced deduction also could be taken for long and short CDS 
security-based swap positions in the same maturity and spread 
categories and that reference corporate entities in the same industry 
sector.\183\ In this case, the market risk of the offsetting positions 
is mitigated to the extent that macroeconomic factors similarly impact 
companies in a particular industry sector, because corporate entities 
in the same industry sector would likely be similarly impacted by 
market events affecting that specific industry. The proposed rule would 
not identify a specific source for determining industry sector 
classifications in order to provide firms flexibility and to avoid 
requiring firms to rely on a specific commercial entity to comply with 
the rule. Instead, a nonbank SBSD would need to use an industry sector 
classification system that is reasonable in terms of grouping types of 
companies with similar business activities and risk characteristics, 
and document the industry sector classification system used for the 
purposes of the rule.\184\ A nonbank SBSD could use a third-party's 
classification system or develop its own classification system, subject 
to these limitations. The nonbank SBSD would need to be able to 
demonstrate the reasonableness of the system it uses.
---------------------------------------------------------------------------

    \183\ Id.
    \184\ See proposed new paragraph (c)(2)(vi)(O)(1)(iii)(A) of 
Rule 15c3-1; paragraph (c)(1)(vi)(A)(3)(i) of proposed new Rule 18a-
1. An example of an industry sector classification system is: 
consumer discretionary, consumer staples, energy, financials, health 
care, industrials, information technology, materials, 
telecommunication services, and utilities. See the Global Industry 
Classification Standard developed by MSCI and Standard & Poor's, 
available at http://www.msci.com/resources/pdfs/MK-GICS-DIR-3-02.pdf. Another example of an industry sector classification system 
is: basic materials, cyclical consumer, energy, financials, 
healthcare, industrials, non-cyclical consumer, technology, 
telecommunications, and utilities. See Thompson Reuters' business 
classifications, available at http://thomsonreuters.com/products_services/financial/thomson_reuters_indices/trbc/sectors/.
---------------------------------------------------------------------------

    Reduced deductions also would apply for strategies where the firm 
is long (short) a bond or asset-backed security and long (short) 
protection through a CDS security-based swap referencing the same 
underlying bond or asset-backed security. In the case where the nonbank 
SBSD is long a bond or an asset-backed security and long protection 
through a credit default swap, the nonbank SBSD would be required to 
take 50% of the deduction required on the bond (i.e., no deduction 
would be required with respect to the CDS security-based swap and a 
lesser deduction would apply to the bond than would be the case if it 
were not paired with a CDS security-based swap).\185\ In other words, 
the deduction the nonbank SBSD would take if it held the bond in 
isolation would be reduced by one-half to account for the protection 
provided by the CDS security-based swap referencing the bond. This 
reduced deduction for the long bond position reflects the risk-reducing 
effects of the protection provided by the long CDS security-based swap 
position. If the nonbank SBSD is short a bond or asset-backed security 
and short protection through a credit default swap, the nonbank SBSD 
would be required to take the deduction required on the bond or asset-
backed security (i.e., no deduction would be required with respect to 
the CDS security-based swap).\186\
---------------------------------------------------------------------------

    \185\ See proposed new paragraph (c)(2)(vi)(O)(1)(iii)(B) of 
Rule 15c3-1; paragraph (c)(1)(vi)(A)(3)(ii) of proposed new Rule 
18a-1.
    \186\ See proposed new paragraph (c)(2)(vi)(O)(1)(iii)(C) of 
Rule 15c3-1; paragraph (c)(1)(vi)(A)(3)(iii) of proposed new Rule 
18a-1.
---------------------------------------------------------------------------

Non-Credit Default Swaps
    Security-based swaps that are not credit default swaps (each, a 
``non-CDS security-based swap'') can be divided into two broad 
categories: those that reference equity securities and those that 
reference debt instruments.\187\ Total return swaps are an example of a 
non-CDS security-based swap. A total return swap is an instrument that 
requires one of the counterparties (the seller) to make a payment to 
the other counterparty (the buyer) that is based on the price 
appreciation of, and income from, the underlying security referenced by 
the security-based swap.\188\ The buyer in return makes a payment that 
is based on a variable interest rate plus any depreciation of the 
underlying security referenced by the security-based swap.\189\ The 
``total return'' consists of the price appreciation or depreciation 
plus any interest or income.\190\
---------------------------------------------------------------------------

    \187\ See Product Definitions Adopting Release, 77 FR at 48207.
    \188\ See id. at 48264.
    \189\ Id.
    \190\ Id. The total return swap is designed to put the buyer in 
the position of having exposure to the reference security without 
actually owning it. Thus, the seller pays the buyer appreciation 
(i.e., gains) and any interest or income on the security and the 
buyer pays the seller any depreciation (i.e., loss) on the reference 
security plus a variable interest rate.
---------------------------------------------------------------------------

    The proposed standardized haircut for a non-CDS security-based swap 
would be the deduction currently prescribed in Rule 15c3-1 applicable 
to the instrument referenced by the security-based swap multiplied by 
the contract's notional amount.\191\ For example, the standardized 
haircut for an exchange traded equity security typically is 15%.\192\ 
Consequently, under the proposal, the standardized haircut for a non-
CDS security-based swap referencing an exchange traded equity security 
would be a deduction equal to the notional amount of the security-based 
swap multiplied by 15%.\193\ The same approach would apply to a non-CDS 
security-based swap referencing a debt instrument. For example, Rule 
15c3-1 prescribes a 7% standardized haircut for a corporate bond that 
has a maturity of five years and is not traded flat or in default as to 
principal or interest and is rated in one of the four highest rating 
categories by at least two NRSROs.\194\ Under the proposal, a non-CDS 
security-based swap referencing such a bond would require a deduction 
equal to the contract's notional amount multiplied by 7%.\195\ Linking 
the

[[Page 70235]]

standardized deduction for the non-CDS security-based swap to the 
standardized deduction that would apply to the instrument referenced by 
the security-based swap is based on the rationale that changes in the 
market value of the instrument underlying the security-based swap will 
result in corresponding changes to the market value of the security-
based swap. The proposal also is consistent with the treatment of 
equity security-based swaps under Rule 15c3-1.\196\ Moreover, the 
potential volatility of the changes in the non-CDS security-based swap 
is expected to be similar to the potential volatility in the instrument 
underlying the security-based swap. For example, as discussed above, 
the standardized haircut for an exchange traded equity security is 
15%,\197\ whereas the standardized haircut is 7% for a corporate bond 
that has a maturity of five years and is not traded flat or in default 
as to principal or interest and is rated in one of the four highest 
rating categories by at least two NRSROs.\198\ The equity security has 
a higher deduction amount because it is expected to have a greater 
amount of market risk.\199\
---------------------------------------------------------------------------

    \191\ See proposed new paragraph (c)(2)(vi)(O)(2) of Rule 15c3-
1; paragraph (c)(1)(vi)(B) of proposed new Rule 18a-1.
    \192\ See 17 CFR 240.15c3-1(c)(2)(vi)(J).
    \193\ If the notional amount was $5 million, the standardized 
haircut would be $750,000 ($5 million x 0.15 = $750,000). The 
approach of multiplying the notional amount by the percentage 
deduction applicable to the reference security is consistent with 
the CFTC's proposed capital charges of equity swaps for nonbank swap 
dealers that are not using models and are FCMs. See CFTC Capital 
Proposing Release, 76 FR at 27812-27813.
    \194\ See 17 CFR 240.15c3-1(c)(2)(vi)(F)(1)(v).
    \195\ If the notional amount was $5 million, the standardized 
haircut would be $350,000 ($5 million x 0.07 = $350,000).
    \196\ See Net Capital Rule, 58 FR at 27490.
    \197\ See 17 CFR 240.15c3-1(c)(2)(vi)(J).
    \198\ See 17 CFR 240.15c3-1(c)(2)(vi)(F)(1).
    \199\ See, e.g., Net Capital Rule, Exchange Act Release No. 
39456 (Dec. 17, 1997), 62 FR 68011 (Dec. 30, 1997) (``[A] broker-
dealer's haircut for equity securities is equal to 15 percent of the 
market value of the greater of the long or short equity position 
plus 15 percent of the market value of the lesser position, but only 
to the extent this position exceeds 25 percent of the greater 
position. In contrast to the uniform haircut for equity securities, 
the haircuts for several types of interest rate sensitive 
securities, such as government securities, are directly related to 
the time remaining until the particular security matures.'').
---------------------------------------------------------------------------

    The examples above reflect the proposed standardized haircuts for a 
single non-CDS security-based swap treated in isolation. It is expected 
that nonbank SBSDs will maintain portfolios of multiple non-CDS 
security-based swaps with offsetting long and short positions to hedge 
their risk. Under the proposed standardized haircuts for non-CDS 
security-based swaps, nonbank SBSDs would be able to recognize the 
offsets currently permitted under Rule 15c3-1.\200\ In particular, as 
discussed below, nonbank SBSDs would be permitted to treat a non-CDS 
security-based swap that references an equity security (``equity 
security-based swap'') under the provisions of Appendix A to Rule 15c3-
1, which produces a single haircut for portfolios of equity options and 
related positions.\201\ Similarly, nonbank SBSDs would be permitted to 
treat a non-CDS security-based swap that references a debt instrument 
(``debt security-based swap'') in the same manner as debt instruments 
are treated in the Rule 15c3-1 grids in terms of allowing offsets 
between long and short positions where the instruments are in the same 
maturity categories, subcategories, and in some cases, adjacent 
categories for the purposes of computing haircuts for debt security-
based swaps.\202\
---------------------------------------------------------------------------

    \200\ See proposed new paragraph (c)(2)(vi)(O)(2) of Rule 15c3-
1; paragraph (c)(1)(vi)(B) of proposed new Rule 18a-1.
    \201\ See 17 CFR 240.15c3-1a; Appendix A to proposed new Rule 
18a-1.
    \202\ See 17 CFR 240.15c3-1(c)(2)(vi).
---------------------------------------------------------------------------

    Appendix A to Rule 15c3-1 prescribes a standardized theoretical 
pricing model to determine a potential loss for a portfolio of equity 
positions involving the same equity security to establish a single 
haircut for the group of positions (``Appendix A methodology'').\203\ 
Proposed amendments to Appendix A to Rule 15c3-1 would permit equity 
security-based swaps to be included in portfolios of equity positions 
for which the Appendix A methodology is used to compute a portfolio 
haircut.\204\ Under these proposed amendments, broker-dealer SBSDs and 
broker-dealers that are not registered as SBSDs would be able to 
include equity security-based swaps in portfolios of equity positions 
for purposes of the Appendix A methodology. In addition, proposed new 
Rule 18a-1 would permit stand-alone SBSDs to use the Appendix A 
methodology as well.\205\ By permitting equity security-based swaps to 
be included in portfolios of related equity positions, broker-dealer 
SBSDs and broker-dealers that are not registered as SBSDs would be able 
to employ a more sensitive measure of the risk when computing net 
capital than would be the case if the positions were treated in 
isolation.
---------------------------------------------------------------------------

    \203\ See 17 CFR 240.15c3-1a; Appendix A to proposed new Rule 
18a-1.
    \204\ Specifically, Appendix A to Rule 15c3-1 would be amended 
to include equity security-based swaps within the definition of the 
term ``underlying instrument'' in paragraph (a)(4) of Appendix A. 
This would allow these positions to be included in portfolios of 
equity positions involving the same equity security for purposes of 
the Appendix A methodology. In addition, the proposals would include 
security futures on single stocks within the definition of the term 
``underlying instrument,'' which would permit these positions to be 
included in portfolios of positions involving the same underlying 
security for purposes of the Appendix A methodology, subject to a 
minimum charge. This proposal is made in response to legislative and 
regulatory developments that have occurred since the Appendix A 
methodology was adopted in 1997. See Net Capital Rule, Exchange Act 
Release No. 38248 (Feb. 6, 1997), 62 FR 6474 (Feb. 12, 1997). When 
the Appendix A methodology was adopted, security futures trading was 
prohibited in the U.S. This prohibition was repealed by the 
Commodity Futures Modernization Act of 2000, which established a 
framework for the joint regulation of security futures products by 
the Commission and the CFTC. Public Law 106-554, 114 Stat. 2763 
(2000). Because security futures contracts on individual stocks 
generally track the price of the underlying stock, and, at 
expiration, the price of the security futures contract equals the 
price of the underlying stock, the proposed amendments would treat a 
security future on an underlying stock as if it were the underlying 
stock. Appendix A to Rule 18a-1 similarly would include equity 
security-based swaps and security futures products in the definition 
of ``underlying instrument.'' See paragraph (a)(4) of proposed new 
Rule 18a-1a. See also letter from Michael A. Macchiaroli, Associate 
Director, Division of Trading and Markets, Commission, to Timothy H. 
Thompson, Senior Vice President and Chief Regulatory Officer, 
Chicago Board Options Exchange, Incorporated (``CBOE''), and Grace 
B. Vogel, Executive Vice President, Member Regulation, Risk 
Oversight and Operational Regulation, FINRA (May 4, 2012) (no-action 
letter permitting broker-dealers when calculating net capital using 
a theoretical pricing model pursuant to Appendix A to Rule 15c3-1 to 
group U.S.-listed security futures contracts on individual stocks 
with equity options on, and positions in, the same underlying 
instrument under paragraph (b)(1)(ii)(A) of Appendix A).
    \205\ See proposed new Rule 18a-1a.
---------------------------------------------------------------------------

    Under the Appendix A methodology (as proposed to be amended), a 
nonbank SBSD could group equity security-based swaps, options, security 
futures, long securities positions, and short securities positions 
involving the same underlying security (e.g., XYZ Company common stock) 
and stress the current market price for each position at ten 
equidistant points along a range of positive and negative potential 
future market movements, using an approved theoretical option pricing 
model that satisfies certain conditions specified in the rule.\206\ For 
equity security-based swaps, the ten stress points for a portfolio of 
related positions would span a range from -15% to +15% (i.e., -15%, -
12%, -9%, -6%, -3%, +3%, +6%, +9%, +12%, +15%).\207\ The gains and 
losses of each position (e.g., a security-based swap, option, and a 
security future referencing XYZ Company and a long position and short 
position in XYZ Company stock) in the portfolio would be allowed to 
offset each other to yield a net gain or loss at each stress 
point.\208\ The stress point

[[Page 70236]]

that yields the largest potential net loss for the portfolio would be 
used to calculate the aggregate haircut for all the positions in the 
portfolio.\209\ This method would permit a nonbank SBSD to compute 
deductions for a portfolio of equity security-based swaps in a more 
risk sensitive manner by accounting for the risk of the entire 
portfolio, rather than the risk of each position within the portfolio.
---------------------------------------------------------------------------

    \206\ See 17 CFR 240.15c3-1a(b)(1); paragraph (b)(1) of proposed 
new Rule18a-1a. Presently, there is only one theoretical options 
pricing model that has been approved for this purpose.
    \207\ This range of price movements () 15% is 
consistent with the prescribed 15% haircut for most equity 
securities. See 17 CFR 240.15c3-1(c)(2)(vi)(J).
    \208\ For example, at the -6% stress point, XYZ Company stock 
long positions would experience a 6% loss, short positions would 
experience a 6% gain, and XYZ Company options would experience gains 
or losses depending on the features of the options. These gains and 
losses are added up resulting in a net gain or loss at that point.
    \209\ Because options are part of the portfolio, the greatest 
portfolio loss (or gain) would not necessarily occur at the largest 
potential market move stress points () 15%. This is 
because a portfolio that holds derivative positions that are far out 
of the money would potentially realize large gains at the greatest 
market move points as these positions come into the money. Thus, the 
greatest net loss for a portfolio conceivably could be at any market 
move stress point. In addition, the Appendix A methodology imposes a 
minimum charge based on the number of options contracts in a 
portfolio that applies if the minimum charge is greater than the 
largest stress point charge. See 17 CFR 240.15c3-1a(b)(1)(v)(C)(2); 
paragraph (b)(1)(iv)(C)(2) of proposed new Rule 18a-1a. This minimum 
charge is designed to address issues such as leverage and liquidity 
risk that may exist even if the market risk of the portfolio is very 
low as a result of closely-correlated hedging.
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    With respect to portfolios of debt security-based swaps, a nonbank 
SBSD could use the offsets permitted in the debt-maturity grids in Rule 
15c3-1.\210\ The debt-maturity grids permit the broker-dealer to reduce 
the amount of the deductions when long debt security positions are 
offset by short debt security positions. For example, as discussed 
above, the maturity grid for nonconvertible debt securities has nine 
maturity categories.\211\ In each category, the broker-dealer is 
required to take the specified deduction on the greater of the long or 
short positions in the category.\212\ Consequently, the broker-dealer 
need not take a deduction on the gross amount of these positions (i.e., 
the broker-dealer need not take a deduction for the long and short 
positions). In addition, the rule permits the broker-dealer to exclude 
nonconvertible debt securities from the maturity categories if they are 
hedged by other similar nonconvertible debt securities or government 
securities or futures on government securities.\213\ The excluded 
positions are subject to a separate maturity grid that imposes lower 
deductions.\214\ The proposed amendments to Rule 15c3-1 and proposed 
new Rule 18a-1 would permit broker-dealer SBSDs and stand-alone SBSDs, 
respectively, to treat debt security-based swaps in the same manner as 
the debt instruments they reference are treated for the purposes of 
determining haircuts. Consequently, nonbank SBSDs could recognize the 
offsets and hedges that those provisions permit to reduce the 
deductions on portfolios of debt security-based swaps.
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    \210\ See proposed new paragraph (c)(2)(vi)(O)(2) of Rule 15c3-
1; paragraph (c)(1)(vi)(B) of proposed new Rule 18a-1 (incorporating 
by reference the standardized haircuts in Rule 15c3-1).
    \211\ See 17 CFR 240.15c3-1(c)(2)(vi)(F)(1).
    \212\ Id.
    \213\ See 17 CFR 240.15c3-1(c)(2)(vi)(F)(2).
    \214\ See 17 CFR 240.15c3-1(c)(2)(vi)(F)(3).
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Request for Comment
    The Commission generally requests comment on the proposed 
standardized haircuts for calculating deductions for security-based 
swaps. In addition, the Commission requests comment, including 
empirical data in support of comments, in response to the following 
questions:
    1. Is the proposed maturity/spread grid approach for CDS security-
based swaps appropriate in terms of addressing the risk of these 
positions? If not, explain why not. How could the proposed maturity/
spread grid approach be modified to better address the risk of these 
positions?
    2. Do broker-dealers currently use the spread/maturity grid in 
FINRA Rule 4240 to determine capital charges for credit default swaps? 
If so, what has been the experience of broker-dealers in using the 
grid? If not, what potential practical issues does the maturity/spread 
grid raise? Are there ways these practical issues could be addressed 
through modifications to the proposed maturity/spread grid?
    3. Is there an alternative maturity/spread grid approach that would 
be a preferable model for the standardized haircuts? If so, identify 
the model and explain why it would be preferable. For example, should 
the standardized haircut for a CDS security-based swap that references 
an obligation be based on the standardized haircut that would apply to 
the obligation under paragraph (c)(2)(vi) of Rule 15c3-1? If so, 
explain why. If not, explain why not. How could a CDS security-based 
swap that references an obligor as an entity be addressed under such a 
standardized haircut approach? For example, could the standardized 
haircut that would apply to obligations (e.g., bonds) issued by the 
obligor be used as a proxy for the standardized haircut that would 
apply to the CDS security-based swap referencing the obligor? If so, 
explain why.
    4. Are the proposed spread categories for the CDS security-based 
swap grid appropriate? If not, explain why not. For example, should 
there be more spread categories? If so, specify the total number of 
recommended spread categories and the basis point ranges that should be 
in each category, and explain why the recommended modifications would 
be preferable. Should there be fewer spread categories? If so, specify 
the total number of recommended spread categories and the basis point 
ranges that should be in each category, and explain why the recommended 
modifications would be preferable.
    5. Would there always be an observable current offered basis point 
spread for purposes of determining the applicable spread category for a 
CDS security-based swap? If it could be the case that a CDS security-
based swap does not have an observable current offered spread, how 
should the spread category be determined and how should the rule be 
modified to require the use of the determined spread category? For 
example, should the rule require that the nonbank SBSD apply the 
greatest percentage deduction applicable to the CDS security-based swap 
based on its maturity (i.e., the deduction prescribed in ``700 or 
more'' basis points spread category) or another deduction amount?
    6. Are the proposed maturity categories for the CDS security-based 
swap grid appropriate? If not, explain why not. For example, should 
there be more maturity categories? If so, specify the total number of 
recommended maturity categories and the time ranges that should be in 
each category, and explain why the recommended modifications would be 
preferable. Should there be fewer maturity categories? If so, specify 
the total number of recommended maturity categories and the time ranges 
that should be in each category, and explain why the recommended 
modifications would be preferable.
    7. Are the proposed percentage deductions in the CDS security-based 
swap grid appropriate? If not, explain why not. For example, should the 
percentage deductions be greater? If so, specify the greater deductions 
and explain why they would be preferable. Should the percentage 
deductions be lesser? If so, specify the lesser deductions and explain 
why it would be preferable.
    8. Is the proposed 50% reduced deduction for long CDS security-
based swaps appropriate? If not, explain why not. For example, should 
the amount of the reduced deduction be greater? If so, specify the 
amount and explain why it would be preferable. Should the amount of the 
reduced deduction be lesser? If so, specify the lesser amount and 
explain why it would be preferable.
    9. Is the proposed offset and corresponding reduced deduction for 
net long and short positions where the CDS security-based swaps 
reference the same obligor or obligation and are in the

[[Page 70237]]

same maturity and spread categories appropriate? If not, explain why 
not.
    10. Is the proposed offset and corresponding reduced deduction for 
net long and short positions where the CDS security-based swaps 
reference the same obligor or obligation, are in the same spread 
category, and are in an adjacent maturity category and have maturities 
within three months of the other maturity category appropriate? If not, 
explain why not.
    11. Is the proposed offset and corresponding reduced deduction for 
long and short CDS security-based swap positions in the same maturity 
and spread categories and that reference obligors or obligations of 
obligors in the same industry sector appropriate? If not, explain why 
not.
    12. Should the rule specify an industry sector classification 
system? If so, specify the recommended industry sector classification 
system and explain why it would be useful for the purposes of the 
standardized haircuts for CDS security-based swaps.
    13. If a nonbank SBSD uses its own industry sector classification 
system, what factors would be relevant in evaluating whether the system 
is reasonable?
    14. Should there be a concentration charge that would apply when 
the notional amount of the long and short CDS security-based swap 
positions in the same maturity and spread categories and that reference 
obligors or obligations of obligors in the same industry sector exceed 
a certain threshold to account for the potential that long and short 
positions may not directly offset each other? If so, explain why. If 
not, explain why not.
    15. Is the proposed deduction for a position where a nonbank SBDS 
is long a bond and long a CDS security-based swap on the same 
underlying obligor appropriate? If not, explain why not. For example, 
is the proposed provision that the reduced deduction would apply only 
if the CDS security-based swap allowed the nonbank SBSD to deliver the 
bond to satisfy the firm's obligation on the swap appropriate? If not, 
explain why not. Additionally, is reducing the deduction applicable to 
the bond by 50% an appropriate reduction level? Should the reduction be 
less than 50% (e.g., 25%) or greater than 50% (e.g., 75%)?
    16. Is the proposed reduced deduction for a position where a 
nonbank SBDS is short a bond and short a CDS security-based swap on the 
same underlying bond appropriate? If not, explain why not.
    17. Should the Commission propose separate grids for CDS security-
based swaps that reference a single obligor or obligation and CDS 
security-based swaps that reference a narrow based index? If so, how 
should the two grids differ?
    18. Are the proposed standardized haircuts for non-CDS security-
based swaps appropriate? If not, explain why not. For example, would 
the risk characteristics of non-CDS security-based swaps (e.g., price 
volatility) be similar to the instruments they reference? If not, 
explain why not.
    19. Are there practical issues with treating equity security-based 
swaps under the Appendix A methodology? If so, describe them. Are there 
modifications that could be made to the Appendix A methodology to 
address any practical issues identified? If so, describe the 
modifications.
    20. Are there provisions in Appendix A to Rule 15c3-1 not included 
in Appendix A to Rule 18a-1 that should be incorporated into the latter 
rule? If so, identify the provisions and explain why they should be 
incorporated into Appendix A to Rule 18a-1. For example, should the 
strategy-based methodology in Appendix A to Rule 15c3-1 be applied to 
equity security-based swaps? If so, explain why.
    21. Are there practical issues with treating debt security-based 
swaps under the debt maturity grids in Rule 15c3-1? If so, describe 
them. Are there modifications that could be made to address any 
practical issues identified? If so, describe the modifications.
iii. VaR Models
    The proposed capital requirements for nonbank SBSDs would permit 
the use of internal VaR models to compute deductions for proprietary 
securities positions, including security-based swap positions, in lieu 
of the standardized haircuts. VaR models are used by financial 
institutions for internal risk management purposes.\215\ In addition, 
VaR models are used to compute market risk charges in international 
bank capital standards \216\ and are permitted by the Commission's 
rules for ANC broker-dealers and OTC derivatives dealers.\217\ 
Furthermore, the prudential regulators and the CFTC have proposed 
permitting the use of VaR models in their capital requirements for bank 
SBSDs, bank swap dealers, and swap dealers.\218\ The use of VaR models 
to calculate market risk charges for security-based swap positions 
would be subject to the conditions described below.
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    \215\ See Alternative Net Capital Requirements Adopting Release, 
69 FR 34428 (The option to use VaR models is ``intended to reduce 
regulatory costs for broker-dealers by allowing very highly 
capitalized firms that have developed robust internal risk 
management practices to use those risk management practices, such as 
mathematical risk measurement models, for regulatory purposes''); 
Net Capital Rule, Exchange Act Release No. 39456 (Dec. 17, 1997), 62 
FR 68011 (Dec. 30, 1997) (``Given the increased use and acceptance 
of VAR as a risk management tool, the Commission believes that it 
warrants consideration as a method of computing net capital 
requirements for broker-dealers.'').
    \216\ See, e.g., Amendment to the capital accord to incorporate 
market risks, Basel Committee on Banking Supervision (Jan. 1996); 12 
CFR part 3; 12 CFR parts 208 and 225; 12 CFR part 325.
    \217\ See 17 CFR 240.15c3-1e; 17 CFR 240.15c3-1f. See also 
Alternative Net Capital Requirements Adopting Release, 69 FR 34428; 
OTC Derivatives Dealers, 63 FR 59362.
    \218\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564; CFTC Capital Proposing Release, 76 FR 27802.
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    Broker-dealer SBSDs that are not already ANC broker-dealers would 
need to obtain approval to operate as ANC broker-dealers to use 
internal VaR models to compute net capital. Stand-alone SBSDs also 
would need to obtain Commission approval to use VaR models for this 
purpose. The requirements for a broker-dealer to apply for approval to 
operate as an ANC broker-dealer are contained in Appendix E to Rule 
15c3-1.\219\ Pursuant to these requirements, the applicant must provide 
the Commission with various types of information about the 
applicant.\220\ A stand-alone SBSD applying for approval to use 
internal models to compute net capital would be required to provide 
similar information (though a stand-alone SBSD would not be required to 
provide certain information relating to its holding company or 
affiliates that is required of ANC broker-dealer applicants).\221\
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    \219\ See 17 CFR 240.15c3-1e. The application covers both the 
use of internal VaR models to compute deductions for proprietary 
positions and internal credit risk models to compute charges for 
unsecured receivables relating to OTC derivatives. Id. Specifically, 
the broker-dealer may apply to the Commission for authorization to 
compute deductions pursuant to Appendix E to Rule 15c3-1 in lieu of 
computing deductions pursuant to paragraph (c)(2)(vi) (the 
standardized haircuts) and paragraph (c)(2)(vii) (the 100% deduction 
for securities with no ready market) of Rule 15c3-1 and to compute 
deductions for credit risk pursuant to Appendix E for unsecured 
receivables arising from transactions in OTC derivatives in lieu of 
computing deductions pursuant to paragraph (c)(2)(iv) of Rule 15c3-1 
(the deductions for unsecured receivables). See 17 CFR 240.15c3-
1e(a). The use of internal credit risk models is discussed below in 
section II.A.2.b.iv. of this release.
    \220\ See Alternative Net Capital Requirements Adopting Release, 
69 FR at 34433.
    \221\ See paragraph (d)(1) of proposed new Rule 18a-1. Appendix 
E to Rule 15c3-1 requires a broker-dealer applying to become an ANC 
broker-dealer to provide information about the broker-dealer's 
ultimate holding company and affiliates. See 17 CFR 240.15c3-
1e(a)(1)(viii)-(ix) and (a)(2). Consistent with the requirements for 
OTC derivatives dealers, the proposed application requirements for 
stand-alone SBSDs seeking approval to use internal models would not 
require the submission of the information about the firm's ultimate 
holding company and affiliates required in paragraphs (a)(1)(viii)-
(ix) and (a)(2)(i)-(xi) of Appendix E to Rule 15c3-1. Compare 17 CFR 
240.15c3-1e(a)(1) and (a)(2), with paragraph (d)(1) of proposed new 
Rule 18a-1 and 17 CFR 240.15c3-1f(a). This additional information 
may be more appropriate for a broker-dealer applying to operate as 
an ANC broker-dealer because of its ability to engage in wider 
ranges of activities than a stand-alone nonbank SBSD, such as 
engaging in a general securities business. The information about the 
ultimate holding company and affiliates is designed to help ensure 
the Commission can monitor activities of the holding company and 
affiliates that could negatively impact the financial well-being of 
the broker-dealer. See Alternative Net Capital Requirements Adopting 
Release, 69 FR at 34430.

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[[Page 70238]]

    A broker-dealer applying to become an ANC broker-dealer is required 
to provide the Commission with, among other things, the following 
information:
     An executive summary of the information provided to the 
Commission with its application and an identification of the ultimate 
holding company of the ANC broker-dealer; \222\
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    \222\ See 17 CFR 240.15c3-1e(a)(1)(i). A stand-alone SBSD also 
would be required to provide this information in an application to 
use internal models. See paragraph (d)(1)(i)(A) of proposed new Rule 
18a-1.
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     A comprehensive description of the internal risk 
management control system of the broker-dealer and how that system 
satisfies the requirements set forth in Rule 15c3-4; \223\
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    \223\ See 17 CFR 240.15c3-1e(a)(1)(ii). A stand-alone SBSD also 
would be required to provide this information in an application to 
use internal models. See paragraph (d)(1)(i)(B) of proposed new Rule 
18a-1. As discussed below in section II.A.2.c. of this release, ANC 
broker-dealers are required to comply with Rule 15c3-4, and to 
provide this information in an application to use internal models. 
See 17 CFR 240.15c3-1e(a)(1)(ii), 17 CFR 240.15c3-1(a)(7)(iii) and 
17 CFR 240.15c3-4. A nonbank SBSD that does not use internal models 
also would be required to comply with Rule 15c3-4, but would not 
have to provide information to the Commission unless it determined 
to apply to the Commission to use internal models. See paragraph (g) 
of proposed new Rule 18a-1 and section II.A.2.c. of this release 
discussing this requirement.
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     A list of the categories of positions that the ANC broker-
dealer holds in its proprietary accounts and a brief description of the 
methods that the ANC broker-dealer will use to calculate deductions for 
market and credit risk on those categories of positions; \224\
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    \224\ See 17 CFR 240.15c3-1e(a)(1)(iii). A stand-alone SBSD also 
would be required to provide this information in an application to 
use internal models. See paragraph (d)(1)(i)(C) of proposed new Rule 
18a-1.
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     A description of the mathematical models to be used to 
price positions and to compute deductions for market risk, including 
those portions of the deductions attributable to specific risk, if 
applicable, and deductions for credit risk; a description of the 
creation, use, and maintenance of the mathematical models; a 
description of the ANC broker-dealer's internal risk management 
controls over those models, including a description of each category of 
persons who may input data into the models; if a mathematical model 
incorporates empirical correlations across risk categories, a 
description of the process for measuring correlations; a description of 
the backtesting procedures the ANC broker-dealer will use to backtest 
the mathematical model used to calculate maximum potential exposure; a 
description of how each mathematical model satisfies the applicable 
qualitative and quantitative requirements set forth in paragraph (d) of 
Appendix E to Rule 15c3-1; and a statement describing the extent to 
which each mathematical model used to compute deductions for market and 
credit risk will be used as part of the risk analyses and reports 
presented to senior management; \225\
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    \225\ See 17 CFR 240.15c3-1e(a)(1)(iv). A stand-alone SBSD also 
would be required to provide this information in an application to 
use internal models. See paragraph (d)(1)(i)(D) of proposed new Rule 
18a-1.
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     If the ANC broker-dealer is applying to the Commission for 
approval to use scenario analysis to calculate deductions for market 
risk for certain positions, a list of those types of positions, a 
description of how those deductions will be calculated using scenario 
analysis, and an explanation of why each scenario analysis is 
appropriate to calculate deductions for market risk on those types of 
positions; \226\
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    \226\ See 17 CFR 240.15c3-1e(a)(1)(v). A stand-alone SBSD also 
would be required to provide this information in an application to 
use internal models. See paragraph (d)(1)(i)(E) of proposed new Rule 
18a-1. As discussed below, ANC broker-dealers can use scenario 
analysis in certain cases to determine deductions for some 
positions.
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     A description of how the ANC broker-dealer will calculate 
current exposure; \227\
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    \227\ See 17 CFR 240.15c3-1e(a)(1)(vi). A stand-alone SBSD also 
would be required to provide this information in an application to 
use internal models. See paragraph (d)(1)(i)(F) of proposed new Rule 
18a-1.
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     A description of how the ANC broker-dealer will determine 
internal credit ratings of counterparties and internal credit risk 
weights of counterparties, if applicable; \228\
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    \228\ See 17 CFR 240.15c3-1e(a)(1)(vii). A stand-alone SBSD also 
would be required to provide this information in an application to 
use internal models. See paragraph (d)(1)(i)(G) of proposed new Rule 
18a-1. As discussed below in section II.A.2.b.iv. of this release, 
internal credit ratings are used to compute the credit risk charge.
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     For each instance in which a mathematical model used by 
the ANC broker-dealer to calculate a deduction for market risk or to 
calculate maximum potential exposure for a particular product or 
counterparty differs from the mathematical model used by the ultimate 
holding company of the ANC broker-dealer to calculate an allowance for 
market risk or to calculate maximum potential exposure for that same 
product or counterparty, a description of the difference(s) between the 
mathematical models; \229\ and
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    \229\ See 17 CFR 240.15c3-1e(a)(2)(xi). A stand-alone SBSD also 
would be required to provide this information in an application to 
use internal models. See paragraph (d)(1)(i)(H) of proposed new Rule 
18a-1.
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     Sample risk reports that are provided to the persons at 
the ultimate holding company who are responsible for managing group-
wide risk and that will be provided to the Commission pursuant to Rule 
15c3-1g.\230\
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    \230\ See 17 CFR 240.15c3-1e(a)(2)(xiii). A stand-alone SBSD 
would be required to provide similar information in an application 
to use internal models. See paragraph (d)(1)(i)(I) of proposed new 
Rule 18a-1. The proposed requirement for stand-alone SBSDs to 
provide this information refers to sample risk reports that are 
provided to ``management'' as opposed to the ``ultimate holding 
company.'' Id. As a practical matter, the two provisions would 
achieve the same result; namely, the submission of sample reports 
that are provided to senior levels of the firm. However, because the 
stand-alone SBSD application provisions do not require information 
about holding companies and affiliates, the proposed text of the 
rule refers to ``management.''
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    The Commission may request that a broker-dealer applying to operate 
as an ANC broker-dealer supplement its application (``ANC 
application'') with other information relating to the internal risk 
management control system, mathematical models, and financial position 
of the broker-dealer.\231\ A broker-dealer's ANC application and all 
submissions in connection with the ANC application are accorded 
confidential treatment, to the extent permitted by law.\232\ If any 
information in an ANC application is found to be or becomes inaccurate 
before the Commission approves the application, the broker-dealer must 
notify the Commission promptly and provide the Commission with a 
description of the circumstances in which the information was 
inaccurate along with updated, accurate information.\233\ The

[[Page 70239]]

Commission may approve, in whole or in part, an ANC application or an 
amendment to the application, subject to any conditions or limitations 
the Commission may require if the Commission finds the approval to be 
necessary or appropriate in the public interest or for the protection 
of investors.\234\
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    \231\ See 17 CFR 240.15c3-1e(a)(4). A similar provision would 
apply to stand-alone SBSDs applying to use internal models. See 
paragraph (d)(2) of proposed new Rule 18a-1.
    \232\ See 17 CFR 240.15c3-1e(a)(5). See also 5 U.S.C. 552; 
Alternative Net Capital Requirements Adopting Release, 69 FR at 
34433 (discussing confidential treatment of ANC applications). A 
similar provision would apply to information submitted by stand-
alone SBSDs applying to use internal models. See paragraph (d)(3) of 
proposed new Rule 18a-1.
    \233\ See 17 CFR 240.15c3-1e(a)(6). A similar provision would 
apply to stand-alone SBSDs applying to use internal models. See 
paragraph (d)(4) of proposed new Rule 18a-1.
    \234\ See 17 CFR 240.15c3-1e(a)(7). A similar provision would 
apply to applications of stand-alone SBSDs applying to use internal 
models. See paragraph (d)(5) of proposed new Rule 18a-1.
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    As part of the ANC application approval process, the Commission 
staff reviews the operation of the broker-dealer's VaR model, including 
a review of associated risk management controls and the use of stress 
tests, scenario analyses, and back-testing.\235\ As part of this 
process and on an ongoing basis, the broker-dealer applicant is 
required to demonstrate to the Commission that the VaR model reliably 
accounts for the risks that are specific to the types of positions the 
broker-dealer intends to include in the model computations. During the 
review, the Commission assesses the quality, rigor, and adequacy of the 
technical components of the VaR model and of related model governance 
processes. Stand-alone SBSDs applying for approval to use internal 
models to compute net capital would be subject to similar reviews of 
their VaR models as part of the application process.
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    \235\ The Commission also reviews the broker-dealer's credit 
risk model.
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    After an ANC application is approved, an ANC broker-dealer is 
required to amend and submit to the Commission for approval its ANC 
application before materially changing its VaR model or its internal 
risk management control system.\236\ Further, an ANC broker-dealer is 
required to notify the Commission 45 days before it ceases using a VaR 
model to compute net capital.\237\ Finally, the Commission, by order, 
can revoke an ANC broker-dealer's ability to use a VaR model to compute 
net capital if the Commission finds that the ANC broker-dealer's use of 
the model is no longer necessary or appropriate in the public interest 
or for the protection of investors.\238\ In this case, the broker-
dealer would need to revert to using the standardized haircuts for all 
positions.
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    \236\ See 17 CFR 240.15c3-1e(a)(8). This requirement also 
applies to material changes to the ANC broker-dealer's internal 
credit risk model. Id. A similar provision would apply to stand-
alone SBSDs approved to use internal models. See paragraph (d)(6) of 
proposed new Rule 18a-1.
    \237\ See 17 CFR 240.15c3-1(a)(10). This requirement also 
applies to the ANC broker-dealer's internal credit risk model. Id. A 
similar provision would apply to stand-alone SBSDs approved to use 
internal models. See paragraph (d)(7) of proposed new Rule 18a-1.
    \238\ See 17 CFR 240.15c3-1e(a)(11). This requirement also 
applies to the ANC broker-dealer's internal credit risk model. Id. A 
similar provision would apply to stand-alone SBSDs approved to use 
internal models. See paragraph (d)(8) of proposed new Rule 18a-1.
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    An ANC broker-dealer must comply with certain qualitative and 
quantitative requirements set forth in Appendix E to Rule 15c3-1.\239\ 
A stand-alone SBSD approved to use a VaR model would be subject to the 
same qualitative and quantitative requirements.\240\ In this regard, 
VaR models estimate the maximum potential loss a portfolio of 
securities and other instruments would be expected to incur over a 
fixed time period at a certain probability level. The model utilizes 
historical market data to generate potential values of a portfolio of 
positions taking into consideration the observed correlations between 
different types of assets.
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    \239\ See 17 CFR 15c3-1e(d).
    \240\ Compare 17 CFR 15c3-1e(d), with paragraph (d)(9) of 
proposed new Rule 18a-1.
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    The qualitative requirements in Appendix E to Rule 15c3-1 specify, 
among other things, that: (1) Each VaR model must be integrated into 
the ANC broker-dealer's daily internal risk management system; \241\ 
(2) each VaR model must be reviewed periodically by the firm's internal 
audit staff, and annually by a registered public accounting firm, as 
that term is defined in section 2(a)(12) of the Sarbanes-Oxley Act of 
2002 (15 U.S.C. 7201 et seq.); \242\ and (3) the VaR measure computed 
by the model must be multiplied by a factor of at least three but 
potentially a greater amount based on the number of exceptions to the 
measure resulting from quarterly back-testing exercises.\243\
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    \241\ See 17 CFR 240.15c3-1e(d)(1)(i). A similar provision would 
apply to stand-alone SBSDs approved to use internal models. See 
paragraph (d)(9)(i)(A) of proposed new Rule 18a-1.
    \242\ See 17 CFR 240.15c3-1e(d)(1)(ii). The annual review must 
be conducted in accordance with procedures agreed upon by the 
broker-dealer and the registered public accounting firm conducting 
the review. A similar provision would apply to stand-alone SBSDs 
approved to use internal models. See paragraph (d)(9)(i)(B) of 
proposed new Rule 18a-1.
    \243\ See 17 CFR 240.15c3-1e(d)(1)(iii). A back-testing 
exception occurs when the ANC broker-dealer's actual one-day loss 
exceeds the amount estimated by its VaR model. See, e.g., 
Supervisory framework for the use of ``backtesting'' in conjunction 
with the internal models approach to market risk capital 
requirements, Basel Committee on Banking Supervision (Jan. 1996) 
(``The essence of all backtesting efforts is the comparison of 
actual trading results with model-generated risk measures. If this 
comparison is close enough, the backtest raises no issues regarding 
the quality of the risk measurement model. In some cases, however, 
the comparison uncovers sufficient differences that problems almost 
certainly must exist, either with the model or with the assumptions 
of the backtest. In between these two cases is a grey area where the 
test results are, on their own, inconclusive.''). Depending on the 
number of back-testing exceptions, the ANC broker-dealer may need to 
increase the market risk multiplier to 3.40, 3.50, 3.65, 3.75, 3.85, 
or 4.00. Id. Increasing the multiplier increases the deduction 
amount, which in turn is designed to account for a model that is 
producing less accurate measures. The same multiplier provision 
would apply to stand-alone SBSDs approved to use internal models. 
See paragraph (d)(9)(i)(C) of proposed new Rule 18a-1.
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    The quantitative requirements specify that the VaR model of the ANC 
broker-dealer must, among other things: (1) Use a 99%, one-tailed 
confidence level with price changes equivalent to a ten-business-day 
movement in rates and prices; \244\ (2) use an effective historical 
observation period of at least one year; \245\ (3) use historical data 
sets that are updated at least monthly and are reassessed whenever 
market prices or volatilities change significantly; \246\ and (4) take 
into account and incorporate all significant, identifiable market risk 
factors applicable to positions of the ANC broker-dealer, including 
risks arising from non-linear price characteristics, empirical 
correlations within and across risk factors, spread risk, and specific 
risk for individual positions.\247\
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    \244\ See 17 CFR 240.15c3-1e(d)(2)(i). This means the potential 
loss measure produced by the model is a loss that the portfolio 
could experience if it were held for ten trading days and that this 
potential loss amount would be exceeded only once every 100 trading 
days. A similar provision would apply to stand-alone SBSDs approved 
to use internal models. See paragraph (d)(9)(ii)(A) of proposed new 
Rule 18a-1.
    \245\ See 17 CFR 240.15c3-1e(d)(2)(iii). A similar provision 
would apply to stand-alone SBSDs approved to use internal models. 
See paragraph (d)(9)(ii)(C) of proposed new Rule 18a-1.
    \246\ See 17 CFR 240.15c3-1e(d)(2)(iii). A similar provision 
would apply to stand-alone SBSDs approved to use internal models. 
See paragraph (d)(9)(ii)(C) of proposed new Rule 18a-1.
    \247\ See 17 CFR 240.15c3-1e(d)(2)(iv). A similar provision 
would apply to stand-alone SBSDs approved to use internal models. 
See paragraph (d)(9)(ii)(D) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

    The deduction an ANC broker-dealer must take to tentative net 
capital in lieu of the standardized haircuts is an amount equal to the 
sum of four charges.\248\ The first is a portfolio market risk charge 
for all positions that are included in the ANC broker-dealer's VaR 
models (i.e., the amount measured by each VaR model multiplied by a 
factor of at least three).\249\ The second charge is a specific risk 
charge for positions where specific risk was not captured in the VaR 
model.\250\ The third

[[Page 70240]]

charge is for positions not included in the VaR model where the ANC 
broker-dealer is approved to determine a charge using scenario 
analysis.\251\ The fourth charge is determined by applying the 
standardized haircuts for all other positions.\252\
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    \248\ See 17 CFR 240.15c3-1e(b). A similar provision would apply 
to stand-alone SBSDs approved to use internal models. See paragraph 
(e)(1) of proposed new Rule 18a-1.
    \249\ See 17 CFR 240.15c3-1e(b)(1). A similar charge would apply 
to stand-alone SBSDs in determining their deduction amount. See 
paragraph (e)(1)(i) of proposed new Rule 18a-1.
    \250\ See 17 CFR 240.15c3-1e(b)(2). Specific risk is the risk 
that a security price will change for reasons unrelated to broader 
market moves. The market risk charge is designed to address the risk 
that the value of a portfolio of trading book assets will decline as 
a result of a broad move in market prices or interest rates. For 
example, the potential that the S&P 500 index will increase or 
decrease on the next trading day creates market risk for a portfolio 
of equity securities positions (longs, shorts, options, and OTC 
derivatives) and the potential that interest rates will increase or 
decrease on the next trading day creates market risk for a portfolio 
of fixed-income positions (longs, shorts, options, and OTC 
derivatives). The specific risk charge is designed to address the 
risk that the value of an individual position would decline for 
reasons unrelated to a broad movement of market prices or interest 
rates. For example, specific risk includes the risk that the value 
of an equity security will decrease because the issuer announces 
poor earnings for the previous quarter or the value of a debt 
security will decrease because the issuer's credit rating is 
lowered. The Commission is proposing a similar charge that would 
apply to stand-alone SBSDs in determining their deduction amount. 
See paragraph (e)(1)(ii) of proposed new Rule 18a-1.
    \251\ See 17 CFR 240.15c3-1e(b)(3). A similar charge would apply 
to stand-alone SBSDs in determining their deduction amount. See 
paragraph (e)(1)(iii) of proposed new Rule 18a-1.
    \252\ See 17 CFR 240.15c3-1e(b)(4). A similar charge would apply 
to stand-alone SBSDs in determining their deduction amount. See 
paragraph (e)(1)(iv) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

    Finally, ANC broker-dealers are subject to on-going supervision 
with respect to their internal risk management, including their use of 
VaR models.\253\ In this regard, the Commission staff meets regularly 
with senior risk managers at each ANC broker-dealer to review the risk 
analytics prepared for the firm's senior management. These reviews 
focus on the performance of the risk measurement infrastructure, 
including statistical models, risk governance issues such as 
modifications to and breaches of risk limits, and the management of 
outsized risk exposures. In addition, Commission staff and personnel 
from an ANC broker-dealer hold regular meetings focused on financial 
results, the management of the firm's balance sheet, and, in 
particular, the liquidity of the balance sheet. The Commission staff 
also monitors the performance of the ANC broker-dealer's internal 
models through regular reports generated by the firms for their 
internal risk management purposes (backtesting, stress test, and other 
monthly risk reports) and discussions with firm personnel (scheduled 
and ad hoc).\254\ Material changes to the internal models are also 
subject to review and approval.\255\ Stand-alone SBSDs approved to use 
internal models to compute net capital would be subject to similar 
monitoring and reviews.
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    \253\ More detailed descriptions of the Commission's ANC broker-
dealer program are available on the Commission's Web site at http://www.sec.gov/divisions/marketreg/bdriskoffice.htm and http://www.sec.gov/divisions/marketreg/bdaltnetcap.htm. The ultimate 
holding companies of the ANC broker-dealers also are subject to 
monitoring by Commission staff.
    \254\ In addition to regularly scheduled meetings, 
communications with ANC broker-dealers may increase in frequency, 
dependent on existing market conditions, and at times, may involve 
daily, weekly or other ad hoc calls or meetings.
    \255\ See 17 CFR 240.15c3-1e(a)(8).
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposed 
requirements for using VaR models to compute net capital. In addition, 
the Commission requests comment, including empirical data in support of 
comments, in response to the following questions:
    1. Would VaR models appropriately account for the risks of 
security-based swaps? If not, explain why not. For example, do the 
characteristics of security-based swaps make it more difficult to 
measure their market risk using VaR models than it is to measure the 
market risk of other types of securities using VaR models? If so, 
explain why.
    2. Are the application requirements in Appendix E to Rule 15c3-1 an 
appropriate model for the application requirements in proposed new Rule 
18a-1? If not, explain why not.
    3. Are there provisions in the application requirements in Appendix 
E to Rule 15c3-1 not incorporated into proposed new Rule 18a-1 that 
should be included in the proposed rule, such as information regarding 
the ultimate holding company of the nonbank SBSD? If so, identify the 
provisions and explain why they should be incorporated into the 
proposed rule.
    4. Is the review process for ANC applications an appropriate model 
for the review process for stand-alone SBSDs seeking approval to use 
internal models to compute net capital? If not, explain why not.
    5. Are there ways to facilitate the timely review of applications 
from nonbank SBSDs to use internal models if a large number of 
applications are filed at the same time? For example, could a more 
limited review process be used if a banking affiliate of a nonbank SBSD 
has been approved by a prudential regulator to use the same model the 
nonbank SBSD intends to use? If so, what conditions should attach to 
such approval? Are there other indicia of the reliability of such 
models that could be relied on?
    6. Are the qualitative requirements in Appendix E to Rule 15c3-1 an 
appropriate model for the qualitative requirements in proposed new Rule 
18a-1?
    7. More generally, are the qualitative requirements in Appendix E 
to Rule 15c3-1 appropriate for VaR models that will include security-
based swaps? If not, explain why not. For example, are there additional 
or alternative qualitative requirements that should be required to 
address the unique risk characteristics of security-based swaps? If so, 
describe them and explain why they would be appropriate qualitative 
requirements.
    8. Are the quantitative requirements in Appendix E to Rule 15c3-1 
an appropriate model for the quantitative requirements in proposed new 
Rule 18a-1? If not, explain why not.
    9. More generally, are the quantitative requirements in Appendix E 
to Rule 15c3-1 appropriate for VaR models that will include security-
based swaps? If not, explain why not. For example, are there additional 
or alternative quantitative requirements that should be required to 
address the unique risk characteristics of security-based swaps? If so, 
describe them and explain why they would be preferable.
    10. Are the components of the deduction an ANC broker-dealer must 
take from tentative net capital under Appendix E to Rule 15c3-1 an 
appropriate model for the components of the deduction a stand-alone 
SBSD approved to use internal models would be required to take from 
tentative net capital under proposed new Rule 18a-1? If not, explain 
why not.
    11. Should the Commission employ the same type of on-going 
monitoring process used for ANC broker-dealers to monitor stand-alone 
SBSDs using internal models? If not, explain why not.
iv. Credit Risk Charges
    Obtaining collateral is one of the ways dealers in OTC derivatives 
manage their credit risk exposure to OTC derivatives 
counterparties.\256\ Collateral may be provided to cover the amount of 
the

[[Page 70241]]

current exposure of the dealer to the counterparty.\257\ In this case, 
the collateral is designed to protect the dealer from losing the 
positive market value of the OTC contract if the counterparty 
defaults.\258\ Collateral also may be provided to cover an amount in 
excess of the current exposure (sometimes referred to as ``residual 
exposure'') of the dealer to the counterparty.\259\ In this case, the 
collateral is designed to protect the dealer from potential future 
credit risk exposure to the counterparty (``potential future 
exposure'').\260\ This risk, among other things, is that the current 
exposure may increase in the future and the counterparty will default 
on the obligation to provide additional collateral to cover the 
increase or an increase in the amount of current exposure will occur 
after the counterparty defaults and is no longer providing 
collateral.\261\
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    \256\ See, e.g., International Swaps and Derivatives 
Association, Inc. (``ISDA''), Market Review of OTC Derivative 
Bilateral Collateralization Practices, Release 2.0 (Mar. 1, 2010), 
available at http://www.isda.org/c_and_a/pdf/Collateral-Market-Review.pdf (``Market Review of OTC Derivative Bilateral 
Collateralization Practices''); Committee on Payment and Settlement 
Systems and the Euro-currency Standing Committee of the Central 
Banks of the Group of Ten countries, OTC Derivatives: Settlement 
Procedures And Counterparty Risk Management, (Sept. 1998), available 
at http://www.bis.org/publ/ecsc08.pdf (``OTC Derivatives: Settlement 
Procedures And Counterparty Risk Management'').
    \257\ See, e.g., ISDA, Independent Amounts, Release 2.0 (Mar. 1, 
2010) (``Independent Amounts''). The current exposure is the amount 
that the counterparty would be obligated to pay the nonbank SBSD if 
all the OTC derivatives contracts with the counterparty were 
terminated (i.e., the net positive value of the OTC contracts to the 
nonbank SBSD and the net negative value of the OTC contracts to the 
counterparty). The amount payable on the OTC derivatives contracts 
(the positive value) is determined by marking-to-market the OTC 
derivatives contracts and netting contracts with a positive value 
against contracts with a negative value. The market value of an OTC 
derivatives contract also is referred to as the replacement value of 
the contract as that is the amount the nonbank SBSD would need to 
pay to enter into an identical contract with a different 
counterparty.
    \258\ Id. at 2 (``The commercial reason for basing the 
collateral requirement around the Exposure is that this represents 
an approximation of the amount of credit default loss that would 
occur between the parties if one were to default.'').
    \259\ Id. at 4.
    \260\ Id. at 6 (``The underlying commercial reason behind 
Independent Amounts is the desire to create a ``cushion'' of 
additional collateral to protect against certain risk * * *'').
    \261\ Id.
---------------------------------------------------------------------------

    As discussed below in section II.B. of this release, the margin 
rule for non-cleared security-based swaps--proposed new Rule 18a-3--
would require a nonbank SBSD to collect collateral from a counterparty 
to cover current and potential future exposure to the 
counterparty.\262\ However, under the rule, a nonbank SBSD would not be 
required to collect collateral from a commercial end user to cover 
current and potential future exposure to the commercial end user.\263\ 
This proposed exception to collecting collateral from commercial end 
users is intended to address concerns that have been expressed by these 
entities and others that the imposition of margin requirements on 
commercial companies that use derivatives to mitigate business risks 
could disrupt their ability to enter into hedging transactions by 
making it prohibitively expensive.\264\ At the same time, because 
collecting collateral is an important means of mitigating risk, nonbank 
SBSDs would be required to take a 100% deduction from net worth if 
collateral is not collected from a commercial end user to cover the 
amount of the nonbank SBSD's uncollateralized current exposure.\265\ In 
addition, as discussed below in section II.A.2.b.v. of this release, 
nonbank SBSDs would be required to take a capital charge equal to the 
amount that the potential future exposure to the commercial end user--
as measured under proposed new Rule 18a-3--is uncollateralized.\266\ As 
an alternative to taking these 100% capital charges for 
uncollateralized current and potential future exposure to a commercial 
end user, an ANC broker-dealer and a stand-alone SBSD using internal 
models could take a credit risk charge using a methodology in Appendix 
E to Rule 15c3-1.\267\ This charge would be designed to balance the 
concern of commercial end users that delivering collateral to nonbank 
SBSDs could disrupt their ability to enter into hedging transactions 
with the need for nonbank SBSDs to account for their credit risk to 
commercial end users.
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    \262\ See proposed new Rule 18a-3.
    \263\ See paragraph (c)(1)(iii)(A) of proposed new Rule 18a-3. 
As discussed in section II.B. of this release, proposed new Rule 
18a-3 would contain three other exceptions to the requirements in 
the rule to collect and hold collateral. See paragraphs 
(c)(1)(iii)(B), (C), and (D) of proposed new Rule 18a-3. The 
proposed alternative credit risk charge discussed in this section of 
the release would not apply to these other exceptions.
    \264\ See, e.g., letter from the Honorable Debbie Stabenow, 
Chairman, Committee on Agriculture, Nutrition and Forestry, U.S. 
Senate, the Honorable Frank D. Lucas, Chairman, Committee on 
Agriculture, U.S. House of Representatives, the Honorable Tim 
Johnson, Chairman, Committee on Banking, Housing, and Urban Affairs, 
U.S. Senate, and the Honorable Spencer Bachus, Chairman, Committee 
on Financial Services, U.S. House of Representatives to Secretary 
Timothy Geithner, Department of Treasury, Chairman Gary Gensler, 
CFTC, Chairman Ben Bernanke, Federal Reserve Board, and Chairman 
Mary Schapiro, Commission (Apr. 6, 2011); letter from the Honorable 
Christopher Dodd, Chairman, Committee on Banking, Housing, and Urban 
Affairs, U.S. Senate, and the Honorable Blanche Lincoln, Chairman, 
Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, to 
the Honorable Barney Frank, Chairman, Financial Services Committee, 
U.S. House of Representatives, and the Honorable Collin Peterson, 
Chairman, Committee on Agriculture, U.S. House of Representatives 
(June 30, 2010); 156 Cong. Rec. S5904 (daily ed. July 15, 2010) 
(statement of Sen. Lincoln). See also letter from Coalition for 
Derivatives End-Users to David A. Stawick, Secretary, CFTC (July 11, 
2011); letter from Paul Cicio, President, Industrial Energy Users of 
America, to David A. Stawick, Secretary, CFTC (July 11, 2011); 
letter from Coalition for Derivatives End-Users to Elizabeth Murphy, 
Secretary, Commission and David A. Stawick, Secretary, CFTC (Sept. 
10, 2010).
    \265\ See 17 CFR 240.15c3-1(c)(2)(iv)(B) (which requires a 
broker-dealer--and would require a broker-dealer SBSD--to deduct 
unsecured and partly secured receivables); paragraph (c)(1)(iii)(B) 
of proposed new Rule 18a-1 (which would contain an analogous 
provision for stand-alone SBSDs).
    \266\ See proposed new paragraph (c)(2)(xiv) of Rule 15c3-1; 
paragraph (c)(1)(viii)(B)(1) of proposed Rule 18a-1.
    \267\ See proposed amendments to paragraph (a)(7) of Rule 15c3-
1; paragraph (a)(2) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

    ANC broker-dealers currently are permitted to add back to net worth 
uncollateralized receivables from counterparties arising from OTC 
derivatives transactions (i.e., they can add back the amount of the 
uncollateralized current exposure).\268\ Instead of the 100% deduction 
that applies to most unsecured receivables under Rule 15c3-1, ANC 
broker-dealers are permitted to take a credit risk charge based on the 
uncollateralized credit exposure to the counterparty.\269\ In most 
cases, the credit risk charge is significantly less than a 100% 
deduction, since it is a percentage of the amount of the receivable 
that otherwise would be deducted in full. ANC broker-dealers are 
permitted to use this approach because they are required to implement 
processes for analyzing credit risk to OTC derivative counterparties 
and to develop mathematical models for estimating credit exposures 
arising from OTC derivatives transactions and determining risk-based 
capital charges for those exposures.\270\ Under the current 
requirements, this approach is used for uncollateralized OTC 
derivatives receivables from all types of counterparties.\271\ For the 
reasons discussed below, this treatment would be narrowed under the 
proposed capital requirements for ANC broker-dealers and stand-alone 
SBSDs using internal models so that it would apply only to 
uncollateralized receivables from commercial end users arising from 
security-based swaps (i.e., uncollateralized receivables from other 
types of counterparties would be subject to the 100% deduction from net 
worth).\272\
---------------------------------------------------------------------------

    \268\ See 17 CFR 240.15c3-1e(c). OTC derivatives dealers are 
permitted to treat such uncollateralized receivables in a similar 
manner. See 17 CFR 240.15c3-1f.
    \269\ See 17 CFR 240.15c3-1e(c); 17 CFR 240.15c3-1(a)(7).
    \270\ Id.
    \271\ Id. While the requirements permit this treatment for 
unsecured receivables from all types of counterparties, the amount 
of the credit risk charge--as discussed below--depends on the 
creditworthiness of the counterparty. Id.
    \272\ See proposed amendments to paragraphs (a) and (c) of Rule 
15c3-1e.

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[[Page 70242]]

    The current requirements for determining risk-based capital charges 
for credit exposures are prescribed in Appendix E to Rule 15c3-1. These 
requirements are based on a method of computing capital charges for 
credit risk exposures in the international capital standards for 
banking institutions. In general terms, credit risk is the risk of loss 
arising from a borrower or counterparty's failure to meet its 
obligations in accordance with agreed terms, including, for example, by 
failing to make a payment of cash or delivery of securities. The 
considerations that inform an entity's assessment of a counterparty's 
credit risk therefore are broadly similar across the various 
relationships that may arise between the dealer and the counterparty. 
Accordingly, the methodology in Appendix E to Rule 15c3-1 should be a 
reasonable model for determining risk-based capital charges for credit 
exposures whether the entity in question is an ANC broker-dealer or a 
stand-alone SBSD using models. Similarly, because credit risk arises 
regardless of the number or size of transactions, the methodology 
should apply in a consistent manner whether an entity deals exclusively 
in OTC derivatives, maintains a significant book of such derivatives, 
or only engages in one from time to time.
    As discussed above in section II.A.2.b.i. of this release, the 
capital standard in Rule 15c3-1 is a net liquid assets test. The rule 
imposes this test by requiring a broker-dealer to deduct all illiquid 
assets, including most unsecured receivables.\273\ The goal is to 
require the broker-dealer to hold more than one dollar of highly liquid 
assets for each dollar of unsubordinated liabilities. The rule requires 
a 100% deduction for most types of unsecured receivables because these 
assets cannot be readily converted into cash to provide immediate 
liquidity to the broker-dealer.\274\ FOCUS Report data and Commission 
staff experience with supervising the ANC broker-dealers indicates that 
ANC broker-dealers have not engaged in a large volume of OTC 
derivatives transactions since these rules were adopted in 2004. 
Therefore, they have not had significant amounts of unsecured 
receivables that could be subject to the credit risk charge provisions 
in Appendix E to Rule 15c3-1. However, when the Dodd-Frank Act's OTC 
derivatives reforms are implemented and become effective, ANC broker-
dealers could significantly increase the amount of the receivables 
these firms have relating to OTC derivatives. This development could 
adversely impact the liquidity of the ANC broker-dealers to the extent 
exposures to OTC derivatives are not collateralized.
---------------------------------------------------------------------------

    \273\ See 17 CFR 240.15c3-1(c)(2)(iv).
    \274\ See Interpretation Guide to Net Capital Computation for 
Brokers and Dealers, 32 FR at 858.
---------------------------------------------------------------------------

    For these reasons, ANC broker-dealers (including broker-dealer 
SBSDs that are approved to use internal models) would be required to 
treat uncollateralized receivables from counterparties arising from 
security-based swaps like most other types of unsecured receivables 
(i.e., subjecting them to a 100% deduction from net worth) except when 
the counterparty is a commercial end user. In the case of a commercial 
end user, the ANC broker-dealer would be permitted to continue to take 
a credit risk charge in lieu of the 100% deduction.\275\ Stand-alone 
SBSDs that are approved to use internal models also would be permitted 
to take a credit risk charge for uncollateralized receivables arising 
from security-based swaps with (and only with) commercial end users in 
lieu of the 100% deduction.\276\
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    \275\ See proposed amendments to paragraphs (a) and (c) of Rule 
15c3-1e.
    \276\ See paragraph (e)(2) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

    Under the proposed capital requirements for nonbank SBSDs, this 
credit risk charge for a commercial end user could serve as an 
alternative to the proposed capital charge in lieu of collecting 
collateral to cover potential future exposure.\277\ The proposed 
capital charge in lieu of margin is designed to address situations 
where a nonbank SBSD does not collect sufficient (or any) collateral to 
cover potential future exposure relating to cleared and non-cleared 
security-based swaps.\278\ This situation may arise with respect to 
counterparties to non-cleared security-based swaps that are commercial 
end users because proposed new Rule 18a-3 would not require nonbank 
SBSDs to collect collateral from them to cover either current or 
potential future exposure.\279\
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    \277\ See proposed new paragraph (c)(2)(xiv) of Rule 15c3-1; 
paragraph (c)(1)(viii)(B)(1) of proposed Rule 18a-1.
    \278\ Id.
    \279\ See paragraph (c)(1)(iii)(A) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    The proposed method for calculating the credit risk charge for 
commercial end users would be the same method ANC broker-dealers 
currently are permitted to use for all OTC derivatives 
counterparties.\280\ A stand-alone SBSD approved to use internal models 
would use the same method.\281\ Under this method, the credit risk 
charge is the sum of three calculated amounts: (1) A counterparty 
exposure charge; (2) a concentration charge if the current exposure to 
a single counterparty exceeds certain thresholds; and (3) a portfolio 
concentration charge if aggregate current exposure to all 
counterparties exceeds certain thresholds.\282\
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    \280\ See 17 CFR 240.15c3-1e(c); paragraph (e)(2) of proposed 
new Rule 18a-1.
    \281\ See paragraph (e)(2) of proposed new Rule 18a-1. While 
this discussion focuses on the application of the method in the 
context of ANC broker-dealers, the same method would be used by 
stand-alone SBSDs for the reasons described above, in particular the 
fact that credit risk exposure should not vary materially depending 
on whether an entity is a broker-dealer SBSD or a stand-alone SBSD.
    \282\ 17 CFR 240.15c3-1e(c).
---------------------------------------------------------------------------

    The first component of the credit risk charge is the counterparty 
exposure charge.\283\ An ANC broker-dealer must determine an exposure 
charge for each OTC derivatives counterparty. The first component of 
the credit risk charge is the aggregate of the exposure charges across 
all counterparties. The exposure charge for a counterparty that is 
insolvent, in a bankruptcy proceeding, or in default of an obligation 
on its senior debt, is the net replacement value of the OTC derivatives 
contracts with the counterparty (i.e., the net amount of the 
uncollateralized current exposure to the counterparty).\284\ The 
counterparty exposure charge for all other counterparties is the credit 
equivalent amount of the ANC broker-dealer's exposure to the 
counterparty multiplied by an applicable credit risk weight factor and 
then multiplied by 8%.\285\ The credit equivalent amount is the sum of 
the ANC broker-dealer's: (1) Maximum potential exposure (``MPE'') to 
the counterparty multiplied by a back-testing determined factor; and 
(2) current exposure to the counterparty.\286\

[[Page 70243]]

The MPE amount is a charge to address potential future exposure and is 
calculated using the ANC broker-dealer's VaR model as applied to the 
counterparty's positions after giving effect to a netting agreement 
with the counterparty, taking into account collateral received from the 
counterparty, and taking into account the current replacement value of 
the counterparty's positions.\287\ The current exposure amount is the 
current replacement value of the counterparty's positions after giving 
effect to a netting agreement with the counterparty and taking into 
account collateral received from the counterparty.\288\
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    \283\ 17 CFR 240.15c3-1e(c)(1). A stand-alone SBSD approved to 
use internal models would be required to take an identical credit 
risk charge for this type of counterparty. See paragraph (e)(2)(i) 
of proposed new Rule 18a-1.
    \284\ See 17 CFR 240.15c3-1e(c)(1)(i). In other words, the 
uncollateralized receivable is deducted in full. A stand-alone SBSD 
approved to use internal models would take an identical credit risk 
charge for this type of counterparty. See paragraph (e)(2)(i)(A) of 
proposed new Rule 18a-1.
    \285\ See 17 CFR 240.15c3-1e(c)(1)(ii). A stand-alone SBSD 
approved to use internal models would take an identical credit risk 
charge for this type of counterparty. See paragraph (e)(2)(i)(B) of 
proposed new Rule 18a-1. The 8% multiplier is consistent with the 
calculation of credit risk in the OTC derivatives dealers rules and 
with the Basel Standard, and is designed to dampen leverage to help 
ensure that the firm maintains a safe level of capital. See 
Alternative Net Capital Requirements Adopting Release, 69 FR at 
34436, note 42.
    \286\ See 17 CFR 240.15c3-1e(c)(4)(i). The amount of the factor 
is based on backtesting exceptions. A stand-alone SBSD approved to 
use internal models would determine the credit equivalent amount in 
the same manner. See paragraph (e)(2)(iv)(A) of proposed new Rule 
18a-1.
    \287\ See 17 CFR 240.15c3-1e(c)(4)(ii). A stand-alone SBSD 
approved to use internal models would compute MPE in the same 
manner. See paragraph (e)(2)(iv)(B) of proposed new Rule 18a-1.
    \288\ See 17 CFR 240.15c3-1e(c)(4)(iii). A stand-alone SBSD 
approved to use internal models would compute current exposure in 
the same manner. See paragraph (e)(2)(iv)(C) of proposed new Rule 
18a-1.
---------------------------------------------------------------------------

    A collateral agreement gives the dealer the right of recourse to an 
asset or assets that can be sold or the value of which can be applied 
in the event the counterparty defaults on an obligation arising from an 
OTC derivatives contract between the dealer and the counterparty.\289\ 
Collateral ``ideally'' is ``an asset of stable and predictable value, 
an asset that is not linked to the value of the transaction in any way 
and an asset that can be sold quickly and easily if the need arises.'' 
\290\ Appendix E to Rule 15c3-1 sets forth requirements for taking 
account of collateral in determining the MPE and current exposure 
amounts.\291\ These requirements are designed to require collateral 
that meets the characteristics noted above. The requirements, among 
other things, include that the collateral is: (1) Marked-to-market each 
day; (2) subject to a daily margin maintenance requirement;\292\ (3) in 
the ANC broker-dealer's possession and control; (4) liquid and 
transferable; (5) capable of being liquidated promptly without 
intervention of any other party; (6) subject to a legally enforceable 
collateral agreement; (7) not comprised of securities issued by the 
counterparty or a party related to the ANC broker-dealer or the 
counterparty; (8) comprised of instruments that can be included in the 
ANC broker-dealer's VaR model; and (9) not used in determining the 
credit rating of the counterparty.\293\
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    \289\ See Market Review of OTC Derivative Bilateral 
Collateralization Practices at 5.
    \290\ Id.
    \291\ See 17 CFR 240.15c3-1e(c)(4)(v). A stand-alone SBSD 
approved to use internal models would be subject to the same 
requirements in order to be permitted to take into account 
collateral when determining the MPE and current exposure amounts. 
See paragraph (e)(2)(iv)(E) of proposed new Rule 18a-1.
    \292\ This refers to an internal maintenance margin requirement 
(i.e., not one imposed by regulation).
    \293\ See 17 CFR 240.15c3-1e(c)(4)(v)(A)-(H). A stand-alone SBSD 
approved to use internal models would be subject to the same 
requirements. See paragraph (e)(2)(iv)(E)(1)-(8) of proposed new 
Rule 18a-1.
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    Appendix E to Rule 15c3-1 sets forth certain minimum requirements 
for giving effect to netting agreements \294\ when determining the MPE 
and current exposure amounts.\295\ Specifically, an ANC broker-dealer 
may include the effect of a netting agreement that allows the netting 
of gross receivables from and gross payables to a counterparty upon 
default of the counterparty if:
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    \294\ Netting agreements are bilateral contracts between two 
counterparties that enter into OTC derivatives contracts with each 
other. In netting agreements, the two parties agree that if one 
counterparty defaults, the pending OTC derivatives contracts between 
the parties will be closed out and a single net payment obligation 
will be determined (as opposed to payment obligations for each 
separate OTC derivatives contract between the parties). The amount 
of the single net payment obligation is determined by offsetting OTC 
derivatives contracts that have a positive value to a counterparty 
with OTC derivatives contracts that have a negative value to the 
counterparty. After the offsets, one counterparty has an amount of 
positive value, which to the other counterparty is a negative value. 
This is the amount of the single net payment obligation. If the non-
defaulting counterparty is owed the single net payment amount, it 
can liquidate collateral held to secure the obligations of the 
defaulting counterparty. However, if the non-defaulting party does 
not hold collateral, it becomes a general creditor of the defaulting 
counterparty with respect to the amount of the single net payment 
obligation.
    \295\ See 17 CFR 240.15c3-1e(c)(4)(iv). A stand-alone SBSD 
approved to use internal models would be subject to the same 
requirements in order to be permitted to take into account netting 
agreements when determining MPE and current exposure amounts. See 
paragraph (e)(2)(iv)(D) of proposed new Rule 18a-1.
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     The netting agreement is legally enforceable in each 
relevant jurisdiction, including in insolvency proceedings;
     The gross receivables and gross payables that are subject 
to the netting agreement with a counterparty can be determined at any 
time; and
     For internal risk management purposes, the ANC broker-
dealer monitors and controls its exposure to the counterparty on a net 
basis.\296\
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    \296\ See 17 CFR 240.15c3-1e(c)(4)(iv)(A)-(C). A stand-alone 
SBSD approved to use internal models would be subject to the same 
requirements. See paragraphs (e)(2)(iv)(D)(1)-(3) of proposed new 
Rule 18a-1.
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These requirements are designed to ensure that the netting agreement 
between the ANC broker-dealer and the counterparty permits the ANC 
broker-dealer to reduce the receivables and payables between the two 
entities to a single net payment obligation.
    The counterparty exposure charge is the sum of the MPE and current 
exposure amounts multiplied by an applicable credit risk weight factor 
and then multiplied by 8%.\297\ Appendix E to Rule 15c3-1 prescribes 
three standardized credit risk weight factors (20%, 50%, and 150%) and, 
as an alternative, permits an ANC broker-dealer with Commission 
approval to use internal methodologies to determine appropriate credit 
risk weights to apply to counterparties.\298\ A higher percentage 
credit risk weight factor results in a larger counterparty exposure 
charge amount. Moreover, because the counterparty exposure charge is 
designed to require the ANC broker-dealer to hold capital to address 
the firm's credit risk exposure to the counterparty, the selection of 
the appropriate risk weight factor to use for a given counterparty is 
based on an assessment of the creditworthiness of the counterparty. ANC 
broker-dealers are permitted to use internally derived credit ratings 
to select the appropriate risk weight factor.\299\
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    \297\ See 17 CFR 240.15c3-1e(c)(1)(ii). As noted above, an 8% 
multiplier is consistent with the international bank capital 
standards and is designed to dampen leverage to help ensure that the 
ANC broker-dealer maintains a safe level of capital. See Alternative 
Net Capital Requirements Adopting Release, 69 FR at 34436.
    \298\ See 17 CFR 240.15c3-1e(c)(4)(vi). A stand-alone SBSD 
approved to use internal models would be subject to the same 
requirements. See paragraph (e)(2)(iv)(F) of proposed new Rule 18a-
1. The credit risk weights in Appendix E to Rule 15c3-1 were based 
on the international bank capital standards. See Alternative Net 
Capital Requirements Adopting Release, 69 FR at 34436 (``These 
proposed credit risk weights were based on the formulas provided in 
the Foundation Internal Ratings-Based approach to credit risk 
proposed by the Basel Committee and were derived using a loss given 
default (the percent of the amount owed by the counterparty the firm 
expects to lose if the counterparty defaults) of 75%.'') (citations 
omitted).
    \299\ See 17 CFR 240.15c3-1e(c)(4)(vi)(D). There is a basic 
method for ANC broker-dealers to determine the applicable risk 
weight factor using external credit ratings of NRSROs. See 17 CFR 
240.15c3-1e(c)(4)(vi)(A)-(C). Currently, all six ANC broker-dealers 
are approved to use internally derived credit ratings. See Reference 
Removal Release, 76 FR at 26555. Pursuant to section 939A of the 
Dodd-Frank Act, the Commission has proposed eliminating the basic 
method of using NRSRO credit ratings and, consequently, if the 
proposals are adopted, an ANC broker-dealer would be required to use 
internally derived credit ratings. See Public Law 111-203 Sec.  939A 
and Reference Removal Release, 76 FR at 26555-26556. Consistent with 
section 939A of the Dodd-Frank Act, there would not be a basic 
method for stand-alone SBSDs approved to use internal models. See 
paragraph (e)(2)(iv)(F) of proposed new Rule 18a-1. Consequently, 
these nonbank SBSDs would be required to use internally derived 
credit ratings to determine the appropriate risk weight factor to 
apply to a counterparty. This does not mean that an ANC broker-
dealer or stand-alone SBSD could not include external credit ratings 
as part of its internal credit rating methodology. See Reference 
Removal Release, 76 FR at 26552-26553 (identifying external credit 
ratings as one of several factors a broker-dealer could consider 
when assessing credit risk under the Commission's proposals to 
substitute NRSRO credit ratings in the broker-dealer rules with a 
different standard of creditworthiness).

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[[Page 70244]]

    The second component of an ANC broker-dealer's credit risk charge 
is a counterparty concentration charge.\300\ This charge accounts for 
the additional risk resulting from a relatively large exposure to a 
single counterparty.\301\ This charge is triggered if the current 
exposure of the ANC broker-dealer to a counterparty exceeds 5% of the 
tentative net capital of the ANC broker-dealer.\302\ In this case, the 
ANC broker-dealer must take a counterparty concentration charge equal 
to: (1) 5% of the amount by which the current exposure exceeds 5% of 
tentative net capital for a counterparty with a risk weight factor of 
20% or less; (2) 20% of the amount by which the current exposure 
exceeds 5% of tentative net capital for a counterparty with a risk 
weight factor of greater than 20% and less than 50%; and (3) 50% of the 
amount by which the current exposure exceeds 5% of tentative net 
capital for a counterparty with a risk weight factor of 50% or 
more.\303\
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    \300\ See 17 CFR 240.15c3-1e(c)(2). A stand-alone SBSD approved 
to use internal models would be subject to the same counterparty 
concentration charge. See paragraph (e)(2)(ii) of proposed new Rule 
18a-1.
    \301\ Concentration charges are intended to provide a liquidity 
cushion if a lack of diversification of positions exposes the firm 
to additional risk.
    \302\ See 17 CFR 240.15c3-1e(c)(2)(i)-(iii). A stand-alone SBSD 
approved to use internal models would be subject to the same 
threshold in determining the counterparty concentration charge. See 
paragraphs (e)(2)(ii)(A)-(C) of proposed new Rule 18a-1.
    \303\ See 17 CFR 240.15c3-1e(c)(1)(i)-(iii). A stand-alone SBSD 
approved to use internal models would be subject to the same 
charges. See paragraphs (e)(2)(ii)(A)-(C) of proposed new Rule 18a-
1.
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    The third--and final--component of the credit risk charge is a 
portfolio concentration charge.\304\ The portfolio concentration charge 
is designed to address the risk of having a relatively large amount of 
unsecured receivables relative to the size of the firm. This charge is 
triggered when the aggregate current exposure of the ANC broker-dealer 
to all counterparties exceeds 50% of the firm's tentative net 
capital.\305\ In this case, the portfolio concentration charge is equal 
to 100% of the amount by which the aggregate current exposure exceeds 
50% of the ANC broker-dealer's tentative net capital.\306\
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    \304\ See 17 CFR 240.15c3-1e(c)(3). A stand-alone SBSD approved 
to use internal models would be subject to the same portfolio 
concentration charge. See paragraph (e)(2)(iii) of proposed new Rule 
18a-1.
    \305\ 17 CFR 240.15c3-1e(c)(3).
    \306\ See 17 CFR 240.15c3-1e(c)(3). A stand-alone SBSD approved 
to use internal models would be subject to the same charge. See 
paragraph (e)(2)(iii) of proposed new Rule 18a-1.
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Request for Comment
    The Commission generally requests comment on the proposed credit 
risk charges. In addition, the Commission requests comment, including 
empirical data in support of comments, in response to the following 
questions:
    1. Should ANC broker-dealers and stand-alone SBSDs using internal 
models be required to deduct in full unsecured receivables from 
commercial end users, rather than being permitted to use the proposed 
credit risk charge? If so, explain why. If not, explain why not. For 
example, would ANC broker-dealers and stand-alone SBSDs using internal 
models have substantial amounts of receivables from commercial end 
users that, if not collateralized, could adversely impact the liquidity 
of these firms? If so, what measures in addition to the proposed credit 
risk charge could be implemented to address the risk of 
uncollateralized credit risk exposure to commercial end users in the 
absence of a required 100% deduction? Commenters should provide data to 
support their responses to these questions.
    2. Should ANC broker-dealers and stand-alone SBSDs using internal 
models be required to take a capital charge in lieu of margin for non-
cleared security-based swaps with commercial end users? If so, explain 
why. If not, explain why not. For example, would ANC broker-dealers and 
stand-alone SBSDs using internal models enter into substantial amounts 
of non-cleared security-based swaps with commercial end users that 
could adversely impact the risk profiles of these firms, if collateral 
was not collected to cover potential future exposure? If so, what 
measures in addition to the proposed credit risk charge could be 
implemented to address this risk in the absence of a required 100% 
deduction? Commenters should provide data to support their responses to 
these questions.
    3. Is the credit risk charge an appropriate measure to address the 
risk to nonbank SBSDs of having uncollateralized current and potential 
future exposure to commercial end users? If so, explain why. If not, 
explain why not. Are there other measures that could be implemented as 
an alternative or in addition to the credit risk charge to address the 
risk of this uncollateralized exposure? If so, identify the measures 
and explain why they would be appropriate alternatives or supplements 
to the credit risk charge.
    4. What will be the economic impact of the credit risk charge? For 
example, will the additional capital that a nonbank SBSD would be 
required to maintain because of the credit risk charge result in costs 
that will be passed through to end users? Please explain.
    5. Should the application of the credit risk charge be expanded to 
unsecured receivables from other types of counterparties? If so, 
explain why. If not, explain why not. How would such an expansion 
impact the liquidity of nonbank SBSDs?
    6. Should the application of the credit risk charge be expanded to 
the other exceptions to the margin collateral requirements in proposed 
new Rule 18a-3? If so, explain why. If not, explain why not. How would 
such an expansion impact the risk profile of nonbank SBSDs?
    7. The ability to take a credit risk charge in lieu of a 100% 
deduction for an unsecured receivable would apply only to unsecured 
receivables from commercial end users arising from security-based swap 
transactions. Consequently, an ANC broker-dealer and a nonbank SBSD 
would need to take a 100% deduction for unsecured receivables from 
commercial end users arising from swap transactions. Should the 
application of the credit risk charge be expanded to include unsecured 
receivables from commercial end users arising from swap transactions? 
If so, explain why. If not, explain why not. How would such an 
expansion impact the liquidity of nonbank SBSDs?
    8. Is the overall method of computing the credit risk charge 
appropriate for nonbank SBSDs? If not, explain why not. For example, 
are there differences between ANC broker-dealers and nonbank SBSDs that 
would make the method of computing the credit risk charge appropriate 
for the former but not appropriate for the latter? If so, identify the 
differences and explain why they would make the credit risk charge not 
appropriate for nonbank SBSDs. What modifications should be made to the 
method of computing the credit risk charge for nonbank SBSDs?
    9. Are the steps required to compute the credit risk charge 
understandable? If not, identify the steps that require further 
explanation.
    10. Is the method of computing the first component of the credit 
risk charge--the counterparty exposure charge--appropriate for nonbank 
SBSDs? If not, explain why not. For example, is the calculation of the 
credit equivalent amount for a counterparty

[[Page 70245]]

(i.e., the sum of the MPE and the current exposure to the counterparty) 
a workable requirement for nonbank SBSDs? If not, explain why not.
    11. Are the conditions for taking collateral into account when 
calculating the credit equivalent amount appropriate for nonbank SBSDs? 
If not, explain why not.
    12. Are the conditions for taking netting agreements into account 
when calculating the credit equivalent amount appropriate for nonbank 
SBSDs? If not, explain why not.
    13. Are the standardized risk weight factors (20%, 50%, and 150%) 
proposed for calculating the credit equivalent amount appropriate for 
nonbank SBSDs? If not, explain why not.
    14. Is the method of computing the second component of the credit 
risk charge--the counterparty concentration charge--appropriate for 
nonbank SBSDs? If not, explain why not.
    15. Is the method of computing the third component of the credit 
risk charge--portfolio concentration charge--appropriate for nonbank 
SBSDs? If not, explain why not.
v. Capital Charge In Lieu of Margin Collateral
    As discussed above in section II.B. of this release, collateral is 
one of the ways dealers in OTC derivatives manage their credit risk 
exposure to OTC derivatives counterparties.\307\ Collateral may be 
provided to cover the amount of the current exposure of the dealer to 
the counterparty.\308\ Collateral also may be provided to cover the 
potential future exposure of the dealer to the counterparty, i.e., 
margin collateral.\309\ Clearing agencies will impose margin collateral 
requirements on their clearing members, including nonbank SBSDs, for 
cleared security-based swaps.\310\ In addition, as discussed below in 
section II.B. of this release, proposed new Rule 18a-3 would establish 
margin collateral requirements for nonbank SBSDs with respect to non-
cleared security-based swaps.\311\ Furthermore, FINRA also prescribes 
margin requirements for security-based swaps.\312\
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    \307\ See Market Review of OTC Derivative Bilateral 
Collateralization Practices.
    \308\ See Independent Amounts.
    \309\ Id. at 4.
    \310\ See discussion below in section II.B. of this release.
    \311\ See proposed new Rule 18a-3.
    \312\ See FINRA Rule 4240.
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    Rule 15c3-1 currently requires a broker-dealer to take a deduction 
from net worth for under-margined accounts.\313\ Specifically, the 
broker-dealer is required to deduct from net worth the amount of cash 
required in each customer's and noncustomer's account to meet a 
maintenance margin requirement of the firm's designated examining 
authority after application of calls for margin, marks to the market, 
or other required deposits which are outstanding five business days or 
less.\314\ These deductions serve the same purpose as the deductions a 
broker-dealer is required to take on proprietary securities positions 
in that they account for risk of the positions in the customer's 
account, which the broker-dealer may need to liquidate if the customer 
defaults on obligations to the broker-dealer.
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    \313\ See 17 CFR 240.15c3-1(c)(2)(xii).
    \314\ Id.
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    In order to prescribe a similar requirement for security-based swap 
positions, Rule 15c3-1 would be amended to require broker-dealer SBSDs 
to take a deduction from net worth for the amount of cash required in 
the account of each security-based swap customer to meet the margin 
requirements of a clearing agency, self-regulatory organization 
(``SRO''), or the Commission, after application of calls for margin, 
marks to the market, or other required deposits which are outstanding 
one business day or less.\315\ An analogous provision would be included 
in new Rule 18a-1, though it would not refer to margin requirements of 
SROs because stand-alone SBSDs will not be members of SROs.\316\ These 
provisions would require broker-dealer SBSDs to take capital charges 
when their security-based swap customers do not meet margin collateral 
requirements of clearing agencies, SROs, or the Commission after one 
business day from the date the margin collateral requirement arises. 
The capital charge would be designed to address the risk to nonbank 
SBSDs that arises from not collecting the margin collateral.\317\
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    \315\ See proposed new paragraph (c)(2)(xii)(B) of Rule 15c3-1.
    \316\ See paragraph (c)(1)(ix) of proposed new Rule 18a-1.
    \317\ See section II.B.1. of this release for a discussion of 
the purpose of margin collateral.
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    As discussed below in section II.B. of this release, proposed new 
Rule 18a-3 would require nonbank SBSDs to collect collateral to meet 
account equity requirements by noon of the next business day from the 
day the account equity requirement arises.\318\ Consequently, to be 
consistent with the proposed requirement to collect collateral within 
one day, the under-margined capital charge for security-based swap 
accounts would be triggered within one day of the margin requirement 
arising, as opposed to the five-day trigger in Rule 15c3-1.
---------------------------------------------------------------------------

    \318\ See paragraph (c)(1)(ii) of proposed new Rule 18a-3.
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    In addition to the deductions for under-margined security-based 
swap accounts, the proposed rules would impose capital charges designed 
to address situations where the account of a security-based swap 
customer is meeting all applicable margin requirements but the margin 
collateral requirement results in the collection of an amount of 
collateral that is insufficient to address the risk because, for 
example, the requirement for cleared security-based swaps established 
by a clearing agency does not result in sufficient margin collateral to 
cover the nonbank SBSD's exposure or because an exception to collecting 
margin collateral for non-cleared security-based swaps exists.\319\ 
These proposed capital charges would not apply in the circumstance, 
discussed in the preceding section, involving unsecured receivables 
from commercial end users, which would be separately addressed by 
proposed new Rule 18a-1 and proposed amendments to Rule 15c3-1.\320\ 
The proposed capital charges relating to margin collateral would be 
required deductions from the nonbank SBSD's net worth when computing 
net capital.\321\ The proposals are intended to require a nonbank SBSD 
to set aside net capital to address the risks of potential future 
exposure that are mitigated through the collection of margin 
collateral. The set aside net capital would serve as an alternative to 
obtaining margin collateral for this purpose.
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    \319\ See proposed new paragraph (c)(2)(xiv) of Rule 15c3-1; 
paragraph (c)(1)(viii) of proposed new Rule 18a-1. The exceptions to 
the proposed margin rule are discussed below.
    \320\ As discussed above in section II.A.2.b.v. of this release, 
nonbank SBSDs would be required to take a 100% deduction to net 
worth when calculating net capital equal to their uncollateralized 
current exposure to a counterparty arising from a security-based 
swap except that an ANC broker-dealer and a stand-alone SBSD 
approved to use internal models could take a credit risk charge as 
an alternative to the 100% deduction if the counterparty was a 
commercial end user. See 17 CFR 240.15c3-1(c)(2)(iv)(B) (which 
requires a broker-dealer--and would require a broker-dealer SBSD--to 
deduct unsecured and partly secured receivables); paragraph 
(c)(1)(iii)(B) of proposed new Rule 18a-1 (which would contain an 
analogous provision for stand-alone SBSDs).
    \321\ Id.
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    With respect to cleared security-based swaps, for which margin 
requirements will not be established by the Commission, the rules would 
impose a capital charge that would apply if a nonbank SBSD collects 
margin collateral from a counterparty in an amount that is less than 
the deduction that would apply to the security-based swap if it was a 
proprietary position of

[[Page 70246]]

the nonbank SBSD (i.e., less than an amount determined by using the 
standardized haircuts in Commission Rule 15c3-1, as proposed to be 
amended, and in proposed new Rule 18a-1 or a VaR model, as 
applicable).\322\ This aspect of the proposal is intended to adequately 
account for the risk of the counterparty defaulting by requiring the 
nonbank SBSD to maintain capital in the place of margin collateral in 
an amount that is no less than would be required for a proprietary 
position.\323\ This requirement also is intended to ensure that there 
is a standard minimum coverage for exposure to cleared security-based 
swap counterparties apart from the individual clearing agency margin 
requirements, which could vary among clearing agencies and over time. 
If the counterparty defaults, the nonbank SBSD would need to liquidate 
the counterparty's cleared security-based swaps and other positions in 
the account to cover the counterparty's obligation to the nonbank SBSD. 
Thus, the nonbank SBSD will become subject to the market risk of these 
positions in the event of the counterparty's default. If the positions 
decrease in value, the nonbank SBSD may not be able to cover the 
defaulted counterparty's obligations to the nonbank SBSD through the 
liquidation of the positions because the cash proceeds from the 
liquidation may yield less than the obligation.
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    \322\ See proposed paragraph (c)(2)(xiv)(A) of Rule 15c3-1; 
paragraph (c)(1)(viii)(A) of proposed Rule 18a-1.
    \323\ As discussed in section II.B.2. of this release, the 
margin requirements for non-cleared security-based swaps would be 
the same as the deductions to net capital that a nonbank SBSD would 
take on the positions under Rule 15c3-1, as proposed to be amended, 
and proposed new Rule 18a-1.
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    Margin collateral is designed to mitigate this risk by serving as a 
buffer to account for a decrease in the market value of the 
counterparty's positions between the time of the default and the 
liquidation. If the amount of the margin collateral is insufficient to 
make up the difference, the nonbank SBSD will incur losses. This 
proposed capital charge is designed to require the nonbank SBSD to hold 
sufficient net capital, as an alternative to margin, to enable it to 
withstand such losses.
    With respect to non-cleared security-based swaps, the rules would 
impose capital charges to address three exceptions in proposed new Rule 
18a-3 (the nonbank SBSD margin rule).\324\ Under these three 
exceptions, a nonbank SBSD would not be required to collect (or, in one 
case, hold) margin collateral. As discussed below in section II.B.2.b. 
of this release, proposed Rule 18a-3 would require a nonbank SBSD to 
perform a daily calculation of a margin amount for the account of each 
counterparty to a non-cleared security-based swap transaction.\325\ 
Proposed new Rule 18a-3 also would require a nonbank SBSD to collect 
and hold margin collateral (in the form of cash, securities, and/or 
money market instruments) from each counterparty in an amount at least 
equal to the calculated margin amount to the extent that amount is 
greater than the amount of positive equity in the account.\326\ The 
rule would, however, provide exceptions in certain cases.\327\ 
Consequently, the three proposed capital charges discussed below are 
designed to serve as an alternative to margin collateral by requiring 
the nonbank SBSD to hold sufficient net capital to enable it to 
withstand losses if the counterparty defaults.
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    \324\ See paragraphs (c)(1)(iii)(A), (C), and (D) of proposed 
new Rule 18a-3. There is a fourth exception in proposed new Rule 
18a-3 under which a nonbank SBSD would not be required to collect 
margin collateral to cover potential future exposure to another 
SBSD. See paragraph (c)(1)(iii)(B)--Alternative A of proposed new 
Rule 18a-3. There would not be a capital charge in lieu of 
collecting margin collateral from another SBSD because capital 
charges could impact the firm's liquidity, and each SBSD would be 
subject to regulatory capital requirements. A second alternative 
(Alternative B) being proposed in new Rule 18a-3 would require a 
nonbank SBSD to have margin collateral posted to an account at a 
third-party custodian in an amount sufficient to cover the nonbank 
SBSD's potential future exposure to the other SBSD. See paragraph 
(c)(1)(iii)(B)--Alternative B--of proposed new Rule 18a-3. These two 
alternatives are discussed in more detail in section II.B.2. of this 
release.
    \325\ See paragraph (c)(1)(i)(B) of proposed new Rule 18a-3. The 
term margin in proposed new Rule 18a-3 would be defined to mean the 
amount of positive equity in an account of a counterparty. See 
paragraph (b)(5) of proposed new Rule 18a-3.
    \326\ See paragraph (c)(1)(ii) of proposed new Rule 18a-3. See 
also paragraph (c)(4) of proposed new Rule 18a-3 (requiring among 
other things that collateral be in the physical possession or 
control of the nonbank SBSD and that the collateral must be capable 
of being liquidated promptly by the nonbank SBSD). As discussed in 
section II.B.2. of this release, the term equity in proposed new 
Rule 18a-3 would be defined to mean the total current fair market 
value of securities positions in an account of a counterparty 
(excluding the time value of an over-the-counter option), plus any 
credit balance and less any debit balance in the account after 
applying a qualifying netting agreement with respect to gross 
derivatives payables and receivables. See paragraph (b)(4) of 
proposed new Rule 18a-3. The term negative equity in proposed new 
Rule 18a-3 would be defined to mean equity of less than $0. See 
paragraph (b)(6) of proposed new Rule 18a-3. The term positive 
equity in proposed new Rule 18a-3 would be defined to mean equity of 
greater than $0. See paragraph (b)(7) of proposed new Rule 18a-3.
    \327\ See paragraphs (c)(1)(iii)(A), (C), and (D) of proposed 
new Rule 18a-3. As noted above and discussed in more detail in 
section II.B.2. of this release, one alternative being considered is 
to establish a fourth exception in proposed new Rule 18a-3 under 
which a nonbank SBSD would not be required to collect margin 
collateral to cover potential future exposure to another SBSD. See 
paragraph (c)(1)(iii)(B) of proposed new Rule 18a-3. Under this 
alternative, there would not be a capital charge in lieu of 
collecting margin collateral from the other SBSD because capital 
charges could impact the firm's liquidity, and each SBSD would be 
subject to regulatory capital requirements. The other alternative 
would require nonbank SBSDs to have margin collateral posted to an 
account at a third-party custodian in an amount sufficient to cover 
the nonbank SBSD's potential future exposure to the other SBSD.
---------------------------------------------------------------------------

    The first proposed capital charge would apply when a nonbank SBSD 
not approved to use internal models does not collect sufficient margin 
collateral from a counterparty to a non-cleared security-based swap 
because the counterparty is a commercial end user.\328\ As discussed 
below in section II.B.2.c.i. of this release, a nonbank SBSD would not 
be required to collect margin collateral from commercial end users for 
non-cleared security-based swaps.\329\ The nonbank SBSD would be 
required to take a capital charge equal to the margin amount less any 
positive equity in the account of the commercial end user if the 
nonbank SBSD did not collect margin collateral from the commercial end 
user pursuant to this exception.\330\ As discussed above in section 
II.A.2.b.iv. of this release, as an alternative to this deduction, an 
ANC broker-dealer and a stand-alone SBSD approved to use internal 
models could incur a credit risk charge.
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    \328\ See proposed paragraph (c)(2)(xiv)(B)(1) of Rule 15c3-1; 
paragraph (c)(1)(viii)(B)(1) of proposed new Rule 18a-1.
    \329\ See paragraph (c)(1)(iii)(A) of proposed new Rule 18a-3.
    \330\ See proposed new paragraph (c)(2)(xiv)(B)(1) of Rule 15c3-
1; paragraph (c)(1)(viii)(B)(1) of proposed new Rule 18a-1. If 
collateral is not collected from a commercial end user, the nonbank 
SBSD would be required to take a 100% deduction for the amount of 
the uncollateralized current exposure. As discussed above in section 
II.A.2.b.iv. of this release, as alternative to this deduction, an 
ANC broker-dealer and a stand-alone SBSD approved to use internal 
models could take a credit risk charge.
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    The second proposed capital charge would apply when the nonbank 
SBSD does not hold the margin collateral because the counterparty to 
the non-cleared security-based swap is requiring the margin collateral 
to be segregated pursuant to section 3E(f) of the Exchange Act.\331\ 
Section 3E(f) of the Exchange Act, among other things, provides that 
the segregated account authorized by that provision must be carried by 
an independent third-party custodian and be designated as a segregated 
account for and on behalf of the counterparty.\332\ Collateral held in 
this manner would not be in the

[[Page 70247]]

physical possession or control of the nonbank SBSD, nor would it would 
be capable of being liquidated promptly by the nonbank SBSD without the 
intervention of another party. Consequently, it would not meet 
collateral requirements in proposed new Rule 18a-3.\333\ Because 
collateral segregated under section 3E(f) of the Exchange Act would not 
be under the control of the nonbank SBSD, consistent with the existing 
capital requirements that apply to broker-dealers, the Commission is 
proposing to require the nonbank SBSD to take a capital charge equal to 
the margin amount less any positive equity in the account of the 
counterparty.\334\
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    \331\ See proposed new paragraph (c)(2)(xiv)(B)(2) of Rule 15c3-
1; paragraph (c)(1)(viii)(B)(2) of proposed new Rule 18a-1.
    \332\ See 15 U.S.C. 78c-5(f)(3).
    \333\ See paragraphs (c)(4)(i) and (iii) of proposed new Rule 
18a-3.
    \334\ See proposed new paragraph (c)(2)(xiv)(B)(2) of Rule 15c3-
1; paragraph (c)(1)(viii)(B)(2) of proposed new Rule 18a-1.
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    The third proposed capital charge would apply when a nonbank SBSD 
does not collect sufficient margin collateral from a counterparty to a 
non-cleared security-based swap because the transaction was entered 
into prior to the effective date of proposed new Rule 18a-3 (a ``legacy 
non-cleared security-based swap'').\335\ The nonbank SBSD would not be 
required to collect margin collateral for accounts holding legacy non-
cleared security-based swaps.\336\ This proposal is designed to avoid 
the difficulties of requiring a nonbank SBSD to renegotiate security-
based swap contracts in order to come into compliance with new margin 
collateral requirements, which would be a complex task.\337\ In lieu of 
collecting the margin collateral, the nonbank SBSD would be required to 
take a capital charge equal to the margin amount less any positive 
equity in the account.\338\
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    \335\ See proposed new paragraph (c)(2)(xiv)(B)(3) of Rule 15c3-
1; paragraph (c)(1)(viii)(B)(3) of proposed new Rule 18a-1.
    \336\ See paragraph (c)(1)(iii)(D) of proposed new Rule 18a-3. A 
nonbank SBSD would need to take a 100% deduction for the amount of 
the uncollateralized current exposure arising from a legacy non-
cleared security-based swap because (as discussed above) this amount 
would be an unsecured receivable from the counterparty and subject 
to a 100% deduction in the computation of net capital under Rule 
15c3-1 and proposed new Rule 18a-1.
    \337\ The CFTC has proposed a similar exception for legacy swap 
transactions. See CFTC Margin Proposing Release, 76 FR at 23734 
(``The Commission believes that the pricing of existing swaps 
reflects the credit arrangements under which they were executed and 
that it would be unfair to the parties and disruptive to the markets 
to require that the new margin rules apply to those positions.''). 
The prudential regulators proposed to permit a covered swap entity 
to exclude pre-effective swaps from initial margin calculations, 
while requiring these entities to collect variation margin, 
consistent with industry practice. Prudential Regulator Margin and 
Capital Proposing Release, 76 FR at 27569.
    \338\ The prudential regulators and CFTC have not proposed new 
capital charges for legacy swaps and legacy security-based swaps; 
nor have they proposed specific margin collateral requirements for 
such positions. See Prudential Regulator Margin and Capital 
Proposing Release, 76 FR 27564; CFTC Capital Proposing Release, 76 
FR 27802; CFTC Margin Proposing Release, 76 FR 23732. With respect 
to banks, the credit risk of holding legacy security-based swap 
positions is already taken into account by existing capital 
requirements for banks. The proposed capital charge in lieu of 
margin for nonbank SBSDs is based on a concern that, after SBSD 
registration requirements take effect, financial institutions may 
transfer large volumes of legacy non-cleared security-based swaps 
from unregulated affiliates to newly registered nonbank SBSDs, 
including broker-dealer SBSDs. As noted above, the Commission 
understands that registered broker-dealers currently do not engage 
in a high volume of security-based swap transactions. An influx of 
legacy non-cleared security-based swaps into a newly registered 
nonbank SBSD could create substantial risks to the entity. Under the 
proposed rule, nonbank SBSDs would be required to hold sufficient 
collateral to cover the current exposure and potential future 
exposure that arise from these transactions or, alternatively, to 
take appropriate capital charges to address these risks. Entities 
holding legacy non-cleared security-based swaps could either obtain 
additional capital in order to register as nonbank SBSDs or legacy 
non-cleared security-based swaps could be held and ``wound down'' in 
one entity while a separate entity is used to conduct new business.
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Request for Comment
    The Commission generally requests comment on the proposed capital 
in lieu of margin requirements. In addition, the Commission requests 
comment, including empirical data in support of comments, in response 
to the following questions:
    1. Would the proposed deductions for under-margined accounts be 
appropriate for cleared security-based swap margin requirements, which 
would be established by clearing agencies and SROs? If not, explain why 
not. For example, is the requirement to take the deduction after one 
business day workable in the context of cleared security-based swaps? 
If not, explain why not. In addition, should the margin requirements of 
clearing agencies be included in the deduction for under-margined 
accounts?
    2. Would the proposed deductions for under-margined accounts be 
appropriate for non-cleared security-based swap margin requirements, 
which would be established by proposed new Rule 18a-3 and, potentially, 
by SROs? If not, explain why not. For example, is the requirement to 
take the deduction after one business day workable in the context of 
non-cleared security-based swaps? If not, explain why not.
    3. Should there be a deduction for under-margined swap accounts? If 
so, explain why. If not, explain why not.
    4. Would the proposed capital charges in lieu of collecting margin 
collateral appropriately address the potential future exposure risk of 
nonbank SBSDs arising from security-based swaps? If not, explain why 
not. Are there alternative means of addressing this risk? If so, 
identify and explain them.
    5. Is the proposed capital charge in lieu of margin for cleared 
security-based swaps appropriate? If not, explain why not. In 
particular, if the amount of margin collateral required to be collected 
for cleared security-based swaps is less than the capital deduction 
that would apply to the positions, would the margin collateral 
nonetheless be sufficient? If so, explain why. In addition, should 
SBSDs approved to use internal models be permitted to use their VaR 
models (as opposed to the standardized haircuts) for purposes of 
determining whether this capital charge applies? If so, explain why.
    6. Is the proposed capital charge in lieu of margin for non-cleared 
security-based swaps with counterparties that are commercial end users 
appropriate? If not, explain why not.
    7. Should there be an exception for broker-dealer SBSDs and stand-
alone SBSDs not using internal models from the requirement to take a 
capital charge in lieu of collecting margin collateral from commercial 
end users? If so, explain why such an exception would not negatively 
impact the risk profiles of these nonbank SBSDs and suggest alternative 
measures that could be implemented to address the risk of 
uncollateralized potential future exposure to commercial end users.
    8. Should there be a capital charge in lieu of margin for non-
cleared swaps with counterparties that are commercial end users? If so, 
explain why. If not, explain why not.
    9. Is it appropriate to apply the proposed capital charge in lieu 
of margin for non-cleared security-based swaps with counterparties that 
require segregation pursuant to section 3E(f) of the Exchange Act? If 
not, explain why not.
    10. Should there be an exception for counterparties that require 
segregation pursuant to section 3E(f) of the Exchange Act from the 
requirement to take a capital charge in lieu of margin collateral? If 
so, explain why such an exception would not negatively impact the risk 
profiles of nonbank SBSDs and suggest alternative measures that could 
be implemented to address the risk of not holding collateral to cover 
the potential future exposure.
    11. Should there be a capital charge in lieu of margin for non-
cleared swaps with counterparties that require margin

[[Page 70248]]

collateral with respect to the swaps to be segregated and held by an 
independent third party custodian? If so, explain why. If not, explain 
why not.
    12. Is the proposed capital charge in lieu of margin for non-
cleared security-based swaps in accounts that hold legacy security-
based swaps appropriate, or should there be an exception from the 
capital charge for legacy security-based swaps? Is there an alternate 
measure that could be implemented to address the risk of 
uncollateralized potential future exposure resulting from legacy 
security-based swaps? If the proposed capital charge applies to legacy 
security-based swaps, explain how the proposed capital charge in lieu 
of margin collateral would change the economics of the transactions 
previously entered into. How would any such change(s) be reflected in 
the cost of maintaining those, or initiating, new positions? Would 
there be any other impacts of the change in treatment of the legacy 
positions?
    13. If there is an exception from the capital charge for legacy 
security-based swaps, how would such an exception impact the risk 
profiles of nonbank SBSDs?
    14. After the SBSD registration requirements take effect, would 
substantial amounts of legacy security-based swaps with 
uncollateralized potential future exposure be transferred to broker-
dealer SBSDs? Would entities with substantial amounts of legacy 
security-based swaps with uncollateralized potential future exposure 
register as stand-alone SBSDs?
    15. Would it be practical for financial institutions to wind down 
legacy security-based swaps in existing entities rather than 
transferring them to nonbank SBSDs? What legal and operational issues 
would this approach raise?
    16. Should there be a capital charge in lieu of margin for non-
cleared swap accounts that hold legacy swaps? If so, explain why. If 
not, explain why not.
    17. What should be deemed a legacy security-based swap? For 
example, if a nonbank SBSD dealer holds an existing legacy security-
based swap that is subsequently modified for risk mitigation purposes, 
should this be deemed a new security-based swap transaction or should 
it continue to be treated as a legacy security-based swap?
vi. Treatment of Swaps
    CFTC Rule 1.17 prescribes minimum capital requirements for 
FCMs.\339\ The rule imposes a net liquid assets test capital 
standard.\340\ Broker-dealers that are registered as FCMs are subject 
to Rule 15c3-1 and CFTC Rule 1.17.\341\ CFTC Rule 1.17 provides that an 
FCM registered as a broker-dealer must maintain a minimum amount of 
adjusted net capital equal to the greater of, among other amounts, the 
minimum amount of net capital required by Rule 15c3-1.\342\ CFTC Rule 
1.17 also prescribes standardized haircuts for securities positions by 
incorporating by reference the standardized haircuts in Rule 15c3-
1.\343\ Similarly, Rule 15c3-1, through Appendix B, prescribes capital 
deductions for commodities positions of a broker-dealer by 
incorporating by reference deductions in CFTC Rule 1.17 to the extent 
Rule 15c3-1 does not otherwise prescribe a deduction for the type of 
commodity position.\344\
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    \339\ See 17 CFR 1.17.
    \340\ Id.
    \341\ See 17 CFR 240.15c3-1; 17 CFR 1.17.
    \342\ See 17 CFR 1.17(a)(1)(i)(D).
    \343\ See 17 CFR 1.17(c)(5)(v)-(vii).
    \344\ See 17 CFR 240.15c3-1b(a)(1).
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    Broker-dealer SBSDs (as broker-dealers) would be subject to 
Appendix B to Rule 15c3-1.\345\ Appendix B to proposed new Rule 18a-1 
would prescribe capital deductions for commodities positions of stand-
alone SBSDs and would be modeled on Appendix B to Rule 15c3-1.\346\ 
Consequently, under the provisions of Rule 15c3-1 and proposed new Rule 
18a-1, nonbank SBSDs would be required to take deductions for commodity 
positions when computing net capital.\347\
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    \345\ 17 CFR 240.15c3.-1b.
    \346\ Compare 17 CFR 240.15c3-1b, with Appendix B to proposed 
new Rule 18a-1. As discussed above in section II.A.2.b.ii. of this 
release, a broker-dealer's minimum net capital requirement is the 
greater of a fixed-dollar amount specified in Rule 15c3-1 and an 
amount determined by applying one of two financial ratios: the 15-
to-1 aggregate indebtedness to net capital ratio or the 2% of 
customer debit items ratio. The minimum net capital requirement for 
a stand-alone SBSD under proposed Rule 18a-1, however, would not use 
either of these financial ratios; rather, its minimum net capital 
requirement would be determined by calculating the 8% margin factor. 
Appendix B to Rule 15c3-1 contains provisions that factor into a 
broker-dealer's calculation of the aggregate indebtedness financial 
ratio. See 17 CFR 240.15c3-1b(a)(1) and (a)(2). Those provisions are 
not included in Appendix B to proposed new Rule 18a-1 because stand-
alone SBSDs would not use the aggregate indebtedness financial ratio 
to determine their minimum net capital requirement.
    \347\ See 17 CFR 240.15c3-1b; Appendix B to proposed new Rule 
18a-1.
---------------------------------------------------------------------------

    In addition, nonbank SBSDs and broker-dealers may have proprietary 
positions in swaps. Consequently, Appendix B to Rule 15c3-1 would be 
amended to establish standardized haircuts for proprietary swap 
positions and analogous provisions would be included in Appendix B to 
proposed new Rule 18a-1.\348\ This would make the standardized swap 
haircuts applicable to nonbank SBSDs and broker-dealers.\349\ An ANC 
broker-dealer and a stand-alone SBSD could apply to include different 
types of swaps in their VaR models. If approved, the firm would not 
need to apply the standardized haircuts for the type of swaps covered 
by the approved models.
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    \348\ See proposed new paragraph (b) of Rule 15c3-1b; paragraph 
(b) of proposed new Rule 18a-1b.
    \349\ A nonbank SBSD that is registered as a swap dealer with 
the CFTC also would be required to comply with the CFTC's capital 
requirements applicable to swap dealers as would a broker-dealer 
that is registered as a swap dealer (just as a broker-dealer 
registered as an FCM must comply with Rule 15c3-1 and CFTC Rule 
1.17).
---------------------------------------------------------------------------

    The proposed standardized haircuts for swaps are similar to the 
proposed standardized haircuts for security-based swaps. Specifically, 
swaps that are credit default swaps referencing a broad based 
securities index (``Index CDS swaps'') would be subject to a maturity 
grid similar to the proposed maturity grid for CDS security-based 
swaps.\350\ All other swaps would be subject to a standardized haircut 
determined by multiplying the notional amount of the swap by the 
percentage deduction that would apply to the type of asset or event 
referenced by the swap.
---------------------------------------------------------------------------

    \350\ See proposed new paragraph (b)(1)(i) of Rule 15c3-1b; 
paragraph (b)(1)(i) of proposed new Rule 18a-1b.
---------------------------------------------------------------------------

Index CDS Swaps
    The standardized haircuts proposed for Index CDS swaps would use 
the maturity grid approach proposed for CDS security-based swaps 
discussed above in section II.A.2.b.ii. of this release. This would 
provide for a consistent standardized haircut approach for Index CDS 
swaps and CDS security-based swaps though, as discussed below, the 
haircuts would be lower for the Index CDS security-based swaps. As with 
CDS security-based swaps, the proposed maturity grid for Index CDS 
swaps prescribes the applicable deduction based on two variables: the 
length of time to maturity of the swap and the amount of the current 
offered spread on the swap.\351\ The vertical axis of the proposed grid 
would contain nine maturity categories ranging from 12 months or less 
(the smallest deduction) to 121 months and longer (the largest 
deduction).\352\ The horizontal axis would contain six spread 
categories ranging from 100 basis points or less (the smallest 
deduction) to

[[Page 70249]]

700 basis points and above (the largest deduction).\353\
---------------------------------------------------------------------------

    \351\ See proposed new paragraph (b)(1)(i)(A) of Rule 15c3-1b; 
paragraph (b)(1)(i)(A) of proposed new Rule 18a-1b.
    \352\ Id.
    \353\ Id.
---------------------------------------------------------------------------

    The haircut percentages in the proposed maturity grid for Index CDS 
swaps would be one-third less than the haircut percentages in the 
maturity grid for CDS security-based swaps to account for the 
diversification benefits of an index.\354\ For example, the proposed 
haircut for an Index CDS swap with a maturity of 12 months or less and 
a spread of 100 basis points or less would be 0.67% as opposed to a 1% 
haircut for a CDS security-based swap in the same maturity and spread 
categories. This one-third reduction in the haircut percentages is 
consistent with how broad-based equity security-indices are treated in 
the Appendix A methodology as compared with single name equity 
securities and narrow-based equity index securities. Specifically, as 
discussed above in section II.A.2.b.ii. of this release, the Appendix A 
methodology requires portfolios of single name equity securities and 
narrow-based equity index securities to be stressed at 10 equidistant 
valuation points within a range consisting of a (+/-) 15% market move. 
Portfolios of broad-based equity index securities are stressed at 10 
equidistant valuation points within a range consisting of a (+/-) 10% 
market move, which is two-thirds of the market move range applicable to 
single name equity securities and narrow-based equity index securities.
---------------------------------------------------------------------------

    \354\ Id.
---------------------------------------------------------------------------

    Consistent with the maturity grid approach for CDS security-based 
swaps, the proposed deduction for an un-hedged long position in an 
Index CDS swap would be 50% of the applicable haircut in the grid.\355\ 
The proposed deduction requirements for Index CDS swaps would permit a 
nonbank SBSD to net long and short positions where the credit default 
swaps reference the same index, are in the same spread categories, are 
in the same maturity categories or in adjacent maturity categories, and 
have maturities within three months of each other.\356\ In this case, 
the nonbank SBSD would need to take the specified haircut only on the 
notional amount of the excess long or short position.\357\
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    \355\ See proposed new paragraph (b)(1)(i)(B) of Rule 15c3-1b; 
paragraph (b)(1)(i)(B) of proposed new Rule 18a-1b.
    \356\ See proposed new paragraph (b)(1)(i)(C)(1) of Rule 15c3-
1b; paragraph (b)(1)(i)(C)(1) of proposed new Rule 18a-1b.
    \357\ Id.
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    Reduced deductions also would apply for strategies where the firm 
is long a basket of securities consisting of the components of an index 
and long (buyer of protection on) an Index CDS swap on the index.\358\ 
The reduced deduction for this strategy would apply only if the credit 
default swap allowed the nonbank SBSD to deliver a security in the 
basket to satisfy the firm's obligation on the swap.\359\ In this case, 
the nonbank SBSD would be required to take 50% of the deduction 
required on the securities in the basket (i.e., no deduction would be 
required with respect to the Index CDS swap and a lesser deduction 
would apply to the securities).\360\ If the nonbank SBSD is short 
(seller of protection) a basket of securities consisting of the 
components of an index and short a credit default swap that references 
the index, the nonbank SBSD would be required only to take the 
deduction required on the securities in the basket (i.e., no deduction 
would be required with respect to the Index CDS swap).\361\
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    \358\ See proposed new paragraph (b)(1)(i)(C)(2) of Rule 15c3-
1b; paragraph (b)(1)(i)(C)(2) of proposed new Rule 18a-1b.
    \359\ Id.
    \360\ Id.
    \361\ See proposed new paragraph (b)(1)(i)(C)(3) of Rule 15c3-
1b; paragraph (b)(1)(i)(C)(3) of proposed new Rule 18a-1b.
---------------------------------------------------------------------------

Interest Rate Swaps
    For interest rate swaps, Appendix B to both Rule 15c3-1 and 
proposed new Rule 18a-1 would prescribe a standardized haircut equal to 
a percentage of the notional amount of the swap that is generally based 
on the standardized haircuts in Rule 15c3-1 for U.S. government 
securities.\362\ An interest rate swap typically involves the exchange 
of specified or determinable cash flows at specified times based upon a 
notional amount.\363\ The notional amount is not exchanged but is used 
to calculate the fixed or floating rate interest payments under the 
swap.
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    \362\ See 17 CFR 240.15c3-1(c)(2)(vi)(A).
    \363\ See Net Capital Rule, Exchange Act Release No. 39455 (Dec. 
17, 1997), 62 FR 67996 (Dec. 30, 1997).
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    Under the proposed rule, each side of the interest rate swap would 
be converted into a synthetic bond position based on the notional 
amount of the swap and the interest rates against which payments are 
calculated. These synthetic bonds would then be placed into the 
standardized haircut grid in Rule 15c3-1 for U.S. government 
securities. Any obligation to receive payments under the swap would be 
categorized as a long position; any obligation to make payments under 
the swap would be categorized as a short position. A position receiving 
or paying based on a floating interest rate generally would be treated 
as having a maturity equal to the period until the next interest reset 
date; a position receiving or paying based on a fixed rate would be 
treated as having a maturity equal to the residual maturity of the 
swap. Synthetic bond equivalents derived from interest rate swaps, when 
offset against one another, would be subject to a one percent charge 
based on the swap's notional amount. Any synthetic bond equivalent that 
would be subject to a standardized haircut of less than one percent 
under the approach described above would be subject to a minimum 
deduction equal to a one percent charge against the notional value of 
the swap.\364\ This minimum haircut of one percent is designed to 
account for potential differences between the movement of interest 
rates on U.S. government securities and interest rates upon which swap 
payments are based.
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    \364\ Under Rule 15c3-1, U.S. government securities with a 
maturity of less than nine months are subject to net capital 
deductions ranging from three-quarters of 1% to 0%. See 17 CFR 
240.15c3-1(c)(2)(vi)(A)(1)(i)-(iii).
---------------------------------------------------------------------------

All Other Swaps
    In the case of a swap that is not an Index CDS swap or an interest 
rate swap, the applicable haircut would be the amount calculated by 
multiplying the notional value of the swap and the percentage specified 
in either Rule 15c3-1 or CFTC Rule 1.17 for the asset, obligation, or 
event referenced by the swap.\365\ For example, a swap referencing a 
commodity that is not covered by an open futures contract or commodity 
option would be subject to a capital deduction applicable to the 
commodity as if it were a long or short inventory position with a 
market value equal to the notional value of the swap. This would 
typically result in a deduction equal to 20% of the notional value of 
the swap.\366\ The deduction for un-hedged currency swaps referencing 
certain major foreign currencies, including the euro, British pounds, 
Canadian dollars, Japanese yen, or Swiss francs, would be 6%.\367\ This

[[Page 70250]]

deduction could be reduced by an amount equal to any reduction 
recognized for a comparable long or short position in the referenced 
instrument, obligation, or event under Appendix B to Rule 15c3-1, as 
proposed to be amended, and proposed new Rule 18a-1, or CFTC Rule 1.17. 
For example, a commodity swap referencing an agricultural product that 
is covered by an open futures contract or commodity option in that 
product would be subject to a 5% deduction from the notional value of 
the swap, rather than the 20% deduction specified above.\368\ Finally, 
swaps referencing an equity index could be treated under Appendix A to 
Rule 15c3-1 and proposed new Rule 18a-1.
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    \365\ See proposed new paragraph (b)(2) of Rule 15c3-1b; 
paragraph (b)(2) of proposed new Rule 18a-1b.
    \366\ See 17 CFR 240.15c3-1b(a)(3)(ix)(C); paragraph 
(a)(2)(ix)(C) of proposed new Rule 18a-1b.
    \367\ See CFTC Rule 1.17(c)(5)(ii)(E) (imposing a 6% haircut). 
17 CFR 1.17(c)(5)(ii)(E). Currency swaps may involve exchanges of 
fixed amounts of currencies. If a nonbank SBSD has a currency swap 
in which it receives one foreign currency and pays out another 
foreign currency, the broker-dealer would treat the currency swap as 
a long position in a forward of the one foreign currency and an 
unrelated short position in the other foreign currency for capital 
purposes. See, e.g., Net Capital Rule, Exchange Act Release No. 
32256 (May 4, 1993), 58 FR 27486, 27490 (May 10, 1993).
    \368\ See 17 CFR 240.15c3-1b(a)(3)(ix)(B); paragraph 
(a)(2)(ix)(B) of proposed new Rule 18a-1b.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposed 
standardized haircuts swaps. In addition, the Commission requests 
comment, including empirical data in support of comments, in response 
to the following questions:
    1. Which types of swap activities would nonbank SBSDs engage in? 
How would nonbank SBSDs use swaps?
    2. Which types of swap activities would broker-dealers engage in? 
How would broker-dealers use swaps?
    3. Do the proposed standardized haircuts for swaps provide a 
reasonable and workable solution for determining capital charges? 
Explain why or why not. Are there preferable alternatives? If so, 
describe those alternatives.
    4. Are there additional categories of swaps, other than commodity 
swaps, currency swaps, and interest rate swaps, that the Commission 
should address in Rule 15c3-1 and/or proposed Rule 18a-1? If so, 
describe them.
    5. Are the proposed standardized haircuts for swaps too high or too 
low? If so, please explain why and provide data to support the 
explanation.
    6. Are there capital charges that should be applied to swaps? If 
so, describe them.
    7. Do the proposed standardized haircuts for swaps adequately 
recognize offsets in establishing capital deductions? If not, what 
offsets should be recognized, for what type of swap, and why? Provide 
data, if applicable, and identify why that offset would be appropriate.
    8. Do the proposed standardized haircuts for swaps provide any 
incentives or disincentives to effect swap transactions in a particular 
type of legal entity (e.g., in a stand-alone SBSD versus a broker-
dealer SBSD)? Describe the incentives and/or disincentives.
    9. Do the proposed standardized haircuts for swaps provide any 
competitive advantages or disadvantages for a particular type of legal 
entity? Describe the advantages and/or disadvantages.
    10. How closely do the movements of interest rates on U.S. 
government securities track the movements of interest rates upon which 
interest rate swap payments are based? Is the proposed 1% minimum 
percentage deduction for interest rate swaps appropriate given that 
U.S. government securities with a maturity of less than nine months 
have a haircut ranging from three-quarters of 1% to 0%?
c. Risk Management
    Prudent financial institutions establish and maintain integrated 
risk management systems that seek to have in place management policies 
and procedures designed to help ensure an awareness of, and 
accountability for, the risks taken throughout the firm and to develop 
tools to address those risks.\369\ A key objective of a risk management 
system is to ensure that the firm does not ignore any material source 
of risk.\370\ Elements of an integrated risk management system include 
a dedicated risk management function, which seeks to promote integrated 
and systematic approaches to risk management and to develop and 
encourage the use of a common set of metrics for risk throughout the 
firm.\371\ This function generally includes establishing common firm-
wide definitions of risk and requiring that different business segments 
of the firm apply such definitions consistently for risk reporting 
purposes.\372\ The risk management function in a financial institution 
also typically prepares background material and data analysis (risk 
reports) for senior managers to review and use to discuss firm-wide 
risks.\373\
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    \369\ See Trends in Risk Integration and Aggregation, Joint 
Forum, Bank of International Settlements (Aug. 2003), available at 
http://www.bis.org/publ/joint07.pdf.
    \370\ Id.
    \371\ Id.
    \372\ Id.
    \373\ Id.
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    Nonbank SBSDs would be required to comply with Rule 15c3-4, which 
requires the establishment of a risk management control system.\374\ 
Rule 15c3-4 was adopted in 1998 as part of the OTC derivatives dealer 
oversight program.\375\ The rule requires an OTC derivatives dealer to 
establish, document, and maintain a system of internal risk management 
controls to assist in managing the risks associated with its business 
activities, including market, credit, leverage, liquidity, legal, and 
operational risks.\376\ It also requires OTC derivatives dealers to 
establish, document, and maintain procedures designed to prevent the 
firm from engaging in securities activities that are not permitted of 
OTC derivatives dealers pursuant to Rule 15a-1.\377\ Rule 15c3-4 
identifies a number of elements that must be part of an OTC derivatives 
dealer's internal risk management control system.\378\ These include, 
for example, that the system have:
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    \374\ See proposed new paragraph (a)(10)(ii) of Rule 15c3-1 (17 
CFR 240.15c3-1); paragraph (g) of proposed new Rule 18a-1. See also 
17 CFR 240.15c3-4.
    \375\ See 17 CFR 240.15c3-4; OTC Derivatives Dealers, 63 FR 
59362.
    \376\ See 17 CFR 240.15c3-4.
    \377\ See 17 CFR 240.15c3-4; 17 CFR 240.15a-1.
    \378\ See 17 CFR 240.15c3-4(c).
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     A risk control unit that reports directly to senior 
management and is independent from business trading units; \379\
---------------------------------------------------------------------------

    \379\ See 17 CFR 240.15c3-4(c)(1).
---------------------------------------------------------------------------

     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; 
\380\
---------------------------------------------------------------------------

    \380\ See 17 CFR 240.15c3-4(c)(2).
---------------------------------------------------------------------------

     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; \381\ and
---------------------------------------------------------------------------

    \381\ See 17 CFR 240.15c3-4(c)(3). The annual review must be 
conducted in accordance with procedures agreed to by the firm and 
the independent certified public accountant conducting the review.
---------------------------------------------------------------------------

     Definitions of risk, risk monitoring, and risk 
management.\382\
---------------------------------------------------------------------------

    \382\ See 17 CFR 240.15c3-4(c)(4).
---------------------------------------------------------------------------

    Rule 15c3-4 further provides that the elements of the internal risk 
management control system must include written guidelines, approved by 
the OTC derivatives dealer's governing body, that cover various topics, 
including, for example:
     Quantitative guidelines for managing the OTC derivatives 
dealer's overall risk exposure; \383\
---------------------------------------------------------------------------

    \383\ See 17 CFR 240.15c3-4(c)(5)(iii).
---------------------------------------------------------------------------

     The type, scope, and frequency of reporting by management 
on risk exposures; \384\
---------------------------------------------------------------------------

    \384\ See 17 CFR 240.15c3-4(c)(5)(iv).
---------------------------------------------------------------------------

     The procedures for and the timing of the governing body's 
periodic review of the risk monitoring and risk

[[Page 70251]]

management written guidelines, systems, and processes; \385\
---------------------------------------------------------------------------

    \385\ See 17 CFR 240.15c3-4(c)(5)(v).
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     The process for monitoring risk independent of the 
business or trading units whose activities create the risks being 
monitored; \386\
---------------------------------------------------------------------------

    \386\ See 17 CFR 240.15c3-4(c)(5)(vi).
---------------------------------------------------------------------------

     The performance of the risk management function by persons 
independent from or senior to the business or trading units whose 
activities create the risks; \387\
---------------------------------------------------------------------------

    \387\ See 17 CFR 240.15c3-4(c)(5)(vii).
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     The authority and resources of the groups or persons 
performing the risk monitoring and risk management functions; \388\
---------------------------------------------------------------------------

    \388\ See 17 CFR 240.15c3-4(c)(5)(viii).
---------------------------------------------------------------------------

     The appropriate response by management when internal risk 
management guidelines have been exceeded; \389\
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    \389\ See 17 CFR 240.15c3-4(c)(5)(ix).
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     The procedures to monitor and address the risk that an OTC 
derivatives transaction contract will be unenforceable; \390\
---------------------------------------------------------------------------

    \390\ See 17 CFR 240.15c3-4(c)(5)(x).
---------------------------------------------------------------------------

     The procedures requiring the documentation of the 
principal terms of OTC derivatives transactions and other relevant 
information regarding such transactions; \391\ and
---------------------------------------------------------------------------

    \391\ See 17 CFR 240.15c3-4(c)(5)(xi).
---------------------------------------------------------------------------

     The procedures authorizing specified employees to commit 
the OTC derivatives dealer to particular types of transactions.\392\
---------------------------------------------------------------------------

    \392\ See 17 CFR 240.15c3-4(c)(5)(xii).
---------------------------------------------------------------------------

    Rule 15c3-4 also requires management to periodically review, in 
accordance with the written procedures, the business activities of the 
OTC derivatives dealer for consistency with risk management 
guidelines.\393\
---------------------------------------------------------------------------

    \393\ See 17 CFR 240.15c3-4(d).
---------------------------------------------------------------------------

    In 2004, when adopting the ANC broker-dealer oversight program, the 
Commission included a requirement that an ANC broker-dealer must comply 
with Rule 15c3-4.\394\ The Commission explained this requirement:
---------------------------------------------------------------------------

    \394\ See 17 CFR 240.15c3-1(a)(7)(iii); Alternative Net Capital 
Requirements Adopting Release, 69 FR 34428. ANC broker-dealers--
because they are not subject to Rule 15a-1--do not need to comply 
with the provisions of Rule 15c3-4 relating to Rule 15a-1. See 17 
CFR 240.15c3-1(a)(7)(iii); 17 CFR 240.15c3-4; 17 CFR 240.15a-1.

Participants in the securities markets are exposed to various risks, 
including market, credit, funding, legal, and operational risk. 
These risks result, in part, from the diverse range of financial 
instruments that broker-dealers now trade. Risk management controls 
within a broker-dealer promote the stability of the firm and, 
consequently, the stability of the marketplace. A firm that adopts 
and follows appropriate risk management controls reduces its risk of 
significant loss, which also reduces the risk of spreading the 
losses to other market participants or throughout the financial 
---------------------------------------------------------------------------
markets as a whole.\395\

    \395\ Alternative Net Capital Requirements Adopting Release, 69 
FR at 34449.
---------------------------------------------------------------------------

    The Commission is proposing to require that nonbank SBSDs comply 
with Rule 15c3-4 because their activities will involve risk management 
concerns similar to those faced by other firms subject to the 
rule.\396\ In particular, dealing in OTC derivatives, including 
security-based swaps, creates various types of risk that need to be 
carefully managed.\397\ These risks are due, in part, to the 
characteristics of OTC derivative products and the way OTC derivative 
markets have evolved in comparison to the markets for exchange-traded 
securities.\398\ For example, individually negotiated OTC derivative 
products, including security-based swaps, generally are less liquid 
than exchange-traded instruments and involve a high degree of leverage. 
Furthermore, market participants face risks associated with the 
financial and legal ability of counterparties to perform under the 
terms of specific transactions. Consequently, a firm that is active in 
dealing in these types of instruments should have an internal risk 
management control system that helps the firm identify and mitigate the 
risks it is facing. Rule 15c3-4 is designed to require an OTC 
derivatives dealer and ANC broker-dealer to take prudent measures to 
protect the firm from losses that can result from failing to account 
for and control risk. Requiring nonbank SBSDs to comply with Rule 15c3-
4 is designed to promote the establishment of effective risk management 
control systems by these firms.\399\ Moreover, based on Commission 
staff experience, it is expected that many nonbank SBSDs will be 
affiliates of firms already subject to these requirements.
---------------------------------------------------------------------------

    \396\ Like ANC broker-dealers, nonbank SBSDs would not need to 
comply paragraphs (c)(5)(xiii), (c)(5)(xiv), (d)(8), and (d)(9) of 
Rule 15c3-4. These are the provisions that specifically reference 
Rule 15a-1. See 17 CFR 240.15c3-4.
    \397\ See OTC Derivatives: Settlement Procedures And 
Counterparty Risk Management at 11-15.
    \398\ See OTC Derivatives Dealers, Exchange Act Release No. 
39454 (Dec. 17, 1997), 62 FR 67940 (Dec. 30, 1997).
    \399\ See paragraph (g) of proposed new Rule 18a-1 (which would 
apply Rule 15c3-4 to stand-alone SBSDs); proposed new paragraph 
(a)(10)(ii) of Rule 15c3-1 (which would apply Rule 15c3-4 to broker-
dealer SBSDs); 17 CFR 240.15c3-1(a)(7)(iii) (which applies Rule 
15c3-4 to ANC broker-dealers); 17 CFR 240.15c3-4.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposed risk 
management requirements. In addition, the Commission requests comment, 
including empirical data in support of comments, in response to the 
following questions:
    1. Are the types of management controls required by Rule 15c3-4 
appropriate for addressing the risks associated with engaging in a 
security-based swap business? If not, explain why not.
    2. Are there types of risk management controls not identified in 
Rule 15c3-4 that would be appropriate to prescribe for nonbank SBSDs? 
If so, identify the controls and explain why they would be appropriate 
for nonbank SBSDs.
    3. Are the factors listed in paragraph (b) of Rule 15c3-4 
appropriate for nonbank SBSDs? If not, explain why not.
    4. Are there any additional factors that a nonbank SBSD should 
consider when adopting its internal control system guidelines, 
policies, and procedures, in addition to the factors listed in 
paragraph (b) of Rule 15c3-4? If so, identify the factors and explain 
why they should be included.
    5. Are the elements prescribed in paragraph (c) of Rule 15c3-4 
appropriate for nonbank SBSDs? If not, explain why not.
    6. Are there any additional elements that a nonbank SBSD should 
include in its internal risk management system in addition to the 
applicable elements prescribed in paragraph (c) of Rule 15c3-4? If so, 
identify the elements and explain why they should be included.
    7. Are there any elements in paragraph (c) of Rule 15c3-4 that 
should not be applicable to nonbank SBSDs other than elements in 
paragraphs (c)(xiii) and (xiv)? If so, identify the elements and 
explain why they should not be applicable.
    8. Are the factors management would need to consider in its 
periodic review of the nonbank SBSD's business activities for 
consistency with the risk management guidelines appropriate for nonbank 
SBSDs? If not, explain why not.
    9. Should management consider any additional factors in its 
periodic review of the nonbank SBSD's business activities for 
consistency with the risk management guidelines other than those listed 
in paragraph (d) of Rule 15c3-4? If so, identify the factors and 
explain why they should be included.
    10. Are there any factors in paragraph (d) of Rule 15c3-4 that 
management should not consider other than the factors in paragraphs 
(d)(8) and (9)? If so, identify the factors and explain why they should 
not be considered.

[[Page 70252]]

d. Funding Liquidity Stress Test Requirement
    The Commission is proposing that ANC broker-dealers and nonbank 
SBSDs approved to use internal models be subject to liquidity risk 
management requirements. Funding liquidity risk has been defined as the 
risk that a firm will not be able to efficiently meet both expected and 
unexpected current and future cash flow and collateral needs without 
adversely impacting either the daily operations or the financial 
condition of the firm.\400\ The consequences of liquidity funding 
strains for financial institutions active in a securities business 
include the inability to continue to issue unsecured long-term debt to 
finance illiquid assets and requirements to deliver additional 
collateral to continue to finance liquid assets on a secured 
basis.\401\ The causes of funding liquidity strain for a financial 
institution include firm-specific events such as credit rating 
downgrades and other negative news leading to a loss of market 
confidence in the firm.\402\ Funding liquidity also can come under 
stress such as occurred during the financial crisis.\403\ 
Traditionally, financial institutions have used liquidity funding 
stress tests as a means to measure liquidity risk.\404\ For 
institutions active in securities trading, liquidity funding stress 
tests generally estimate cash and collateral needs over a period of 
time and assume that sources to meet those needs (e.g., issuance of 
long and short unsecured term debt, secured funding lines, and lines of 
credit) will become impaired or be unavailable.\405\ To manage funding 
liquidity risk, these firms maintain pools of liquid unencumbered 
assets that can be used to raise funds during a liquidity stress event 
to meet cash needs.\406\ The size of the liquidity pool is based on the 
firm's estimation of how much funding will be lost from external 
sources during a stress event and the duration of the event.\407\
---------------------------------------------------------------------------

    \400\ See Joint Forum, Bank of International Settlements, The 
management of liquidity risk in financial groups, (May 2006), at 1, 
note 1 (``The management of liquidity risk in financial groups''). 
See also Basel Committee on Banking Supervision, Principles for 
Sound Liquidity Risk Management and Supervision (Sept. 2008), at 1, 
note 2 (``Funding liquidity risk is the risk that the firm will not 
be able to meet efficiently both expected and unexpected current and 
future cash flow and collateral needs without affecting either daily 
operations or the financial condition of the firm. Market liquidity 
risk is the risk that a firm cannot easily offset or eliminate a 
position at the market price because of inadequate market depth or 
market disruption.''); Amendments to Financial Responsibility Rules 
for Broker-Dealers, Exchange Act Release No. 55432 (Mar. 9, 2007), 
72 FR 12862, 12870, note 72 (Mar. 19, 2007) (``Liquidity risk 
includes the risk that a firm will not be able to unwind or hedge a 
position or meet cash demands as they become due.''); Enhanced 
Prudential Standards and Early Remediation Requirements for Covered 
Companies, Federal Reserve, 77 FR 594 (Jan. 5, 2012) (proposing a 
rule to require certain large financial institutions to conduct 
liquidity stress testing at least monthly).
    \401\ See The management of liquidity risk in financial groups 
at 10.
    \402\ See id. at 6-8.
    \403\ See Risk Management Lessons from the Global Bank Crisis of 
2008, Senior Supervisors Group (SSG) (Oct. 21, 2009) (``Risk 
Management Lessons from the Global Bank Crisis of 2008'').
    \404\ The management of liquidity risk in financial groups at 8-
12.
    \405\ Id. at 10-11.
    \406\ Id.
    \407\ Id.
---------------------------------------------------------------------------

    The financial crisis demonstrated that the funding liquidity risk 
management practices of certain individual financial institutions were 
not sufficient to handle a liquidity stress event of that 
magnitude.\408\ In particular, it has been observed that the stress 
tests utilized by financial institutions had weaknesses \409\ and the 
amount of contingent liquidity they maintained to replace external 
sources of funding was insufficient to cover the institutions' 
liquidity needs.\410\
---------------------------------------------------------------------------

    \408\ See Risk Management Lessons from the Global Bank Crisis of 
2008.
    \409\ Id. at 14 (``Market conditions and the deteriorating 
financial state of firms exposed weaknesses in firms' approaches to 
liquidity stress testing, particularly with respect to secured 
borrowing and contingent funding needs. These deteriorating 
conditions underscored the need for greater consideration of the 
overlap between systemic and firm-specific events and longer time 
horizons, and the connection between stress tests and business-as-
usual liquidity management.'').
    \410\ Id. at 15 (``Interviewed firms typically calculated and 
maintained a measurable funding cushion, such as `months of 
coverage,' which is conceptually similar to rating agencies' twelve-
month liquidity alternatives analyses. Some institutions were 
required to maintain a liquidity cushion that could withstand the 
loss of unsecured funding for one year. Many institutions found that 
this metric did not capture important elements of stress that the 
organizations faced, such as the loss of secured funding and demands 
for collateral to support clearing and settlement activity and to 
mitigate the risks of accepting novations.'') (emphasis in the 
original).
---------------------------------------------------------------------------

    As discussed above in section II.A.2.c. of this release, nonbank 
SBSDs approved to use internal models would be subject to Rule 15c3-4, 
which currently applies to ANC broker-dealers and OTC derivatives 
dealers.\411\ Rule 15c3-4 requires each firm subject to the rule to 
``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.'' \412\ The Commission's supervision of 
ANC broker-dealers consists of regular meetings with firm personnel to 
review each firm's financial results, the management of the firm's 
balance sheet, and, in particular, the liquidity of the firm's balance 
sheet.\413\ Emphasis is placed on funding and liquidity risk management 
plans and liquidity stress scenarios.\414\ The Commission staff also 
meets regularly with the firm's financial controllers to review and 
discuss price verification results and other financial controls, 
particularly concerning illiquid or hard-to-value assets or large asset 
concentrations.\415\
---------------------------------------------------------------------------

    \411\ See 17 CFR 240.15c3-4.
    \412\ 17 CFR 240.15c3-4.
    \413\ A more detailed description of the Commission's ANC 
broker-dealer program is available on the Commission's Web site at 
http://www.sec.gov/divisions/marketreg/bdaltnetcap.htm.
    \414\ Id.
    \415\ Id.
---------------------------------------------------------------------------

    Given the large size of ANC broker-dealers and the potentially 
substantial role that stand-alone SBSDs approved to use internal models 
may play in the security-based swap markets, these firms would be 
required to take steps to manage funding liquidity risk.\416\ 
Specifically, these firms would be required to perform a liquidity 
stress test at least monthly and, based on the results of that test, 
maintain liquidity reserves to address potential funding needs during a 
stress event.\417\
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    \416\ See proposed new paragraph (f) to Rule 15c3-1; paragraph 
(f) of proposed new Rule 18a-1.
    \417\ Id. The requirement to conduct the liquidity stress test 
on at least a monthly basis is designed to ensure that the test is 
conducted at sufficiently regular intervals to account for material 
changes that could impact the firm's liquidity profile. In this 
regard, the ANC broker-dealers are required to prepare and file 
monthly financial reports, which are designed to allow securities 
regulators to monitor their financial condition. See 17 CFR 240.17a-
5; compare Enhanced Prudential Standards and Early Remediation 
Requirements for Covered Companies, 77 FR 594 (Jan. 5, 2012) 
(Federal Reserve's proposed rule to require a ``covered company'' to 
conduct liquidity stress testing at least monthly).
---------------------------------------------------------------------------

    Under the proposal, an ANC broker-dealer and stand-alone SBSD using 
internal models would need to perform a liquidity stress test at least 
monthly that takes into account certain assumed conditions lasting for 
30 consecutive days.\418\ The results of the liquidity stress test 
would need to be provided within ten business days of the month end to 
senior management that has responsibility to oversee risk management at 
the firm. In addition, the assumptions underlying the liquidity stress 
test would need to be reviewed at least quarterly by senior management 
that has responsibility to oversee risk management at the firm and at 
least annually by senior management of the firm. These provisions are 
designed to

[[Page 70253]]

promote the engagement of senior level risk managers and managers of 
the firm in the implementation of the liquidity stress test and senior 
level risk managers in monitoring the results of the liquidity stress 
test.
---------------------------------------------------------------------------

    \418\ Based on the Commission staff's experience, ANC broker-
dealers currently perform regular liquidity stress tests.
---------------------------------------------------------------------------

    These required assumed conditions are designed to be consistent 
with the liquidity stress tests performed by the ANC broker-dealers 
(based on Commission staff experience supervising the firms) and to 
address the types of liquidity outflows experienced by ANC broker-
dealers and other broker-dealers in times of stress. The required 
assumed conditions would be:
     A stress event that includes a decline in creditworthiness 
of the firm severe enough to trigger contractual credit-related 
commitment provisions of counterparty agreements;
     The loss of all existing unsecured funding at the earlier 
of its maturity or put date and an inability to acquire a material 
amount of new unsecured funding, including intercompany advances and 
unfunded committed lines of credit;
     The potential for a material net loss of secured funding;
     The loss of the ability to procure repurchase agreement 
financing for less liquid assets;
     The illiquidity of collateral required by and on deposit 
at clearing agencies or other entities which is not deducted from net 
worth or which is not funded by customer assets;
     A material increase in collateral required to be 
maintained at registered clearing agencies of which the firm is a 
member; and
     The potential for a material loss of liquidity caused by 
market participants exercising contractual rights and/or refusing to 
enter into transactions with respect to the various businesses, 
positions, and commitments of the firm, including those related to 
customer businesses of the firm.\419\
---------------------------------------------------------------------------

    \419\ See proposed new paragraph (f)(1) to Rule 15c3-1; 
paragraph (f)(1) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

These proposed minimum elements are designed to ensure that ANC broker-
dealers and stand-alone SBSDs using internal models employ a stress 
test that is severe enough to produce an estimate of a potential 
funding loss of a magnitude that might be expected in a severely 
stressed market. As discussed below, the results of the stress test 
would be used by the firm to determine the amount of contingent 
liquidity to be maintained. The proposals would require that the ANC 
broker-dealer and stand-alone SBSD itself must maintain at all times 
liquidity reserves based on the results of the liquidity stress 
test.\420\ The liquidity reserves would need to be comprised of 
unencumbered cash or U.S. government securities.\421\ This limitation 
with respect to the assets that can be used for the liquidity reserves 
requirement is designed to ensure that only the most liquid instruments 
are held in the reserves, given that the market for less liquid 
instruments is generally disproportionately volatile during a time of 
market stress.
---------------------------------------------------------------------------

    \420\ See proposed new paragraph (f)(3) of Rule 15c3-1; 
paragraph (f)(3) of proposed new Rule 18a-1.
    \421\ See proposed new paragraph (f)(3) of Rule 15c3-1; 
paragraph (f)(3) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

    The results of stress tests play a key role in shaping an entity's 
liquidity risk contingency planning.\422\ Thus, stress testing and 
contingency planning are closely intertwined.\423\ Under the proposals, 
the ANC broker-dealer and a stand-alone SBSD using internal models 
would be required to establish a written contingency funding plan.\424\ 
The plan would need to clearly set out the strategies for addressing 
liquidity shortfalls in emergency situations,\425\ and would need to 
address the policies, roles, and responsibilities for meeting the 
liquidity needs of the firm and communicating with the public and other 
market participants during a liquidity stress event.\426\
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    \422\ See, e.g., Federal Reserve, FDIC, OCC, OTS, and NCUA, 
Interagency Policy Statement on Funding and Liquidity Risk 
Management 7, SR 10-6 (Mar. 17, 2010).
    \423\ Id.
    \424\ Based on staff experience supervising the ANC broker-
dealers, all of the ANC broker-dealers that are part of a holding 
company generally have a written contingency funding plan, generally 
at the holding company level. This proposed rule would require that 
each ANC broker-dealer and stand-alone SBSD using internal models 
maintain a written contingency funding plan at the entity level (in 
addition to any holding company plan). See also Enhanced Prudential 
Standards and Early Remediation Requirements for Covered Companies, 
77 FR at 604. The Federal Reserve stated that the objectives of the 
contingency funding plan are to provide a plan for responding to a 
liquidity crisis, to identify alternate liquidity sources that a 
covered company can access during liquidity stress events, and to 
describe steps that should be taken to ensure that the covered 
company's sources of liquidity are sufficient to fund its operating 
costs and meet its commitments while minimizing additional costs and 
disruptions. Id. at 610.
    \425\ See proposed new paragraph (f)(4) of Rule 15c3-1; 
paragraph (f)(4) of proposed new Rule 18a-1.
    \426\ See proposed new paragraph (f)(4) of Rule 15c3-1; 
paragraph (f)(4) of proposed new Rule 18a-1. To promote the flow of 
necessary information during a liquidity stress, the Federal 
Reserve's proposed rule would require the event management process 
to include a mechanism that ensures effective reporting and 
communication within the covered company and with outside parties, 
including the Federal Reserve and other relevant supervisors, 
counterparties, and other stakeholders. Enhanced Prudential 
Standards and Early Remediation Requirements for Covered Companies, 
77 FR at 611.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposed liquidity 
stress test requirement. In addition, the Commission requests comment, 
including empirical data in support of comments, in response to the 
following questions:
    1. Are the proposed funding liquidity requirements appropriate for 
ANC broker-dealers and nonbank SBSDs that use internal models? If not, 
explain why not. Are there modifications that would improve the funding 
liquidity provisions? If so, explain them.
    2. Should the proposed funding liquidity requirements apply to a 
broader group of broker-dealers (e.g., all broker-dealers that hold 
customer securities and cash or all broker-dealer with total assets in 
excess of minimum threshold)? Explain why or why not.
    3. Should the proposed funding liquidity requirements apply to all 
nonbank SBSDs? If so, explain why. If not, explain why not.
    4. Is monthly an appropriate frequency for the liquidity stress 
test? For example, would it be preferable to require the liquidity 
stress test on a more frequent basis such as weekly, or, alternatively, 
on a less frequent basis such as quarterly? If so, explain why.
    5. Is the requirement to provide the results of the liquidity 
stress test within ten business days to senior management that has 
responsibility to oversee risk management at the firm appropriate? If 
not, explain why not. Should results be provided in a shorter or longer 
timeframe than ten business days? For example, is ten business days 
sufficient time to run the stress tests, generate the results, and 
provide them to senior management? If the time-frame should be longer 
or shorter, identify the different timeframe and explain why it would 
be more appropriate than ten business days.
    6. Is the requirement that the assumptions underlying the liquidity 
stress test be reviewed at least quarterly by senior management that 
has responsibility to oversee risk management at the firm and at least 
annually by senior management of firm appropriate? If not, explain why 
not. Should the reviews be more or less frequent? If so, identify the 
frequency and explain why it would be more appropriate than quarterly 
and annually.
    7. Are the required assumptions of the funding liquidity stress 
test appropriate? If not, explain why not.

[[Page 70254]]

    8. Are there additional or alternative assumptions that should be 
required in the funding liquidity stress test? If so, identify the 
additional or alternative assumptions and explain why they should be 
included.
    9. Are the required assumptions of the funding liquidity stress 
test understandable? If not, identify the elements that require further 
explanation.
    10. Should other types of securities in addition to U.S. government 
securities be permitted for the liquidity pool? If so, identify the 
types of securities and explain why they should be permitted.
    11. Are the requirements for the written contingency funding plan 
appropriate? If not, explain why not.
    12. Should additional or alternative requirements for the written 
contingency funding plan be required? If so, identify the additional or 
alternative requirements and explain why they should be required.
e. Other Rule 15c3-1 Provisions Incorporated into Rule 18a-1
    Rule 15c3-1 has four other sets of provisions that are proposed to 
be included in new Rule 18a-1: (1) Debt-equity ratio requirements; 
\427\ (2) capital withdrawal notice requirements; \428\ (3) subsidiary 
consolidation requirements (Appendix C); \429\ and (4) subordinated 
loan agreement requirements (Appendix D).\430\
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    \427\ See 17 CFR 240.15c3-1(d).
    \428\ See 17 CFR 240.15c3-1(e).
    \429\ See 17 CFR 240.15c3-1c.
    \430\ See 17 CFR 240.15c3-1d.
---------------------------------------------------------------------------

i. Debt-Equity Ratio Requirements
    Rule 15c3-1 sets limits on the amount of a broker-dealer's 
outstanding subordinated loans.\431\ The limits are prescribed in terms 
of debt-to-equity amounts.\432\ The debt-to-equity limits are designed 
to ensure that a broker-dealer has a base of permanent capital in 
addition to any subordinated loans, which--as discussed above--are 
permitted to be added back to net worth when computing net 
capital.\433\ Proposed new Rule 18a-1 would contain the same debt-to-
equity limits.\434\ The objective of this parallel provision in Rule 
18a-1 is to require nonbank SBSDs to maintain a base of permanent 
capital.
---------------------------------------------------------------------------

    \431\ See 17 CFR 240.15c3-1(d).
    \432\ Id.
    \433\ See Net Capital Rule, Exchange Act Release No. 9891 (Dec. 
5, 1972), 38 FR 56, 59 (Jan. 3, 1973) (``The Commission has 
discovered a large number of instances in which broker-dealers were 
able to comply with the net capital although the firms [sic] net 
worth been entirely depleted. Compliance with the rule was possible 
only because subordinated debt is a permissible form of capital. 
Such conditions rendered the firm technically insolvent since its 
liabilities exceeded its assets.'').
    \434\ See paragraph (h) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposal to 
incorporate the debt-equity ratio provisions of Rule 15c3-1 into 
proposed new Rule 18a-1. In addition, the Commission requests comment, 
including empirical data in support of comments, in response to the 
following question:
    1. Are the debt-equity ratio requirements in Rule 15c3-1 
appropriate standards for stand-alone SBSDs? If not, explain why not 
and suggest an alternative standard.
ii. Capital Withdrawal Requirements
    Rule 15c3-1 requires that a broker-dealer provide notice when it 
seeks to withdraw capital in an amount that exceeds certain 
thresholds.\435\ For example, a broker-dealer must give the Commission 
a two-day notice before a withdrawal that would exceed 30% of the 
firm's excess net capital and a notice within two days after a 
withdrawal that exceeded 20% of that measure.\436\ The notice 
provisions are designed to alert the Commission and the firm's 
designated examining authority that capital is being withdrawn to 
assist in the monitoring of the financial condition of the broker-
dealer. Rule 15c3-1 also restricts capital withdrawals that could have 
certain financial impacts on the firm, including withdrawals that 
reduce net capital below certain numerical levels.\437\ These 
restrictions are designed to ensure that the broker-dealer maintains a 
buffer of net capital above its minimum required amount. Finally, under 
the rule, the Commission may issue an order temporarily restricting a 
broker-dealer from withdrawing capital or making loans or advances to 
stockholders, insiders, and affiliates under certain 
circumstances.\438\ This provision and several of the notice and 
restriction provisions were put in place after the failure of the 
investment bank Drexel Burnham Lambert, Inc. (``Drexel'').\439\ Drexel, 
prior to its bankruptcy, transferred significant funds from its broker-
dealer subsidiary to the holding company without notice to the 
Commission or Drexel's designated examining authority.\440\
---------------------------------------------------------------------------

    \435\ See 17 CFR 240.15c3-1(e)(1).
    \436\ See 17 CFR 240.15c3-1(e)(1).
    \437\ See 17 CFR 240.15c3-1(e)(2).
    \438\ See 17 CFR 240.15c3-1(e)(3).
    \439\ See Net Capital Rule, Exchange Act Release No. 28927 (Feb. 
28, 1991), 56 FR 9124 (Mar. 5, 1991).
    \440\ Id. at 9125.
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    Stand-alone SBSDs would be subject to the same provisions, with one 
difference.\441\ In 2007, the Commission proposed amendments to Rule 
15c3-1 to eliminate certain of the conditions required in an order 
restricting the withdrawals or the making of loans or advances to 
stockholders, insiders, and affiliates.\442\ More specifically, under 
Rule 15c3-1, the Commission can, by order, restrict a broker-dealer for 
a period up to 20 business days from making capital withdrawals, loans, 
and advances only to the extent the withdrawal, loan, or advance would 
exceed 30% of the broker-dealer's excess net capital when aggregated 
with other such transactions over a 30-day period.\443\ The current 
requirement raises a concern, based on Commission staff experience, 
that to the extent the books and records of a broker-dealer that is in 
financial distress are incomplete or inaccurate it can be difficult for 
regulators to determine the firm's actual net capital and excess net 
capital amounts.\444\ An order that limits withdrawals to a percentage 
of excess net capital may be difficult to enforce as it may not always 
be clear when that threshold had been reached.\445\ Given these 
concerns and consistent with the proposed amendment to Rule 15c3-1, the 
Commission is proposing that its ability to restrict withdrawals of 
capital, loans or advances by stand-alone SBSDs not be limited based on 
the amount of the withdrawal, loan or advance in relation to the amount 
of the firms' excess net capital.\446\
---------------------------------------------------------------------------

    \441\ See paragraph (i) of proposed new Rule 18a-1.
    \442\ Amendments to Financial Responsibility Rules for Broker-
Dealers, 72 FR 12862.
    \443\ See 17 CFR 240.15c3-1(e)(3)(i). To issue an order, the 
Commission must, based on the facts and information available, 
conclude that the withdrawal, advance or loan may be detrimental to 
the financial integrity of the broker-dealer, or may unduly 
jeopardize the broker-dealer's ability to repay its customer claims 
or other liabilities which may cause a significant impact on the 
markets or expose the customers or creditors of the broker-dealer to 
loss without taking into account the application of the Securities 
Investor Protection Act of 1970 (``SIPA''). See 17 CFR 240.15c3-
1(e)(3)(i)(B). Furthermore, the rule provides that an order 
temporarily prohibiting the withdrawal of capital shall be rescinded 
if the Commission determines that the restriction on capital 
withdrawal should not remain in effect and that the hearing will be 
held within two business days from the date of the request in 
writing by the broker-dealer. See 17 CFR 240.15c3-1(e)(3)(ii).
    \444\ See Amendments to Financial Responsibility Rules for 
Broker-Dealers, 72 FR at 12873.
    \445\ Id.
    \446\ See paragraph (i) of proposed new Rule 18a-1; Amendments 
to Financial Responsibility Rules for Broker-Dealers, 72 FR at 
12873.
    .

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[[Page 70255]]

Request for Comment
    The Commission generally requests comment on the proposal to 
incorporate the capital withdrawal provisions of Rule 15c3-1 into 
proposed new Rule 18a-1. In addition, the Commission requests comment, 
including empirical data in support of comments, in response to the 
following questions:
    1. Are the capital withdrawal requirements in Rule 15c3-1 
appropriate standards for stand-alone SBSDs? If not, explain why and 
suggest an alternative standard.
    2. Under Rule 15c3-1, a broker-dealer must give the Commission 
notice two days before a withdrawal that would exceed 30% of the firm's 
excess net capital and two days after a withdrawal that exceeded 20% of 
that measure. Are these thresholds appropriate for stand-alone SBSDs? 
If not, explain why not and suggest alternative thresholds.
    3. Rule 15c3-1 also restricts capital withdrawals that would have 
certain financial impacts on a broker-dealer such as lowering net 
capital below certain levels. Are these same requirements appropriate 
standards for stand-alone SBSDs?
    4. Under the proposed amendments, the 30% of excess net capital 
limitation currently contained in Rule 15c3-1 with respect to 
Commission orders restricting withdrawals would be eliminated. However, 
under the proposed amendments, the Commission in issuing an order 
restricting withdrawals could impose such terms and conditions as the 
Commission deems necessary or appropriate in the public interest or 
consistent with the protection of investors. Please identify terms and 
conditions that the Commission should consider to be included in such 
orders. For example, under certain circumstances, would it be 
appropriate for the current limitation in Rule 15c3-1 to be included in 
the order? Alternatively, should the 30% of excess net capital 
limitation currently contained in Rule 15c3-1 be retained in proposed 
new Rule 18a-1? If so, please explain why.
iii. Appendix C
    Appendix C to Rule 15c3-1 requires a broker-dealer in computing its 
net capital and aggregate indebtedness to consolidate in a single 
computation assets and liabilities of any subsidiary or affiliate for 
which it guarantees, endorses or assumes directly or indirectly 
obligations or liabilities.\447\ The assets and liabilities of a 
subsidiary or affiliate whose liabilities and obligations have not been 
guaranteed, endorsed, or assumed directly or indirectly by the broker-
dealer may also be consolidated.\448\ By including the assets and 
liabilities of a subsidiary in its net capital computation, a firm may 
receive flow-through net capital benefits because the consolidation may 
serve to increase the firm's net capital and thereby assist it in 
meeting the minimum requirements of Rule 15c3-1. Appendix C sets forth 
the requirements that must be met to consolidate in a single net 
capital computation the assets and liabilities of subsidiaries and 
affiliates in order to obtain flow-through capital benefits for a 
parent broker-dealer.\449\ Specifically, the broker-dealer must possess 
majority ownership and control over the consolidated subsidiary or 
affiliate and obtain an opinion of counsel essentially stating that at 
least the portion of the subsidiary's or affiliate's net asset value 
related to the broker-dealer's ownership interest therein may be 
distributed to the broker-dealer (or a trustee in a SIPA liquidation) 
within thirty days, at the request of the distributee.\450\ In 
addition, subordinated obligations of the subsidiary or affiliate may 
not serve to increase the net worth of the broker-dealer unless the 
obligations also are subordinated to the claims of present and future 
creditors of the broker-dealer.\451\ Appendix C also requires that 
liabilities and obligations of a subsidiary or affiliate of the broker-
dealer that are guaranteed, endorsed, or assumed either directly or 
indirectly by the broker-dealer must be reflected in the firm's net 
capital computation.\452\
---------------------------------------------------------------------------

    \447\ See 17 CFR 240.15c3-1c.
    \448\ Id.
    \449\ See 17 CFR 240.15c3-1c.
    \450\ See 17 CFR 240.15c3-1c(b). FINRA Rule 4150(a) requires 
that prior written notice be given to FINRA whenever a FINRA member 
guarantees, endorses or assumes, directly or indirectly, the 
obligations or liabilities of another person. Paragraph (b) of the 
rule requires that prior written approval must be obtained from 
FINRA whenever any member seeks to receive flow-through capital 
benefits in accordance with Appendix C to Rule 15c3-1. This makes 
compliance with the rule more stringent because FINRA must pre-
approve the subordinated debt for FINRA member firms who wish to 
take advantage of the capital benefits available under Appendix C of 
Rule 15c3-1. As of June 1, 2012, of the 4,711 broker-dealers 
registered with the Commission, 4,437 were FINRA member firms.
    \451\ See 17 CFR 240.15c3-1c(c)(2).
    \452\ See 17 CFR 240.15c3-1c(d).
---------------------------------------------------------------------------

    Based on Commission staff experience and information from an SRO, 
very few broker-dealers consolidate subsidiaries or affiliates to 
obtain the flow-through capital benefits under Appendix C to Rule 15c3-
1. The review and information from the SRO indicate that the limited 
use results from the difficulty in obtaining the required opinion of 
counsel. Consequently, Appendix C to proposed new Rule 18a-1 would 
contain only the requirement that a stand-alone SBSD include in its net 
capital computation all liabilities or obligations of a subsidiary or 
affiliate of the stand-alone SBSD that the SBSD guarantees, endorses, 
or assumes either directly or indirectly. Thus, stand-alone SBSDs would 
not be able to claim flow-through capital benefits for consolidated 
subsidiaries or affiliates. The Commission does not expect that this 
difference in approach between Rule 15c3-1 and proposed new Rule 18a-1 
would create any competitive disadvantage for stand-alone SBSDs vis-
[agrave]-vis broker-dealer SBSDs, given the limited use of the flow-
through benefits provision under the current rule.
Request for Comment
    The Commission generally requests comment on Appendix C of both 
Rule 15c3-1 and proposed Rule 18a-1. In addition, the Commission 
requests comment, including empirical data in support of comments, in 
response to the following questions:
    1. Should the flow-through capital benefit provisions of Appendix C 
to Rule 15c3-1 be eliminated? If so, explain why. Alternatively, should 
the flow-through capital benefit provisions in Appendix C to Rule 15c3-
1 be incorporated into proposed Rule 18a-1? If so, explain why.
    2. Would stand-alone SBSDs be subject to a competitive disadvantage 
vis-[agrave]-vis broker-dealer SBSDs as a result of the differences 
between proposed Appendix C of Rule 18a-1 and Appendix C of Rule 15c3-
1? Would these differences provide an incentive for an entity to 
register a nonbank SBSD as a broker-dealer SBSD? Please explain.
iv. Appendix D
    Appendix D to Rule 15c3-1 sets forth the minimum and non-exclusive 
requirements for satisfactory subordination agreements.\453\ A 
subordination agreement is a contract between a broker-dealer and a 
third party pursuant to which the third party lends money or provides a 
collateralized note to the broker-dealer. Generally, broker-dealers use 
subordination agreements to borrow from third parties (typically 
affiliates) to increase the broker-dealer's net capital.\454\ Nonbank 
SBSDs also are expected to use subordinated debt to obtain financing 
for their activities and the proposals discussed below would prescribe 
when

[[Page 70256]]

such loans would receive favorable capital treatment.
---------------------------------------------------------------------------

    \453\ 17 CFR 240.15c3-1d.
    \454\ See 17 CFR 240.15c3-1(c)(2)(ii).
---------------------------------------------------------------------------

    In order to receive beneficial regulatory capital treatment under 
Rule 15c3-1, the obligation to the third party must be subordinated to 
the claims of creditors pursuant to a satisfactory subordination 
agreement, as defined under Appendix D.\455\ Among other things, a 
satisfactory subordination agreement must prohibit, except under 
strictly defined limitations, prepayments or any payment of an 
obligation before the expiration of at least one year from the 
effective date of the subordination agreement.\456\ This provision was 
designed to ensure the adequacy as well as the permanence of capital in 
the industry.\457\
---------------------------------------------------------------------------

    \455\ Id.
    \456\ See 17 CFR 240.15c3-1d(b)(1).
    \457\ See Net Capital Requirements for Broker-Dealers; Amended 
Rules, Exchange Act Release No. 18417 (Jan. 13, 1982), 47 FR 3512, 
3516 (Jan. 25, 1982).
---------------------------------------------------------------------------

    There are two types of subordination agreements under Appendix D to 
Rule 15c3-1: (1) a subordinated loan agreement, which is used when a 
third party lends cash to a broker-dealer; \458\ and (2) a secured 
demand note agreement, which is a promissory note in which a third 
party agrees to give cash to a broker-dealer on demand during the term 
of the note and provides cash or securities to the broker-dealer as 
collateral.\459\
---------------------------------------------------------------------------

    \458\ See 17 CFR 240.15c3-1d(a)(2)(ii).
    \459\ See 17 CFR 240.15c3-1d(a)(2)(v)(A). Under a secured demand 
note agreement, the third party cannot sell or otherwise use the 
collateral unless the third party substitutes securities of equal 
value for the deposited securities. See 17 CFR 240.15c3-
1d(a)(2)(v)(D).
---------------------------------------------------------------------------

    A broker-dealer SBSD would be subject to the provisions of Appendix 
D to Rule 15c3-1 through parallel provisions in Appendix D to proposed 
new Rule 18a-1.\460\ However, only the subordinated loan agreement 
provisions would be included in Appendix D to proposed new Rule 18a-1. 
Thus, stand-alone SBSDs would not be able to use secured demand note 
agreements to obtain beneficial regulatory capital treatment under 
proposed Appendix D to Rule 18a-1. Based on Commission staff 
experience, broker-dealers infrequently utilize secured demand notes as 
a source of capital, and the amounts of these notes are relatively 
small in size. Therefore, this form of regulatory capital is not being 
proposed for stand-alone SBSDs. Accordingly, Appendix D to proposed new 
Rule 18a-1 would refer solely to ``subordinated loan agreements'' in 
the provisions where Appendix D to Rule 15c3-1 refers more broadly to 
``subordination agreements.'' \461\
---------------------------------------------------------------------------

    \460\ Appendix D to Rule 15c3-1d has provisions that apply if an 
action (e.g., repayment of the subordinated loan) would cause the 
broker-dealer's net capital to fall below certain thresholds (e.g., 
120% of the broker-dealer's minimum net capital requirement) and a 
provision that applies if the broker-dealer's net capital has fallen 
below its minimum net capital requirement. See paragraphs (b)(7), 
(b)(8)(i), (b)(10)(ii)(B), (c)(2), and (c)(5)(i)(B) of 17 CFR 
240.15c3-1d. Proposed new Rule 18a-1 would contain analogous 
provisions that would be based on the proposed minimum net capital 
and tentative net capital requirements for stand-alone SBSDs. See 
paragraphs (b)(6), (b)(7), (b)(9)(ii)(A), (c)(2), and (c)(4)(i) of 
proposed new Rule 18a-1d. In addition, in order to reflect the 
minimum net capital requirements that would apply to broker-dealer 
SBSDs, conforming amendments are being proposed for Rule 15c3-1d. 
See proposed amendments to paragraphs (b)(7), (b)(8)(i), 
(b)(10)(ii)(B), (c)(2), and (c)(5)(i)(B) of 17 CFR 240.15c3-1d.
    \461\ The term ``subordination agreements'' as used in Appendix 
D to Rule 15c3-1 references both subordinated loan agreements and 
secured demand note agreements.
---------------------------------------------------------------------------

    Subordination agreements under Appendix D to Rule 15c3-1 are 
approved by a broker-dealer's designated examining authority.\462\ A 
broker-dealer also is required to notify its designated examining 
authority upon the occurrence of certain events under Appendix D to 
Rule 15c3-1.\463\ Because the term ``designated examining authority'' 
applies only to registered broker-dealers (i.e., stand-alone SBSDs 
would not have a designated examining authority), the provisions of 
Appendix D to Rule 18a-1 refer to the ``Commission'' instead of the 
``designated examining authority.'' Specifically, under paragraph 
(c)(5) of Appendix D to proposed Rule 18a-1, a stand-alone SBSD would 
be required to file two copies of any proposed subordinated loan 
agreement (including nonconforming subordinated loan agreements) at 
least 30 days prior to the proposed execution date of the agreement 
with the Commission.\464\ The rule would also require an SBSD to file 
with the Commission a statement setting forth the name and address of 
the lender, the business relationship of the lender to the SBSD, and 
whether the SBSD carried an account for the lender effecting 
transactions in security-based swaps at or about the time the proposed 
agreement was filed.\465\
---------------------------------------------------------------------------

    \462\ See 17 CFR 240.15c3-1d(c)(6)(i). See also FINRA Rule 
4110(e)(1), which provides that subordinated loans and secured 
demand notes must be approved by FINRA in order to receive 
beneficial regulatory capital treatment.
    \463\ See, e.g., 17 CFR 240.15c3-1d(b)(6).
    \464\ See paragraph (c)(5) of proposed new Rule 18a-1d.
    \465\ Id.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on Appendix D to both 
Rule 15c3-1 and proposed new Rule 18a-1. In addition, the Commission 
requests comment, including empirical data in support of comments, in 
response to the following questions:
    1. Should the secured demand note provisions of Appendix D to Rule 
15c3-1 be eliminated? Alternatively, should the secured demand note 
provisions be incorporated into Appendix D to proposed new Rule 18a-1? 
If so, explain why.
    2. Would stand-alone SBSDs be disadvantaged vis-[agrave]-vis 
broker-dealer SBSDs as a result of the differences between proposed 
Appendix D to proposed new Rule 18a-1 and Appendix D to Rule 15c3-1? 
Would these differences provide an incentive for an entity to register 
a nonbank SBSD as a broker-dealer SBSD? Please explain.
3. Proposed Capital Rules for Nonbank MSBSPs
    Proposed new Rule 18a-2 would establish capital requirements for 
nonbank MSBSPs. In particular, a nonbank MSBSP would be required at all 
times to have and maintain positive tangible net worth.\466\ A tangible 
net worth standard is being proposed for nonbank MSBSPs, rather than 
the net liquid assets test in Rule 15c3-1, because the entities that 
may need to register as nonbank MSBSPs may engage in a diverse range of 
business activities different from, and broader than, the securities 
activities conducted by broker-dealers or SBSDs (otherwise they would 
be required to register as an SBSD and/or broker-dealer). For example, 
these entities may engage in commercial activities that require them to 
have substantial fixed assets to support manufacturing and/or result in 
them having significant assets comprised of unsecured receivables. 
Requiring them to adhere to a net liquid assets test could result in 
their having to obtain significant additional capital or engage in 
costly restructurings.
---------------------------------------------------------------------------

    \466\ See paragraph (a) of proposed new Rule 18a-2. If a broker-
dealer is required to register as a nonbank MSBSP, it would need to 
continue to comply with Rule 15c3-1 in addition to proposed new Rule 
18a-2.
---------------------------------------------------------------------------

    The term tangible net worth would be defined to mean the nonbank 
MSBSP's net worth as determined in accordance with generally accepted 
accounting principles in the United States, excluding goodwill and 
other intangible assets.\467\ In determining net worth, all long and 
short positions in security-based swaps, swaps, and related positions 
would need to be marked to

[[Page 70257]]

their market value.\468\ Further, a nonbank MSBSP would be required to 
include in its computation of tangible net worth all liabilities or 
obligations of a subsidiary or affiliate that the participant 
guarantees, endorses, or assumes, either directly or indirectly.\469\ 
The proposed definition of tangible net worth would allow nonbank 
MSBSPs to include as regulatory capital assets that would be deducted 
from net worth under Rule 15c3-1, such as property, plant, equipment, 
and unsecured receivables. At the same time, it would require the 
deduction of goodwill and other intangible assets.\470\
---------------------------------------------------------------------------

    \467\ See paragraph (b) of proposed new Rule 18a-2.
    \468\ Id. This provision is modeled on paragraph 
(c)(2)(vi)(B)(1) of Rule 15c3-1. See 17 CFR 240.15c3-
1(c)(2)(vi)(B)(1). See also paragraph (c)(1)(i)(B)(1) of proposed 
new Rule 18a-1.
    \469\ See paragraph (b) of proposed new Rule 18a-2.
    \470\ The proposed definition of tangible net worth is 
consistent with the CFTC's proposed definition of tangible net 
equity. See CFTC Capital Proposing Release, 76 FR at 27828 (defining 
tangible net equity as ``equity as determined under U.S. generally 
accepted accounting principles, and excludes goodwill and other 
intangible assets.'').
---------------------------------------------------------------------------

    Because nonbank MSBSPs, by definition, will be entities that engage 
in a substantial security-based swap business, they would be required 
to comply with Rule 15c3-4 with respect to their security-based swap 
and swap activities.\471\ As discussed above in section II.A.2.c. of 
this release, Rule 15c3-4 requires OTC derivatives dealers and ANC 
broker-dealers to establish, document, and maintain a system of 
internal risk management controls to assist in managing the risks 
associated with their business activities, including market, credit, 
leverage, liquidity, legal, and operational risks.\472\ The proposal 
that nonbank MSBSPs be subject to Rule 15c3-4 is designed to promote 
sound risk management practices with respect to the risks associated 
with OTC derivatives.
---------------------------------------------------------------------------

    \471\ See paragraph (c) of proposed new Rule 18a-2.
    \472\ See 17 CFR 240.15c3-4.
---------------------------------------------------------------------------

    Finally, the risk that the failure of a nonbank MSBSP could have a 
destabilizing market impact is being addressed in part by the account 
equity requirements in proposed new Rule 18a-3--as discussed below in 
section II.B.2.c.ii. of this release--that would require a nonbank 
MSBSP to deliver collateral to counterparties to cover the 
counterparty's current exposure to the nonbank MSBSP. The proposed 
requirement that nonbank MSBSPs deliver collateral to counterparties is 
designed to address a risk that arose during the 2008 credit crisis 
(i.e., the existence of large uncollateralized exposures of market 
participants to a single entity). The proposed requirements in proposed 
new Rule 18a-2 that a nonbank MSBSP maintain positive tangible net 
worth and establish risk management controls are designed to serve as 
an extra measure of protection but be flexible enough to account for 
the potential range of business activities of these entities.
Request for Comment
    The Commission generally requests comment on the proposed capital 
requirements for nonbank MSBSPs. In addition, the Commission requests 
comment, including empirical data in support of comments, in response 
to the following questions:
    1. Is a tangible net worth test an appropriate standard for a 
nonbank MSBSP? Would a net liquid assets test capital standard be more 
appropriate? If so, describe the rationale for such an approach.
    2. Should nonbank MSBSPs be permitted to calculate their tangible 
net worth using generally accepted accounting principles in 
jurisdictions other than U.S., such as where the nonbank MSBSP is 
incorporated, organized, or has its principal office? If so, explain 
why.
    3. Can the risks to market stability presented by nonbank MSBSPs be 
largely addressed through margin requirements?
    4. Should proposed new Rule 18a-2 require that a nonbank MSBSP 
maintain a minimum fixed-dollar amount of tangible net equity, for 
example, equal to $20,000,000 or some greater or lesser amount? If so, 
explain the merits of imposing a fixed-dollar amount and identify the 
recommended fixed-dollar amount.
    5. Should proposed new Rule 18a-2 require that a nonbank MSBSP 
compute capital charges for market risk and credit risk? For example, 
should such a requirement be modeled on the CFTC's proposed market and 
credit risk charges for nonbank swap dealers and nonbank major swap 
participants that are not using internal models and are not FCMs? \473\ 
If nonbank SBSDs should be required to take market and credit risk 
charges, explain why. If not, explain why not.
---------------------------------------------------------------------------

    \473\ See CFTC Capital Proposing Release, 76 FR at 27809-27812.
---------------------------------------------------------------------------

    6. Should nonbank MSBSPs be subject to a leverage test and if so, 
how should it be designed? Explain the rationale for such a test.
    7. Should a nonbank MSBSP be subject to a minimum tangible net 
worth requirement that is proportional to the amount of risk incurred 
by the MSBSP through its outstanding security-based swap transactions? 
More specifically, should an MSBSP calculate an ``adjusted tangible net 
worth'' by subtracting market risk deductions for their security-based 
swaps (either based on the standardized haircuts or on approved models) 
from their tangible net worth and be required to maintain sufficient 
capital such that this adjusted tangible net worth figure is positive?

B. Margin

1. Introduction
    As discussed above in section II.A.2.b.iv. of this release, dealers 
in OTC derivatives manage credit risk to their OTC derivatives 
counterparties through collateral and netting agreements.\474\ The two 
types of credit exposure arising from OTC derivatives are current 
exposure and potential future exposure. The current exposure is the 
amount that the counterparty would be obligated to pay the dealer if 
all the OTC derivatives contracts with the counterparty were terminated 
(i.e., it is the amount of the current receivable from the 
counterparty). This form of credit risk arises from the potential that 
the counterparty may default on the obligation to pay the current 
receivable. The potential future exposure is the amount that the 
current exposure may increase in favor of the dealer in the future. 
This form of credit risk arises from the potential that the 
counterparty may default before providing the dealer with additional 
collateral to cover the incremental increase in the current exposure or 
that the current exposure will increase after a default when the 
counterparty has ceased to provide additional collateral to cover such 
increases and before the dealer can liquidate the position.
---------------------------------------------------------------------------

    \474\ See Market Review of OTC Derivative Bilateral 
Collateralization Practices; OTC Derivatives: Settlement Procedures 
and Counterparty Risk Management.
---------------------------------------------------------------------------

    Dealers may require counterparties to provide collateral to cover 
their current and potential future exposures to the counterparty.\475\ 
On the other hand, they may not require collateral for these purposes 
because, for example, the counterparty is deemed to be of low

[[Page 70258]]

credit risk.\476\ Alternatively, agreements between a dealer and its 
counterparties could require the counterparties to begin delivering 
collateral during the pendency of the transaction if certain ``trigger 
events,'' e.g., a downgrade of the counterparty's credit rating, occur. 
Prior to the financial crisis, the ability to enter into OTC 
derivatives transactions without having to deliver collateral allowed 
counterparties to enter into OTC derivatives transactions without the 
necessity of using capital to support the transactions.\477\ So, when 
``trigger events'' occurred during the financial crisis, counterparties 
faced significant liquidity strains in seeking to meet the requirements 
to deliver collateral.\478\ As a result, some dealers experienced large 
uncollateralized exposures to counterparties experiencing financial 
difficulty, which, in turn, risked exacerbating the already severe 
market dislocation.\479\
---------------------------------------------------------------------------

    \475\ In the Dodd-Frank Act, collateral collected to cover 
current exposure is referred to as variation margin and collateral 
collected to cover potential future exposure is referred to as 
initial margin. See, e.g., section 15F(e)(2)(B)(i)-(ii) of the 
Exchange Act (15 U.S.C. 78o-10(e)(2)(B)(i)-(ii)) and section 
4s(e)(1)(A)-(B) of the CEA (7 U.S.C. 6s(e)(1)(A)-(B)), added by the 
Dodd-Frank Act. In this release, collateral collected to cover 
potential future exposure is referred to as margin collateral.
    \476\ See, e.g., Orice M. Williams, Director, Financial Markets 
and Community Investment, General Accountability Office (``GAO''), 
Systemic Risk: Regulatory Oversight and Recent Initiatives to 
Address Risk Posed by Credit Default Swaps, GAO-09-397T (Mar. 2009), 
available at http://www.gao.gov/new.items/d09397t.pdf (testimony 
before the U.S. House Financial Services Subcommittee on Capital 
Markets, Insurance, and Government Sponsored Enterprises).
    \477\ Id. at 13.
    \478\ Id. See also GAO, Financial Crisis: Review of Federal 
Reserve System Financial Assistance to American International Group, 
Inc., GAO-11-616 (Sept. 2011), available at http://www.gao.gov/assets/590/585560.pdf (``Financial Crisis: Review of Federal Reserve 
System Financial Assistance to American International Group, 
Inc.'').
    \479\ See Financial Crisis: Review of Federal Reserve System 
Financial Assistance to American International Group, Inc. at 5-6.
---------------------------------------------------------------------------

    The Dodd-Frank Act seeks to address the risk of uncollateralized 
credit risk exposure arising from OTC derivatives by, among other 
things, mandating margin requirements for non-cleared security-based 
swaps and swaps. In particular, section 764 of the Dodd-Frank Act added 
new section 15F to the Exchange Act.\480\ Section 15F(e)(2)(B) of the 
Exchange Act provides that the Commission shall adopt rules for nonbank 
SBSDs and nonbank MSBSPs imposing ``both initial and variation margin 
requirements on all security-based swaps that are not cleared by a 
registered clearing agency.'' \481\ Section 15F(e)(2)(A) of the 
Exchange Act provides that the prudential regulators shall prescribe 
initial and variation margin requirements for non-cleared security-
based swap transactions applicable to bank SBSDs and bank MSBSPs.\482\ 
Section 15F(e)(3)(A) also provides that ``[t]o offset the greater risk 
to the security-based swap dealer or major security-based swap 
participant and the financial system arising from the use of security-
based swaps that are not cleared,'' the margin requirements proposed by 
the Commission and prudential regulators shall ``help ensure the safety 
and soundness'' of the SBSDs and the MSBSPs, and ``be appropriate for 
the risk associated with non-cleared security-based swaps held'' by an 
SBSD or MSBSP.\483\
---------------------------------------------------------------------------

    \480\ See Public Law 111-203 Sec.  764.
    \481\ 15 U.S.C. 78o-10(e)(2)(B).
    \482\ See 15 U.S.C. 78o-10(e)(2)(A). The prudential regulators 
have proposed margin rules with respect to non-cleared swaps and 
security-based swaps that would apply to bank swap dealers, bank 
major swap participants, bank SBSDs, and bank MSBSPs. See Prudential 
Regulator Margin and Capital Proposing Release, 76 FR 27564. The 
prudential regulators refer to collateral to cover current exposure 
as variation margin and collateral to cover potential future 
exposure as initial margin. Id.
    \483\ 15 U.S.C. 78o-10(e)(3)(A).
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    Similarly, sections 4s(e)(1)(A) and (B) of the CEA provide that the 
prudential regulators and the CFTC shall prescribe margin requirements 
for, respectively, bank swap dealers and bank major swap participants, 
and nonbank swap dealers and nonbank major swap participants.\484\ 
Further, section 4s(e)(3)(A) of the CEA provides, among other things, 
that ``[t]o offset the greater risk to the swap dealer or major swap 
participant and the financial system arising from the use of swaps that 
are not cleared,'' the margin requirements adopted by the prudential 
regulators and the CFTC shall ``help ensure the safety and soundness'' 
of swap dealers and major swap participants, and ``be appropriate for 
the risk associated with non-cleared swaps held'' by these 
entities.\485\
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    \484\ See 7 U.S.C. 6s(e)(1)(A) and (B). The CFTC has proposed 
margin requirements with respect to non-cleared swaps that would 
apply to nonbank swap dealers and nonbank major swap participants. 
See CFTC Margin Proposing Release, 76 FR 23732. The CFTC refers to 
collateral to cover current exposure as variation margin and 
collateral to cover potential future exposure as initial margin. Id.
    \485\ 7 U.S.C. 6s(e)(3)(A).
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    The margin requirements that must be established with respect to 
non-cleared security-based swaps and non-cleared swaps will operate in 
tandem with provisions in the Dodd-Frank Act requiring that security-
based swaps and swaps must be cleared through a registered clearing 
agency or registered DCO, respectively, unless an exception to 
mandatory clearing exists.\486\ More specifically, section 3C of the 
Exchange Act,\487\ as added by section 763(a) of the Dodd-Frank Act, 
creates, among other things, a clearing requirement with respect to 
certain security-based swaps. Specifically, this section provides that 
``[i]t shall be unlawful for any person to engage in a security-based 
swap unless that person submits such security-based swap for clearing 
to a clearing agency that is registered under this Act or a clearing 
agency that is exempt from registration under this Act if the security-
based swap is required to be cleared.'' \488\
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    \486\ See Public Law 111-203 Sec.  763 (adding section 3C(a)(1) 
of the Exchange Act (15 U.S.C. 78c-3(a)(1) (mandatory clearing of 
security-based swaps)) and Public Law 111-203 Sec.  723 (adding 
section 2(h) of the CEA (7 U.S.C. 2(h) (mandatory clearing of 
swaps)). The mandatory clearing provisions in the Exchange Act and 
CEA contain exceptions from the mandatory clearing requirement for 
certain types of entities, security-based swaps, and swaps. See 
Process for Submissions for Review of Security-Based Swaps for 
Mandatory Clearing and Notice Filing Requirements for Clearing 
Agencies; Technical Amendments to Rule 19b-4 and Form 19b-4 
Applicable to All Self-Regulatory Organizations, Exchange Act 
Release No. 67286 (June 28, 2012), 77 FR 41602 (July 13, 2012) 
(explaining exceptions to mandatory clearing for security-based 
swaps) (``Process for Submissions of Security-Based Swaps''); 
Process for a Designated Contract Market or Swap Execution Facility 
To Make a Swap Available To Trade, 76 FR 77728 (Dec. 30, 2010) 
(explaining exceptions to mandatory clearing for swaps). Security-
based swaps and swaps that are not required to be cleared would be 
non-cleared security-based swaps and swaps.
    \487\ 15 U.S.C. 78c-3 et seq.
    \488\ 15 U.S.C. 78c-3(a)(1) (as added by section 763(a) of the 
Dodd-Frank Act). The requirement that a security-based swap must be 
cleared will stem from the determination to be made by the 
Commission. Such determination may be made in connection with the 
review of a clearing agency's submission regarding a security-based 
swap, or any group, category, type or class of security-based swap, 
the clearing agency plans to accept for clearing. See 15 U.S.C. 78c-
3(b)(2)(C)(ii) (as added by section 763(a) of the Dodd-Frank Act) 
(``[t]he Commission shall * * * review each submission made under 
subparagraphs (A) and (B), and determine whether the security-based 
swap, or group, category, type, or class of security-based swaps, 
described in the submission is required to be cleared''.). In 
addition, section 3C(b)(1) of the Exchange Act provides that ``[t]he 
Commission on an ongoing basis shall review each security-based 
swap, or any group, category, type, or class of security-based swaps 
to make a determination that such security-based swap, or group, 
category, type, or class of security-based swaps should be required 
to be cleared.''
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    Clearing agencies and DCOs that operate as central counterparties 
(``CCPs'') manage credit and other risks through a range of controls 
and methods, including prescribed margin rules for their members.\489\ 
Thus, the

[[Page 70259]]

mandatory clearing requirements established by the Dodd-Frank Act for 
security-based swaps and swaps, in effect, will establish margin 
requirements for cleared security-based swaps and cleared swaps and, 
thereby, complement the margin requirements for non-cleared security-
based swaps and non-cleared swaps established by the Commission, the 
prudential regulators, and the CFTC.\490\
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    \489\ See Clearing Agency Standards for Operation and 
Governance, Exchange Act Release No. 64017 (Mar. 3, 2011), 76 FR 
14472 (Mar. 16, 2011) (``Clearing Agency Standards for Operation and 
Governance''). A CCP interposes itself between two counterparties to 
a transaction. See Process for Submissions of Security-Based Swaps, 
77 FR at 41603. For example, when an OTC derivatives contract 
between two counterparties that are members of a CCP is executed and 
submitted for clearing, it is typically replaced by two new 
contracts--separate contracts between the CCP and each of the two 
original counterparties. At that point, the original counterparties 
are no longer counterparties to each other. Instead, each acquires 
the CCP as its counterparty, and the CCP assumes the counterparty 
credit risk of each of the original counterparties that are members 
of the CCP. To address the credit risk of acting as a CCP, clearing 
agencies and DCOs require their clearing members to post collateral 
for proprietary and customer positions of the member cleared by the 
clearing agency or DCO. They also may require their clearing members 
to collect collateral from their customers. In addition, as 
discussed below, the Federal Reserve and the broker-dealer SROs 
prescribe margin rules requiring broker-dealers to collect margin 
collateral from their customers for financed securities transactions 
and facilitated short sales of securities. Id.
    \490\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27567 (``In the derivatives clearing process, 
central counterparties (CCPs) manage the credit risk through a range 
of controls and methods, including a margining regime that imposes 
both initial margin and variation margin requirements on parties to 
cleared transactions. Thus, the mandatory clearing requirement 
established by the Dodd-Frank Act for swaps and security-based swaps 
will effectively require any party to any transaction subject to the 
clearing mandate to post initial and variation margin to the CCP in 
connection with that transaction.'') (footnote omitted). See also 
Clearing Agency Standards for Operation and Governance, 76 FR at 
14482 (proposing a requirement that clearing agencies acting as CCPs 
must establish, implement, maintain, and enforce written policies 
and procedures reasonably designed to use margin requirements to 
limit credit exposures to members in normal market conditions, use 
risk-based models and parameters to set margin requirements, and 
review the models and parameters at least monthly).
---------------------------------------------------------------------------

    Pursuant to section 15F(e) of the Exchange Act, the Commission is 
proposing new Rule 18a-3 to establish margin requirements for nonbank 
SBSDs and nonbank MSBSPs with respect to non-cleared security-based 
swaps. The provisions of proposed Rule 18a-3 are based on the margin 
rules applicable to broker-dealers (the ``broker-dealer margin 
rules'').\491\ The goal of modeling proposed new Rule 18a-3 on the 
broker-dealer margin rules is to promote consistency with existing 
rules and to facilitate the portfolio margining of security-based swaps 
with other types of securities. In the securities markets, margin rules 
have been set by relevant regulatory authorities (the Federal Reserve 
and the SROs) since the 1930s.\492\ The requirement that an SRO file 
proposed margin rules with the Commission has promoted the 
establishment of consistent margin levels across the SROs, which 
mitigates the risk that SROs (as well as their member firms) will 
compete by implementing lower margin levels and also helps ensure that 
margin levels are set at sufficiently prudent levels to reduce systemic 
risk.\493\ Basing proposed Rule 18a-3 on the broker-dealer margin rules 
is intended to achieve these same objectives in the market for 
security-based swaps.
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    \491\ Broker-dealers are subject to margin requirements in rules 
promulgated by the Federal Reserve (12 CFR 220.1, et seq.), SROs 
(see, e.g., FINRA Rules 4210-4240), and, with respect to security 
futures, jointly by the Commission and the CFTC (17 CFR 242.400-
406).
    \492\ The Federal Reserve originally adopted Regulation T 
pursuant to section 7 of the Exchange Act shortly after the 
enactment of the Exchange Act. See 1934 Fed. Res. Bull. 675. The 
purposes of the Federal Reserve's margin rules include: (1) 
Regulation of the amount of credit directed into securities 
speculation and away from other uses; (2) protection of the 
securities markets from price fluctuations and disruptions caused by 
excessive margin credit; (3) protection of investors against losses 
arising from undue leverage in securities transactions; and (4) 
protection of broker-dealers from the financial exposure involved in 
excessive margin lending to customers. See Charles F. Rechlin, 
Securities Credit Regulation Sec.  1:3 (2d ed. 2008).
    \493\ Pursuant to section 19(b)(1) of the Exchange Act, each SRO 
must file with the Commission any proposed change in, addition to, 
or deletion from the rules of the exchange electronically on a Form 
19b-4 through the Electronic Form 19b-4 Filing System, which is a 
secure Web site operated by the Commission. 15 U.S.C. 78s(b)(1); 17 
CFR 240.19b-4.
---------------------------------------------------------------------------

    Under the broker-dealer margin rules, an accountholder is required 
to maintain a specified level of equity in a securities account at a 
broker-dealer (i.e., the market value of the assets in the account must 
exceed the amount of the accountholder's obligations to the broker-
dealer by a prescribed amount).\494\ This equity serves as a buffer in 
the event the accountholder fails to meet an obligation to the broker-
dealer and the broker-dealer must liquidate the assets in the account 
to satisfy the obligation.\495\ The equity also provides liquidity to 
the broker-dealer with which to fund the credit extended to the 
accountholder. The amount of the equity required to be maintained in 
the account depends on the securities transactions being facilitated 
through the resources of the broker-dealer because the equity 
requirement increases as the risk of the securities purchased with 
borrowed funds or sold short with borrowed securities increases.
---------------------------------------------------------------------------

    \494\ See, e.g., 12 CFR 220.2; FINRA Rule 4210(a)(5); 17 CFR 
242.401(a)(8). Accountholder obligations to the broker-dealer 
generally arise from the accountholder borrowing funds from the 
broker-dealer to finance securities purchases and the accountholder 
relying on the broker-dealer to borrow securities or use its own 
securities to make delivery on short sales of securities by the 
accountholder.
    \495\ The account equity requirement, in effect, mandates that 
the account contain sufficient collateral to cover the broker-
dealer's current exposure to the accountholder plus a buffer to 
address potential future exposure.
---------------------------------------------------------------------------

    Proposed new Rule 18a-3 is based on these same principles and is 
intended to form part of an integrated program of financial 
responsibility requirements, along with the proposed capital and 
segregation standards. For example, proposed new Rule 18a-1 would 
impose a capital charge in certain cases for uncollateralized exposures 
arising from security-based swaps. The segregation requirements are 
intended to ensure that initial margin collected by SBSDs is protected 
from their proprietary business risks.\496\
---------------------------------------------------------------------------

    \496\ See proposed new Rules 18a-1, 18a-3, and 18a-4.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposal to model 
the nonbank SBSD margin rule for non-cleared security-based swaps on 
the broker-dealer margin rules. In addition, the Commission requests 
comment, including empirical data in support of comments, in response 
to the following questions:
    1. Are there other margin standards that would more appropriately 
address the risks of non-cleared security-based swaps and/or be more 
practical margining programs for non-cleared security-based swaps? If 
so, identify them and explain how they would be more appropriate and/or 
practical.
    2. What are the current margining practices of dealers in OTC 
derivatives with respect to contracts that likely would be security-
based swaps subject to proposed new Rule 18a-3? How do those margining 
practices differ from the proposed requirements in proposed new Rule 
18a-3?
    3. As a practical matter, would the structure of proposed new Rule 
18a-3 accommodate portfolio margining of security-based swaps and 
swaps? If so, explain why. If not, explain why not.
2. Proposed Margin Requirements for Nonbank SBSDs and Nonbank MSBSPs
a. Scope of Rule 18a-3
    Proposed new Rule 18a-3 would apply to nonbank SBSDs and nonbank 
MSBSPs.\497\ As discussed in more detail below, the proposed rule would 
require nonbank SBSDs to collect collateral from their counterparties 
to non-cleared security-based swaps to cover both current exposure and 
potential future exposure to the counterparty (i.e., the rule would 
require the account to have prescribed minimum levels of equity); 
however, there would be exceptions to

[[Page 70260]]

these requirements for certain types of counterparties and for certain 
types of transactions. The collateral collected to address the 
potential future exposure (the margin collateral) would need to be 
sufficient to meet the level of account equity required by the proposed 
rule. The required level of account equity would be based on the risk 
of the positions in the account.
---------------------------------------------------------------------------

    \497\ See paragraph (a) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    Proposed new Rule 18a-3 would require a nonbank MSBSP to collect 
collateral from counterparties to which the nonbank MSBSP has current 
exposure and deliver collateral to counterparties that have current 
exposure to the nonbank MSBSP; however, there would be exceptions to 
these requirements for certain types of counterparties. These 
requirements would apply only to current exposure (i.e., nonbank MSBSPs 
and their counterparties would not be required to exchange collateral 
to cover potential future exposure to each other).
    The proposed rule would not identify the types of instruments that 
must be delivered as collateral (e.g., U.S. government securities). 
However, it would place limitations on the collateral that could be 
collected by nonbank SBSDs. First, the rule would require the nonbank 
SBSD to take haircuts on the collateral equal to the amounts of the 
deductions required under Rule 15c3-1, as proposed to be amended, and 
proposed new Rule 18a-1, as applicable to the nonbank SBSD. Second, the 
rule would prescribe conditions with respect to the collateral modeled 
on the conditions in Appendix E to Rule 15c3-1, discussed above in 
section II.A.2.b.iv. of this release, that determine when collateral 
can be taken into account for purposes of determining a potential 
credit risk charge for exposure to certain counterparties.\498\
---------------------------------------------------------------------------

    \498\ See 17 CFR 240.15c3-1e(c)(4)(v)(A)-(H).
---------------------------------------------------------------------------

    Finally, the provisions in proposed new Rule 18a-3 are intended to 
establish minimum margin requirements for non-cleared security-based 
swaps. A nonbank SBSD and a nonbank MSBSP could establish ``house'' 
margin requirements that are more conservative than those specified in 
the proposed new rule.\499\ For example, a nonbank SBSD could require 
that a minimum level of equity must be maintained in the accounts of 
counterparties that exceed the level of equity required to be 
maintained pursuant to the proposed new rule. In addition, a nonbank 
SBSD and a nonbank MSBSP could specifically identify and thereby limit 
the types of instruments they will accept as collateral.
---------------------------------------------------------------------------

    \499\ Under broker-dealer margin rules, broker-dealers also can 
establish ``house'' margin requirements as long as they are at least 
as restrictive as the Federal Reserve and SRO margin rules. See, 
e.g., FINRA Rule 4210(d).
---------------------------------------------------------------------------

b. Daily Calculations
i. Nonbank SBSDs
    Proposed new Rule 18a-3 would require nonbank SBSDs to collect 
collateral from their counterparties to non-cleared security-based 
swaps to cover both current exposure and potential future exposure, 
subject to certain exceptions discussed below.\500\ Consequently, 
proposed new Rule 18a-3 would require a nonbank SBSD to perform two 
calculations as of the close of each business day with respect to each 
account carried by the firm for a counterparty to a non-cleared 
security-based swap transaction.\501\ A nonbank SBSD would be required 
to increase the frequency of the calculations (i.e., perform intra-day 
calculations) during periods of extreme volatility and for accounts 
with concentrated positions.\502\ These more frequent calculations 
would be designed to monitor the nonbank SBSD's counterparty risk 
exposure in situations where a default by a counterparty or multiple 
counterparties would have a more significant adverse impact on the 
financial condition of the nonbank SBSD than under more normal 
circumstances.\503\ One consequence of the more frequent calculations 
could be that the nonbank SBSD requests that a counterparty deliver 
collateral during the day pursuant to a ``house'' margin requirement to 
account for changes in the value of the securities and money market 
instruments held in the account.
---------------------------------------------------------------------------

    \500\ See paragraphs (c)(1)(ii) and (iii) of proposed new Rule 
18a-3.
    \501\ See paragraphs (c)(1)(i)(A) and (B) of proposed new Rule 
18a-3. For purposes of proposed new Rule 18a-3, the term account 
would mean an account carried by a nonbank SBSD or nonbank MSBSP for 
a counterparty that holds non-cleared security-based swaps. See 
paragraph (b)(1) of proposed new Rule 18a-3. In addition, the term 
counterparty would mean a person with whom the nonbank SBSD or 
nonbank MSBSP has entered into a non-cleared security-based swap 
transaction. See paragraph (b)(3) of proposed new Rule 18a-3.
    \502\ See paragraph (c)(7) of proposed new Rule 18a-3.
    \503\ Compare FINRA Rule 4210(d) which states that procedures 
shall be established by members to: ``(1) review limits and types of 
credit extended to all customers; (2) formulate their own margin 
requirements; and (3) review the need for instituting higher margin 
requirements, mark-to-markets and collateral deposits than are 
required by this [margin rule] for individual securities or customer 
accounts.''
---------------------------------------------------------------------------

    As discussed below in section II.B.2.c.i. of this release, the 
daily calculations would form the basis for the nonbank SBSD to 
determine the amount of collateral the counterparty would need to 
deliver to cover any current exposure and potential future exposure the 
nonbank SBSD has to the counterparty. The proposed rule would except 
certain counterparties from this requirement. Even if the counterparty 
is not required to deliver collateral, the calculations--by measuring 
the current and potential future exposure to the counterparty--would 
assist the nonbank SBSD in managing its credit risk and understanding 
the extent of its uncollateralized credit exposure to the counterparty 
and across all counterparties. In addition, as discussed above in 
section II.A.2.a. of this release, the calculations would be used for 
determining the risk margin amount for purposes of calculating the 8% 
margin factor to determine the nonbank SBSD's minimum net capital 
requirement.\504\
---------------------------------------------------------------------------

    \504\ See proposed new paragraph (c)(16) of Rule 15c3-1; 
paragraph (c)(6) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

    The first calculation would be to determine the amount of equity in 
the account.\505\ For purposes of the rule, the term equity would mean 
the total current fair market value of securities positions in an 
account of a counterparty (excluding the time value of an over-the-
counter option), plus any credit balance and less any debit balance in 
the account after applying a qualifying netting agreement with respect 
to gross derivatives payables and receivables.\506\ Consequently, the 
first step in calculating the equity would be to mark-to-market all of 
the securities positions in the account, including non-cleared 
security-based swap positions. The second step would be to add to that 
amount any credit balance in the account or subtract from that amount 
any debit balance in the account. Credit balances would include 
payables the nonbank SBSD owed to the counterparty. Payables could 
relate to cash deposited into the account, the proceeds of the sales of 
securities held in the account, and/or interest and dividends earned 
from securities held in the account. In addition, payables could relate 
to derivatives in the account, including non-cleared security-based 
swaps with a net replacement value in the favor of the counterparty. 
Debit balances would be receivables to the nonbank SBSD owed by the

[[Page 70261]]

counterparty, including any net replacement values in favor of the 
nonbank SBSD arising from derivatives positions and any other amounts 
owed to the nonbank SBSD by the counterparty.
---------------------------------------------------------------------------

    \505\ See paragraph (c)(1)(i)(A) of proposed new Rule 18a-3.
    \506\ See paragraph (b)(4) of proposed new Rule 18a-3. The time 
value of an OTC option is the amount that the current market value 
of the option exceeds the in-the-money amount of the option. See 
also, generally, FINRA Rule 4210(a)(5) (defining equity to mean the 
customer's ownership interest in the account, computed by adding the 
current market value of all securities ``long'' and the amount of 
any credit balance and subtracting the current market value of all 
securities ``short'' and the amount of any debit balance).
---------------------------------------------------------------------------

    As indicated by the proposed definition of equity, the nonbank SBSD 
could offset payables and receivables relating to derivatives in the 
account by applying a qualifying netting agreement with the 
counterparty. To qualify for this treatment, a netting agreement would 
need to meet the minimum requirements prescribed in Appendix E to Rule 
15c3-1 to qualify for purposes of the credit risk charge discussed 
above in section II.A.2.b.iv. of this release.\507\ These requirements 
are designed to ensure that the netting agreement between the nonbank 
SBSD and the counterparty permits the nonbank SBSD to reduce the 
receivables and payables relating to derivatives between the two 
entities to a single net payment obligation.
---------------------------------------------------------------------------

    \507\ See paragraph (c)(5) of proposed new Rule 18a-3; 17 CFR 
240.15c3-1e(c)(4)(iv).
---------------------------------------------------------------------------

    The equity is the amount that results after marking-to-market the 
securities positions and adding the credit balance or subtracting the 
debit balance (including giving effect to qualifying netting 
agreements). If the value of the securities positions in the account 
exceeds the amount of any debit balance, the account would have a 
positive equity.\508\ On the other hand, if the amount of the debit 
balance is greater, the account would have a negative equity.\509\ The 
negative equity in an account would be equal to the nonbank SBSD's 
current exposure to the counterparty.
---------------------------------------------------------------------------

    \508\ The proposed rule would define the term positive equity to 
mean equity of greater than $0. See paragraph (b)(7) of proposed new 
Rule 18a-3.
    \509\ The proposed rule would define the term negative equity to 
mean equity of less than $0. See paragraph (b)(6) of proposed new 
Rule 18a-3.
---------------------------------------------------------------------------

    The second calculation would be to determine a margin amount for 
the account to address potential future exposure.\510\ The proposed 
rule would prescribe a standardized method and a model-based method for 
calculating the margin amount.\511\ The method for determining the 
margin amount would be similar to the approach a nonbank SBSD would 
need to use to determine haircuts on proprietary security-based swap 
positions when computing net capital.\512\ This approach would maintain 
consistency between the proposed margin and capital rules. 
Specifically, paragraph (d) of proposed new Rule 18a-3 would divide 
security-based swaps into two classes: CDS security-based swaps and all 
other security-based swaps. Paragraph (d) would define the standardized 
methodology for determining the margin amount for each class of 
security-based swap by reference to the standardized haircuts that 
would apply to the class in proposed new Rule 18a-1 (if a stand-alone 
SBSD) or Rule 15c3-1, as proposed to be amended (if a broker-dealer 
SBSD).\513\ Paragraph (d) would provide further that, if the nonbank 
SBSD was approved to use internal models to compute net capital, the 
firm could use its internal VaR model to determine the margin amount 
for security-based swaps for which the firm had been approved to use 
the model, except that the margin amount for equity security-based 
swaps would need to be determined exclusively using the standardized 
haircuts.\514\ Consequently, for debt security-based swaps, a nonbank 
SBSD approved to use internal models could calculate the margin amount 
using the firm's VaR model to the extent the firm is approved to 
include these types of positions in the model for the purposes of 
computing net capital. For all other positions, a nonbank SBSD would 
need to use the standardized haircut approach. Nonbank SBSDs that are 
not approved to use internal models to compute net capital would need 
to use the standardized haircuts for all positions to calculate the 
margin amount.
---------------------------------------------------------------------------

    \510\ See paragraph (c)(1)(i)(B) of proposed new Rule 18a-3.
    \511\ See paragraph (d) of proposed new Rule 18a-3. Similarly, 
the prudential regulators have proposed that bank SBSDs and bank 
swap dealers have the option of using internal models to calculate 
initial margin requirements for non-cleared security-based swaps. 
See Prudential Regulator Margin and Capital Proposing Release, 76 FR 
at 27567-27568 (``With respect to initial margin, the proposed rule 
permits a covered swap entity to select from two alternatives to 
calculate its initial margin requirements. A covered swap entity may 
calculate its initial margin requirements using a standardized 
`lookup' table that specifies the minimum initial margin that must 
be collected, expressed as a percentage of the notional amount of 
the swap or security-based swap. These percentages depend on the 
broad asset class of the swap or security-based swap. Alternatively, 
a covered swap entity may calculate its minimum initial margin 
requirements using an internal margin model that meets certain 
criteria and that has been approved by the relevant prudential 
regulator.'') (footnotes omitted). On the other hand, the CFTC, 
because of concerns about the resources necessary to approve the use 
of internal models for margining purposes and the fact that nonbank 
swap dealers may not have internal models, proposed that nonbank 
swap dealers must use either external models or a standardized 
approach to determine initial margin (though the CFTC did propose a 
provision under which the CFTC could approve the use of an internal 
model should the CFTC obtain sufficient resources). See CFTC Margin 
Proposing Release, 76 FR at 23737. The external models proposed by 
the CFTC are: (1) a model currently in use for margining cleared 
swaps at a DCO; (2) a model currently in use for modeling non-
cleared swaps by an entity subject to regular assessment by a 
prudential regulator; or (3) a model available for licensing to any 
market participant by a vendor. Id. The use of external models is 
not being proposed for nonbank SBSDs because the basis for 
permitting firms to use VaR models to compute net capital is to 
align their internally developed (i.e., not vender-developed) risk 
management processes with the process for computing net capital. See 
Alternative Net Capital Requirements Adopting Release, 69 FR at 
34428 (the option to use VaR models is ``intended to reduce 
regulatory costs for broker-dealers by allowing very highly 
capitalized firms that have developed robust internal risk 
management practices to use those risk management practices, such as 
mathematical risk measurement models, for regulatory purposes'').
    \512\ See paragraph (d) of proposed new Rule 18a-3; proposed new 
paragraph (c)(2)(vi)(O) of Rule 15c3-1; paragraph (c)(1)(vi) of 
proposed new Rule 18a-1.
    \513\ See paragraphs (d)(1)(i) and (ii) of proposed new Rule 
18a-3. As discussed in section II.A.2.b.ii. of this release, 
proposed new Rule 18a-1 and Rule 15c3-1, as proposed to be amended, 
would prescribe standardized haircuts for security-based swaps. See 
proposed new paragraph (c)(2)(vi)(O) of Rule 15c3-1; paragraph 
(c)(1)(vi) of proposed new Rule 18a-1. Consequently, for CDS 
security-based swaps, the nonbank SBSD would use the proposed 
maturity/spread grid in proposed new paragraph (c)(2)(vi)(O)(1) of 
Rule 15c3-1 and paragraph (c)(1)(vi)(A) of proposed new Rule 18a-1 
to determine the margin amount. See paragraph (d)(1)(i) of proposed 
new Rule 18a-3. While the required standardized haircuts would be 
the same in Rule 15c3-1, as proposed to be amended, and proposed new 
Rule 18a-1, the nonbank SBSD would refer to Rule 15c3-1 if it is a 
broker-dealer SBSD and proposed new Rule 18a-1 if it is a stand-
alone SBSD. For all equity security-based swaps and debt security-
based swaps (other than CDS security-based swaps), the nonbank SBSD 
would use the method of multiplying the notional amount of the 
position by the standardized haircut that would apply to the 
underlying security as specified in proposed new paragraph 
(c)(2)(vi)(O)(2) of Rule 15c3-1 and paragraph (c)(1)(vi)(B) of 
proposed new Rule 18a-1. See paragraph (d)(ii) of proposed new Rule 
18a-3. For equity security-based swaps, this would include being 
able to use the methodology in Appendix A to Rule 15c3-1, as 
proposed to be amended, and in Appendix A to proposed new Rule 18a-
1, as applicable to the nonbank SBSD. For debt security-based swaps, 
this would include being able to use the offsets that are permitted 
in the debt maturity grids in paragraph (c)(2)(vi) of Rule 15c3-1. 
See 17 CFR 240.15c3-1(c)(2)(vi).
    \514\ See paragraph (d)(2) of proposed new Rule 18a-3.
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    As noted above, a nonbank SBSD (regardless of whether it is 
approved to use internal models to compute net capital) would be 
required to calculate the margin amount for equity security-based swaps 
using the standardized haircuts, which includes the ability to use the 
methodology in Appendix A to Rule 15c3-1. This proposal is designed to 
establish a margin requirement for equity security-based swaps that is 
consistent with SRO portfolio margin rules for equity securities, which 
are based on the Appendix A methodology.\515\ This provision would

[[Page 70262]]

allow broker-dealer SBSDs to include equity security-based swaps in the 
portfolios of equity securities positions for which they calculate 
margin requirements using the SRO portfolio margin rules.\516\ The 
proposal also would ensure a consistent portfolio margin approach for 
equity security products across nonbank SBSDs and broker-dealers that 
are not SBSDs, and thereby reduce opportunity for regulatory arbitrage.
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    \515\ See FINRA Rule 4210(g); CBOE Rule 12.4. See also FINRA, 
Portfolio Margin Frequently Asked Questions, available at 
www.finra.org. As discussed in section II.A.2.b.ii. of this release, 
Appendix A to Rule 15c3-1 permits a broker-dealer to group options, 
futures, long securities positions, and short securities positions 
involving the same underlying security and stress the current market 
price for each position at ten equidistant points along a range of 
positive and negative potential future market movements, using an 
approved theoretical options pricing model that satisfies certain 
conditions specified in the rule. See 17 CFR 240.15c3-1a. The gains 
and losses of each position in the portfolio offset each other to 
yield a net gain or loss at each stress point. The stress point that 
yields the largest potential net loss for the portfolio would be 
used to calculate the aggregate haircut for all the positions in the 
portfolio. Id.
    \516\ See, e.g., FINRA Rule 4210(g)(2)(G) (defining the term 
``unlisted derivative'' for purposes of inclusion in the Appendix A 
methodology as used in the rule to calculate a portfolio margin 
requirement to mean ``any equity-based or equity index-based 
unlisted option, forward contract, or security-based swap that can 
be valued by a theoretical pricing model approved by the 
[Commission].'') (emphasis added).
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Request for Comment
    The Commission generally requests comment on the proposed daily 
calculation requirements for nonbank SBSDs in proposed new Rule 18a-3. 
In addition, the Commission requests comment, including empirical data 
in support of comments, in response to the following questions:
    1. Is the proposed definition of equity appropriate? For example, 
would the proposed definition be practical in terms of determining the 
net equity in an account holding non-cleared security-based swaps? If 
the proposed definition is not appropriate, explain why and provide 
suggested alternative definitions.
    2. Should the definition of equity include the time value of an 
over-the-counter option? If so, explain why.
    3. Should the terms current market value, credit balance, and debit 
balance be defined for the purpose of proposed new Rule 18a-3? For 
example, would defining these terms provide greater clarity to the 
definition of equity in the proposed rule? If these terms should be 
defined, explain why and provide suggested definitions.
    4. Are the proposed requirements for netting agreements to qualify 
for purposes of determining the amount of equity in an account 
appropriate? If not, explain why not. Are there additional or 
alternative provisions that should be contained in the netting 
agreement requirements? If so, identify and explain them.
    5. Is the proposed method for calculating the margin amount 
appropriate? If not, explain why not. For example, is it appropriate to 
use the techniques in Rule 15c3-1, as proposed to be amended, and 
proposed new Rule 18a-1 to determine the margin amount? If not, explain 
why not. Are there alternative methods for calculating the margin 
amount that would be preferable? If so, identify them and explain why 
they would be preferable.
    6. Should proposed new Rule 18a-3 allow an alternative method of 
calculating the margin amount that would permit a nonbank SBSD to 
determine the margin amount for a non-cleared security-based swap based 
on the margin required by a registered clearing agency for a cleared 
security-based swap whose terms and conditions closely resemble the 
terms and conditions of the non-cleared security-based swap (similar to 
the CFTC's proposal)? Would there be sufficient similarity between 
certain cleared and non-cleared security-based swaps to make this 
approach workable? In addition, if this alternative approach was 
permitted, how could the potential differences in margin requirements 
across clearing agencies be addressed?
    7. In addition to internal models, should external models be 
permitted such as: (1) a model currently in use for margining cleared 
security-based swaps at a clearing agency; (2) a model currently in use 
for modeling non-cleared swaps by an entity subject to regular 
assessment by a prudential regulator; or (3) a model available for 
licensing to any market participant by a vendor? What would be the 
advantages and disadvantages of permitting external models?
    8. How would the proposed standardized approaches to determining 
the margin amount differ from the standardized approaches the 
prudential regulators proposed for determining the initial margin 
amount?
    9. The provisions for using VaR models to compute net capital 
require that the model use a 99%, one-tailed confidence level with 
price changes equivalent to a ten-business-day movement in rates and 
prices. This means the VaR model used for the purpose of determining a 
counterparty's margin amount also would need to use a 99%, one-tailed 
confidence level with price changes equivalent to a ten-business-day 
movement in rates and prices. The ten-business-day requirement is 
designed to account for market movements that occur over a period of 
time as opposed to a single day. This is designed to ensure that the 
VaR model uses potential market moves that are large enough to capture 
multi-day moves in rates and prices. Given this purpose, should the VaR 
model be required to use a longer period of time (e.g., 15, 20, 25, or 
30 business days) to establish a potentially greater margin collateral 
requirement for customers given that they may not be subject to capital 
and other prudential requirements? Would the 3-times multiplication 
factor proposed to be required for VaR models used by nonbank SBSDs 
(which, under the proposal, would need to be increased in response to 
back-testing exceptions) be necessary if the time period were longer 
than 10 business days? If not, explain why not.
ii. Nonbank MSBSPs
    Proposed new Rule 18a-3 would require nonbank MSBSPs to collect 
collateral from counterparties to which the nonbank MSBSP has current 
exposure and provide collateral to counterparties that have current 
exposure to the nonbank MSBSP.\517\ Consequently, a nonbank MSBSP would 
be required to calculate as of the close of business each day the 
amount of equity in each account of a counterparty.\518\ Consistent 
with the proposal for nonbank SBSDs, a nonbank MSBSP would be required 
to increase the frequency of its calculations (i.e., perform intra-day 
calculations) during periods of extreme volatility and for accounts 
with concentrated positions.\519\
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    \517\ See paragraph (c)(2)(ii) of proposed new Rule 18a-3.
    \518\ See paragraph (c)(2)(i) of proposed new Rule 18a-3. A 
nonbank MSBSP would apply the definitions in paragraph (b) of 
proposed new Rule 18a-3 for the purposes of complying with the 
requirements in the rule. See paragraph (b) of proposed new Rule 
18a-3. The term equity would be defined to mean the total current 
fair market value of securities positions in an account of a 
counterparty (excluding the time value of an over-the-counter 
option), plus any credit balance and less any debit balance in the 
account after applying a qualifying netting agreement with respect 
to gross derivatives payables and receivables. See paragraph (b)(4) 
of proposed new Rule 18a-3. The time value of an OTC option is the 
amount that the current market value of the option exceeds the in-
the-money amount of the option. In addition, the term account is 
proposed to be defined to mean an account carried by a nonbank SBSD 
or nonbank MSBSP for a counterparty that holds non-cleared security-
based swaps. See paragraph (b)(1) of proposed new Rule 18a-3. 
Furthermore, the term counterparty is proposed to mean a person with 
whom the nonbank SBSD or nonbank MSBSP has entered into a non-
cleared security-based swap transaction. See paragraph (b)(3) of 
proposed new Rule 18a-3.
    \519\ See paragraph (c)(7) of proposed new Rule 18a-3. These 
more frequent calculations would be designed to monitor the nonbank 
MSBSP's counterparty risk exposure in situations where a default by 
a counterparty or multiple counterparties would have a more 
significant adverse impact on the financial condition of the nonbank 
MSBSP than under more normal circumstances. One consequence of the 
more frequent calculations could be that the nonbank MSBSP requests 
that a counterparty deliver collateral during the day pursuant to a 
``house'' margin requirement to account for changes in the value of 
the securities and money market instruments held in the account.

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[[Page 70263]]

    As would be the case for a nonbank SBSD, the first step for a 
nonbank MSBSP in calculating the equity in an account would be to mark-
to-market all of the securities positions in the account, including 
non-cleared security-based swap positions. The second step would be to 
add to that amount any credit balance in the account or subtract from 
that amount any debit balance.\520\ The nonbank MSBSP could offset 
payables and receivables relating to derivatives in the account by 
applying a qualifying netting agreement with the counterparty. To 
qualify for this treatment, a netting agreement would need to meet the 
minimum requirements prescribed in Appendix E to Rule 15c3-1 to qualify 
for purposes of the credit risk charge discussed above in section 
II.A.2.b.iv. of this release.\521\ These requirements, set forth in 
paragraph (c)(5) of Rule 18a-3, are designed to ensure that the netting 
agreement between the nonbank MSBSP and the counterparty permits the 
nonbank MSBSP to reduce the receivables and payables between the two 
entities to a single net payment obligation.\522\
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    \520\ Credit balances would include payables the nonbank MSBSP 
owed to the counterparty. Payables could relate to cash deposited 
into the account, the proceeds of the sales of securities held in 
the account, and interest and dividends earned from securities held 
in the account. In addition, payables could relate to derivatives in 
the account such as non-cleared security-based swaps with a net 
replacement value in the favor of the counterparty. Debit balances 
would be receivables to the nonbank MSBSP owed by the counterparty. 
Receivables could relate to derivatives in the account such as non-
cleared security-based swaps with a net replacement value in the 
favor of the nonbank MSBSP.
    \521\ See paragraph (c)(5) of proposed new Rule 18a-3; 17 CFR 
240.15c3-1e(c)(4)(iv).
    \522\ See paragraph (c)(5) of proposed new Rule 18a-3.
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    If the value of the securities positions plus the amount of any 
cash in the account exceeds the amount of the debit balance, the 
account would have positive equity.\523\ This would mean the 
counterparty has current exposure to the nonbank MSBSP. On the other 
hand, if the amount of the debit balance is greater, the account would 
have negative equity.\524\ This would mean the nonbank MSBSP has 
current exposure to the counterparty.
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    \523\ The proposed rule would define the term positive equity to 
mean equity of greater than $0. See paragraph (b)(7) of proposed new 
Rule 18a-3.
    \524\ The proposed rule would define the term negative equity to 
mean equity of less than $0. See paragraph (b)(6) of proposed new 
Rule 18a-3.
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    Nonbank MSBSPs would not be required to deliver or collect margin 
collateral to collateralize potential future exposure.\525\ For that 
reason, Rule 18a-3 would not require nonbank MSBSPs to calculate a 
margin amount, and the rule would not require counterparties to provide 
margin collateral to nonbank MSBSPs to maintain equity levels above the 
nonbank MSBSP's current exposure. When a counterparty provides margin 
collateral to collateralize potential future exposure, the counterparty 
is exposed to credit risk in the amount that the collateral provided to 
the dealer exceeds the dealer's current exposure to the counterparty. 
With respect to nonbank SBSDs, collateralizing potential future 
exposure is intended to promote the financial responsibility of the 
nonbank SBSD, as the margin collateral received from the counterparty 
protects the nonbank SBSD from the risks arising from fluctuations in 
the value of the underlying positions before the collateral can be 
sold. The counterparty, in turn, would be protected by the net liquid 
assets test standard applicable to the nonbank SBSD,\526\ which is 
significantly more conservative than the tangible net worth capital 
standard proposed for nonbank MSBSPs.\527\ The counterparties also 
would be protected by the proposed segregation requirements with 
respect to the margin collateral delivered by counterparties.\528\
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    \525\ See paragraph (c)(2)(i) of proposed new Rule 18a-3 (only 
requiring calculation of the equity in the account of each 
counterparty).
    \526\ See 17 CFR 240.15c3-1; proposed new Rule 18a-1.
    \527\ See proposed new Rule 18a-2.
    \528\ See proposed new Rule 18a-4.
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    The proposed margin requirements for nonbank MSBSPs are designed to 
``neutralize'' the credit risk between a nonbank MSBSP and a 
counterparty. The collection of collateral from counterparties would 
strengthen the liquidity of the nonbank MSBSP by collateralizing its 
current exposure to counterparties. Nonbank MSBSPs, in contrast to 
nonbank SBSDs, would be required to deliver collateral to 
counterparties to collateralize their current exposure to the nonbank 
MSBSP, which would lessen the impact on the counterparties if the 
nonbank MSBSP failed, and is intended to account for the fact that 
nonbank MSBSPs would be subject to less stringent capital requirements 
than nonbank SBSDs.
    In addition, as discussed in section II.A.3. of the release, the 
entities that may need to register as nonbank MSBSPs could include 
companies that engage in commercial activities that are not necessarily 
financial in nature (e.g., manufacturing, agriculture, and energy) and 
for which a net liquid assets test could be impractical. Finally, 
because of these differences in business models, nonbank MSBSPs may not 
have the systems and personnel necessary to operate daily margin 
collateral programs to address potential future exposure.
Request for Comment
    The Commission generally requests comment on the proposed daily 
calculation requirements for nonbank MSBSPs. Commenters are referred to 
the questions about the daily calculation requirements for nonbank 
SBSDs above in section II.B.2.b.i. of this release to the extent those 
questions address provisions in proposed new Rule 18a-3 that also apply 
to nonbank MSBSPs. In addition, the Commission requests comment, 
including empirical data in support of comments, in response to the 
following questions:
    1. Which types of counterparties would be expected to transact with 
nonbank MSBSPs? Which types of security-based swap transactions would 
these counterparties enter into with nonbank MSBSPs?
    2. Should nonbank MSBSPs be required to calculate a daily margin 
amount for each counterparty? For example, even if they were not 
required to collect collateral to cover potential future exposure, 
would the calculation of the margin amount better enable them to 
measure and understand their counterparty risk?
    3. If nonbank MSBSPs should calculate a daily margin amount, how 
should such amount be calculated? Should a nonbank MSBSP be required to 
calculate a margin amount using the methods prescribed in paragraph (d) 
of proposed new Rule 18a-3 or some other method? For example, should 
nonbank MSBSPs be permitted to use external models to determine a 
margin amount?
    4. Would nonbank MSBSPs have the systems and personnel necessary to 
operate daily margin collateral programs to calculate a daily margin 
amount?
c. Account Equity Requirements
i. Nonbank SBSDs
    A nonbank SBSD would be required to calculate as of the close of 
each business day: (1) the amount of equity

[[Page 70264]]

in the account of each counterparty; and (2) a margin amount for the 
account of each counterparty.\529\ On the next business day following 
the calculations, the nonbank SBSD would be required to collect cash, 
securities, and/or money market instruments from the counterparty in an 
amount at least equal to the negative equity (current exposure) in the 
account plus the margin amount (potential future exposure).\530\ The 
collateral collected would be designed to ensure that the counterparty 
maintains a minimum level of positive net equity in the account. The 
proposed rule would require the nonbank SBSD to collect collateral for 
this purpose from each counterparty, except as discussed below.
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    \529\ See paragraph (c)(1)(i) of proposed new Rule 18a-3. See 
also paragraph (b)(4) of proposed new Rule 18a-3 (defining the term 
equity).
    \530\ See paragraph (c)(1)(ii) of proposed new Rule 18a-3.
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    A nonbank SBSD would need to collect cash, securities, and/or money 
market instruments to meet the account equity requirements in proposed 
new Rule 18a-3. Other types of assets would not be eligible as 
collateral. In addition, under proposed new Rule 18a-3, the fair market 
value of securities and money market instruments held in the account of 
a counterparty would need to be reduced by the amount of the deductions 
the nonbank SBSD would apply to the positions pursuant to Rule 15c3-1, 
as proposed to be amended, or proposed new Rule 18a-1, as applicable, 
for the purpose of determining whether the level of equity in the 
account meets the minimum requirement.\531\ Accordingly, securities and 
money market instruments with no ``ready market'' or which cannot be 
publicly offered or sold because of statutory, regulatory, or 
contractual arrangements or other restrictions would be subject to a 
100% deduction and, therefore, these types of securities and money 
market instruments would have no value in terms of meeting the account 
equity requirement.\532\ All other securities and money market 
instruments in the account would be reduced in value by the amount of 
the deductions required in Rule 15c3-1, as proposed to be amended, and 
proposed new Rule 18a-1, as applicable to the nonbank SBSD.\533\ The 
amount of the deductions would increase for securities and money market 
instruments with greater market risk and, thereby, account for the risk 
that the nonbank SBSD may not be able to liquidate the securities and 
money market instruments at current market values to satisfy the 
obligation of a defaulted counterparty.\534\ These deductions would 
limit the types of securities and money market instruments a 
counterparty could provide as collateral and require a counterparty to 
increase the amount of collateral delivered to account for the 
deductions taken on securities collateral in the account.\535\
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    \531\ See paragraph (c)(3) of proposed new Rule 18a-3.
    \532\ See 17 CFR 240.15c3-1(c)(2)(vii); paragraph (c)(1)(iv) of 
proposed new Rule 18a-1.
    \533\ See 17 CFR 240.15c3-1(c)(2)(vi); paragraphs (c)(1)(vi)-
(vii) of proposed new Rule 18a-1.
    \534\ See 17 CFR 240.15c3-1(c)(2)(vi); paragraphs (c)(1)(vi)-
(vii) of proposed new Rule 18a-1.
    \535\ For example, assume an account holds securities and money 
market instruments valued at $50, a credit balance of $10, and a 
debit balance of $58. The equity in the account would be $2 ($50 of 
securities and money market instruments' value + $10 in credits-$58 
in debits = $2). Assume that the margin amount calculated for the 
account is $10. This would mean that the account needs to have 
positive equity of at least $10 (it currently has positive equity of 
only $2). Assume that the deduction under Rule 15c3-1 for the $50 of 
securities and money market positions held in the account is $7. 
This would mean that the counterparty would need to deliver $15 in 
cash (i.e., not $8) to meet the minimum $10 account equity 
requirement ($50 of securities and money market instruments' value-
$7 deduction + $10 in credits-$58 in debits + $15 cash collateral 
deposit = $10). Moreover, if the counterparty delivered securities 
and/or money market instruments to meet the account equity 
requirement, the fair market value of the securities and money 
market instruments would need to be greater than $15 because their 
value would be reduced by the amount of the deduction in Rule 15c3-1 
or proposed new Rule 18a-1, as applicable.
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    The prudential regulators and the CFTC are proposing to 
specifically identify the asset classes that would be eligible 
collateral for purposes of their margin rules.\536\ Proposed new Rule 
18a-3 would not limit collateral in this way. However, comment is 
sought below in section II.B.3. of this release on the question of 
whether to define the term eligible collateral in a manner that is 
similar to the proposals of the prudential regulators and the CFTC.
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    \536\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564; CFTC Margin Proposing Release, 76 FR 23732. 
The proposal of the prudential regulators would limit eligible 
collateral to cash, foreign currency to the extent the payment 
obligation under the security-based swap or swap is denominated in 
the currency, obligations guaranteed by the United States as to 
principal and interest, and, with respect to initial margin only, a 
senior debt obligation of the Federal National Mortgage Association, 
the Federal Home Loan Mortgage Corporation, the Federal Home Loan 
Banks, and the Federal Agricultural Mortgage Corporation, or any 
obligation that is an ``insured obligation,'' as the term is defined 
in 12 U.S.C. 2277a(3), of a Farm Credit System bank. See Prudential 
Regulator Margin and Capital Proposing Release, 76 FR at 27589. The 
proposal of the CFTC would limit eligible collateral for initial 
margin to cash, foreign currency to the extent the payment 
obligation under the security-based swap or swap is denominated in 
the currency, obligations guaranteed by the United States as to 
principal and interest, and a senior debt obligation of the Federal 
National Mortgage Association, the Federal Home Loan Mortgage 
Corporation, the Federal Home Loan Banks, and the Federal 
Agricultural Mortgage Corporation, or any obligation that is an 
``insured obligation,'' as the term is defined in 12 U.S.C. 
2277a(3), of a Farm Credit System bank. CFTC Margin Proposing 
Release, 76 FR at 23747. The CFTC's proposal would limit eligible 
collateral for variation margin to cash and obligations guaranteed 
by the United States as to principal and interest. Id.
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    The reason for not proposing a definition of eligible collateral is 
that counterparties are expected to engage in a wide range of trading 
strategies that include security-based swaps. Consequently, the account 
of a counterparty may hold, for example, the security underlying a 
security-based swap, as well as a short position, option, and single 
stock future on the underlying security.\537\ Because of the 
relationship between security-based swaps and these other security 
positions, permitting various types of securities to count as 
collateral may be more practical for margin arrangements involving 
security-based swaps than for other types of derivatives. A more 
limited definition of eligible collateral could require a counterparty 
that has positive equity in an account equal to or in excess of the 
margin amount to deliver additional collateral to the extent the 
positions in the account did not meet the definition. The 
counterparty's credit exposure to the nonbank SBSD therefore would be 
increased in a way that may not be necessary to account for the nonbank 
SBSD's potential future exposure to the counterparty.\538\
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    \537\ See, e.g., FINRA Rule 4210(g) (permitting customer 
portfolio margining); 17 CFR 240.15c3-1a; Appendix A to proposed new 
Rule 18a-1.
    \538\ A counterparty will have credit exposure to a nonbank SBSD 
to the extent that collateral held in the account of the 
counterparty has a mark-to-market value in excess of the nonbank 
SBSD's current exposure to the counterparty.
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    The Commission is proposing certain additional requirements for 
eligible collateral, which are modeled on the existing collateral 
requirements in Appendix E to Rule 15c3-1.\539\ As discussed above in 
section II.A.2.b.iv. of this release, collateral ``ideally'' is ``an 
asset of stable and predictable value, an asset that is not linked to 
the value of the transaction in any way, and an asset that can be sold 
quickly and easily if the need arises.'' \540\ The requirements in 
Appendix E to Rule 15c3-1 are designed to achieve these 
objectives.\541\ The proposed additional requirements include:
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    \539\ See paragraph (c)(4) of proposed new Rule 18a-3.
    \540\ Market Review of OTC Derivative Bilateral 
Collateralization Practices at 5.
    \541\ See 17 CFR 240.15c3-1e(c)(4)(v).
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     The collateral must be subject to the physical possession 
or control of the nonbank SBSD;

[[Page 70265]]

     The collateral must be liquid and transferable;
     The collateral must be capable of being liquidated 
promptly by the nonbank SBSD without intervention by any other party;
     The collateral agreement between the nonbank SBSD and the 
counterparty must be legally enforceable by the nonbank SBSD against 
the counterparty and any other parties to the agreement;
     The collateral must not consist of securities issued by 
the counterparty or a party related to the nonbank SBSD, or to the 
counterparty; and
     If the Commission has approved the nonbank SBSD's use of a 
VaR model to compute net capital, the approval allows the nonbank SBSD 
to calculate deductions for market risk for the type of 
collateral.\542\
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    \542\ See paragraphs (c)(4)(i)-(c)(4)(vi) of proposed new Rule 
18a-3.
---------------------------------------------------------------------------

    These proposed collateral requirements are designed to ensure that 
the treatment of collateral requirements remains consistent between the 
proposed capital and margin requirements. As discussed above in section 
II.A.2.b.v. of this release, a nonbank SBSD would be required to take a 
capital charge if a counterparty does not deliver cash, securities, 
and/or money market instruments to the nonbank SBSD to meet an account 
equity requirement within one business day of the requirement being 
triggered. In addition, proposed new Rule 18a-3 would require the 
nonbank SBSD to take prompt steps to liquidate securities and money 
market instruments in the account to the extent necessary to eliminate 
the account equity deficiency.\543\ Under this provision, which is 
modeled on a similar requirement in the broker-dealer margin 
rules,\544\ a nonbank SBSD could need to liquidate positions in the 
account to reduce debits arising from those transactions. The rule 
would not require that the liquidations must be completed within a 
specific timeframe.\545\ Instead, the rule is designed to give the 
nonbank SBSD the flexibility to conduct an orderly liquidation, taking 
into account market conditions and the risk profile of the account.
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    \543\ See paragraph (c)(8) of proposed new Rule 18a-3.
    \544\ See 12 CFR 220.4(d) (providing that if a margin call is 
not met within the required time, the broker-dealer must liquidate 
securities sufficient to meet the margin call or to eliminate any 
margin deficiency existing on the day such liquidation is required, 
whichever is less).
    \545\ See paragraph (c)(8) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    There would be four exceptions to the account equity 
requirements.\546\ The first would apply to counterparties that are 
commercial end users.\547\ The second would apply to counterparties 
that are SBSDs.\548\ The third would apply to counterparties that are 
not commercial end users and that require their margin collateral to be 
segregated pursuant to section 3E(f) of the Exchange Act.\549\ The 
fourth would apply to accounts of counterparties that are not 
commercial end users and that hold legacy non-cleared security-based 
swaps.\550\ Under these exceptions, applicable accounts would not need 
to meet certain account equity requirements in proposed new Rule 18a-3 
and, therefore, the nonbank SBSD would be exempted from the 
requirements to take prompt steps to liquidate securities in the 
account to the extent necessary to eliminate the account equity 
deficiency. However, as discussed above in section II.A.2.b.v. of this 
release, in these cases the nonbank SBSD would need to take capital 
charges in lieu of meeting the account equity requirements in certain 
circumstances.\551\
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    \546\ See paragraphs (c)(1)(iii)(A)-(D) of proposed new Rule 
18a-3.
    \547\ See paragraph (c)(1)(iii)(A) of proposed new Rule 18a-3.
    \548\ See paragraph (c)(1)(iii)(B)--Alternative A of proposed 
new Rule 18a-3. An alternative approach is being proposed that would 
not be an exception to the account equity requirement under which a 
nonbank SBSD would need to collect collateral from another SBSD to 
cover the negative equity in the account and the margin amount for 
the account. In addition, the collateral collected to cover the 
margin amount would need to be held by an independent third-party 
custodian. See paragraph (c)(1)(iii)(B)--Alternative B of proposed 
new Rule 18a-3.
    \549\ See paragraph (c)(1)(iii)(C) of proposed new Rule 18a-3.
    \550\ See paragraph (c)(1)(iii)(D) of proposed new Rule 18a-3.
    \551\ See proposed new paragraph (c)(2)(xiv) of Rule 15c3-1; 
paragraph (c)(1)(viii) of proposed Rule 18a-1.
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Exception for Commercial End Users
    Under the first exception to the account equity requirements, a 
nonbank SBSD would not be required to collect cash, securities, and/or 
money market instruments to cover the negative equity (current 
exposure) or margin amount (potential future exposure) in the account 
of a counterparty that is a commercial end user.\552\ As discussed 
above in section II.A.2.b.v. of this release, this proposed exception 
to the requirement to collect collateral is intended to address 
concerns that have been expressed by commercial end users and others 
that the imposition of margin requirements on commercial companies that 
use derivatives to mitigate the risk of business activities that are 
not financial in nature could unduly disrupt their ability to enter 
into hedging transactions. The proposed exception is intended to permit 
nonbank SBSDs and commercial end users to negotiate individual 
agreements that would reflect the credit risk of the commercial end 
user and the nature and extent of the non-cleared security-based swap 
transactions with the end user, without creating an undue impediment to 
the ability of the commercial end user to hedge its commercial 
risks.\553\
---------------------------------------------------------------------------

    \552\ See paragraph (c)(1)(iii)(A) of proposed Rule 18a-3. The 
exception would apply to negative equity in the account and the 
margin amount calculated for the account. However, a nonbank SBSD 
would be required to take a 100% deduction from net worth for the 
amount of the uncollateralized negative equity and take the proposed 
capital charge in lieu of margin collateral discussed above in 
section II.A.2.b.v. of this release. See 17 CFR 240.15c3-
1(c)(2)(iv)(B) (deductions for unsecured receivables); paragraph 
(c)(1)(iii)(B) of proposed new Rule 18a-1 (deductions for unsecured 
receivables); proposed new paragraph (c)(2)(xiv) of Rule 15c3-1 
(proposed capital charge in lieu of margin); paragraph (c)(1)(viii) 
of proposed Rule 18a-1 (proposed capital charge in lieu of margin). 
As an alternative to these capital charges, ANC broker-dealers and 
stand-alone SBSDs using internal models could take the credit risk 
charge discussed in section II.A.2.b.iv. of this release. See 
amendments to paragraph (a)(7) of Rule 15c3-1; paragraph (a)(2) of 
proposed new Rule 18a-1.
    \553\ The margin rule proposed by the prudential regulators 
would require the entities subject to the rule to establish credit 
exposure limits for each nonfinancial end user ``under appropriate 
credit processes and standards,'' and to collect collateral to the 
extent that individual exposures exceed those limits. See Prudential 
Regulator Margin and Capital Proposing Release, 76 FR at 27587. The 
margin rule proposed by the CFTC would permit entities subject to 
the rule and nonfinancial end users ``to set initial margin and 
variation margin requirements in their discretion'' but each entity 
subject to the proposed rule would be required to calculate daily 
exposure amounts for nonfinancial end users for risk management 
purposes. See CFTC Margin Proposing Release, 76 FR at 27736.
---------------------------------------------------------------------------

    The proposed exception for commercial end users also is intended to 
account for the different risk profiles of commercial end users as 
compared with financial end users.\554\ When credit markets are under 
strain, as in 2008, financial end users, such as hedge funds, can face 
liquidity stress, which increases their risk of default. Further,

[[Page 70266]]

financial end users as a group, due to the nature of their business, 
may engage in security-based swap transactions in greater volume than 
commercial end users, increasing the risk of substantial concentration 
of counterparty exposure to nonbank SBSDs, and potentially creating 
greater systemic risk from the failure of a single entity.\555\
---------------------------------------------------------------------------

    \554\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27571 (``Among end users, financial end users are 
considered more risky than nonfinancial end users because the 
profitability and viability of financial end users is more tightly 
linked to the health of the financial system than nonfinancial end 
users. Because financial counterparties are more likely to default 
during a period of financial stress, they pose greater systemic risk 
and risk to the safety and soundness of the covered swap entity.''). 
See also CFTC Margin Proposing Release, 76 FR at 27735 (``The 
Commission believes that financial entities, which are generally not 
using swaps to hedge or mitigate commercial risk, potentially pose 
greater risk to CSEs than non-financial entities.'').
    \555\ The margin rules proposed by the prudential regulators and 
the CFTC would differentiate collateral requirements based on 
whether a financial end user is ``high risk'' or ``low risk.'' See 
Prudential Regulator Margin and Capital Proposing Release, 76 FR at 
27571-27572; CFTC Margin Proposing Release, 76 FR at 23736-23737. A 
``low risk'' financial end user is defined in their proposals as an 
entity that: (1) is subject to capital requirements established by a 
prudential regulator or a state insurance regulator; (2) 
predominantly uses OTC derivatives for hedging purposes; and (3) 
does not have significant OTC derivatives exposure. See Prudential 
Regulator Margin and Capital Proposing Release, 76 FR at 27572; CFTC 
Margin Proposing Release, 76 FR at 23735-23736. A low risk financial 
end user would not be required to deliver initial or variation 
margin if the amounts required are less than certain prescribed 
thresholds. See id. While not all financial end users present the 
same degree of counterparty risk, an exception from the account 
equity requirements based on the risk profile of the financial end 
user is not being proposed. This is because margin collateral is an 
important means of managing credit risk and the concerns expressed 
with respect to commercial end users being required to deliver 
margin collateral generally do not apply to financial end users as 
they customarily deliver margin collateral. As discussed in sections 
II.A.1. and II.A.2.b.i. of this release, the proposed capital 
standard for nonbank SBSDs is based on the net liquid assets test 
embodied in Rule 15c3-1. Under this test, most unsecured receivables 
are deducted in full when computing net capital because of their 
illiquidity. Proposed new Rule 18a-3 is designed to complement this 
treatment of unsecured receivables by limiting the exceptions to the 
requirement to collect collateral from counterparties to 
circumstances that provide a compelling reason for the trade-off 
between the risk-mitigating benefits of collateral and practical 
impediments to delivering collateral. With respect to nonbank SBSDs, 
there does not appear to be a compelling reason to establish a two-
tiered approach for financial end users. First, financial end users 
generally pose more risk than commercial end users. Second, the 
different credit risk profiles of financial end users may not always 
be clear, which may make it difficult to differentiate between high 
and low risk financial end users. Third, market participants have 
told the Commission staff that financial end users entering into 
security-based swap transactions generally already deliver 
collateral to dealers to cover current and potential future 
exposure.
---------------------------------------------------------------------------

    For purposes of the rule, the term commercial end user means any 
person (other than a natural person) that: (1) Engages primarily in 
commercial activities that are not financial in nature and that is not 
a financial entity as that term is defined in section 3C(g)(3) of the 
Exchange Act; \556\ and (2) is using non-cleared security-based swaps 
to hedge or mitigate risk relating to the commercial activities.\557\ 
The proposed definition of commercial end user is modeled on the 
exception to the mandatory clearing provisions for security-based swaps 
in section 3C of the Exchange Act.\558\ Among other things, to qualify 
for the mandatory clearing exception, one of the counterparties to the 
security-based swap transaction must not be a financial entity and must 
be using security-based swaps to hedge or mitigate commercial 
risk.\559\
---------------------------------------------------------------------------

    \556\ See 15 U.S.C. 78o-3(g)(3). Section 3C(g) of the Exchange 
Act defines the term financial entity to mean: (1) a swap dealer; 
(2) an SBSD; (3) a major swap participant; (4) an MSBSP; (5) a 
commodity pool as defined in section 1a(10) of the CEA; (6) a 
private fund as defined in section 202(a) of the Investment Advisors 
Act of 1940; (7) an employee benefit plan as defined in paragraphs 
(3) and (32) of section 3 of the Employee Retirement Income and 
Security Act of 1974 (29 U.S.C. 1002); or (8) a person predominantly 
engaged in activities that are in the business of banking, or in 
activities that are financial in nature as defined in section 4(k) 
of the Bank Holding Company Act of 1956.
    \557\ See paragraph (b)(2) of proposed new Rule 18a-3.
    \558\ Compare 15 U.S.C. 78c-3(g)(1), with paragraph (b)(2) of 
proposed new Rule 18a-3.
    \559\ See 15 U.S.C. 78c-3(g)(1).
---------------------------------------------------------------------------

    Under the proposed definition, an individual could not qualify as a 
commercial end user. In addition, because the proposed definition 
provides that a commercial end user must engage primarily in commercial 
activities that are not financial in nature and must not be a financial 
entity as defined in section 3C(g)(3) of the Exchange Act, entities 
such as banks, broker-dealers, FCMs, SBSDs, swap dealers, MSBSPs, swap 
participants, mutual funds, private funds, commodity pools, and 
employee benefit plans would not qualify as a commercial end user.\560\ 
Furthermore, the proposed definition provides that the commercial end 
user must be using non-cleared security-based swaps to hedge or 
mitigate commercial risk.
---------------------------------------------------------------------------

    \560\ See, e.g., 15 U.S.C. 78c-3(g)(3). The prudential 
regulators and the CFTC have proposed definitions of financial end 
user and financial entity, respectively, in their non-cleared 
security-based swap margin rules in addition to their proposed 
definitions of nonfinancial end user. See Prudential Regulator 
Margin and Capital Proposing Release, 76 FR at 27571 (defining 
financial end user), and CFTC Capital Proposing Release, 76 FR at 
23736 (defining financial entity). As discussed above, the CFTC and 
prudential regulators are proposing margin requirements that would 
differentiate collateral requirements based on whether a financial 
end user or financial entity is ``high risk'' or ``low risk.'' Id. 
In other words, their proposals would provide for potentially 
different treatment for three classes of entities: (1) Nonfinancial 
end users; (2) financial end users (low risk and high risk); and (3) 
entities that are neither a nonfinancial end user nor a financial 
end user. Therefore, they need to define the terms financial end 
user and financial entity, respectively. Because proposed new Rule 
18a-3 would treat financial end users no differently than entities 
that are neither a commercial end user nor a financial end user, the 
Commission's proposed margin rule does not contain a definition of 
financial end user. However, as discussed below, the proposed rule 
would provide different treatment for counterparties that are SBSDs.
---------------------------------------------------------------------------

    The rationale for exempting commercial end users from the 
requirement to deliver collateral to meet the account equity 
requirements is that these end users often do not deliver collateral by 
current practice, and requiring them to do so could adversely impact 
their ability to mitigate the risk of their commercial activities by 
entering into hedging transactions. If an end user is using non-cleared 
security-based swaps for purposes other than hedging (e.g., to take 
directional investment positions), the rationale for exempting the end 
user from the account equity requirements would not apply. An end user 
that is using non-cleared security-based swaps for investment purposes 
is not acting like a commercial end user, and, as such, no exemption 
would be available under the rule.
    As discussed below in section II.B.2.e. of this release, a nonbank 
SBSD would be required to establish, maintain, and document procedures 
and guidelines for monitoring the risk of accounts holding non-cleared 
security-based swaps.\561\ Among other things, a nonbank SBSD would be 
required to have procedures and guidelines for determining, approving, 
and periodically reviewing credit limits for each counterparty to a 
non-cleared security-based swap.\562\ Consequently, if a nonbank SBSD 
does not collect collateral from a commercial end user, it would need 
to establish a credit limit for the end user and periodically review 
the credit limit in accordance with its risk monitoring 
guidelines.\563\ The rule would not prohibit a nonbank SBSD from 
requiring margin collateral from a commercial end user.
---------------------------------------------------------------------------

    \561\ See paragraph (e) of proposed new Rule 18a-3.
    \562\ See paragraph (e)(2) of proposed new Rule 18a-3. This is 
also consistent with the broker-dealer margin rules. See FINRA Rule 
4210(d), which requires that FINRA member firms establish procedures 
to: (1) Review limits and types of credit extended to all customers; 
(2) formulate their own margin requirements; and (3) review the need 
for instituting higher margin requirements, mark-to-markets and 
collateral deposits than are required by the Rule for individual 
securities or customer accounts. See also FINRA Interpretation 
4210(d)/01, available at http://www.finra.org/web/groups/industry/@ip/@reg/@rules/documents/industry/p122203.pdf (noting that FINRA 
Rule 4210(d) ``requires that members determine the total dollar 
amount of credit to be extended to any one customer or on any one 
security to limit the potential loss or exposure to the member. It 
is important that specific limits be established to prevent any one 
customer or group of customers from endangering the member's 
capital.'').
    \563\ See id.

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

[[Page 70267]]

Exception for Counterparties That Are SBSDs
    The second exception to the account equity requirements in proposed 
new Rule 18a-3 would apply to counterparties that are SBSDs.\564\ Two 
alternatives with respect to SBSD counterparties are being proposed. 
Under the first alternative, a nonbank SBSD would not need to collect 
cash, securities, and/or money instruments to collateralize the margin 
amount (potential future exposure) in the account of a counterparty 
that is another SBSD (``Alternative A''). This approach is consistent 
with the broker-dealer margin rules, which generally do not require a 
broker-dealer to collect margin collateral from another broker-dealer. 
Under the second alternative, a nonbank SBSD would be required to 
collect cash, securities and/or money market instruments to 
collateralize both the negative equity (current exposure) and the 
margin amount (potential future exposure) in the account of a 
counterparty that is another SBSD (``Alternative B'').\565\ Moreover, 
the cash, securities, and/or money market instruments would be required 
to be segregated in an account at an independent third-party custodian 
pursuant to the requirements of section 3E(f) of the Exchange Act.\566\ 
Alternative B is consistent with the proposals of the prudential 
regulators and the CFTC.\567\
---------------------------------------------------------------------------

    \564\ See paragraph (c)(1)(iii)(B) of proposed new Rule 18a-3.
    \565\ Alternative B is not an exception to the account equity 
requirements in proposed new Rule 18a-3 because it would require 
collateral to cover the negative equity and margin amount in an 
account of another SBSD. However, its requirement for how the 
collateral must be held--at an independent third-party custodian on 
behalf of the counterparty--is different from how the proposed rule 
requires that collateral from other types of counterparties be held 
(other than counterparties that elect segregation under section 
3E(f) of the Exchange Act (15 U.S.C. 78c-5(f)).
    \566\ See 15 U.S.C. 78c-5(f).
    \567\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564; CFTC Margin Proposing Release, 76 FR 23732.
---------------------------------------------------------------------------

    The two alternatives are being proposed in order to elicit detailed 
comment on each approach in terms of comparing how they would meet the 
goals of the Dodd-Frank Act,\568\ address systemic issues relating to 
non-cleared security-based swaps, raise practical issues, alter current 
market practices and conventions, result in benefits and costs, and 
impact the security-based swap markets and the participants in those 
markets.
---------------------------------------------------------------------------

    \568\ See 15 U.S.C. 78o-10(e)(3)(A) (``[t]o offset the greater 
risk to the security-based swap dealer or major security-based swap 
participant and the financial system arising from the use of 
security-based swaps that are not cleared,'' the margin requirements 
proposed by the Commission and prudential regulators shall ``help 
ensure the safety and soundness'' of the SBSD and the MSBSP and ``be 
appropriate for the risk associated with non-cleared security-based 
swaps held'' by an SBSD and MSBSP).
---------------------------------------------------------------------------

    Under Alternative A, a nonbank SBSD would be required to collect 
cash, securities, and/or money market instruments from another SBSD 
only to cover the amount of negative equity (the current exposure) in 
the account of the counterparty.\569\ Accordingly, under this approach, 
the nonbank SBSD would not be required to collect cash, securities, 
and/or money market instruments from another SBSD to collateralize the 
margin amount (the potential future exposure).\570\ In other words, a 
counterparty that is another SBSD would not be required to maintain a 
minimum level of positive equity in the counterparty's account.
---------------------------------------------------------------------------

    \569\ See paragraph (c)(1)(iii)(B) of proposed new Rule 18a-3-
Alternative A. To the extent the margin amount was not 
collateralized, the nonbank SBSD would be required to take the 
proposed capital charge in lieu of margin collateral discussed above 
in section II.A.2.b.v. of this release.
    \570\ Id. Like all counterparties to non-cleared security-based 
swaps, counterparties that are SBSDs would be subject to the risk 
monitoring requirements in paragraph (e) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    Requiring a nonbank SBSD to deliver collateral to cover potential 
future exposure could impact its liquidity. As discussed above in 
sections II.A.1. and II.A.2.b.i. of this release, the proposed capital 
requirements for nonbank SBSDs are based on a net liquid assets test. 
The objective of the test is to require the firm to maintain in excess 
of a dollar of highly liquid assets for each dollar of liabilities in 
order to facilitate the liquidation of the firm if necessary and 
without the need for a formal proceeding. When assets are delivered to 
another party as margin collateral, they become unsecured receivables 
from the party holding the margin collateral. Consequently, they no 
longer are readily available to be liquidated by the delivering party. 
In times of market stress, a nonbank SBSD may need to liquidate assets 
to raise funds and reduce its leverage. However, if assets are in the 
control of another nonbank SBSD, they would not be available for this 
purpose. For this reason, the assets would need to be deducted from net 
worth when the nonbank SBSD computes net capital under the proposed 
capital requirements.\571\ As a result, the nonbank SBSD would need to 
maintain the required minimum amount of net capital after taking into 
account these deductions.
---------------------------------------------------------------------------

    \571\ See 17 CFR 240.15c3-1(c)(2)(iv)(B); paragraph 
(c)(1)(iii)(B) of proposed Rule 18a-1. Collateral provided to 
another party as margin would be subject to this 100% deduction.
---------------------------------------------------------------------------

    Promoting the liquidity of nonbank SBSDs is the policy 
consideration underlying Alternative A. In addition, the prudential 
regulators and the CFTC have received comments on this issue in 
response to their proposals raising concerns about requiring bank SBSDs 
and swap dealers to exchange collateral to cover potential future 
exposure and to have the collateral held by an independent third-party 
custodian. For example, some commenters assert that imposing segregated 
initial margin requirements on trades between swap entities would 
result in a tremendous cost to the financial system in the form of a 
massive liquidity drain, and that swap dealers will lose the ability to 
reinvest this collateral to finance other lending or derivatives 
transactions, thereby reducing capital formation and increasing 
costs.\572\ One commenter stated that, in general, with respect to non-
cleared swaps, charging more initial margin (as compared to cleared 
swaps) could have unintended consequences, including the inefficient 
use of capital by sophisticated market participants in highly regulated 
industries, which could create a drag on the financial system, slow 
economic

[[Page 70268]]

growth, and diminish customer choice.\573\
---------------------------------------------------------------------------

    \572\ See, e.g., letter from Robert Pickel, Executive Vice 
Chairman, ISDA, and Kenneth E. Bentsen, Jr., Executive Vice 
President, Public Policy and Advocacy, Securities Industry and 
Financial Markets Association (``SIFMA''), to David Stawick, 
Secretary, CFTC (July 11, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=47802&SearchText=SIFMA (``SIFMA/ISDA Comment 
Letter to the CFTC''); letter from Robert Pickel, Executive Vice 
Chairman, ISDA, and Kenneth E. Bentsen, Jr., Executive Vice 
President, Public Policy and Advocacy, SIFMA, to Jennifer J. 
Johnson, Secretary, Federal Reserve, et al. (July 6, 2011), 
available at http://www.fdic.gov/regulations/laws/federal/2011/11c22ad79.PDF (``SIFMA/ISDA Comment Letter to the Prudential 
Regulators''); letter from the Honorable Darrell Issa, Chairman, 
Committee on Oversight and Government Reform, U.S. House of 
Representatives, to Ben Bernanke, Chairman, Federal Reserve et al. 
(July 22, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=47943&SearchText=issa, and letter 
from Mark Scanlan, Vice President, Agriculture and Rural Policy, 
Independent Community Bankers of America, to the CFTC et al. (July 
11, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=47762&SearchText=scanlan. One commenter noted 
that there is no statutory requirement for covered swap entities to 
hold initial margin of other covered swap entities at an independent 
third party custodian. See letter from Christine Cochran, President, 
Commodity Markets Council, to the OCC et al. (July 11, 2011), 
available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=47777&SearchText=cochran. Here and below, this 
release refers to public comments on the margin proposals by the 
CFTC and the prudential regulators to more fully reflect the 
available views without endorsing those comments or expressing a 
view as to the validity of the comments.
    \573\ See letter from Mark R. Thresher, Executive Vice 
President, Chief Financial Officer, Nationwide, to the OCC (June 24, 
2011), available at http://www.federalreserve.gov/SECRS/2011/June/20110628/R-1415/R-1415_062311_81363_349039663039_1.pdf.
---------------------------------------------------------------------------

    Another commenter stated that a combination of daily variation 
margin, robust operational procedures, legally enforceable netting and 
collateral agreements, and regulatory capital requirements provide 
comprehensive risk mitigation for collateralized derivatives, and that 
any additional initial margin requirements for swaps between swap 
entities would be unnecessary and unwarranted.\574\ A commenter argued 
that the proposed initial margin requirements are inconsistent with 
proven market practice, ignore significant differences in credit 
quality among swap dealers and financial entities which justify 
different margining treatment, and will lead to excessive amounts of 
collateral being required in comparison to the actual risks of the 
underlying swap transactions and portfolios.\575\ Finally, a commenter 
argued that initial margin requirements should differentiate based on 
credit quality, and that the prudential regulators' margin rulemaking 
identifies no risk-based justification for layering zero threshold, 
bilateral initial margin requirements for all swap dealers above and 
beyond their existing variation margin requirements.\576\
---------------------------------------------------------------------------

    \574\ See SIFMA/ISDA Comment Letter to the CFTC; SIFMA/ISDA 
Comment Letter to the Prudential Regulators. This commenter also 
stated that precedent exists in the broker-dealer margin rules for 
not imposing any initial margin requirements on trades between swap 
entities. Id.
    \575\ See letter from Don Thompson, Managing Director and 
Associate General Counsel, J.P. Morgan Chase & Co., to the OCC et 
al. (June 24, 2011), available at http://www.federalreserve.gov/SECRS/2011/June/20110627/R-1415/R-1415_062311_81366_349039350535_1.pdf (``J.P. Morgan Letter''). Another commenter 
pointed out that life insurers also typically do not post initial 
margin and recommended that initial margin requirements be 
appropriately sized to reflect the potential exposure during the 
close out of a defaulting party. See letter from Carl B. Wilkerson, 
Vice President and Chief Counsel, Securities and Litigation, 
American Council of Life Insurers, to the OCC et al. (July 11, 
2011), available at http://www.federalreserve.gov/SECRS/2011/July/20110728/R-1415/R-1415_071111_81817_507164831320_1.pdf.
    \576\ See J.P. Morgan Letter. This commenter stated that initial 
margin is appropriate in some circumstances, but it must take into 
account the credit quality of counterparties.
---------------------------------------------------------------------------

    On the other hand, a number of comments submitted in response to 
the proposals of the prudential regulators and the CFTC supported 
bilateral margining and argued that it should be extended to require 
SBSDs and swap dealers to exchange margin collateral with all 
counterparties.\577\ For example, one commenter stated that the 
financial crisis demonstrated that the premise of one-way margin is 
flawed.\578\ This commenter stated that two-way margin requirements 
would aid safety and soundness by helping a swap dealer and its 
counterparty offset their exposures and prevent them from building up 
exposures they cannot fulfill.\579\
---------------------------------------------------------------------------

    \577\ See, e.g., letter from Scott C. Goebel, Senior Vice 
President, General Counsel, FMR Co., to John Walsh, Acting 
Comptroller of the Currency, OCC (July 11, 2011); letter from Kevin 
M. Budd, Associate General Counsel, and Todd F. Lurie, Assistant 
General Counsel, MetLife, to OCC et al. (July 11, 2011); letter from 
John R. Gidman, on behalf of the Association of Institutional 
Investors, to Ms. Jennifer Johnson, Secretary, Federal Reserve, et 
al. (July 11, 2011); letter from R. Glenn Hubbard, Co-Chair, John L. 
Thornton, Co-Chair, and Hal S. Scott, Director, Committee on Capital 
Markets Regulation, to John Walsh, Acting Comptroller, OCC (July 11, 
2011), available at http://www.federalreserve.gov/SECRS/2011/July/20110719/R-1415/R-1415_071111_81821_322996697020_1.pdf; letter 
from Dennis M. Kelleher, President and Chief Executive Officer, and 
Wallace C. Turbeville, Derivatives Specialist, Better Markets, Inc., 
to Jennifer J. Johnson, Secretary, Federal Reserve (July 11, 2011), 
available at http://www.federalreserve.gov/SECRS/2011/July/20110728/R-1415/R-1415_071111_81861_504963784471_1.pdf; letter from 
Americans for Financial Reform, to John Walsh, Acting Comptroller, 
OCC (July 11, 2011), available at http://www.federalreserve.gov/SECRS/2011/July/20110728/R-1415/R-1415_071111_81864_448738394756_1.pdf.
    \578\ Letter from Karrie McMillan, General Counsel, Investment 
Company Institute, to David Stawick, Secretary, CFTC (July 11, 
2011), available at is http://www.ici.org/pdf/25344.pdf (``ICI 
Letter'').
    \579\ See the ICI Letter.
---------------------------------------------------------------------------

    The prudential regulators explained the reasoning behind their 
proposal as follows:

    Non-cleared swaps transactions with counterparties that are 
themselves swap entities pose risk to the financial system because 
swap entities are large players in swap and security-based swap 
markets and therefore have the potential to generate systemic risk 
through their swap activities. Because of their interconnectedness 
and large presence in the market, the failure of a single swap 
entity could cause severe stress throughout the financial system. 
Accordingly, it is the preliminary view of the Agencies that all 
non-cleared swap transactions with swap entities should require 
margin.\580\
---------------------------------------------------------------------------

    \580\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27570-27571 (footnote omitted). See also CFTC 
Margin Proposing Release, 76 FR at 23735 (``It is the nature of the 
dealer business that dealers are at the center of the markets in 
which they participate. Similarly, a major swap participant, by its 
terms, is a significant trader. Collectively, [swap dealers and 
major swap participants] pose greater risk to the markets and the 
financial system than other swap market participants. Accordingly, 
under the mandate of Section 4s(e), the Commission believes that 
they should be required to collect margin from one another.'').

    Alternative B is being proposed in light of the policy 
considerations underlying the proposals of the prudential regulators 
and the CFTC.\581\ Under Alternative B, a nonbank SBSD would be 
required to obtain cash, securities, and/or money market instruments 
from another SBSD to cover the negative equity (current exposure) and 
margin amount (potential future exposure) in the other SBSD's 
account.\582\ In addition, the cash, securities, and/or money market 
instruments delivered to cover the margin amount would need to be 
carried by an independent third party custodian pursuant to the 
requirements of section 3E(f) of the Exchange Act.\583\ Therefore, not 
only would there be no exception to the account equity requirement for 
counterparties that are SBSDs, but the treatment of the collateral 
would be different than for other types of counterparties in that it 
would be required to be held by an independent third-party 
custodian.\584\
---------------------------------------------------------------------------

    \581\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564; CFTC Margin Proposing Release, 76 FR 23744.
    \582\ See paragraph (c)(1)(iii)(B) of proposed Rule 18a-3--
Alternative B.
    \583\ Id.
    \584\ Id.
---------------------------------------------------------------------------

Exception for Counterparties That Elect Segregation Under Section 3E(f)
    Under the third exception to the account equity requirements in 
proposed new Rule 18a-3, a nonbank SBSD would not be required to hold 
the cash, securities, and/or money market instruments delivered by a 
counterparty that is not a commercial end user to cover the margin 
amount (potential future exposure), if the counterparty elects to have 
the cash, securities, and/or money market instruments segregated 
pursuant to section 3E(f) of the Exchange Act.\585\ Section 3E(f) sets 
forth provisions under which a counterparty to a non-cleared security-
based swap with an SBSD can require that collateral to cover potential 
future exposure must be segregated.\586\ Among other things, section 
3E(f) provides that the collateral must be segregated in an account 
carried by an independent third-party custodian and designated as a 
segregated account for and on behalf of the counterparty.\587\
---------------------------------------------------------------------------

    \585\ See paragraph (c)(1)(iii)(C) of proposed new Rule 18a-3. 
This exception would not apply to negative equity in the 
counterparty's account, which would need to be collateralized by 
cash, securities, and/or money market instruments held by the 
nonbank SBSD. See 15 U.S.C. 78c-5(f)(2)(B)(i) (providing that the 
segregation provisions in section 3E(f) of the Exchange Act do not 
apply to variation margin payments).
    \586\ See 15 U.S.C. 78c-5(f)(1)-(3).
    \587\ See 15 U.S.C. 78c-5(f)(3).
---------------------------------------------------------------------------

    As discussed below in section II.C. of this release, proposed new 
Rule 18a-3 would establish certain conditions that

[[Page 70269]]

collateral would need to meet before its value could be included in the 
determination of the amount of equity in an account.\588\ Among other 
conditions, the collateral would need to be subject to the physical 
possession or control of the nonbank SBSD and capable of being 
liquidated promptly by the nonbank SBSD without intervention by any 
other party.\589\ Margin collateral segregated pursuant to section 
3E(f) of the Exchange Act would not meet either of these conditions. 
First, the collateral would be in the physical possession or control of 
an independent third-party custodian rather than the nonbank SBSD. 
Second, the collateral could not be liquidated by the nonbank SBSD 
without the intervention of the independent third-party custodian. For 
these reasons, the value of the margin collateral held by the 
independent third-party custodian could not be included when 
determining the amount of equity in the account of the counterparty at 
the nonbank SBSD.
---------------------------------------------------------------------------

    \588\ See paragraph (c)(4) of proposed new Rule 18a-3.
    \589\ See paragraphs (c)(4)(i)-(iii) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

Exception for Accounts Holding Legacy Security-Based Swaps
    Under the fourth exception to the account equity requirements in 
proposed new Rule 18a-3, a nonbank SBSD would not be required to 
collect cash, securities, and/or money market instruments to cover the 
negative equity (current exposure) or margin amount (potential future 
exposure) in a security-based swap legacy account.\590\ Proposed new 
Rule 18a-3 would define security-based swap legacy account to mean an 
account that holds no security-based swaps entered into after the 
effective date of the rule and that is used to hold only security-based 
swaps entered into prior to the effective date of the rule, as well as 
collateral for those security-based swaps.\591\ As discussed above in 
section II.A.2.b.v. of this release, this exception would be designed 
to address the impracticality of renegotiating contracts governing 
security-based swap transactions that predate the effectiveness of 
proposed new Rule 18a-3 in order to come into compliance with the 
account equity requirements in the rule.\592\
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    \590\ See paragraph (c)(1)(iii)(D) of proposed new Rule 18a-3. 
While this exception would apply to negative equity in the account 
and the margin amount calculated for the account, a nonbank SBSD 
would be required to take a 100% deduction from net worth for the 
amount of the uncollateralized current exposure and take the 
proposed capital charge in lieu of margin collateral discussed above 
in section II.A.2.b.v. of this release. See proposed new paragraph 
(c)(2)(xiv) of Rule 15c3-1; paragraph (c)(1)(viii) of proposed new 
Rule 18a-1. In addition, like all counterparties to non-cleared 
security-based swaps, these counterparties would be subject to the 
risk monitoring requirements in paragraph (e) of proposed new Rule 
18a-3.
    \591\ See paragraph (b)(9) of proposed new Rule 18a-3.
    \592\ As noted above in section II.A.2.b.v. of this release, the 
CFTC has proposed a similar exception for legacy swaps. See CFTC 
Margin Proposing Release, 76 FR at 23734. The prudential regulators 
proposed to permit a covered swap entity to exclude pre-effective 
swaps from initial margin calculations, while requiring these 
entities to collect variation margin, consistent with industry 
practice. See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27569.
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Request for Comment
    The Commission generally requests comment on the proposed account 
equity requirements for counterparties of nonbank SBSDs in proposed new 
Rule 18a-3.\593\ In addition, the Commission requests comment, 
including empirical data in support of comments, in response to the 
following questions:
---------------------------------------------------------------------------

    \593\ As discussed earlier, the Commission is soliciting comment 
below in section II.B.3. of this release on whether to define the 
term eligible collateral in a manner similar to the prudential 
regulators and the CFTC.
---------------------------------------------------------------------------

    1. Would it be appropriate to limit the assets that could be used 
to collateralize the negative equity and margin amounts in an account 
to cash, securities, and money market instruments? Are there other 
types of assets that should be permitted to meet the account equity 
requirements in proposed new Rule 18a-3? If so, identify the other 
asset types and compare their liquidity to cash, securities, and money 
market instruments.
    2. Is the proposed requirement to take deductions on securities and 
money market instruments in calculating the amount of equity in an 
account appropriate? If not, explain why not. Are there other measures 
that a nonbank SBSD could be required to take to address the risk that 
securities and money market instruments may not be able to be 
liquidated at current market values to cover the obligations of a 
defaulted counterparty? If so, explain how the other measures would be 
an adequate substitute to deductions.
    3. Are the proposed conditions (modeled on the Appendix E 
conditions) for taking into account collateral in determining the 
amount of equity in an account appropriate for proposed new Rule 18a-3? 
If not, explain why not. Should any individual condition be eliminated? 
If so, explain why. Are there additional conditions that should be 
added? If so, identify them and explain how they would promote the goal 
of ensuring that collateral can be promptly liquidated to cover the 
obligation of a defaulted counterparty.
    4. Is the proposed requirement that a nonbank SBSD take prompt 
steps to liquidate securities in an account to the extent necessary to 
eliminate an account equity deficiency appropriate? For example, should 
there be a specific time-frame (e.g., 1, 2, 3, 4, 5, or some other 
number of business days) in which the nonbank SBSD is required to 
liquidate securities in the account? If so, explain why a specific 
time-frame would be preferable to requiring the nonbank SBSD to act 
promptly.
    5. Is the proposed exception to the account equity requirements for 
commercial end users appropriate? If not, explain why not. Should 
commercial end users be required to collateralize negative equity and 
the margin amount in their accounts? Explain why or why not. Should the 
exception apply only to the margin amount (i.e., should commercial end 
users be required to collateralize the negative equity in their 
accounts)? Explain why or why not.
    6. Is the proposed definition of commercial end user appropriate? 
If not, explain why not. For example, would the proposed definition of 
commercial end user be too broad, or too narrow, in terms of capturing 
types of counterparties for which the exception would not be 
appropriate? If so, explain why and suggest how the definition could be 
modified to address this issue.
    7. Should the rule contain a proposed definition of financial end 
user? If so, explain why. For example, would a definition of financial 
end user similar to the definitions of the prudential regulators and 
CFTC provide needed clarity to the definition of commercial end user 
(i.e., by specifying certain entities that are not commercial end 
users)?
    8. Do commercial end users use security-based swaps to hedge 
commercial risk? If so, identify the type of commercial risk they hedge 
with security-based swaps and explain how security-based swaps are used 
to hedge this risk.
    9. Should proposed new Rule 18a-3 define the term commercial risk 
for the purpose of providing greater clarity as to the meaning of the 
term commercial end user? If so, how should the term commercial risk be 
defined?
    10. Should there be a two-tiered approach with respect to the 
account equity requirements for financial end users based on whether 
they are low risk or high risk, similar to the proposed approach of the 
prudential regulators and the CFTC? If so, explain why.

[[Page 70270]]

    11. How do non-commercial end users presently use security-based 
swaps? For example, do they use them to hedge commercial risk? If so, 
identify the type of commercial risk they hedge with security-based 
swaps.
    12. With respect to counterparties that are SBSDs, how would 
Alternatives A and B compare in terms of promoting the goals of the 
Dodd-Frank Act, including limiting the risks posed by non-cleared 
security-based swaps? How would each address or fail to address 
systemic issues relating to non-cleared security-based swaps?
    13. What would be the impact of Alternatives A and B on the 
efficient use of capital?
    14. What would be the practical effects of Alternatives A and B on 
the capital and liquidity positions, or the financial health generally, 
of nonbank SBSDs? How would each alter current market practices and 
conventions with respect to collateralizing credit exposures arising 
from non-cleared security-based swaps? Are there practical issues with 
respect to Alternatives A and B? If so, identify and explain them.
    15. How would the benefits of Alternatives A and B compare? How 
would the costs compare?
    16. How would Alternatives A and B impact the market for security-
based swaps? How would they impact participants in those markets?
    17. How would Alternatives A and B promote the clearing of 
security-based swaps? For example, would Alternative B--because of the 
requirement to fund margin collateral requirements--incentivize nonbank 
SBSDs to transact in cleared security-based swaps? If so, explain why.
    18. What would be the potential impact if the Commission adopted 
Alternative A and the prudential regulators and the CFTC adopted rules 
similar to Alternative B? Consider and explain the impact competitively 
and practically.
    19. Would the proposed exception to the account equity requirements 
for counterparties that elect segregation under section 3E(f) of the 
Exchange Act be appropriate? If not, explain why not.
    20. Would the proposed exception to the account equity requirements 
for accounts that elect to hold legacy security-based swaps be 
appropriate? If not, explain why not.
    21. Would it be appropriate to permit legacy security-based swaps 
to be held in an entity that is not an SBSD? If so, why, and what 
conditions should be imposed on such an entity?
    22. Should counterparties be required to post variation margin with 
respect to legacy swaps? Is this consistent with current market 
practice?
    23. Should there be an exception from the account equity 
requirements for small banks, savings associations, farm credit system 
institutions, and credit unions from the account equity requirements 
(e.g., for entities with assets of $10 billion or less)? \594\ Explain 
why or why not.
---------------------------------------------------------------------------

    \594\ See, e.g., 15 U.S.C. 78c-3(g)(3)(B) (requiring the 
Commission to consider whether to exempt small banks, savings 
associations, farm credit system institutions and credit unions from 
the definition of ``financial entity'' contained in Exchange Act 
section 3C(g)(3)(A) for the purposes of mandatory clearing of 
security-based swaps). See also End-User Exception to Mandatory 
Clearing of Security-Based Swaps, Exchange Act Release No. 63556 
(Dec. 15, 2010), 75 FR 79992, 80000-80002 (Dec. 21, 2010).
---------------------------------------------------------------------------

    24. Should there be an exception from the account equity 
requirements for affiliates of the nonbank SBSD? For example, do 
affiliates present less credit risk than non-affiliates? If there 
should be an exception for affiliates, should it be limited to certain 
affiliates? For example, should the exception only apply to affiliates 
that are subject to capital and other regulatory requirements? Please 
explain.
    25. Should there be an exception for foreign governmental entities? 
Explain why or why not. Should types of foreign governmental entities 
be distinguished for purposes of an exception? For example, are there 
objective benchmarks based on creditworthiness that could be used to 
distinguish between foreign governmental entities for which the 
exception to the account equity requirements would and would not be 
appropriate? If so, identify the benchmarks and explain how they could 
be incorporated into the rule.
    26. Do dealers in OTC derivatives currently collect collateral from 
foreign governmental entities for their OTC derivatives transactions? 
If so, from which types of foreign governmental entities?
    27. Do national foreign governments typically guarantee the 
obligations of political subdivisions and agencies? If so, identify the 
types of political subdivisions and agencies that are guaranteed and 
are not guaranteed.
ii. Nonbank MSBSPs
    A nonbank MSBSP would be required to calculate as of the close of 
each business day the amount of equity in the account of each 
counterparty to a non-cleared security-based swap.\595\ On the next 
business day following the calculation, the nonbank MSBSP would be 
required to either collect or deliver cash, securities, and/or money 
market instruments to the counterparty depending on whether there was 
negative or positive equity in the account of the counterparty.\596\ 
Specifically, if the account has negative equity as calculated on the 
previous business day, the nonbank MSBSP would be required to collect 
cash, securities, and/or money market instruments in an amount equal to 
the negative equity.\597\ Conversely, if the account has positive 
equity as calculated on the previous business day, the nonbank MSBSP 
would be required to deliver cash, securities, and/or money market 
instruments to the counterparty in an amount equal to the positive 
equity.\598\
---------------------------------------------------------------------------

    \595\ See paragraph (c)(2)(i) of proposed new Rule 18a-3.
    \596\ See paragraph (c)(2)(ii) of proposed new Rule 18a-3. As 
indicated, the nonbank MSBSP would need to deliver cash, securities, 
and/or money market instruments and, consequently, other types of 
assets would not be eligible as collateral.
    \597\ See paragraph (c)(2)(ii)(A) of proposed new Rule 18a-3. In 
this case, the nonbank MSBSP would have current exposure to the 
counterparty in an amount equal to the negative equity.
    \598\ See paragraph (c)(2)(ii)(B) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    Nonbank MSBSPs may not maintain two-sided markets or otherwise 
engage in activities that would require them to register as an 
SBSD.\599\ They will, however, by definition, maintain substantial 
positions in particular categories of security-based swaps.\600\ These 
positions could create significant risk to counterparties to the extent 
the counterparties have uncollateralized current exposure to the 
nonbank MSBSP. In addition, they could pose significant risk to the 
nonbank MSBSP to the extent it has uncollateralized current exposure to 
its counterparties. The proposed account equity requirements for 
nonbank MSBSPs are designed to address these risks by imposing a 
requirement that nonbank MSBSPs on a daily basis must ``neutralize'' 
the credit risk between the nonbank MSBSP and the counterparty either 
by collecting or delivering cash, securities, and/or money market 
instruments in an amount equal to the positive or negative equity in 
the account.
---------------------------------------------------------------------------

    \599\ See Entity Definitions Adopting Release, 77 FR 30596.
    \600\ See 15 U.S.C. 78c(a)(67); Entity Definitions Adopting 
Release, 77 FR 30596.
---------------------------------------------------------------------------

    Unlike nonbank SBSDs, nonbank MSBSPs would not be required to 
reduce the fair market value of securities and money market instruments 
held in the account of a counterparty (or delivered to a counterparty) 
for purposes of determining whether the level of equity in the account 
meets the minimum

[[Page 70271]]

requirement. As discussed above in section II.B.2.c.i. of this release, 
the reductions taken by a nonbank SBSD would be based on the deductions 
that would apply to the positions pursuant to Rule 15c3-1, as proposed 
to be amended, and proposed new Rule 18a-1, as applicable.\601\ Nonbank 
MSBSPs would not be subject to these rules and, consequently, would not 
be required to comply with them for purposes of proposed new Rule 18a-
3.
---------------------------------------------------------------------------

    \601\ See paragraph (c)(3) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    Like nonbank SBSDs, nonbank MSBSPs would be subject to the 
requirements in paragraph (c)(4) of proposed new Rule 18a-3, which are 
modeled on the existing collateral requirements in Appendix E to Rule 
15c3-1.\602\ As discussed above in section II.A.2.b.iv of this release, 
these requirements are designed to ensure that the collateral is an 
asset of stable and predictable value, an asset that is not linked to 
the value of the transaction in any way, and an asset that can be sold 
quickly and easily if the need arises.
---------------------------------------------------------------------------

    \602\ See paragraph (c)(4) of proposed new Rule 18a-3; 17 CFR 
240.15c3-1e(c)(4)(v).
---------------------------------------------------------------------------

    Nonbank MSBSPs would be required to take prompt steps to liquidate 
securities and money market instruments in the account to the extent 
necessary to eliminate an account equity deficiency.\603\ These steps 
could include liquidating non-cleared security-based swap positions in 
the account to reduce debits arising from those transactions. The rule 
would not require that the liquidations must be completed within a 
specific timeframe in order to provide the nonbank MSBSP flexibility to 
conduct an orderly liquidation, taking into account market conditions 
and the risk profile of the account.
---------------------------------------------------------------------------

    \603\ See paragraph (c)(8) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    There would be three exceptions to the account equity requirements 
for nonbank MSBSPs.\604\ The first exception would apply to 
counterparties that are commercial end users.\605\ Under this 
exception, the nonbank MSBSP would not be required to collect 
collateral from a commercial end user when the account of the end user 
has negative equity.\606\ This exception would be consistent with the 
proposed exception from the account equity requirements for accounts of 
commercial end users at nonbank SBSDs. However, nonbank MSBSPs would 
not be required to take a credit risk charge or capital charge relating 
to the amount of the uncollected margin.\607\ The reason for this 
proposed exception is the concern that requiring commercial end users 
to deliver collateral could impair their ability to manage commercial 
risks through hedging transactions. A nonbank MSBSP would be required 
to deliver cash, securities, and/or money market instruments to a 
commercial end user as necessary to collateralize the end user's 
current exposure to the nonbank MSBSP.
---------------------------------------------------------------------------

    \604\ See paragraph (c)(2)(iii) of proposed new Rule 18a-3. 
MSBSPs could choose to collect collateral in these cases.
    \605\ See paragraph (c)(2)(iii)(A) of proposed new Rule 18a-3.
    \606\ Id.
    \607\ Compare paragraph (c)(1)(iii)(A) of proposed new Rule 18a-
3, with paragraph (c)(2)(iii)(A) of proposed Rule new 18a-3.
---------------------------------------------------------------------------

    Under the second exception, a nonbank MSBSP would not be required 
to collect cash, securities, and/or money market instruments from an 
SBSD to collateralize the amount of the negative equity in the account 
of the SBSD. Under the account equity requirements in proposed new Rule 
18a-3, a nonbank SBSD would be required to collect collateral from a 
nonbank MSBSP to cover the negative equity and margin amount in the 
account of the nonbank MSBSP carried by the nonbank SBSD.\608\ Once a 
nonbank SBSD collected these amounts, a nonbank MSBSP would have 
current exposure to the nonbank SBSD, at a minimum, equal to the amount 
of the positive equity required to be maintained in the nonbank MSBSP's 
account at the nonbank SBSD. A regulatory requirement that the nonbank 
MSBSP must collect collateral from the nonbank SBSD to collateralize 
the amount of the positive equity in the account at the nonbank SBSD 
could defeat the purpose of proposed new Rule 18a-3; namely, that 
nonbank SBSDs collect cash, securities, and/or money market instruments 
to collateralize their potential future exposure to the counterparties, 
including nonbank MSBSPs.\609\ In essence, the proposed requirements 
reflect a general preference in favor of requiring counterparties to 
nonbank SBSDs to fully collateralize their obligations to the nonbank 
SBSDs.
---------------------------------------------------------------------------

    \608\ See paragraph (c)(1)(ii) of proposed Rule 18a-3. As 
discussed above, MSBSPs would not be included in the definition of 
commercial end user. Consequently, an MSBSP would be required to 
deliver cash, securities, and/or money market instruments to 
collateralize the negative equity and the margin amount in its 
security-based swap account at a nonbank SBSD.
    \609\ For example, assume a nonbank SBSD calculates that the 
account of a nonbank MSBSP has a negative equity of $20 (current 
exposure) and a margin amount of $50 (potential future exposure) 
pursuant to paragraph (c)(1)(i) of proposed new Rule 18a-3. On the 
next business day, the nonbank SBSD would need to collect cash, 
securities, and/or money market instruments to collateralize these 
amounts pursuant to paragraph (c)(1)(ii) of proposed new Rule 18a-3. 
Assume the nonbank MSBSP delivers cash as collateral. It would need 
to deliver $70 in cash, of which $50 (as collateral for the margin 
amount) would be a receivable from the nonbank SBSD to the nonbank 
MSBSP. In other words, the $50 (as a receivable from the nonbank 
SBSD) would be the nonbank MSBSP's current exposure to the nonbank 
SBSD. If the nonbank MSBSP was required to collect collateral from 
the nonbank SBSD to cover this amount, the account of the nonbank 
MSBSP at the nonbank SBSD would not meet the minimum equity 
requirement of $50.
---------------------------------------------------------------------------

    The third exception would apply to a security-based swap legacy 
account.\610\ Under this exception, consistent with the proposed 
corresponding exception applying to accounts with nonbank SBSDs, a 
nonbank MSBSP would not be required to collect cash, securities, and/or 
money market instruments to collateralize the negative equity in a 
security-based swap legacy account. In addition, the MSBSP would not be 
required to deliver collateral to cover the positive equity in the 
account. This exception would be designed to address the impracticality 
of renegotiating contracts governing security-based swap transactions 
that predate the effectiveness of proposed new Rule 18a-3 in order to 
come into compliance with the account equity requirements in the rule.
---------------------------------------------------------------------------

    \610\ See paragraph (c)(2)(iii)(C) of proposed new Rule 18a-3. 
The term security-based swap legacy account would be defined to mean 
an account that holds no security-based swaps entered into after the 
effective date of the rule and that is used only to hold security-
based swaps entered into prior to the effective date of the rule and 
collateral for those security-based swaps. See paragraph (b)(9) of 
proposed new Rule 18a-3.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the proposed account 
equity requirements for counterparties of nonbank MSBSPs in proposed 
Rule 18a-3. Commenters are referred to the questions about the account 
equity requirements for nonbank SBSDs above in section II.B.2.c.i. of 
this release to the extent those questions address provisions in 
proposed new Rule 18a-3 that also apply to nonbank MSBSPs. In addition, 
the Commission requests comment, including empirical data in support of 
comments, in response to the following questions:
    1. Are the proposed account equity requirements for nonbank MSBSPs 
appropriate? If not, explain why not.
    2. Should nonbank MSBSPs be required to reduce the fair market 
value of securities and money market instruments for purposes of 
determining whether the level of equity in the account meets the 
minimum requirement? What would be the impact of not requiring nonbank 
MSBSPs to reduce the fair market value of

[[Page 70272]]

securities and money market instruments for purposes of determining 
whether the level of equity in the account meets the minimum 
requirement?
    3. Should nonbank MSBSPs be required to collect or deliver cash, 
securities, and/or money market instruments to collateralize a margin 
amount (potential future exposure) in addition to the negative equity 
amount (current exposure)? Should they be required to deliver cash, 
securities, and/or money market instruments to a commercial end user to 
collateralize a margin amount? Please explain.
    4. Is the proposed exception to the account equity requirements for 
credit exposures to commercial end users appropriate? If not, explain 
why not. For example, because nonbank MSBSPs would not be required to 
take a credit risk charge or capital charge relating to the amount of 
uncollected margin collateral, would nonbank MSBSPs be subject to 
additional risks not applicable to nonbank SBSDs? If so, explain why. 
If not, explain why not.
    5. Is the proposed exception to the account equity requirements for 
credit exposures to SBSDs appropriate? If not, explain why not.
    6. Is the proposed exception to the account equity requirements for 
credit exposures in security-based swap legacy accounts appropriate? If 
not, explain why not.
d. $100,000 Minimum Transfer Amount
    Proposed new Rule 18a-3 would establish a minimum transfer amount 
of $100,000 with respect to a particular counterparty.\611\ Under this 
provision, a nonbank SBSD and a nonbank MSBSP would not be required to 
collect or deliver collateral to meet an account equity requirement if 
the amount required to be collected or delivered is equal to or less 
than $100,000. If the minimum transfer amount is exceeded, the entire 
account equity requirement would need to be collateralized, not just 
the amount of the requirement that exceeds $100,000.
---------------------------------------------------------------------------

    \611\ See paragraph (c)(6) of proposed Rule 18a-3.
---------------------------------------------------------------------------

    The proposed minimum transfer provision is designed to establish a 
threshold so that the degree of risk reduction achieved by requiring 
account equity requirements to be collateralized is sufficiently small 
that the costs of delivering collateral may not be justified. The 
proposed $100,000 threshold is based on the proposals of the prudential 
regulators and the CFTC.\612\
---------------------------------------------------------------------------

    \612\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27575; CFTC Margin Proposing Release, 76 FR at 
23735 (``In order to reduce transaction costs, proposed Sec.  23.150 
would establish a `minimum transfer amount' of $100,000. Initial and 
variation margin payments would not be required to be made if below 
that amount. This amount was selected in consultation with the 
prudential regulators. It represents an amount sufficiently small 
that the level of risk reduction might not be worth the transaction 
costs of moving the money. It only affects the timing of collection; 
it does not change the amount of margin that must be collected once 
the $100,000 level is exceeded.''). Some commenters to the CFTC and 
Prudential Regulators proposed margin rules, while generally 
supporting the use of minimum transfer amounts, stated that they 
should have the flexibility to set higher minimum transfer amounts 
and that minimum transfer amounts up to $250,000 were more 
consistent with prevailing industry practice. See letter from the 
Coalition for Derivatives End-Users, to David A. Stawick, Secretary, 
CFTC (July 11, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=47804; letter from Carl B. 
Wilkerson, Vice President & Chief Counsel, Securities & Litigation, 
American Council of Life Insurers, to the Prudential Regulators and 
David A. Stawick, Secretary, CFTC (July 11, 2011), available at 
http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=47742; 
letter from Lisa M. Ledbetter, Vice President and Deputy General 
Counsel, Legislative and Regulatory Affairs, Freddie Mac, to David 
A. Stawick, Secretary, CFTC (July 11, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=47771.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the minimum transfer 
amount in proposed new Rule 18a-3. In addition, the Commission requests 
comment, including empirical data in support of comments, in response 
to the following questions:
    1. Is it appropriate to have a minimum transfer amount? If not, 
explain why not. For example, should an account equity requirement be 
collateralized regardless of the amount of cash, securities, and/or 
money market instruments that would need to be transferred to meet the 
requirement?
    2. Is $100,000 an appropriate minimum transfer amount? Should the 
amount be greater than $100,000 (e.g., $150,000, $200,000, $500,000, or 
some other amount)? If so, identify the amount and explain why it would 
be a better threshold. Should the amount be less than $100,000 (e.g., 
$75,000, $50,000, $25,000, or some other amount)? If so, identify the 
amount and explain why it would be a better threshold.
e. Risk Monitoring and Procedures
    A nonbank SBSD would be required to monitor the risk of each 
account of a counterparty to a non-cleared security-based swap and 
establish, maintain, and document procedures and guidelines for 
monitoring the risk of such accounts.\613\ The nonbank SBSD also would 
be required to review, in accordance with written procedures, and at 
reasonable periodic intervals, its non-cleared security-based swap 
activities for consistency with the risk monitoring procedures and 
guidelines.\614\ The risk monitoring procedures and guidelines would 
need to include, at a minimum, procedures and guidelines for:
---------------------------------------------------------------------------

    \613\ See paragraph (e) of proposed new Rule 18a-3. Paragraph 
(e) of proposed new Rule 18a-3 would not apply to nonbank MSBSPs. As 
discussed below, the proposed risk monitoring procedures are 
designed to address the risk that results from dealing in non-
cleared security-based swaps (i.e., the type of activity that would 
require a nonbank MSBSP to register as an SBSD). See 15 U.S.C. 78o-
10(a)(1); Entity Definitions Proposing Release, 75 FR at 80174. As 
discussed above in section II.A.3 of this release, a nonbank MSBSP 
would be required to comply with Rule 15c3-4, which requires an 
entity subject to its provisions to establish a risk management 
control system.
    \614\ See paragraph (e) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

     Obtaining and reviewing the account documentation and 
financial information necessary for assessing the amount of current and 
potential future exposure to a given counterparty permitted by the 
nonbank SBSD;
     Determining, approving, and periodically reviewing credit 
limits for each counterparty, and across all counterparties;
     Monitoring credit risk exposure to the security-based swap 
dealer from non-cleared security-based swaps, including the type, 
scope, and frequency of reporting to senior management;
     Using stress tests to monitor potential future exposure to 
a single counterparty and across all counterparties over a specified 
range of possible market movements over a specified time period;
     Managing the impact of credit exposure related to non-
cleared security-based swaps on the nonbank SBSD's overall risk 
exposure;
     Determining the need to collect collateral from a 
particular counterparty, including whether that determination was based 
upon the creditworthiness of the counterparty and/or the risk of the 
specific non-cleared security-based swap contracts with the 
counterparty;
     Monitoring the credit exposure resulting from concentrated 
positions with a single counterparty and across all counterparties, and 
during periods of extreme volatility; and
     Maintaining sufficient equity in the account of each 
counterparty to protect against the largest individual potential future 
exposure of a non-cleared security-based swap carried in the account of 
the counterparty as measured by computing the largest maximum possible 
loss that could result from the exposure.

[[Page 70273]]

    These proposed requirements are modeled on similar requirements in 
FINRA Rule 4240, which establishes an interim pilot program imposing 
margin requirements for transactions in credit default swaps executed 
by a FINRA member.\615\ As discussed above in section II.A.2.c. of this 
release, nonbank SBSDs would be required to comply with Rule 15c3-
4.\616\ Rule 15c3-4 requires an OTC derivatives dealer to establish, 
document, and maintain a system of internal risk management controls to 
assist in managing the risks associated with its business activities, 
including market, credit, leverage, liquidity, legal, and operational 
risks.\617\ Risk management systems are designed to help ensure an 
awareness of, and accountability for, the risks taken throughout a firm 
and to develop tools to address those risks.\618\ A key objective of a 
risk management system is to ensure that a firm does not ignore any 
material source of risk.\619\
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    \615\ See FINRA Rule 4240. The risk monitoring requirements in 
FINRA Rule 4240 were, in turn, modeled on risk monitoring 
requirement in SRO portfolio margining rules. See FINRA Rule 
4210(g); Rules 12.4 and 15.8A of the CBOE.
    \616\ 17 CFR 240.15c3-4.
    \617\ Id.
    \618\ See Joint Forum, Bank of International Settlements, Trends 
in Risk Integration and Aggregation, (Aug. 2003), available at 
http://www.bis.org/publ/joint07.pdf.
    \619\ Id.
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    The procedures and guidelines that a nonbank SBSD would establish 
pursuant to proposed new Rule 18a-3 would be a part of the broader 
system of risk management controls the nonbank SBSD would establish 
pursuant to Rule 15c3-4.\620\ The requirement in proposed new Rule 18a-
3 is designed to require specific risk management procedures and 
guidelines with respect to the risks of acting as a dealer in non-
cleared security-based swaps, which could result in a nonbank SBSD 
carrying accounts for significant numbers of counterparties and 
effecting numerous transactions for counterparties on a daily basis. 
For example, the nonbank SBSD would be required to have procedures and 
guidelines for determining, approving, and periodically reviewing 
credit limits for each counterparty, and across all 
counterparties.\621\ In addition, the nonbank SBSD would be required to 
have procedures and guidelines for determining the need to collect 
collateral from a particular counterparty, including whether that 
determination was based upon the creditworthiness of the counterparty 
and/or the risk of the specific non-cleared security-based swap 
contracts with the counterparty.\622\ As discussed above in section 
II.B.2.c.i. of this release, nonbank SBSDs would not be required to 
collect collateral from a commercial end user to meet the account 
equity requirements in proposed new Rule 18a-3.\623\ However, the firm 
would be required to determine credit limits for the end user and 
analyze the need for collecting collateral from the end user. These 
risk monitoring procedures and guidelines are designed to prevent the 
nonbank SBSD from allowing its credit exposure to the end user to reach 
a level that creates a substantial risk that the default of the end 
user could have a material adverse impact on the nonbank SBSD.
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    \620\ 17 CFR 240.15c3-4.
    \621\ See paragraph (e)(2) of proposed new Rule 18a-3.
    \622\ See paragraph (e)(6) of proposed new Rule 18a-3.
    \623\ See paragraph (c)(1)(iii)(A) of proposed new Rule 18a-3.
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Request for Comment
    The Commission generally requests comment on the requirements in 
proposed new Rule 18a-3 to monitor risk and to have risk monitoring 
procedures and guidelines. In addition, the Commission requests 
comment, including empirical data in support of comments, in response 
to the following questions:
    1. Are the required elements of the risk monitoring procedures and 
guidelines appropriate? If not, explain why not. Should there be 
additional or alternative required elements to the risk monitoring 
procedures and guidelines? If so, identify them and explain why they 
should be included.
    2. Are the descriptions of the required elements of the risk 
monitoring procedures and guidelines in paragraphs (e)(1) through (8) 
of proposed new Rule 18a-3 sufficiently clear in terms of what is 
proposed to be required of nonbank SBSDs? If not, explain why not and 
suggest changes to make the elements more clear.
    3. Is it appropriate to require that the risk monitoring procedures 
and guidelines be a part of the system of risk management control 
prescribed in Rule 15c3-4? If not, explain why not.
    4. What are the current practices of dealers in OTC derivatives in 
terms of monitoring the risk of counterparties? Are the requirements in 
proposed new Rule 18a-3 consistent with current practices? Are they 
more limited or are they broader than current practices?
    5. Should nonbank MSBSPs be subject to the requirements of 
paragraph (e) of proposed new Rule 18a-3? If so, explain why. If not, 
explain why not.
3. Specific Request for Comment To Limit the Use of Collateral
    Proposed new Rule 18a-3 does not specifically identify classes of 
assets that could be used to meet the account equity requirements in 
the rule. The Commission, however, is considering whether it would be 
appropriate to adopt limits on eligible collateral similar to those the 
prudential regulators and the CFTC proposed.\624\ Specifically, comment 
is sought on whether proposed new Rule 18a-3 should define the term 
eligible collateral in order to narrowly prescribe the classes of 
assets that would qualify as collateral to meet the account equity 
requirements. For example, one approach would be to limit eligible 
collateral to cash and U.S. government securities.
---------------------------------------------------------------------------

    \624\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27578; CFTC Margin Proposing Release, 76 FR at 
23738-23739.
---------------------------------------------------------------------------

    Limiting eligible collateral to cash and U.S. government securities 
could be a way to ensure that a nonbank SBSD will be able to liquidate 
the collateral promptly and at current market prices if necessary to 
cover the obligations of a defaulting counterparty. During a period of 
market stress, the value of collateral other than cash pledged as 
margin also may come under stress through rapid market declines and 
systemic liquidations and deleveraging by financial institutions. 
Generally, U.S. government securities are substantially less 
susceptible to this risk than other types of securities and, in fact, 
may become the investment of choice during a period of market stress as 
investors seek the relative safety of these securities.\625\
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    \625\ See IMF, Global Financial Stability Report, The Quest for 
Lasting Stability (Apr. 2012), available at http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/text.pdf.
---------------------------------------------------------------------------

    Another approach would be to adopt the definition of eligible 
collateral proposed by the prudential regulators or to adopt the 
``forms of margin'' proposed by the CFTC.\626\ Both of these proposed 
approaches would extend eligible collateral beyond cash and U.S. 
government securities but would not permit the use of certain 
securities (e.g., listed equities that would be permitted by proposed 
Rule 18a-3).
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    \626\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27578; CFTC Margin Proposing Release, 76 FR at 
23738-23739 (proposing that only certain types of financial 
instruments be eligible collateral).
---------------------------------------------------------------------------

    The Commission also seeks comment in response to the following 
questions, including empirical data in support of comments:
    1. Should the types of assets that could be used to meet the 
nonbank

[[Page 70274]]

SBSD account equity requirements in proposed new Rule 18a-3 be more 
limited? Explain why or why not. For example, are the proposed 
provisions that would require a nonbank SBSD to mark-to-market the 
value of the collateral, apply haircuts to the collateral, and adhere 
to the collateral requirements incorporated from Appendix E to Rule 
15c3-1 sufficient to ensure that collateral is able to serve the 
purpose of protecting the nonbank SBSD from the credit exposure of a 
counterparty to a non-cleared security-based swap? If so, explain why. 
If not, explain why not.
    2. Explain the risk to nonbank SBSDs if they are permitted to 
accept a broader range of securities and money market instruments (as 
proposed in new Rule 18a-3) to meet the account equity requirements.
    3. Should the types of assets that could be used to meet the 
nonbank MSBSP account equity requirements in proposed new Rule 18a-3 be 
more limited? Explain why or why not. Since nonbank MSBSPs would not be 
required to apply haircuts to the collateral or adhere to the 
collateral requirements incorporated from Appendix E to Rule 15c3-1, 
should the types of collateral they are allowed to accept be more 
limited? Explain why or why not.
    4. Explain the risk to nonbank MSBSPs if they are permitted to 
accept a broader range of securities and money market instruments (as 
proposed in new Rule 18a-3) to meet the account equity requirements.
    5. If the term eligible collateral is defined for purposes of 
proposed new Rule 18a-3, should the definition include securities of 
government-sponsored entities? If so, identify the government-sponsored 
entities and explain why the securities of the identified entity would 
be appropriate collateral. Alternatively, explain why securities of 
government-sponsored entities generally or individually should not be 
included in a potential definition of eligible collateral.
    6. If the term eligible collateral is defined for purposes of 
proposed new Rule 18a-3, should the definition include immediately-
available cash funds denominated in a foreign currency when the 
currency is the same currency in which payment obligations under the 
security-based swap are required to be settled? If so, should eligible 
collateral be limited to specific foreign currencies? If so, identify 
the currencies and explain why the identified currencies would be 
appropriate collateral. Alternatively, explain why foreign currencies 
generally or individually should not be included in a potential 
definition of eligible collateral.
    7. If the term eligible collateral is defined for purposes of 
proposed new Rule 18a-3, should the definition include immediately-
available cash funds denominated in foreign currency even in cases 
where the currency is not the same currency in which payment 
obligations under the security-based swap are required to be settled? 
If so, should eligible collateral be limited to specific foreign 
currencies? If so, identify the currencies and explain why the 
identified currencies would be appropriate collateral in this 
circumstance. Alternatively, explain why foreign currencies in this 
circumstance should not be included in a potential definition of 
eligible collateral.
    8. If the term eligible collateral is defined for purposes of 
proposed new Rule 18a-3, should the definition include securities of 
foreign sovereign governments? If so, identify the foreign sovereign 
governments and explain why the securities of the identified foreign 
sovereign governments would be appropriate collateral. Alternatively, 
explain why securities of foreign sovereign governments should not be 
included in the definition of eligible collateral.
    9. If the term eligible collateral is defined for purposes of 
proposed new Rule 18a-3, should the definition include a fully paid 
margin equity security, as that term is defined in 12 CFR 220.2,\627\ 
in the case where a non-cleared equity security-based swap references 
the margin equity security? If so, explain why margin equity securities 
would be appropriate collateral in this circumstance. Alternatively, 
explain why margin equity securities in this circumstance should not be 
included in the definition of eligible collateral.
---------------------------------------------------------------------------

    \627\ Regulation T defines margin equity security as a margin 
security that is an equity security (as defined in section 3(a)(11) 
of the Exchange Act). See 12 CFR 220.2.
---------------------------------------------------------------------------

    10. Should there be separate eligible collateral requirements for 
collateralizing negative equity and the margin amount? For example, 
should the assets permitted to collateralize negative equity be limited 
to cash and U.S. government securities, while the assets permitted to 
collateralize the margin amount encompass a broader range of 
securities?

C. Segregation

1. Background
    The U.S. Bankruptcy Code provides special protections for customers 
of stockbrokers (the ``stockbroker liquidation provisions'').\628\ 
Among other protections, customers share ratably with other customers 
ahead of all other creditors in the customer property held by the 
failed stockbroker.\629\ Segregation requirements are designed to 
identify customer property as distinct from the proprietary assets of 
the firm and to protect customer property by, for example, preventing 
the firm from using it to make proprietary investments. The goal of 
segregation is to facilitate the prompt return of customer property to 
customers either before or during a liquidation proceeding if the firm 
fails.\630\
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    \628\ See 11 U.S.C. 741-753. SIPA provides similar protections 
for ``customers'' of registered broker-dealers. See 15 U.S.C. 78aaa 
et seq. However, SIPA also provides additional protections such as 
the right for each customer to receive an advance of up to $500,000 
to facilitate the prompt satisfaction of a claim for securities and 
cash ($250,000 of the $500,000 may be used to satisfy the cash 
portion of a claim).
    \629\ See 11 U.S.C. 752.
    \630\ See Michael P. Jamroz, The Customer Protection Rule, 57 
Bus. Law. 1069 (May 2002).
---------------------------------------------------------------------------

    The Dodd-Frank Act contains provisions designed to ensure that cash 
and securities held by an SBSD relating to security-based swaps will be 
deemed customer property under the stockbroker liquidation 
provisions.\631\ In particular, section 3E(g) of the Exchange Act 
provides, among other things, that a security-based swap shall be 
considered to be a security as such term is ``used in section 
101(53A)(B) and subchapter III of title 11, United States Code'' \632\ 
and in the stockbroker liquidation provisions.\633\ Section 3E(g) also 
provides that an account that holds a security-based swap shall be 
considered to be a securities account as that term is ``defined'' in 
the stockbroker liquidation provisions.\634\ In addition, section 3E(g) 
provides that the terms purchase and sale as defined in sections 
3(a)(13) and (14) of the Exchange Act, respectively, shall be applied 
to the terms purchase and sale as used in the

[[Page 70275]]

stockbroker liquidation provisions.\635\ Finally, section 3E(g) 
provides that the term customer as defined in the stockbroker 
liquidation provisions excludes any person to the extent the person has 
a claim based on a non-cleared security-based swap transaction except 
to the extent of any margin delivered to or by the customer with 
respect to which there is a customer protection requirement under 
section 15(c)(3) of the Exchange Act or a segregation requirement.\636\
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    \631\ See Public Law 111-203 Sec.  763(d) adding section 3E(g) 
to the Exchange Act (15 U.S.C. 78c-5(g)).
    \632\ See 15 U.S.C. 78c-5(g); 11 U.S.C. 101(53A)(B). Section 
101(53A)(B) defines a stockbroker to mean a person--(1) with respect 
to which there is a customer, as defined in section 741, subchapter 
III, title 11, United States Code (the definition section of the 
stockbroker liquidation provisions); and (2) that is engaged in the 
business of effecting transactions in securities--(i) for the 
account of others; or (ii) with members of the general public, from 
or for such person's own account. 11 U.S.C. 101(53A)(B).
    \633\ See 15 U.S.C. 78c-5(g); 11 U.S.C. 741-753.
    \634\ See 15 U.S.C. 78c-5(g); 11 U.S.C. 741. There is no 
definition of securities account in 11 U.S.C. 741. The term 
securities account is used in 11 U.S.C. 741(2) and (4) in defining 
the terms customer and customer property.
    \635\ See 15 U.S.C. 78c-5(g); 11 U.S.C. 741-753. Section 
3(a)(13) of the Exchange Act, as amended by the Dodd-Frank Act (Pub. 
L. 111-203 Sec.  761(a)), defines the term purchase to mean, in the 
case of security-based swaps, the execution, termination (prior to 
its scheduled maturity date), assignment, exchange, or similar 
transfer or conveyance of, or extinguishing of rights or obligations 
under, a security-based swap, as the context may require. 15 U.S.C. 
78c(a)(13). Section 3(a)(14) of the Exchange Act, as amended by the 
Dodd-Frank Act (Pub. L. 111-203 Sec.  761(a)), defines the term sale 
to mean, in the case of security-based swaps, the execution, 
termination (prior to its scheduled maturity date), assignment, 
exchange, or similar transfer or conveyance of, or extinguishing of 
rights or obligations under, a security-based swap, as the context 
may require. See 15 U.S.C. 78c(a)(14).
    \636\ See 15 U.S.C. 78c-5(g); 11 U.S.C. 741(2).
---------------------------------------------------------------------------

    The provisions of section 3E(g) of the Exchange Act apply the 
customer protection elements of the stockbroker liquidation provisions 
to cleared security-based swaps, including related collateral, and, if 
subject to segregation requirements, to collateral delivered as margin 
for non-cleared security-based swaps.\637\ The Dodd-Frank Act 
established segregation requirements for cleared and non-cleared 
security-based swaps and provided the Commission with the authority to 
adopt rules with respect to segregation. In particular, section 763 of 
the Dodd-Frank Act amended the Exchange Act to add new section 3E.\638\ 
Section 3E sets forth requirements applicable to SBSDs and MSBSPs with 
respect to the segregation of cleared and non-cleared security-based 
swap collateral and provides the Commission with rulemaking authority 
in this area.\639\ The Commission also has concurrent authority under 
section 15(c)(3) of the Exchange Act to prescribe segregation 
requirements for broker-dealers.\640\
---------------------------------------------------------------------------

    \637\ See 15 U.S.C. 78c-5(g); 11 U.S.C. 741-753.
    \638\ See Public Law 111-203 Sec.  763; 15 U.S.C. 78c-5.
    \639\ See 15 U.S.C. 78c-5. Unlike the grants of capital and 
margin rulemaking authority in the Dodd-Frank Act, section 3E does 
not divide rulemaking authority for segregation requirements for 
SBSDs and MSBSPs between the Commission and the prudential 
regulators. Compare 15 U.S.C. 78o-10(e)(1), with 15 U.S.C. 78c-5. 
Consequently, the Commission's rulemaking authority in this area 
extends to bank SBSDs and bank MSBSPs. 15 U.S.C. 78c-5.
    \640\ See 15 U.S.C. 78o(c)(3). See also Public Law 111-203 Sec.  
771 (codified at 15 U.S.C. 78o-10(e)(3)(B)). Section 771 of the 
Dodd-Frank Act states that unless otherwise provided by its terms, 
its provisions relating to the regulation of the security-based swap 
markets do not divest any appropriate Federal banking agency, the 
Commission, the CFTC, or any other Federal or State agency, of any 
authority derived from any other provision of applicable law. See 
Public Law 111-203 Sec.  771. In addition, section 15F(e)(3)(B) of 
the Exchange Act provides that nothing in section 15F ``shall limit, 
or be construed to limit, the authority'' of the Commission ``to set 
financial responsibility rules for a broker or dealer * * * in 
accordance with Section 15(c)(3).'' 15 U.S.C. 78o-8(e)(3)(B).
---------------------------------------------------------------------------

    Section 3E(b)(1) of the Exchange Act provides that a broker, 
dealer, or SBSD shall treat and deal with all money, securities, and 
property of any security-based swap customer received to margin, 
guarantee, or secure a cleared security-based swap transaction as 
belonging to the customer.\641\ Section 3E(b)(2) provides that the 
money, securities, and property shall be separately accounted for and 
shall not be commingled with the funds of the broker, dealer, or SBSD 
or used to margin, secure, or guarantee any trades or contracts of any 
security-based swap customer or person other than the person for whom 
the money, securities, or property are held.\642\
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    \641\ See section 3E(b)(1) of the Exchange Act (15 U.S.C. 78c-
5(b)(1)). As indicated, the provisions of section 3E(b) do not apply 
to MSBSPs.
    \642\ See section 3E(b)(2) of the Exchange Act (15 U.S.C. 78c-
5(b)(2)).
---------------------------------------------------------------------------

    Section 3E(c)(1) of the Exchange Act provides that, notwithstanding 
section 3E(b), money, securities, and property of cleared security-
based swap customers of a broker, dealer, or SBSD may, for convenience, 
be commingled and deposited in the same one or more accounts with any 
bank, trust company, or clearing agency.\643\ Section 3E(c)(2) further 
provides that the Commission may by rule, regulation, or order 
prescribe terms and conditions under which money, securities, and 
property of a customer with respect to cleared security-based swaps may 
be commingled and deposited with any other money, securities, and 
property received by the broker, dealer, or SBSD and required by the 
Commission to be separately accounted for and treated and dealt with as 
belonging to the security-based swap customer of the broker, dealer, or 
SBSD.\644\
---------------------------------------------------------------------------

    \643\ See section 3E(c)(1) of the Exchange Act (15 U.S.C. 78c-
5(c)(1)).
    \644\ See section 3E(c)(2) of the Exchange Act (15 U.S.C. 78c-
5(c)(2)).
---------------------------------------------------------------------------

    With respect to non-cleared security-based swaps, section 
3E(f)(1)(A) of the Exchange Act provides that an SBSD and an MSBSP 
shall be required to notify a counterparty of the SBSD or MSBSP at the 
beginning of a non-cleared security-based swap transaction that the 
counterparty has the right to require the segregation of the funds or 
other property supplied to margin, guarantee, or secure the obligations 
of the counterparty.\645\ Section 3E(f)(1)(B) provides that, if 
requested by the counterparty, the SBSD or MSBSP shall segregate the 
funds or other property for the benefit of the counterparty and, in 
accordance with such rules and regulations as the Commission may 
promulgate, maintain the funds or other property in a segregated 
account separate from the assets and other interests of the SBSD or 
MSBSP.\646\ Section 3E(f)(3) provides that the segregated account shall 
be carried by an independent third-party custodian and be designated as 
a segregated account for and on behalf of the counterparty 
(``individual segregation'').\647\ In the case of non-cleared security-
based swaps, therefore, each counterparty has the right to require its 
collateral to be isolated in an account at an independent custodian 
that identifies the counterparty by name, rather than commingled with 
collateral of other counterparties.
---------------------------------------------------------------------------

    \645\ See 15 U.S.C. 78c-5(f)(1)(A). See also section 3E(f)(2)(A) 
of the Exchange Act, which provides that the provisions of section 
3E(f)(1) apply only to a security-based swap between a counterparty 
and SBSD or MSBSP that is not submitted for clearing to a clearing 
agency. See 15 U.S.C. 78c-5(f)(2)(A).
    \646\ See 15 U.S.C. 78c-5(f)(1)(B).
    \647\ See 15 U.S.C. 78c-5(f)(3).
---------------------------------------------------------------------------

    The objective of individual segregation is for the funds and other 
property of the counterparty to be carried in a manner that will keep 
these assets separate from the bankruptcy estate of the SBSD or MSBSP 
if it fails financially and becomes subject to a liquidation 
proceeding. Having these assets carried in a bankruptcy-remote manner 
protects the counterparty from the costs of retrieving assets through a 
bankruptcy proceeding caused, for example, because another counterparty 
of the SBSD or MSBSP defaults on its obligations to the SBSD or MSBSP.
    Section 3E(f)(2)(B)(i) of the Exchange Act provides that the 
segregation requirements for non-cleared security-based swaps do not 
apply to variation margin payments, so that the right of a counterparty 
to require individual account segregation applies only to initial and 
not variation margin.\648\ It also provides that the segregation 
requirements shall not preclude any commercial arrangement regarding 
the investment of segregated funds or other property that may only be 
invested in such investments as the Commission may permit by rule or 
regulation, and the related allocation of gains and losses

[[Page 70276]]

resulting from any investment of the segregated funds or other 
property.\649\ Finally, section 3E(f)(4) provides that if the 
counterparty does not choose to require segregation of funds or other 
property, the SBSD or MSBSP shall send a quarterly report to the 
counterparty that the firm's back office procedures relating to margin 
and collateral requirements are in compliance with the agreement of the 
counterparties.\650\
---------------------------------------------------------------------------

    \648\ See 15 U.S.C. 78c-5(f)(2)(B)(i).
    \649\ See 15 U.S.C. 78c-5(f)(2)(B)(ii). No requirements are 
being proposed at this time pursuant to the authority in section 
3E(f)(1)(B)(ii) of the Exchange Act.
    \650\ See section 3E(f)(4) of the Exchange Act (15 U.S.C. 78c-
5(f)(4)).
---------------------------------------------------------------------------

    Pursuant, in part, to the grants of rulemaking authority in 
sections 3E and 15(c)(3) of the Exchange Act, the Commission is 
proposing new Rule 18a-4 to establish segregation requirements for 
SBSDs with respect to cleared and non-cleared security-based swaps that 
would supplement the requirements in section 3E.\651\ Proposed new Rule 
18a-4 would apply to all types of SBSDs (i.e., it would apply to bank 
SBSDs, stand-alone SBSDs, and broker-dealer SBSDs).\652\ As discussed 
in more detail below, proposed new Rule 18a-4 would prescribe detailed 
requirements for how cash, securities, and money market instruments of 
a customer with cleared security-based swaps must be segregated when an 
SBSD commingles those assets with the cash and securities of other 
customers (``omnibus segregation'') pursuant to section 3E(c)(1) of the 
Exchange Act.\653\ In addition, the proposed rule would require that 
cash, securities, and money market instruments of a customer with 
respect to non-cleared security-based swaps must be treated in the same 
manner as cash, securities, and money market instruments of a customer 
with respect to cleared security-based swaps in cases where the 
counterparty does not elect individual segregation \654\ and does not 
affirmatively waive segregation altogether.\655\ In other words, 
proposed new Rule 18a-4 would establish an alternative omnibus, or 
``commingled'', segregation approach for non-cleared security-based 
swaps. This approach would be the default requirement under which an 
SBSD would be required to segregate securities and funds relating to 
non-cleared security-based swaps and, therefore, apply in the absence 
of a counterparty electing individual segregation or affirmatively 
waiving segregation.\656\
---------------------------------------------------------------------------

    \651\ See 15 U.S.C. 78c-5; 15 U.S.C. 78o(c)(3).
    \652\ Unlike section 15F of the Exchange Act that divides 
responsibility for capital and margin rules between the Commission 
and the prudential regulators, section 3E of the Exchange Act 
provides authority solely to the Commission. Compare 15 U.S.C. 78o-
10, with 15 U.S.C. 78c-5.
    \653\ See 15 U.S.C. 78c-5(c)(1).
    \654\ See 15 U.S.C. 78c-5(f)(1)-(3).
    \655\ See 15 U.S.C. 78c-5(f)(4).
    \656\ As discussed below in section II.C.2.c. of this release, 
an SBSD would be required to obtain a subordination agreement from a 
counterparty that waives segregation. By entering into the 
subordination agreement, the counterparty would affirmatively waive 
segregation. The absence of a subordination agreement would mean 
that the counterparty is presumed not to have waived segregation and 
the SBSD would need to treat the counterparty's cash, securities, 
and/or money market instruments pursuant to the omnibus segregation 
requirements of proposed new Rule 18a-4.
---------------------------------------------------------------------------

    The omnibus segregation requirements in Rule 18a-4 would not apply 
to MSBSPs.\657\ Consequently, if an MSBSP holds collateral from a 
counterparty with respect to non-cleared security-based swaps, it would 
be subject only to the segregation requirements in section 3E of the 
Exchange Act with respect to the collateral, and would not be required 
to segregate the collateral unless the counterparty required individual 
segregation under section 3E.\658\ The omnibus segregation requirements 
in Rule 18a-4 may not be practical for MSBSPs for the same reasons 
discussed in sections II.A.3. and II.B.2. of this release with respect 
to the proposed capital and margin requirements for MSBSPs (i.e., the 
potentially wide range of business models under which nonbank MSBSPs 
may operate under the proposed rule, and the uncertain impact that 
requirements designed for broker-dealers could have on these entities). 
MSBSPs will instead be subject to the provisions in section 3E(f) of 
the Exchange Act, which provide certain baseline segregation 
requirements for non-cleared security-based swaps.\659\ In addition, 
counterparties would be able to negotiate customized segregation 
agreements with MSBSPs, subject to these provisions.\660\
---------------------------------------------------------------------------

    \657\ As discussed in more detail below, MSBSPs would be subject 
to a notification requirement. See paragraph (d)(1) of proposed new 
Rule 18a-4.
    \658\ The provisions of section 3E of the Exchange Act governing 
cleared security-based swaps do not apply to nonbank MSBSPs. See 15 
U.S.C. 78c-5(b) (referring specifically to a ``broker, dealer, or 
security-based swap dealer'' and not to an MSBSP.).
    \659\ See 15 U.S.C. 78c-5(f).
    \660\ Id.
---------------------------------------------------------------------------

    As discussed in more detail below, the omnibus segregation 
requirements of Rule 18a-4 are modeled on the provisions of the broker-
dealer segregation rule--Rule 15c3-3.\661\ Rule 15c3-3 is designed ``to 
give more specific protection to customer funds and securities, in 
effect forbidding brokers and dealers from using customer assets to 
finance any part of their businesses unrelated to servicing securities 
customers; e.g., a firm is virtually precluded from using customer 
funds to buy securities for its own account.'' \662\ To meet this 
objective, Rule 15c3-3 requires a broker-dealer that maintains custody 
of customer securities and cash (a ``carrying broker-dealer'') to take 
two primary steps to safeguard these assets. The steps are designed to 
protect customers by segregating their securities and cash from the 
broker-dealer's proprietary business activities. If the broker-dealer 
fails financially, the securities and cash should be readily available 
to be returned to the customers. In addition, if the failed broker-
dealer is liquidated in a formal proceeding under SIPA, the securities 
and cash should be isolated and readily identifiable as ``customer 
property'' and, consequently, available to be distributed to customers 
ahead of other creditors.\663\
---------------------------------------------------------------------------

    \661\ See 17 CFR 240.15c3-3.
    \662\ See Net Capital Requirements for Brokers and Dealers, 
Exchange Act Release No. 21651 (Jan. 11, 1985), 50 FR 2690, 2690 
(Jan. 18, 1985). See also Broker-Dealers; Maintenance of Certain 
Basic Reserves, Exchange Act Release No. 9856 (Nov. 10, 1972), 37 FR 
25224, 25224 (Nov. 29, 1972).
    \663\ See 15 U.S.C. 78aaa et seq.
---------------------------------------------------------------------------

    The first step required by Rule 15c3-3 is that a carrying broker-
dealer must maintain physical possession or control over customers' 
fully paid and excess margin securities.\664\ Physical possession or 
control means the broker-dealer must hold these securities in one of 
several locations specified in Rule 15c3-3 and free of liens or any 
other

[[Page 70277]]

interest that could be exercised by a third-party to secure an 
obligation of the broker-dealer.\665\ Permissible locations include a 
bank, as defined in section 3(a)(6) of the Exchange Act, and a clearing 
agency.\666\
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    \664\ See 17 CFR 240.15c3-3(d). The term fully paid securities 
includes all securities carried for the account of a customer in a 
special cash account as defined in Regulation T promulgated by the 
Board of Governors of the Federal Reserve System, as well as margin 
equity securities within the meaning of Regulation T which are 
carried for the account of a customer in a general account or any 
special account under Regulation T during any period when section 8 
of Regulation T (12 CFR 220.8) specifies that margin equity 
securities shall have no loan value in a general account or special 
convertible debt security account, and all such margin equity 
securities in such account if they are fully paid: provided, 
however, that the term ``fully paid securities'' shall not apply to 
any securities which are purchased in transactions for which the 
customer has not made full payment. 17 CFR 240.15c3-3(a)(3). The 
term margin securities means those securities carried for the 
account of a customer in a general account as defined in Regulation 
T, as well as securities carried in any special account other than 
the securities referred to in paragraph (a)(3) of Rule 15c3-3. 17 
CFR 240.15c3-3(a)(4). The term excess margin securities means those 
securities referred to in paragraph (a)(4) of Rule 15c3-3 carried 
for the account of a customer having a market value in excess of 140 
percent of the total of the debit balances in the customer's account 
or accounts encompassed by paragraph (a)(4) of Rule 15c3-3 which the 
broker-dealer identifies as not constituting margin securities. 17 
CFR 240.15c3-3(a)(5).
    \665\ See 17 CFR 240.15c3-3(c). Customer securities held by the 
carrying broker-dealer are not assets of the firm. Rather, the 
carrying broker-dealer holds them in a custodial capacity and the 
possession and control requirement is designed to ensure that the 
carrying broker-dealer treats them in a manner that allows for their 
prompt return.
    \666\ Id.
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    The second step is that a carrying broker-dealer must maintain a 
reserve of funds or qualified securities in an account at a bank that 
is at least equal in value to the net cash owed to customers.\667\ The 
account must be titled ``Special Account for the Exclusive Benefit of 
Customers of the Broker-Dealer'' (``customer reserve account'').\668\ 
The amount of net cash owed to customers is computed pursuant to a 
formula set forth in Exhibit A to Rule 15c3-3 (``Exhibit A 
formula'').\669\ Under the Exhibit A formula, the broker-dealer adds up 
customer credit items (e.g., cash in customer securities accounts) and 
then subtracts from that amount customer debit items (e.g., margin 
loans).\670\ If credit items exceed debit items, the net amount must be 
on deposit in the customer reserve account in the form of cash and/or 
qualified securities.\671\ A broker-dealer cannot make a withdrawal 
from the customer reserve account until the next computation and even 
then only if the computation shows that the reserve requirement has 
decreased.\672\ The broker-dealer must make a deposit into the customer 
reserve account if the computation shows an increase in the reserve 
requirement.
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    \667\ 17 CFR 240.15c3-3(e). The term ``qualified security'' is 
defined in Rule 15c3-3 to mean a security issued by the United 
States or a security in respect of which the principal and interest 
are guaranteed by the United States (``U.S. government security''). 
See 17 CFR 240.15c3-3(a)(6).
    \668\ See 17 CFR 240.15c3-3(e)(1). The purpose of giving the 
account this title is to alert the bank and creditors of the broker-
dealer that this reserve fund is to be used to meet the broker-
dealer's obligations to customers (and not the claims of general 
creditors) in the event the broker-dealer must be liquidated in a 
formal proceeding.
    \669\ 17 CFR 240.15c3-3a.
    \670\ See id.
    \671\ 17 CFR 240.15c3-3(e). Customer cash is a balance sheet 
item of the carrying broker-dealer (i.e., the amount of cash 
received from a customer increases the amount of the carrying 
broker-dealer's assets and creates a corresponding liability to the 
customer). The reserve formula is designed to isolate these broker-
dealer assets so that an amount equal to the net liabilities to 
customers is held as a reserve in the form of cash or U.S. 
government securities. The requirement to establish this reserve is 
designed to effectively prevent the carrying broker-dealer from 
using customer funds for proprietary business activities such as 
investing in securities. The goal is to put the carrying broker-
dealer in a position to be able to readily meet its cash obligations 
to customers by requiring the firm to make deposits of cash and/or 
U.S. government securities into the customer reserve account in the 
amount of the net cash owed to customers.
    \672\ See 17 CFR 240.15c3-3(e).
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    In addition, the Exhibit A formula permits the broker-dealer to 
offset customer credit items only with customer debit items.\673\ This 
means the broker-dealer can use customer cash to facilitate customer 
transactions such as financing customer margin loans and borrowing 
securities to make deliveries of securities customers have sold 
short.\674\ As discussed above in section II.B. of this release, the 
broker-dealer margin rules require securities customers to maintain a 
minimum level of equity in their securities accounts. In addition to 
protecting the broker-dealer from the consequences of a customer 
default, this equity serves to over-collateralize the customers' 
obligations to the broker-dealer. This buffer protects the customers 
whose cash was used to facilitate the broker-dealer's financing of 
securities purchases and short-sales by customers. For example, if the 
broker-dealer fails, the customer debits, because they generally are 
over-collateralized, should be attractive assets for another broker-
dealer to purchase or, if not purchased by another broker-dealer, they 
should be able to be liquidated to a net positive equity.\675\ The 
proceeds of the debits sale or liquidation can be used to repay the 
customer cash used to finance the customer obligations. This cash plus 
the funds and/or U.S. government securities held in the customer 
reserve account should equal or exceed the total amount of customer 
credit items (i.e., the total amount owed by the broker-dealer to its 
customers).\676\
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    \673\ See 17 CFR 240.15c3-3a.
    \674\ For example, if a broker-dealer holds $100 for customer A, 
the broker-dealer can use that $100 to finance a security purchase 
of customer B. The $100 the broker-dealer owes customer A is a 
credit in the formula and the $100 customer B owes the broker-dealer 
is a debit in the formula. Therefore, under the Exhibit A formula 
there would be no requirement to maintain cash and/or U.S. 
government securities in the customer reserve account. However, if 
the broker-dealer did not use the $100 held in customer A's account 
for this purpose, there would be no offsetting debit and, 
consequently, the broker-dealer would need to have on deposit in the 
customer reserve account cash and/or U.S. government securities in 
an amount at least equal to $100.
    \675\ The attractiveness of the over-collateralized debits 
facilitates the bulk transfer of customer accounts from a failing or 
failed broker-dealer to another broker-dealer.
    \676\ See Net Capital Requirements for Broker-Dealers; Amended 
Rules, Exchange Act Release No. 18417 (Jan. 13, 1982), 47 FR 3512, 
3513 (Jan. 25, 1982) (``The alternative approach is founded on the 
concept that, if the debit items in the Reserve Formula can be 
liquidated at or near their contract value, these assets along with 
any cash required to be on deposit under the [customer protection] 
rule, will be sufficient to satisfy all liabilities to customers 
(which are represented as credit items in the Reserve Formula).'').
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    Proposed new Rule 18a-4 would contain certain provisions that are 
modeled on corresponding provisions of Rule 15c3-3.\677\ Paragraph (a) 
of the proposed rule would define key terms used in the rule.\678\ 
Paragraph (b) would require an SBSD to promptly obtain and thereafter 
maintain physical possession or control of all excess securities 
collateral (a term defined in paragraph (a)) and specify certain 
locations where excess securities collateral could be held and would be 
deemed to be in the SBSD's control.\679\ Paragraph (c) would require an 
SBSD to maintain a special account for the exclusive benefit of 
security-based swap customers and have on deposit in that account at 
all times an amount of cash and/or qualified securities (a term defined 
in paragraph (a)) determined through a computation using the formula in 
Exhibit A to proposed new Rule 18a-4.\680\ A broker-dealer SBSD would 
need to treat security-based swap accounts separately from other 
securities accounts and, consequently, would need to perform separate 
possession and control and reserve account computations for security-
based swap accounts and other securities accounts. The former would be 
subject to the possession and control and reserve account requirements 
in proposed new Rule 18a-4 and the latter would continue to be subject 
to the analogous requirements in Rule 15c3-3. This would keep separate 
the segregated customer property related to security-based swaps from 
customer property related to other securities, including property of 
retail securities customers.
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    \677\ Compare 17 CFR 240.15c3-3, with proposed new Rule 18a-4.
    \678\ Compare 17 CFR 240.15c3-3(a), with paragraph (a) of 
proposed new Rule 18a-4.
    \679\ Compare 17 CFR 240.15c3-3(b)-(d), with paragraph (b) of 
proposed new Rule 18a-4.
    \680\ Compare 17 CFR 240.15c3-3(e), with paragraph (c) of 
proposed new Rule 18a-4.
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    Paragraph (d) of Rule 18a-4 would contain certain additional 
provisions that do not have analogues in Rule 15c3-3. First, it would 
require an SBSD and an MSBSP to provide the notice required by section 
3E(f)(1)(A) of the Exchange Act prior to the execution of the first 
non-cleared security-based swap transaction with the counterparty.\681\ 
Second, it would require the SBSD to obtain subordination agreements 
from counterparties that opt out of the segregation requirements in 
proposed

[[Page 70278]]

new Rule 18a-4 because they either elect individual segregation 
pursuant to the provisions of section 3E(f) of the Exchange Act \682\ 
or agree that the SBSD need not segregate their assets at all.\683\
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    \681\ See 15 U.S.C. 78c-5(f)(1)(A); paragraph (d)(1) of proposed 
new Rule 18a-4.
    \682\ See 15 U.S.C. 78c-5(f)(1)-(3).
    \683\ See 15 U.S.C. 78c-5(f)(4).
---------------------------------------------------------------------------

    As discussed in more detail below, the omnibus segregation 
requirements in proposed new Rule 18a-4 are designed to accommodate the 
operational aspects of an SBSD collecting cash, securities, and/or 
money market instruments from security-based swap customers to margin 
cleared security-based swaps and delivering cash, securities, and/or 
money market instruments to registered clearing agencies to meet margin 
requirements of the clearing agencies with respect to the customers' 
transactions. Similarly, the omnibus segregation requirements are 
designed to accommodate the current practice of dealers in OTC 
derivatives to collect cash, securities, and/or money market 
instruments from a counterparty to cover current and potential future 
exposure arising from an OTC derivatives transaction with the 
counterparty and concurrently deliver cash, securities, and/or money 
market instruments to another dealer as collateral for an OTC 
derivatives transaction that hedges (takes the opposite side of) the 
OTC derivatives transaction with the counterparty. At the same time, 
the omnibus segregation requirements are designed to isolate, identify, 
and protect cash, securities, and/or money market instruments received 
by the SBSD as collateral for cleared and non-cleared security-based 
swaps, whether the collateral is held by the SBSD, a registered 
clearing agency, or another SBSD.
    Finally, the Commission is proposing a conforming amendment to add 
new paragraph (p) to Rule 15c3-3 to state that a broker-dealer that is 
registered as an SBSD pursuant to section 15F of the Exchange Act must 
also comply with the provisions of Rule 18a-4.\684\ This proposed 
amendment would clarify that a broker-dealer SBSD must comply with both 
Rule 15c3-3 and Rule 18a-4.
---------------------------------------------------------------------------

    \684\ See proposed paragraph (p) of Rule 15c3-3.
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Request for Comment
    The Commission generally requests comment on the approach of 
proposed new Rule 18a-4. In addition, the Commission requests comment, 
including empirical data in support of comments, in response to the 
following questions:
    1. Should there be rules under section 3E(f)(1)(B)(i) of the 
Exchange Act with respect to how an SBSD and an MSBSP must segregate 
funds and other property relating to non-cleared security-based swaps 
to supplement the individual segregation provisions in section 3E(f)? 
If so, describe the types of requirements the rules should impose.
    2. Should there be rules under section 3E(f)(2)(B)(ii)(I) of the 
Exchange Act with respect to how an SBSD and an MSBSP may invest funds 
or other property relating to non-cleared security-based swaps to 
supplement the individual segregation provisions in section 3E(f)? If 
so, describe the types of requirements the rules should impose. For 
example, should the rules require that the funds may be invested only 
in U.S. government securities or in qualified securities as that term 
is defined in paragraph (a)(5) of proposed new Rule 18a-4? Explain why 
or why not.
    3. Is it appropriate to model the segregation provisions for 
security-based swap customers on the provisions of Rule 15c3-3? If not, 
explain why and identify another segregation model.
    4. Should MSBSPs be required to comply with all the omnibus 
segregation requirements of proposed new Rule 18a-4? If so, explain 
why. If not, explain why not.
    5. Should the omnibus segregation requirements accommodate the 
ability to hold swaps in security-based swap customer accounts to 
facilitate a portfolio margin treatment for related or offsetting 
positions in the account? What practical or legal impediments may exist 
to doing so? If swaps could be held in the account along with security-
based swaps, how would the existence of differing bankruptcy regimes 
for securities and commodities instruments impact the ability to unwind 
positions or distribute assets to customers in the event of insolvency 
of the SBSD?
2. Proposed Rule 18a-4
a. Possession and Control of Excess Securities Collateral
    Paragraph (b)(1) of Rule 18a-4 would require an SBSD to promptly 
obtain and thereafter maintain physical possession or control of all 
excess securities collateral carried for the accounts of security-based 
swap customers.\685\ Physical possession or control as used in Rule 
15c3-3 means a broker-dealer cannot lend or hypothecate securities 
subject to the requirement and must hold them itself or, as is more 
common, in a satisfactory control location.\686\ As discussed below, 
physical possession or control is intended to have the same meaning in 
proposed new Rule 18a-4.
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    \685\ This paragraph is modeled on paragraph (b)(1) of Rule 
15c3-1. Compare 17 CFR 240.15c3-1(b)(1), with paragraph (b)(1) of 
proposed new Rule 18a-4.
    \686\ See Amendments to Financial Responsibility Rules for 
Broker-Dealers, 72 FR 12862.
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    The term security-based swap customer would be defined to mean any 
person from whom or on whose behalf the SBSD has received or acquired 
or holds funds or other property for the account of the person with 
respect to a cleared or non-cleared security-based swap 
transaction.\687\ The definition would exclude a person to the extent 
that person has a claim for funds or other property which by contract, 
agreement or understanding, or by operation of law, is part of the 
capital of the SBSD or is subordinated to all claims of security-based 
swap customers of the SBSD.\688\ This proposed definition of security-
based swap customer is modeled on the current definition of customer in 
Rule 15c3-3.\689\ As discussed above, an SBSD would be required to 
obtain subordination agreements from counterparties that elect 
individual segregation pursuant to the self-executing provisions of 
section 3E(f) of the Exchange Act \690\ or that waive segregation.\691\ 
Because these counterparties would enter into subordination agreements, 
they would not meet the definition of security-based swap customer and, 
consequently, the omnibus segregation requirements of proposed new Rule 
18a-4 would not apply to their funds and other property.\692\
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    \687\ See paragraph (a)(6) of proposed new Rule 18a-4. Paragraph 
(a)(1) of proposed Rule 18a-4 would define the term cleared 
security-based swap to mean a security-based swap that is, directly 
or indirectly, submitted to and cleared by a clearing agency 
registered with the Commission pursuant to section 17A of the 
Exchange Act (15 U.S.C. 78q-1). Any other security-based swap would 
be a non-cleared security-based swap.
    \688\ See paragraph (a)(6) of proposed new Rule 18a-4.
    \689\ Compare 17 CFR 240.15c3-3(a)(1), with paragraph (a)(6) of 
proposed new Rule 18a-4. The proposed definition also is based on 
the definitions of ``customer'' in 11 U.S.C. 741(2) and 15 U.S.C. 
78lll(2), which, respectively, apply to liquidations of stockbrokers 
under the stockbroker liquidation provisions and broker-dealers 
under the SIPA. As discussed above in section II.C.1 of this 
release, under these liquidation provisions, customers receive 
special protections such as priority claims to customer property 
over general creditors. See 11 U.S.C. 101 et seq.; 15 U.S.C. 78aaa 
et seq.
    \690\ See 15 U.S.C. 78c-5(f)(1)-(3).
    \691\ See 15 U.S.C. 78c-5(f)(4).
    \692\ Counterparties that elect individual segregation would not 
need the protections of the omnibus segregation requirements because 
their funds and other property would be held by an independent 
third-party custodian and, therefore, the third-party custodian--
rather than the SBSD--would owe the securities and funds to the 
counterparty. Counterparties that waive segregation, in effect, have 
agreed that their funds and other property can be used by the SBSD 
for its proprietary business purposes. Therefore, they have agreed 
to forego the benefits of segregation.

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[[Page 70279]]

    Proposed new Rule 18a-4 would define the term excess securities 
collateral to mean securities and money market instruments carried for 
the account of a security-based swap customer that have a market value 
in excess of the current exposure of the SBSD to the customer, 
excluding: (1) Securities and money market instruments held in a 
qualified clearing agency account but only to the extent the securities 
and money market instruments are being used to meet a margin 
requirement of the clearing agency resulting from a security-based swap 
transaction of the customer; and (2) securities and money market 
instruments held in a qualified registered security-based swap dealer 
account but only to the extent the securities and money market 
instruments are being used to meet a margin requirement of the other 
SBSD resulting from the SBSD entering into a non-cleared security-based 
swap transaction with the other SBSD to offset the risk of a non-
cleared security-based swap transaction between the SBSD and the 
customer. The proposed definition of excess securities collateral is 
based on the provisions of Rule 15c3-3 requiring a broker-dealer to 
maintain physical possession or control of fully paid and excess margin 
securities (i.e., securities that are not being used to secure the 
obligations of the customer to the broker-dealer).\693\ Under the 
proposed definition of excess securities collateral, securities and 
money market instruments of a security-based swap customer of the SBSD 
that are not being used to collateralize the SBSD's current exposure to 
the customer would need to be in the physical possession or control of 
the SBSD unless one of the two exceptions in the definition applies to 
the securities and money market instruments.
---------------------------------------------------------------------------

    \693\ See 17 CFR 240.15c3-3(d); 17 CFR 240.15c3-3(a)(3) 
(defining the term fully paid securities); 17 CFR 240.15c3-3(a)(4) 
(defining the term margin securities); 17 CFR 240.15c3-3(a)(5) 
(defining the term excess margin securities).
---------------------------------------------------------------------------

    The first exception in the definition refers to securities and 
money market instruments held in a qualified clearing agency account 
but only to the extent the securities and money market instruments are 
being used to meet a margin requirement of the clearing agency 
resulting from a security-based swap transaction of the customer. This 
exception is designed to accommodate the margin requirements of 
clearing agencies, which will require SBSDs to deliver margin 
collateral to the clearing agency to cover exposures arising from 
cleared security-based swaps of the SBSD's security-based swap 
customers.\694\ Customer securities and money market instruments 
provided to the clearing agency for this purpose would not meet the 
definition of excess securities collateral and, therefore, would not be 
subject to the physical possession or control requirement.\695\ This 
exception would allow the clearing agency to hold the securities as 
collateral against obligations of the SBSD's customers arising from 
their cleared security-based swaps.
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    \694\ As discussed above, security-based swap clearing agencies 
will require SBSDs to deliver margin collateral for the security-
based swap transactions of the SBSD's customers that are cleared by 
the clearing agency.
    \695\ While the Commission is proposing this exemption, these 
customer securities and money market instruments would still be 
required to be included in the SBSD's reserve formula calculation 
under proposed new Rule 18a-4a.
---------------------------------------------------------------------------

    The term qualified clearing agency account would be defined to mean 
an account of an SBSD at a clearing agency established to hold funds 
and other property in order to purchase, margin, guarantee, secure, 
adjust, or settle cleared security-based swaps of the SBSD's security-
based swap customers that meets the following conditions:
     The account is designated ``Special Clearing Account for 
the Exclusive Benefit of the Cleared Security-Based Swap Customers of 
[name of the SBSD]''; \696\
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    \696\ See paragraph (a)(3)(i) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (e)(1) of Rule 15c3-3, which 
requires a broker-dealer to maintain a ``Special Reserve Bank 
Account for the Exclusive Benefit of Customers.'' Compare 17 CFR 
240.15c3-3(e), with paragraph (a)(3)(i) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

     The clearing agency has acknowledged in a written notice 
provided to and retained by the SBSD that the funds and other property 
in the account are being held by the clearing agency for the exclusive 
benefit of the security-based swap customers of the SBSD in accordance 
with the regulations of the Commission and are being kept separate from 
any other accounts maintained by the SBSD with the clearing agency; 
\697\ and
---------------------------------------------------------------------------

    \697\ See paragraph (a)(3)(ii) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (f) of Rule 15c3-3, which requires 
a broker-dealer to obtain a written notification from a bank where 
it maintains a customer reserve account. Compare 17 CFR 240.15c3-
3(f), with paragraph (a)(3)(iii) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

     The account is subject to a written contract between the 
SBSD and the clearing agency which provides that the funds and other 
property in the account shall be subject to no right, charge, security 
interest, lien, or claim of any kind in favor of the clearing agency or 
any person claiming through the clearing agency, except a right, 
charge, security interest, lien, or claim resulting from a cleared 
security-based swap transaction effected in the account.\698\
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    \698\ See paragraph (a)(3)(iii) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (f) of Rule 15c3-3, which requires 
a broker-dealer to obtain a contract from a bank where it maintains 
a ``Special Reserve Bank Account for the Exclusive Benefit of 
Customers.'' Compare 17 CFR 240.15c3-3(f), with paragraph (a)(3)(ii) 
of proposed new Rule 18a-4.
---------------------------------------------------------------------------

    These provisions are designed to ensure that securities and money 
market instruments of security-based swap customers related to cleared 
security-based swaps provided to a clearing agency are isolated from 
the proprietary assets of the SBSD and identified as property of the 
security-based swap customers.
    The second exception in the definition of excess securities 
collateral is for securities and money market instruments held in a 
qualified registered security-based swap dealer account but only to the 
extent the securities and money market instruments are being used to 
meet a margin requirement of the other SBSD resulting from the SBSD 
entering into a non-cleared security-based swap transaction with the 
other SBSD to offset the risk of a non-cleared security-based swap 
transaction between the SBSD and the customer. This exception is 
designed to accommodate the practice of dealers in OTC derivatives 
transactions maintaining ``matched books'' of transactions in which an 
OTC derivatives transaction with a counterparty is hedged with an 
offsetting transaction with another dealer. SBSDs, as dealers in 
security-based swaps, are expected to actively manage the risk of their 
non-cleared security-based swap positions by entering into offsetting 
transactions with other SBSDs.\699\ These other SBSDs may require 
margin collateral from the SBSD.\700\ Customer securities and

[[Page 70280]]

money market instruments provided to another SBSD for this purpose 
would be excepted from the definition of excess securities collateral 
and, therefore, would not be subject to the physical possession or 
control requirement. Thus, this provision would allow an SBSD to 
finance customer transactions in non-cleared security-based swaps by 
using customer collateral to secure offsetting transactions with 
another SBSD, provided that the collateral is held in an account with 
the other SBSD that meets certain requirements.
---------------------------------------------------------------------------

    \699\ For example, assume an SBSD and a counterparty enter into 
a CDS security-based swap on XYZ Company with a notional amount of 
$10 million and term of five years and in which the SBSD is the 
seller of protection and counterparty is the buyer of protection. 
The SBSD could enter into a matching transaction (a CDS security-
based swap on XYZ Company with a notional amount of $10 million and 
term of five years) with another SBSD in which the SBSD is the buyer 
of protection and the other SBSD is the seller of protection. This 
would match the transaction with the counterparty with the 
transaction with the other SBSD and hedge the SBSD's risk resulting 
from the transaction with the customer.
    \700\ As discussed above in section II.B.2.c.i. of this release, 
an SBSD would not be required to collect collateral equal to the 
margin amount if the counterparty was another SBSD under the 
Alternative A account equity requirement in proposed new Rule 18a-3. 
See paragraph (c)(1)(iii)(B)--Alternative A of proposed new Rule 
18a-3. Consequently, an SBSD would not be required to maintain a 
minimum level of positive equity in its account at another SBSD with 
respect to non-cleared security-based swaps. This would mean that 
the SBSD may not need to provide collateral to the other SBSD other 
than an amount necessary to cover the current exposure of the other 
SBSD, which, in turn could reduce the need to use securities and 
money market instruments of security-based swap customers to 
collateralize hedging transactions. However, under the Alternative B 
account equity requirement, an SBSD would be required to provide 
collateral equal to the margin amount to the other SBSD. See 
paragraph (c)(1)(iii)(B)--Alternative B of proposed new Rule 18a-3. 
This could increase the need to use securities and money market 
instruments of security-based swap customers to collateralize 
hedging transactions.
---------------------------------------------------------------------------

    The term qualified registered security-based swap dealer account 
(``qualified SBSD account'') would be defined to mean an account at 
another SBSD registered with the Commission pursuant to section 15F of 
the Exchange Act that is not an affiliate of the SBSD and that meets 
the following conditions:
     The account is designated ``Special Account for the 
Exclusive Benefit of the Security-Based Swap Customers of [name of the 
SBSD]''; \701\
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    \701\ See paragraph (a)(4)(i) of proposed new Rule 18a-4. 
Similar to the proposed conditions for a qualified clearing agency 
account, this provision is modeled on paragraph (e)(1) of Rule 15c3-
3, which requires a broker-dealer to maintain a ``Special Reserve 
Bank Account for the Exclusive Benefit of Customers.'' Compare 17 
CFR 240.15c3-3(e), with paragraph (a)(4)(i) of proposed new Rule 
18a-4.
---------------------------------------------------------------------------

     The account is subject to a written acknowledgement by the 
other SBSD provided to and retained by the SBSD that the funds and 
other property held in the account are being held by the other SBSD for 
the exclusive benefit of the security-based swap customers of the SBSD 
in accordance with the regulations of the Commission and are being kept 
separate from any other accounts maintained by the SBSD with the other 
SBSD; \702\
---------------------------------------------------------------------------

    \702\ See paragraph (a)(4)(ii) of proposed new Rule 18a-4. 
Similar to the proposed conditions for a qualified clearing agency 
account, this provision is modeled on paragraph (f) of Rule 15c3-3, 
which requires a broker-dealer to obtain a written notification from 
a bank where it maintains a ``Special Reserve Bank Account for the 
Exclusive Benefit of Customers.'' Compare 17 CFR 240.15c3-3(f), with 
paragraph (a)(4)(ii) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

     The account is subject to a written contract between the 
SBSD and the other SBSD which provides that the funds and other 
property in the account shall be subject to no right, charge, security 
interest, lien, or claim of any kind in favor of the other SBSD or any 
person claiming through the SBSD, except a right, charge, security 
interest, lien, or claim resulting from a non-cleared security-based 
swap transaction effected in the account; \703\ and
---------------------------------------------------------------------------

    \703\ See paragraph (a)(4)(iii) of proposed new Rule 18a-4. 
Similar to the proposed conditions for a qualified clearing agency 
account, this provision is modeled on paragraph (f) of Rule 15c3-3, 
which requires a broker-dealer to obtain a contract from a bank 
where it maintains a ``Special Reserve Bank Account for the 
Exclusive Benefit of Customers.'' Compare 17 CFR 240.15c3-3(f), with 
paragraph (a)(4)(iii) of proposed new Rule 18a-4.
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     The account and the assets in the account are not subject 
to any type of subordination agreement.\704\
---------------------------------------------------------------------------

    \704\ See paragraph (a)(4)(iv) of proposed new Rule 18a-4.

These conditions are largely identical to the conditions for a 
qualified clearing agency account and are similarly designed to ensure 
that securities and money market instruments of security-based swap 
customers relating to non-cleared security-based swaps provided to 
another SBSD are isolated from the proprietary assets of the SBSD and 
are identified as property of the security-based swap customers. 
Further, the account and the assets in the account could not be subject 
to any type of subordination agreement. This condition is designed to 
ensure that if the other SBSD holding the qualified SBSD account fails, 
the SBSD accountholder will be treated as a security-based swap 
customer in a liquidation proceeding and, therefore, could make a pro 
rata claim for customer property with other customers ahead of all 
other creditors.\705\
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    \705\ See paragraph (a)(6) of proposed new Rule 18a-4 (excluding 
persons who subordinate their claims against the SBSD to all other 
creditors from the definition of security-based swap customer).
---------------------------------------------------------------------------

    Paragraph (b)(2) of proposed new Rule 18a-4 would identify five 
satisfactory control locations for excess securities collateral.\706\ 
Rule 15c3-3 identifies the same locations as satisfactory control 
locations.\707\ Proposed new Rule 18a-4 would provide that an SBSD has 
control of excess securities collateral only if the securities and 
money market instruments:
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    \706\ See paragraph (b)(2) of proposed new Rule 18a-4.
    \707\ Compare 17 CFR 240.15c3-3(c), with paragraph (b)(2) of 
proposed new Rule 18a-4. Rule 15c3-3 identifies two control 
locations that the Commission is not proposing be identified in 
proposed new Rule 18a-4. First, paragraph (c)(2) of Rule 15c3-3 
identifies as a control location ``a special omnibus account in the 
name of such broker or dealer with another broker or dealer in 
compliance with the requirements of section 4(b) of Regulation T 
under the Act (12 CFR 220.4(b)), such securities being deemed to be 
under the control of such broker or dealer to the extent that he has 
instructed such carrying broker or dealer to maintain physical 
possession or control of them free of any charge, lien, or claim of 
any kind in favor of such carrying broker or dealer or any persons 
claiming through such carrying broker or dealer.'' See 17 CFR 
240.15c3-3(c)(2). Stand-alone SBSDs are not expected to maintain 
such accounts. Second, Rule 15c3-3 identifies as a control location 
``a foreign depository, foreign clearing agency or foreign custodian 
bank which the Commission upon application from a broker or dealer, 
a registered national securities exchange or a registered national 
securities association, or upon its own motion shall designate as a 
satisfactory control location for securities.'' See 17 CFR 240.15c3-
3(c)(4). See also Interpretative Release: Guidelines for Control 
Locations for Foreign Securities, Exchange Act Release No. 10429 
(Oct. 12, 1973), 38 FR 29217, 29217 (Oct. 23, 1973). As discussed 
below, the last control location identified in Rule 15c3-3 and 
proposed to be identified in new Rule 18a-4 is such other location 
``as the Commission shall upon application from a broker or dealer 
find and designate to be adequate for the protection of customer 
securities.'' See 17 CFR 240.15c3-3(c)(7) and paragraph (b)(2)(v) of 
proposed new Rule 18a-4. Under the Commission's proposal, SBSDs 
seeking to have a foreign depository, foreign clearing agency, or 
foreign custodian bank identified as a satisfactory control location 
would need to apply to the Commission under paragraph (b)(2)(v) of 
proposed new Rule 18a-4.
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     Are represented by one or more certificates in the custody 
or control of a clearing corporation or other subsidiary organization 
of either national securities exchanges, or of a custodian bank in 
accordance with a system for the central handling of securities 
complying with the provisions of Exchange Act Rule 8c-1(g) and Exchange 
Act Rule 15c2-1(g) the delivery of which certificates to the SBSD does 
not require the payment of money or value, and if the books or records 
of the SBSD identify the security-based swap customers entitled to 
receive specified quantities or units of the securities so held for 
such security-based swap customers collectively; \708\
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    \708\ See paragraph (b)(2)(i) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (c)(1) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(c)(1), with paragraph (b)(2)(i) of proposed new Rule 
18a-4.
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     Are the subject of bona fide items of transfer; provided 
that securities and money market instruments shall be deemed not to be 
the subject of bona fide items of transfer if, within 40 calendar days 
after they have been transmitted for transfer by the SBSD to the issuer 
or its transfer agent, new certificates conforming to the instructions 
of the SBSD have not been received by the SBSD, the SBSD has not

[[Page 70281]]

received a written statement by the issuer or its transfer agent 
acknowledging the transfer instructions and the possession of the 
securities and money market instruments, or the security-based swap 
dealer has not obtained a revalidation of a window ticket from a 
transfer agent with respect to the certificate delivered for transfer; 
\709\
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    \709\ See paragraph (b)(2)(ii) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (c)(3) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(c)(3), with paragraph (b)(2)(ii) of proposed new Rule 
18a-4.
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     Are in the custody or control of a bank as defined in 
section 3(a)(6) of the Act, the delivery of which securities and money 
market instruments to the SBSD does not require the payment of money or 
value and the bank having acknowledged in writing that the securities 
and money market instruments in its custody or control are not subject 
to any right, charge, security interest, lien or claim of any kind in 
favor of a bank or any person claiming through the bank; \710\
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    \710\ See paragraph (b)(2)(iii) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (c)(5) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(c)(5), with paragraph (b)(2)(iii) of proposed new 
Rule 18a-4.
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     Are held in or are in transit between offices of the SBSD; 
or are held by a corporate subsidiary if the SBSD owns and exercises a 
majority of the voting rights of all of the voting securities of such 
subsidiary, assumes or guarantees all of the subsidiary's obligations 
and liabilities, operates the subsidiary as a branch office of the 
SBSD, and assumes full responsibility for compliance by the subsidiary 
and all of its associated persons with the provisions of the Federal 
securities laws as well as for all of the other acts of the subsidiary 
and such associated persons; \711\ or
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    \711\ See paragraph (b)(2)(iv) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (c)(6) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(c)(6), with paragraph (b)(2)(iv) of proposed new Rule 
18a-4.
---------------------------------------------------------------------------

     Are held in such other locations as the Commission shall 
upon application from an SBSD find and designate to be adequate for the 
protection of customer securities.\712\
---------------------------------------------------------------------------

    \712\ See paragraph (b)(2)(v) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (c)(7) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(c)(7), with paragraph (b)(2)(v) of proposed new Rule 
18a-4. See Guidelines for Control Locations for Foreign Securities, 
Exchange Act Release No. 10429 (Oct. 12, 1973, 38 FR 29217 (Oct. 23, 
1973) (prescribing the process under Rule 15c3-3 for a broker-dealer 
to apply to the Commission to utilize a foreign control location). 
Among other things, certain conditions must be met for the foreign 
control location to be deemed satisfactory. A broker-dealer must 
represent in an application to the Commission that the conditions 
are satisfied. An application submitted shall be considered accepted 
unless the Commission rejects the application within 90 days of 
receipt by the Commission. Id.

The identification of these locations as satisfactory control locations 
is designed to limit where the SBSD can hold excess securities 
collateral. The identified locations are places from which the 
securities and money market instruments can promptly be retrieved and 
returned to the security-based swap customers.
    Paragraph (b)(3) of Rule 18a-4 would require that each business day 
the SBSD must determine from its books and records the quantity of 
excess securities collateral that the firm had in possession and 
control as of the close of the previous business day and the quantity 
of excess securities collateral the firm did not have in possession or 
control on that day.\713\ The paragraph would provide further that the 
SBSD must take steps to retrieve excess securities collateral from 
certain specifically identified non-control locations if securities and 
money market instruments of the same issue and class are at these 
locations.\714\ Specifically, paragraph (b)(3) would provide that if 
securities or money market instruments of the same issue and class are:
---------------------------------------------------------------------------

    \713\ See paragraph (b)(3) of proposed new Rule 18a-4. The 
provisions in this paragraph are modeled on the provisions in 
paragraph (d) of Rule 15c3-3. Compare 17 CFR 240.15c3-3(d), with 
paragraph (b)(3) of proposed new Rule 18a-4.
    \714\ See paragraph (b)(3) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

     Subject to a lien securing an obligation of the SBSD, then 
the SBSD, not later than the next business day on which the 
determination is made, must issue instructions for the release of the 
securities or money market instruments from the lien and must obtain 
physical possession or control of the securities and money market 
instruments within two business days following the date of the 
instructions; \715\
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    \715\ See paragraph (b)(3)(i) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (d)(1) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(d)(1), with paragraph (b)(3)(i) of proposed new Rule 
18a-4.
---------------------------------------------------------------------------

     Held in a qualified clearing agency account, then the 
SBSD, not later than the next business day on which the determination 
is made, must issue instructions for the release of the securities or 
money market instruments by the clearing agency and must obtain 
physical possession or control of the securities or money market 
instruments within two business days following the date of the 
instructions; \716\
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    \716\ See paragraph (b)(3)(ii) of proposed new Rule 18a-4. As 
discussed above, securities held in a qualified clearing agency 
account are not excess securities collateral, but only to the extent 
the securities are being used to meet a margin requirement of the 
clearing agency resulting from a security-based swap transaction of 
the customer. See paragraph (a)(2)(i) of proposed new Rule 18a-4. 
Consequently, if securities held in a qualified clearing agency 
account are not necessary to meet a margin requirement of the 
clearing agency, they would be excess securities collateral and the 
SBSD would need to move them to a satisfactory control location.
---------------------------------------------------------------------------

     Held in a qualified SBSD account maintained by another 
SBSD, then the SBSD, not later than the next business day on which the 
determination is made, must issue instructions for the release of the 
securities and money market instruments by the other SBSD and must 
obtain physical possession or control of the securities or money market 
instruments within two business days following the date of the 
instructions; \717\
---------------------------------------------------------------------------

    \717\ See paragraph (b)(3)(iii) of proposed new Rule 18a-4. As 
discussed above, securities held in a qualified SBSD account are not 
excess securities collateral but only to the extent the securities 
are being used to meet a margin requirement of the other SBSD 
resulting from the SBSD entering into a non-cleared security-based 
swap transaction with the other SBSD to offset the risk of a non-
cleared security-based swap transaction between the SBSD and the 
customer. See paragraph (a)(2)(ii) of proposed new Rule 18a-4. 
Consequently, if securities held in a qualified clearing agency 
account are not necessary to meet a margin requirement of the other 
SBSD and/or are not collateralizing a transaction that offsets the 
risk of n non-cleared security-based swap with the customer, they 
would be excess securities collateral and the SBSD would need to 
move them to a satisfactory control location.
---------------------------------------------------------------------------

     Loaned by the SBSD, then the SBSD, not later than the next 
business day on which the determination is made, must issue 
instructions for the return of the loaned securities and money market 
instruments and must obtain physical possession or control of the 
securities or money market instruments within five business days 
following the date of the instructions; \718\
---------------------------------------------------------------------------

    \718\ See paragraph (b)(3)(iv) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (d)(1) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(d)(1), with paragraph (b)(3)(iv) of proposed new Rule 
18a-4.
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     Failed to receive more than 30 calendar days, then the 
SBSD, not later than the next business day on which the determination 
is made, must take prompt steps to obtain physical possession or 
control of the securities or money market instruments through a buy-in 
procedure or otherwise; \719\
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    \719\ See paragraph (b)(3)(v) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (d)(2) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(d)(2), with paragraph (b)(3)(v) of proposed new Rule 
18a-4.
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     Receivable by the SBSD as a security dividend, stock split 
or similar distribution for more than 45 calendar days, then the SBSD, 
not later than the next business day on which the determination is 
made, must take

[[Page 70282]]

prompt steps to obtain physical possession or control of the securities 
or money market instruments through a buy-in procedure or otherwise; 
\720\ or
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    \720\ See paragraph (b)(3)(vi) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (d)(3) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(d)(3), with paragraph (b)(3)(vi) of proposed new Rule 
18a-4.
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     Included on the books or records of the SBSD as a 
proprietary short position or as a short position for another person 
more than 10 business days (or more than 30 calendar days if the SBSD 
is a market maker in the securities), then the SBSD must, not later 
than the business day following the day on which the determination is 
made, take prompt steps to obtain physical possession or control of 
such securities or money market instruments.\721\
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    \721\ See paragraph (b)(3)(vii) of proposed new Rule 18a-4. This 
provision is modeled on a proposed amendment to Rule 15c3-3 that is 
still pending. See Amendments to Financial Responsibility Rules for 
Broker-Dealers, 72 FR at 12895. The provisions of paragraph 
(b)(3)(vii) of proposed new Rule 18a-4 are intended to achieve the 
same objectives of the proposed amendments to Rule 15c3-3. See id. 
at 12865-66 (explaining the basis for the proposed amendment to Rule 
15c3-3).
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Request for Comment
    The Commission generally requests comment on the proposed physical 
possession and control requirements in proposed new Rule 18a-4. In 
addition, the Commission requests comment, including empirical data in 
support of comments, in response to the following questions:
    1. Are possession and control requirements modeled on Rule 15c3-3 
appropriate for security-based swaps? If not, explain why not.
    2. Is the proposed definition of security-based swap customer 
appropriate? If not, explain why not and suggest modifications to the 
definition.
    3. Is the proposed definition of excess securities collateral 
appropriate? If not, explain why not and suggest modifications to the 
definition.
    4. Is the proposed exception in the definition of excess securities 
collateral for securities and money market instruments held in a 
qualified clearing agency account appropriate? If not, explain why not. 
Would this proposed exception raise practical or legal issues? If so, 
explain why.
    5. Is the proposed definition of qualified clearing agency account 
appropriate? If not, explain why not and suggest modifications to the 
definition.
    6. Is the proposed exception in the definition of excess securities 
collateral for securities and money market instruments held in a 
qualified registered security-based swap dealer account appropriate? If 
not, explain why not. Would this proposed exception raise practical or 
legal issues? If so, explain why.
    7. Is the proposed definition of qualified registered security-
based swap dealer account appropriate? For example, is the condition 
that the qualified registered security-based swap dealer account not be 
held by an affiliate of the SBSD appropriate? If the definition is not 
appropriate, explain why not and suggest modifications to the 
definition.
    8. How do dealers in OTC derivatives that will be security-based 
swaps use offsetting transactions to hedge the risk of these positions? 
Would the proposed possession and control requirements for non-cleared 
security-based swaps adversely affect the ability of SBSDs to enter 
into hedging transactions? If so, explain why and suggest modifications 
to the requirements that could address this issue.
    9. Are the control locations identified in proposed new Rule 18a-4 
appropriate for security-based swaps? If not, explain why not. Should 
the two additional control locations in paragraphs (c)(2) and (c)(4) of 
Rule 15c3-3 that are not being incorporated into proposed new Rule 18a-
4 be included in the rule? If so, explain why.
    10. Should the process for applying to the Commission to have a 
location designated to be adequate for the protection of customer 
securities and money market instruments under paragraph (b)(2)(v) of 
proposed new Rule 18a-4 be similar to the current process for a broker-
dealer to utilize a foreign control location under Rule 15c3-3 (i.e., a 
process in which the SBSD must submit an application representing that 
certain conditions are met and in which an application is deemed 
accepted if not specifically rejected by the Commission within 90 
days)? Alternatively, should the Commission be required to formally act 
on each application through the issuance of an order?
    11. Are the steps in paragraph (b)(3) of proposed new Rule 18a-4 
that an SBSD would be required to take to move securities and money 
market instruments from non-control locations to control locations 
appropriate for security-based swaps? If not, explain why not.
    12. Are there any possession and control provisions in Rule 15c3-3 
that are not being incorporated in proposed new Rule 18a-4 that should 
be included in the rule? If so, identify them and explain why they 
should be incorporated into proposed new Rule 18a-4.
b. Security-Based Swap Customer Reserve Account
    Paragraph (c)(1) of Rule 18a-4 would require an SBSD, among other 
things, to maintain a special account for the exclusive benefit of 
security-based swap customers separate from any other bank account of 
the SBSD.\722\ The term special account for the exclusive benefit of 
security-based swap customers (``Rule 18a-4 Customer Reserve Account'') 
would be defined to mean an account at a bank that is not the SBSD or 
an affiliate of the SBSD and that meets the following conditions:
---------------------------------------------------------------------------

    \722\ See paragraph (c) of proposed new Rule 18a-4. The 
provisions of paragraph (c) of proposed new Rule 18a-4 are modeled 
on paragraph (e) of Rule 15c3-3. Compare 17 CFR 240.15c3-3(e), with 
paragraph (c) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

     The account is designated ``Special Account for the 
Exclusive Benefit of the Security-Based Swap Customers of [name of the 
SBSD]''; \723\
---------------------------------------------------------------------------

    \723\ See paragraph (a)(7)(i) of proposed new Rule 18a-4. 
Similar to the proposed conditions for a qualified clearing agency 
account and a qualified SBSD account, this provision is modeled on 
paragraph (e)(1) of Rule 15c3-3, which requires a broker-dealer to 
maintain a ``Special Reserve Bank Account for the Exclusive Benefit 
of Customers'' (the ``Rule 15c3-3 Customer Reserve Account''). 
Compare 17 CFR 240.15c3-3(e), with paragraph (a)(7)(i) of proposed 
new Rule 18a-4.
---------------------------------------------------------------------------

     The account is subject to a written acknowledgement by the 
bank provided to and retained by the SBSD that the funds and other 
property held in the account are being held by the bank for the 
exclusive benefit of the security-based swap customers of the SBSD in 
accordance with the regulations of the Commission and are being kept 
separate from any other accounts maintained by the SBSD with the bank; 
\724\ and
---------------------------------------------------------------------------

    \724\ See paragraph (a)(7)(ii) of proposed new Rule 18a-4. 
Similar to the proposed conditions for a qualified clearing agency 
account and a qualified SBSD account, this provision is modeled on 
paragraph (f) of Rule 15c3-3, which requires a broker-dealer to 
obtain a written notification from a bank where it maintains a Rule 
15c3-3 Customer Reserve Account. Compare 17 CFR 240.15c3-3(f), with 
paragraph (a)(7)(ii) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

     The account is subject to a written contract between the 
SBSD and the bank which provides that the funds and other property in 
the account shall at no time be used directly or indirectly as security 
for a loan or other extension of credit to the SBSD by the bank and, 
shall be subject to no right, charge, security interest, lien, or claim 
of any kind in favor of the bank or any person claiming through the 
bank.\725\
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    \725\ See paragraph (a)(7)(iii) of proposed new Rule 18a-4. 
Similar to the proposed conditions for a qualified clearing agency 
account and a qualified SBSD account, this provision is modeled on 
paragraph (f) of Rule 15c3-3, which requires a broker-dealer to 
obtain a written contract from a bank where it maintains a ``Special 
Reserve Bank Account for the Exclusive Benefit of Customers.'' 
Compare 17 CFR 240.15c3-3(f), with paragraph (a)(7)(iii) of proposed 
new Rule 18a-4.


[[Page 70283]]


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These conditions are largely identical to the conditions for a 
qualified clearing agency account and qualified SBSD account and are 
similarly designed to ensure that cash and qualified securities 
deposited into the special bank account (as discussed below) are 
isolated from the proprietary assets of the SBSD and identified as 
property of the security-based swap customers.
    Paragraph (c)(1) of proposed new Rule 18a-4 would provide that the 
SBSD must at all times maintain in a Rule 18a-4 Customer Reserve 
Account, through deposits into the account, cash and/or qualified 
securities in amounts computed in accordance with the formula set forth 
in Exhibit A to Rule 18a-4.\726\ The formula in Exhibit A to proposed 
new Rule 18a-4 is modeled on the formula in Exhibit A to Rule 15c3-1, 
which requires a broker-dealer to add up various credit items and debit 
items.\727\ The credit items include credit balances in customer 
accounts and funds obtained through the use of customer 
securities.\728\ The debit items include money owed by customers (e.g., 
from margin lending), securities borrowed by the broker-dealer to 
effectuate customer short sales, and required margin posted to certain 
clearing agencies as a consequence of customer securities 
transactions.\729\ If, under the formula, customer credit items exceed 
customer debit items, the broker-dealer must maintain cash and/or 
qualified securities in that net amount in a Rule 15c3-3 Customer 
Reserve Account.
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    \726\ See paragraph (c)(1) of proposed new Rule 18a-4; Exhibit A 
to proposed new Rule 18a-4.
    \727\ Compare 17 CFR 240.15c3-3a, with Exhibit A to proposed new 
Rule 18a-4.
    \728\ See 17 CFR 240.15c3-3a, Items 1-9. Broker-dealers are 
permitted to use customer margin securities to, for example, obtain 
bank loans to finance the funds used to lend to customers to 
purchase the securities. The amount of the bank loan is a credit in 
the formula because this is the amount that the broker-dealer would 
need to pay the bank to retrieve the securities. Similarly, broker-
dealers may use customer margin securities to make stock loans to 
other broker-dealers in which the lending broker-dealer typically 
receives cash in return. The amount payable to the other broker-
dealer on the stock loan is a credit in the formula because this is 
the amount the broker-dealer would need to pay the other broker-
dealer to retrieve the securities.
    \729\ See 17 CFR 240.15c3-3a, Items 10-14. Item 13 identifies as 
a debit item margin required and on deposit with the Options 
Clearing Corporation for all option contracts written or purchased 
in accounts of securities customers. See 17 CFR 240.15c3-3a, Item 
13. Similarly, Item 14 identifies as a debit item margin related to 
security futures products written, purchased, or sold in accounts 
carried for security-based swap customers required and on deposit 
with a clearing agency registered with the Commission under section 
17A of the Exchange Act (15 U.S.C. 78q-1) or a DCO registered with 
the CFTC under section 5b of the CEA (7 U.S.C. 78q-1). These debits 
reflect the fact that customer options and security futures 
transactions that are cleared generate margin requirements in which 
the broker-dealer must deliver collateral to the Options Clearing 
Corporation in the case of options or a clearing agency or DCO in 
the case of security futures products. Identifying the collateral 
delivered to the Options Clearing Corporation, a clearing agency, or 
a DCO as a debit item permits the broker-dealer to use customer cash 
or securities to meet margin requirements generated by customer 
transactions.
---------------------------------------------------------------------------

    The formula in Exhibit A for determining the amount to be 
maintained in a Rule 18a-4 Customer Reserve Account similarly would 
require an SBSD to add up credit items and debit items.\730\ If, under 
the formula, the credit items exceed the debit items, the SBSD would be 
required to maintain cash and/or qualified securities in that net 
amount in a Rule 18a-4 Customer Reserve Account.\731\ The credit and 
debit items identified in Exhibit A to proposed new Rule 18a-4 are the 
same as the credit and debit items in Exhibit A to Rule 15c3-1, though 
Exhibit A to proposed new Rule 18a-4 would identify two additional 
debit items.\732\ As discussed above, SBSDs will be required to deliver 
collateral to meet margin requirements of clearing agencies arising 
from cleared security-based swap transactions of their customers. In 
addition, SBSDs may deliver collateral to other SBSDs to meet margin 
requirements under proposed new Rule 18a-3 and, possibly, to meet 
``house'' margin requirements of the other SBSD with respect to non-
cleared security-based swaps the SBSD is using to hedge the risk of 
customer non-cleared security-based swaps. Consequently, Exhibit A to 
proposed new Rule 18a-4 would identify the following debit items that 
are not identified in Exhibit A to Rule 15c3-3:
---------------------------------------------------------------------------

    \730\ See proposed new Rule 18a-4a. Exhibit A to Rule 15c3-3 has 
a number of ``Notes'' that provide further explanation of the credit 
and debit items. See 17 CFR 240.15c3-3a, Notes A-G. Exhibit A to 
proposed new Rule 18a-4 would have substantially similar notes. See 
Notes A-G to Exhibit A to proposed new Rule 18a-4.
    \731\ As discussed above, the account would need to be at a bank 
that is not the SBSD or an affiliate of the SBSD and that meets 
certain additional conditions. See paragraph (a)(7) of proposed new 
Rule 18a-4.
    \732\ Compare 17 CFR 240.15c3-3a, with Exhibit A to proposed new 
Rule 18a-4.
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     Margin related to cleared security-based swap transactions 
in accounts carried for security-based swap customers required and on 
deposit at a clearing agency registered with the Commission pursuant to 
section 17A of the Exchange Act (15 U.S.C. 78q-1); and
     Margin related to non-cleared security-based swap 
transactions in accounts carried for security-based swap customers held 
in a qualified registered SBSD account at another SBSD.

These debit items would serve the same purpose as the debit items in 
Exhibit A to Rule 15c3-3 that identify margin required and on deposit 
at the Options Clearing Corporation, a registered clearing agency, and 
a DCO.\733\
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    \733\ See 17 CFR 240.15c3-3a, Items 13-14.
---------------------------------------------------------------------------

    If the total credits exceed the total debits, an SBSD would need to 
maintain that amount on deposit in a Rule 18a-4 Customer Reserve 
Account in the form of funds and/or qualified securities.\734\ An SBSD 
would be permitted under the proposed rule to use qualified securities 
to meet this account deposit requirement to implement section 3E(d) of 
the Exchange Act.\735\ Section 3E(d) provides that money of security-
based swap customers received by an SBSD to margin, guarantee, or 
secure a cleared security-based swap may be invested in obligations of 
the United States, obligations fully guaranteed as to principal and 
interest by the United States, general obligations of a State or any 
subdivision of a State (``municipal securities''), and in any other 
investment that the Commission may by rule or regulation 
prescribe.\736\ Section 3E(d) further provides that such investments 
shall be made in accordance with such rules and regulations and subject 
to such conditions as the Commission may prescribe.\737\
---------------------------------------------------------------------------

    \734\ See paragraph (c)(1) of proposed new Rule 18a-4.
    \735\ 15 U.S.C. 78c-5(d).
    \736\ Id.
    \737\ Id.
---------------------------------------------------------------------------

    The term qualified security as used in proposed new Rule 18a-4 
would be defined to mean: (1) Obligations of the United States; (2) 
obligations fully guaranteed as to principal and interest by the United 
States; and (3) general obligations of any State or subdivision of a 
State that are not traded flat or are not in default, were part of an 
initial offering of $500 million or greater, and were issued by an 
issuer that has published audited financial statements within 120 days 
of its most recent fiscal year-end.\738\ Rule 15c3-3 contains a similar 
definition of qualified security, except the definition does not 
include municipal securities.\739\
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    \738\ See paragraph (a)(5) of proposed new Rule 18a-4.
    \739\ See 17 CFR 240.15c3-3(a)(6) (defining the term qualified 
security to mean a security issued by the United States or a 
security in respect of which the principal and interest are 
guaranteed by the United States).
---------------------------------------------------------------------------

    While section 3E(d) of the Exchange Act permits the use of 
municipal

[[Page 70284]]

securities, the rule imposes conditions on their use designed to ensure 
that only municipal securities with the most reliable valuations--and 
therefore greater safety and liquidity--are permitted to meet the Rule 
18a-4 Customer Reserve Account funding requirement in paragraph (c)(1) 
of proposed new Rule 18a-4 (consistent with the objective of the 
current definition of ``qualified security'' in Rule 15c3-3).\740\ 
Because of the diversity and breadth of the municipal market, the 
availability of issuer information and the related ability to value and 
trade a particular municipal security can vary considerably.\741\ The 
objective of segregation requirements is to isolate customer assets 
from a firm's proprietary business and, therefore, enable the firm to 
quickly return the assets to the customers if the firm fails. Rule 
15c3-3 limits the definition of qualified securities to U.S. government 
securities to ensure that securities deposited in a customer reserve 
account can be liquidated quickly at current market values even in 
stressed market conditions. The proposed conditions for depositing 
municipal securities into the SBSD's Rule 18a-4 Customer Reserve 
Account are designed to help ensure that only securities that are 
likely to have significant issuer information available and that can be 
valued and liquidated quickly at current market values are permitted to 
meet the minimum account deposit requirement.\742\
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    \740\ See paragraphs (a)(5)(iii)(A)-(C) of proposed new Rule 
18a-4.
    \741\ Despite its size and importance, the municipal securities 
market has not been subject to the same level of regulation as other 
sectors of the U.S. capital markets. See Commission, Report on the 
Municipal Securities Market (July 31, 2012) (``Municipal Securities 
Report''), available at http://www.sec.gov/news/studies/2012/munireport073112.pdf. The Municipal Securities Report notes concerns 
about access to issuer information; the presentation and 
comparability of information; and the existence/adequacy of 
disclosure controls and procedures. Id. at iv, 108-09. For example, 
the Municipal Securities Report notes that studies have shown that 
disclosure of audited annual financial statements by many municipal 
issuers is particularly slow. Id. at 76. By the time annual 
financial statements are filed or otherwise publicly available, many 
municipal market analysts and investors believe that the financial 
information has diminished usefulness or has lost relevance in 
assessing the current financial position of a municipal issuer. Id. 
Correspondingly, weaker or more distressed entities are more likely 
to have later audit completion times. Id. In addition, the Municipal 
Securities Report notes that although there have been improvements 
in the availability of pricing information about completed trades 
(i.e., post-trade information), the secondary market for municipal 
securities remains opaque. Investors have very limited access to 
information regarding which market participants would be interested 
in buying or selling a municipal security, and at which prices 
(i.e., pre-trade information). Id. at vi, 115.
    \742\ See Municipal Securities Report at 113-115 (recognizing 
the municipal securities market's ``relatively low liquidity'' and 
the ``relatively opaque'' pre-trade information about municipal 
securities' prices).
---------------------------------------------------------------------------

    The first proposed condition for municipal securities is that they 
must be general obligation bonds. General obligation bonds are backed 
by the full faith and credit and/or taxing authority of the 
issuer.\743\ They normally are issued to finance non-revenue producing 
public works projects (e.g., schools and roads) and generally are paid 
off with funds from taxes or fees. Issuers typically have the ability 
to raise taxes in order to service the debt obligations of these 
municipal securities. In contrast, revenue bonds are issued to fund 
projects that will eventually generate revenue (e.g., a toll road). The 
anticipated revenue is used to make payments of principal and interest 
owing on the bonds. Revenue bonds generally do not permit the 
bondholders to compel taxation or legislative appropriation of funds 
not pledged for the purpose of servicing the debt obligations of these 
municipal securities.\744\ Consequently, the creditworthiness of 
revenue bonds depends on the success of the project being financed, 
whereas the creditworthiness of general obligation bonds ultimately 
depends on the taxing authority of the issuer. Therefore, general 
obligation bonds tend to have lower rates of default than other types 
of municipal securities.\745\ In order to limit the use of municipal 
securities in the Rule 18a-4 Customer Reserve Account to the most 
creditworthy instruments,\746\ the proposed definition of qualified 
security would limit the use of municipal securities to general 
obligation bonds.
---------------------------------------------------------------------------

    \743\ See Municipal Securities Report at 7.
    \744\ Id.
    \745\ See, e.g., Moody's Investor Services (``Moody's''), 
Special Comment: U.S. Municipal Bonds Defaults and Recoveries, 1970-
2011, at 1 (Mar. 7, 2012), available at http://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_140114. See also 
Municipal Securities Report, at 7 (noting reports indicate that a 
majority of defaults in the municipal securities market are in 
conduit revenue bonds issued for nongovernmental purposes, such as 
multi-family housing, healthcare (hospitals and nursing homes), and 
industrial development bonds (for economic development and 
manufacturing purposes).
    \746\ See Fitch Ratings (``Fitch''), Default Risk and Recovery 
Rates on U.S. Municipal Bonds, note 116, at 1 (Jan. 9, 2007), 
available at http://www.cdfa.net/cdfa/cdfaweb.nsf/ordredirect.html?open&id=fitchdefaultreport.html Fitch is not aware 
of any state or local municipality of size that has experienced a 
permanent or extended default on its general obligation bonds since 
the Great Depression, so that in one of its studies, Fitch assumed a 
100% recovery rate on general obligation bonds). Id. See also 
Moody's, Special Comment: Moody's US Municipal Bond Rating Scale, 11 
(Nov. 2002), available at http://www.moodys.com/sites/products/DefaultResearch/2001700000407258.pdf. Similarly, Moody's 
acknowledged the ``anticipated near 100% recovery rate on any 
defaulted general obligation bond,'' because there have been no 
defaults among Moody's-rated issuers of general obligation bonds 
since at least 1970. Id.
---------------------------------------------------------------------------

    The second proposed condition for the use of municipal securities 
is that they must be part of an initial offering of $500 million or 
greater. The size of the initial offering is an indication of the size 
of the market for a particular issuer's municipal securities. 
Additionally, the secondary market for a municipal security is 
generally smaller than for the initial offering.\747\ The $500 million 
threshold is designed to be large enough to ensure that the market for 
a particular issuer's securities is large enough that the securities 
can be liquidated quickly and at their current market price in order to 
raise cash to return to an SBSD's customers.
---------------------------------------------------------------------------

    \747\ While almost all municipal bonds trade in the first month 
following the initial offering, only 15% trade in the second month, 
and even fewer trade in subsequent months. Municipal Securities 
Report at 113-14 (citing Richard C. Green, Burton Hollifield and 
Normal Sch[uuml]rhoff, Financial Intermediation and the Costs of 
Trading in an Opaque Market, 20 Rev. Fin. Stud. 275, 282 (2007)).
---------------------------------------------------------------------------

    The third proposed condition for the use of municipal securities is 
that they must be issued by an issuer that has published audited 
financial statements within 120 days of its most recent fiscal year-
end.\748\ Prices for municipal securities issued by issuers that have 
published relatively current information about their financial 
condition may tend to be more transparent than prices for municipal 
securities issued by issuers for which such financial information is 
not available, because investors and analysts have more current 
information to assess the creditworthiness of the issuer and to inform 
pricing decisions.\749\
---------------------------------------------------------------------------

    \748\ See, e.g., Notice of Filing of Amendment No. 2 and Order 
Granting Accelerated Approval of Proposed Rule Change, as Modified 
by Amendment Nos. 1 and 2 Thereto, Relating to Additional Voluntary 
Submissions by Issuers to the MSRB's Electronic Municipal Market 
Access System (``EMMA[supreg]''), Exchange Act Release No. 62183 
(May 26, 2010), 75 FR 30876 (June 2, 2010) (``MSRB Rule Filing''). 
The MSRB stated that, ``issuers that seek to make their financial 
information available under the voluntary annual filing undertaking 
also would be bringing the timing of their disclosures into closer 
conformity with the timeframes that investors in the registered 
securities market have come to rely upon.'' Id. at 30882.
    \749\ See MSRB Notice 2010-15 (June 2, 2010), available at 
http://www.msrb.org/Rules-and-Interpretations/Regulatory-Notices/2010/2010-15.aspx?n=1 (requesting voluntary submissions of audited 
financial statements within 120 calendar days of the fiscal year-
end, or as a transitional alternative available through December 31, 
2013, within 150 calendar days of the fiscal year-end). Timely 
financial reporting ``is critical to the functioning of an efficient 
trading market,'' especially since bond ratings are only updated 
when a significant change is about to occur, and credit reports 
represent a costly alternative. Municipal Securities Report at 74 
(citing Jeff L. Payne and Kevin L. Jensen, An Examination of 
Municipal Audit Delay, J. Acc. & Pub. Pol'y, Vol. 21, Issue 1, 3 
(2002)).

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[[Page 70285]]

    As discussed above, an SBSD would be required to add up credit 
items and debit items pursuant to the formula in Exhibit A to proposed 
new Rule 18a-1. If, under the formula, the credit items exceed the 
debit items, the SBSD would be required to maintain cash and/or 
qualified securities in that net amount in the Rule 18a-4 Customer 
Reserve Account. Paragraph (c)(1) of proposed new Rule 18a-4 would 
require an SBSD to take certain deductions for purposes of this 
requirement.\750\ The amount of cash and/or qualified securities in the 
Rule 18a-4 Customer Reserve Account would need to equal or exceed the 
amount required pursuant to the formula in Exhibit A to proposed new 
Rule 18a-1after applying the deductions.
---------------------------------------------------------------------------

    \750\ See paragraph (c)(1) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

    First, the SBSD would need to deduct the percentage of the value of 
municipal securities specified in paragraph (c)(2)(vi) of Rule 15c3-
1.\751\ Paragraph (c)(2)(vi) of Rule 15c3-1 prescribes the standardized 
haircuts a broker-dealer must apply to municipal securities when 
computing net capital. For the purposes of proposed new Rule 18a-4, the 
SBSD would need to apply the standardized haircuts to municipal 
securities held in the Rule 18a-4 Customer Reserve Account even if the 
firm is approved to use VaR models for purposes of computing its net 
capital under Appendix E to Rule 15c3-1, as proposed to be amended, or 
proposed new Rule 18a-1. The purpose of these deductions would be to 
account for potential market losses that may be incurred when municipal 
securities held in a Rule 18a-4 Customer Reserve Account are liquidated 
to return funds to security-based swap customers.
---------------------------------------------------------------------------

    \751\ See 17 CFR 240.15c3-1(c)(2)(vi)(B).
---------------------------------------------------------------------------

    Second, the SBSD would need to deduct the aggregate value of the 
municipal securities of a single issuer to the extent the value exceeds 
2% of the amount required to be maintained in the Rule 18a-4 Customer 
Reserve Account. The Commission preliminarily believes that this 
deduction would serve as a reasonable benchmark designed to avoid the 
potential that the SBSD might use customer funds to establish a 
concentrated position in municipal securities of a single issuer. A 
concentrated position could be more difficult to liquidate at current 
market values.
    Third, the SBSD would need to deduct the aggregate value of all 
municipal securities to the extent the amount of the securities exceeds 
10% of the amount required to be maintained in the Rule 18a-4 Customer 
Reserve Account. The Commission preliminarily believes that this 
deduction would serve as a reasonable benchmark designed to limit the 
amount of customer funds an SBSD could invest in municipal 
securities.\752\ As noted above, the segregation provisions are 
designed to prevent an SBSD from using customer property for 
proprietary business purposes such as paying expenses. The purpose of 
the deposits into the Rule 18a-4 Customer Reserve Account is to create 
a reserve to protect the funds of security-based swap customers. The 
deposits are not intended as a means for the SBSD to earn investment 
returns by, for example, establishing positions in higher yielding 
municipal securities. The 10% threshold is designed to limit the 
ability of the SBSD to use the Rule 18a-4 Customer Reserve Account 
deposit requirement to invest in municipal securities, for the purpose 
of obtaining higher yields than U.S. government securities.
---------------------------------------------------------------------------

    \752\ Compare to Rule 15c3-1(c)(2)(vi)(M)(1) (imposing undue 
concentration charges on certain securities in the proprietary 
account of a broker-dealer whose market value exceeds more than 10% 
of the ``net capital'' of a broker-dealer before application of 
haircuts).
---------------------------------------------------------------------------

    Fourth, the SBSD would be required to deduct the amount of funds 
held in a Rule 18a-4 Customer Reserve Account at a single bank to the 
extent the amount exceeds 10% of the equity capital of the bank as 
reported by the bank in its most recent Consolidated Report of 
Condition and Income (``Call Report'').\753\ This provision is 
consistent with a pending proposed amendment to Rule 15c3-3.\754\ As 
the Commission stated when proposing the amendment to Rule 15c3-3:
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    \753\ With the passage of the Dodd-Frank Act, the supervision of 
savings associations was transferred from the Office of Thrift 
Supervision to the OCC for federal savings associations and to the 
FDIC for state savings associations on the ``transfer date,'' which 
is defined as one year after enactment of the Dodd-Frank Act, 
subject to an additional six month extension. See section Public Law 
111-203 Sec. Sec.  300-378. See also List of OTS Regulations to be 
Enforced by the OCC and the FDIC Pursuant to the Dodd-Frank Act, 
OCC, FDIC, 76 FR 39246 (July 6, 2011). Supervision of savings and 
loan holding companies and their subsidiaries (other than depository 
institutions) was transferred from the OTS to the Federal Reserve. 
Therefore, in February 2011, the OTS, the OCC, and the FDIC proposed 
to require, ``savings associations currently filing the Thrift 
Financial Report to convert to filing the Consolidated Reports of 
Condition and Income or Call Reports beginning with the reporting 
period ending on March 31, 2012.'' Proposed Agency Information 
Collection Activities; Comment Request, 76 FR 7082, 7082 (Feb. 8, 
2011).
    \754\ Amendments to Financial Responsibility Rules for Broker-
Dealers, 72 FR at 12864.

    Broker-dealers must deposit cash or ``qualified securities'' 
into the customer reserve account maintained at a ``bank'' under 
Rule 15c3-3(e). Rule 15c3-3(f) further requires the broker-dealer to 
obtain a written contract from the bank in which the bank agrees not 
to re-lend or hypothecate securities deposited into the reserve 
account. Consequently, the securities should be readily available to 
the broker-dealer. Cash deposits, however, are fungible with other 
deposits carried by the bank and may be freely used in the course of 
the bank's commercial lending activities. Therefore, to the extent a 
broker-dealer deposits cash in a reserve bank account, there is a 
risk the cash could be lost or inaccessible for a period if the bank 
experiences financial difficulties. This could adversely impact the 
broker-dealer and its customers if the balance of the reserve 
deposit is concentrated at one bank in the form of cash.\755\
---------------------------------------------------------------------------

    \755\ Id.

The deduction in proposed new Rule 18a-4 is designed to address the 
same risk to SBSDs that the Commission identified with respect to 
concentrating in a single bank cash deposits in a customer reserve 
account maintained under Rule 15c3-1.
    Paragraph (c)(2) of proposed new Rule 18a-4 would provide that it 
is unlawful for an SBSD to accept or use credits identified in the 
items of the formula set forth in Exhibit A to proposed new Rule 18a-4 
except to establish debits for the specified purposes in the items of 
the formula.\756\ This provision would prohibit the SBSD from using 
customer cash and cash realized from the use of customer securities for 
purposes other than those identified in the debit items in Exhibit A to 
proposed new Rule 18a-4. Thus, the SBSD would be prohibited from using 
customer cash to, for example, pay expenses.
---------------------------------------------------------------------------

    \756\ See paragraph (c)(2) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (e)(2) of Rule 15c3-3. Compare 17 
CFR 240.15c3-3(e)(2), with paragraph (c)(2) of proposed new Rule 
18a-4.
---------------------------------------------------------------------------

    Paragraph (c)(3) of proposed new Rule 18a-4 would provide that the 
computations necessary to determine the amount required to be 
maintained in the Rule 18a-4 Customer Reserve Account must be made 
daily as of the close of the previous business day and any deposit 
required to be made into the account must be made on the next business 
day following the computation no later than one hour after the opening 
of the bank that maintains the account.\757\ Paragraph (c)(3) also 
would provide that the SBSD may make a

[[Page 70286]]

withdrawal from the Rule 18a-4 Customer Reserve Account only if the 
amount remaining in the account after the withdrawal is equal to or 
exceeds the amount required to be maintained in the account.\758\
---------------------------------------------------------------------------

    \757\ See paragraph (c)(3) of proposed new Rule 18a-4.
    \758\ Id.
---------------------------------------------------------------------------

    Proposed new Rule 18a-4 would require a daily computation as 
opposed to the weekly computation that is required by Rule 15c3-3. The 
margin requirements of clearing agencies and other SBSDs for security-
based swaps are expected generally to be determined on a daily basis, 
which will require SBSDs to deliver collateral to, and receive the 
return of collateral from, clearing agencies and other SBSDs on a daily 
basis.\759\ If the Rule 18a-4 Customer Reserve Account computation were 
performed on a weekly basis, the SBSD might need to fund margin 
requirements relating to customer security-based swaps using its own 
funds for up to a week because the customer cash necessary to meet the 
requirement is ``locked up'' in the Rule 18a-4 Customer Reserve Account 
and cannot be withdrawn for a number of days, which could cause 
liquidity strains on the SBSD.
---------------------------------------------------------------------------

    \759\ As discussed above in section II.B.2.b.i. of this release, 
proposed new Rule 18a-3 would require a nonbank SBSD to calculate 
the equity in the account of each counterparty on a daily basis and 
to collect collateral needed to collateralize an account equity 
requirement on the next business day. See paragraphs (c)(1)(i)-(ii) 
of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    Finally, paragraph (c)(4) of proposed new Rule 18a-4 would require 
an SBSD to promptly deposit funds or qualified securities into a Rule 
18a-4 Customer Reserve Account of the SBSD if the amount of funds and/
or qualified securities held in one or more Rule 18a-4 Customer Reserve 
Accounts falls below the amount required to be maintained pursuant to 
the rule.\760\ This proposal is designed to require an SBSD to use its 
own resources to fund the deposit requirement if there is a shortfall 
in the amount of cash or qualified securities maintained in its Rule 
18a-4 Customer Reserve Account.
---------------------------------------------------------------------------

    \760\ See paragraph (c)(4) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the requirements for 
the Rule 18a-4 Customer Reserve Account in proposed new Rule 18a-4. In 
addition, the Commission requests comment, including empirical data in 
support of comments, in response to the following questions:
    1. Are Rule 18a-4 Customer Reserve Account requirements modeled on 
Rule 15c3-3 appropriate for security-based swaps? If not, explain why 
not.
    2. Is the proposed definition of special account for the exclusive 
benefit of security-based swap customers appropriate? If not, explain 
why not and suggest modifications to the definition.
    3. Are the proposed credit and debit items in Exhibit A to proposed 
new Rule 18a-4 appropriate? If not, explain why not. Are there 
alternative or additional credit and debit items that should be 
included in the formula? If so, describe them and explain why they 
should be included in the formula.
    4. How would the formula computation for a broker-dealer SBSD 
differ from the formula computation for a stand-alone SBSD? For 
example, the debit items relating to financing securities transactions 
would not apply to stand-alone SBSDs as financing securities 
transactions would need to be conducted in a broker-dealer. 
Consequently, should there be a separate Exhibit A formula for stand-
alone SBSDs?
    5. Are the two additional debit items in Exhibit A to proposed new 
Rule 18a-4 relating to margin collateral required and on deposit at 
clearing agencies, DCOs, and other SBSDs appropriate? If not, explain 
why not.
    6. Note G to Exhibit A to proposed new Rule 18a-4 is analogous to 
Note G to Exhibit A to Rule 15c3-3. Note G to Exhibit A to Rule 15c3-3 
prescribes (and Note G to Exhibit A to proposed new Rule 18a-1 would 
prescribe) the conditions for when a clearing agency or DCO can qualify 
for purposes of including debits in the reserve formula under Item 14 
(margin related to security futures products). Should these conditions 
apply to when a clearing agency would qualify for purposes of including 
debits in the Rule 18a-4 Customer Reserve Account formula under Item 
15? If so, explain why. If not, explain why not. For example, could the 
Note G conditions, if applied to Item 15, be used instead of the 
proposed definition of qualified clearing agency account in proposed 
new Rule 18a-4? Would the Note G conditions be a workable alternative 
to the proposed definition? Would the Note G conditions achieve the 
same customer protection objectives as the proposed definition?
    7. Is the proposed definition of qualified security appropriate? If 
not, explain why not and suggest modifications to the definition. For 
example, should additional types of securities be included in the 
definition? If so, identify the types of securities and explain why 
they should be included in the definition and how their inclusion would 
meet the objective of segregation that customer cash is not used to 
make proprietary investments.
    8. Is the proposed condition to the definition of qualified 
security that municipal securities be general obligation bonds in the 
definition appropriate? If not, explain why not. Identify other types 
of municipal securities that should be included and explain how their 
inclusion would be consistent with the objective that only the most 
highly liquid securities (i.e., securities capable of being liquidated 
at market value even during times of market stress) be permitted to 
meet the Rule 18a-4 Customer Reserve Account deposit requirement.
    9. It is expected that the proposed condition that municipal 
securities be part of an initial offering of $500 million or greater in 
the definition of qualified security would limit qualifying securities 
to a very small percentage of general obligation municipal security 
issuances.\761\ Would the $500 million threshold be appropriate? If 
not, explain why not. For example, should this threshold be a greater 
amount (e.g., $750 million, $1 billion, or some other amount) or a 
lesser amount (e.g., $250 million, $100 million, or some other amount)? 
If so, indicate the recommended threshold and explain why it would be 
preferable.
---------------------------------------------------------------------------

    \761\ Data source: Mergent's Municipal Bond Securities Database.
---------------------------------------------------------------------------

    10. Is the proposed condition that municipal securities must be 
issued by an issuer that has published audited financial statements 
within 120 days of its most recent fiscal year-end in the definition of 
qualified security appropriate? If not, explain why not.
    11. The MSRB Rule Filing contemplates those issuers who are engaged 
in the voluntary annual filing undertaking will be able to provide the 
information to the MSRB's Electronic Muni Market Access System within 
150 calendar days after the end of the applicable fiscal year prior to 
January 1, 2014. The 150 calendar day time frame is an interim measure 
and would no longer be available after January 1, 2014. Should 
municipal securities that otherwise meet the definition of qualified 
securities be permitted if the issuer submits financial information 
within 150 calendar days after the end of the applicable fiscal year 
during this transitional period that would end on January 1, 2014?
    12. Is the proposed deduction for municipal securities held in a 
Rule 18a-4 Customer Reserve Account equal to the percentage specified 
in paragraph

[[Page 70287]]

(c)(2)(vi) of Rule 15c3-1 appropriate? If not, explain why not.
    13. Is the proposed deduction for municipal securities of a single 
issuer held in a Rule 18a-4 Customer Reserve Account in excess of 2% of 
the amount required to be maintained in the account appropriate? If 
not, explain why not. For example, should the threshold be greater 
(e.g., 3%, 5%, 7%, 10%, or some other amount) or lesser (e.g., 1.5%, 
1%, 0.5%, or some other amount)? If so, identify the recommended 
threshold and explain why it would be preferable.
    14. Is the proposed deduction for municipal securities held in a 
Rule 18a-4 Customer Reserve Account in excess of 10% of the amount 
required to be maintained in the account appropriate? If not, explain 
why not. For example, should the threshold be greater (e.g., 15%, 20%, 
25%, 30%, or some other amount) or lesser (e.g., 7%, 5%, 3%, or some 
other amount)? If so, identify the recommended threshold and explain 
why it would be preferable.
    15. Is the proposed deduction for the amount that funds held in a 
Rule 18a-4 Customer Reserve Account at a single bank exceed 10% of the 
equity capital of the bank as reported by the bank in its most recent 
Call Report appropriate? If not, explain why not. For example, should 
the threshold be greater (e.g., 15%, 20%, 25%, 30%, or some other 
amount) or lesser (e.g., 7%, 5%, 3%, or some other amount)? If so, 
identify the recommended threshold and explain why it would be 
preferable.
    16. Is it appropriate to require that the computations to determine 
the amount required to be maintained in the Rule 18a-4 Customer Reserve 
Account must be made daily as of the close of the previous business day 
and any deposit required to be made into the account must be made on 
the next business day following the computation? If not, explain why 
not. For example, should the computations be required on a weekly basis 
consistent with Rule 15c3-3? If so, explain why.
    17. Are there any customer reserve account provisions in Rule 15c3-
1 that are not being incorporated in proposed new Rule 18a-4 that 
should be included in the rule? If so, identify them and explain why 
they should be incorporated into proposed new Rule 18a-4.
    18. More generally, are there any provisions in Rule 15c3-1 that 
are not being incorporated in proposed new Rule 18a-4 that should be 
included in the rule? If so, identify them and explain why they should 
be incorporated into proposed new Rule 18a-4.
c. Special Provisions for Non-Cleared Security-Based Swap 
Counterparties
    Paragraph (d) of proposed new Rule 18a-4 would require an SBSD and 
an MSBSP to provide the notice required by section 3E(f)(1)(A) of the 
Exchange Act prior to the execution of the first non-cleared security-
based swap with the counterparty.\762\ Paragraph (d) also would require 
an SBSD to obtain subordination agreements from counterparties that opt 
out of the omnibus segregation requirements in proposed new Rule 18a-4 
because they either elect individual segregation pursuant to the self-
executing provisions of section 3E(f) of the Exchange Act \763\ or 
agree that the SBSD need not segregate their assets at all.\764\
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    \762\ See 15 U.S.C. 78c-5(f)(1)(A); paragraph (d)(1) of proposed 
new Rule 18a-4.
    \763\ See 15 U.S.C. 78c-5(f)(1)-(3).
    \764\ See 15 U.S.C. 78c-5(f)(4).
---------------------------------------------------------------------------

Notice Requirement
    The provisions in section 3E(f) of the Exchange Act allow a program 
by which a counterparty to non-cleared security-based swaps with an 
SBSD or an MSBSP can choose individual segregation.\765\ These 
provisions provide a framework of baseline requirements that can be 
supplemented by commercial arrangements between counterparties and 
SBSDs and MSBSPs. Proposed new Rule 18a-4 would augment these 
provisions by prescribing when the notice specified in section 
3E(f)(1)(A) must be provided to the counterparty by the SBSD or MSBSP. 
Section 3E(f)(1)(A) provides that an SBSD and an MSBSP shall be 
required to notify the counterparty at the ``beginning'' of a non-
cleared security-based swap transaction about the right to require 
segregation of the funds or other property supplied to margin, 
guarantee, or secure the obligations of the counterparty.\766\ To 
provide greater clarity as to the meaning of ``beginning'' as used in 
the statute, paragraph (d)(1) of proposed new Rule 18a-4 would require 
an SBSD or MSBSP to provide the notice in writing to a counterparty 
prior to the execution of the first non-cleared security-based swap 
transaction with the counterparty occurring after the effective date of 
the rule.\767\ Consequently, the notice would need to be given in 
writing to the counterparty prior to the execution of a transaction 
and, therefore, before the counterparty is required to deliver margin 
collateral to the SBSD or MSBSP. The notice, therefore, would give the 
counterparty an opportunity to determine whether to elect individual 
segregation, waive segregation, or, by not electing individual 
segregation or waiving segregation, to have the collateral segregated 
pursuant to the omnibus segregation provisions of proposed new Rule 
18a-4.
---------------------------------------------------------------------------

    \765\ See 15 U.S.C. 78c-5(f)(1)-(3).
    \766\ See 15 U.S.C. 78c-5(f)(4).
    \767\ See paragraph (c)(1) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

Subordination Agreements
    Paragraph (d)(2) of proposed new Rule 18a-4 would require an SBSD 
to obtain agreements from counterparties that either elect individual 
segregation or waive segregation altogether that such counterparties 
subordinate all of their claims against the SBSD to the claims of 
security-based swap customers.\768\ By entering into subordination 
agreements, these counterparties would not meet the definition of 
security-based swap customer in proposed new Rule 18a-4.\769\ They also 
would not be entitled to share ratably with security-based swap 
customers in the fund of customer property held by the SBSD if it is 
liquidated. This provision would be consistent with text in Rule 15c3-3 
concerning the exclusion of persons whose interests are subordinated 
from the definition of ``customer.'' \770\
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    \768\ See paragraph (d)(2) of proposed new Rule 18a-4.
    \769\ See paragraph (a)(6) of proposed new Rule 18a-4.
    \770\ See paragraph (a)(1) of Rule 15c3-3 defining ``customer'' 
for purposes of Rule 15c3-3 to specifically exclude ``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-dealer or is subordinated 
to the claims of creditors of the broker-dealer. 17 CFR 240.15c3-
3(a)(1).
---------------------------------------------------------------------------

    As discussed in section II.C.1. of this release, segregation 
requirements are designed to identify customer property as distinct 
from the proprietary assets of the firm and to protect the customer 
property by, for example, preventing the firm from using it to make 
proprietary investments. The goal of segregation is to facilitate the 
prompt return of customer property to customers either before or during 
a liquidation proceeding if the firm fails. However, if a 
counterparty's property is held by a third-party custodian because the 
counterparty elects individual segregation or if the counterparty 
waives segregation, there is no need to isolate the counterparty's 
property since it is with the third-party custodian in the former case 
or the counterparty has agreed that the SBSD can use it for proprietary 
purposes in the latter case. The subordination provisions in proposed 
new Rule 18a-4 are designed to clarify the rights of counterparties

[[Page 70288]]

that have their property held by the SBSD and elect segregation and the 
rights of counterparties that either elect to have their property held 
by a third-party custodian or waive segregation.
    An SBSD would need to obtain a conditional subordination agreement 
from a counterparty that elects individual segregation.\771\ The 
agreement would be conditional because the subordination agreement 
required under the proposed rule would not be effective in a case where 
the counterparty's assets are included in the bankruptcy estate of the 
SBSD. Specifically, the proposed rule would provide that the 
counterparty would need to subordinate claims but only to the extent 
that funds or other property provided by the counterparty to the 
independent third-party custodian are not treated as customer property 
under the stockbroker liquidation provisions in a liquidation of the 
security-based swap dealer.\772\ Counterparties that choose individual 
segregation are opting to have their funds and other property held in a 
manner that makes the counterparty's property bankruptcy remote from 
the SBSD. If the arrangement is effective, the counterparties should 
not have any customer claims to cash, securities, or money market 
instruments used to margin their non-cleared security-based swap 
transactions in a liquidation of the SBSD, as their property will be 
held by the independent third party custodian. However, because there 
is a possibility that an individual segregation arrangement would not 
be effective, the subordination agreement of a counterparty that 
chooses individual segregation would be conditioned on the funds and 
other property of the counterparty not being included in the bankruptcy 
estate of the SBSD. If a counterparty elects individual segregation but 
the election is not effective in keeping the counterparty's assets 
bankruptcy remote, then the counterparty should be treated as a 
security-based swap customer with a pro rata priority claim to customer 
property.
---------------------------------------------------------------------------

    \771\ See paragraph (d)(2)(i) of proposed new Rule 18a-4.
    \772\ Id.
---------------------------------------------------------------------------

    An SBSD also would need to obtain an unconditional subordination 
agreement from a counterparty that waives segregation altogether.\773\ 
By opting out of segregation, the counterparty agrees that cash, 
securities, and money market instruments delivered to the SBSD can be 
used by the SBSD for proprietary purposes and need not be isolated from 
the proprietary assets of the SBSD. Therefore, these counterparties are 
foregoing the protections of segregation, which include the right to 
share ratably with other customers in customer property held by the 
SBSD. If these counterparties were deemed security-based swap 
customers, they could have a pro rata priority claim on customer 
property. This result could disadvantage the security-based swap 
customers that did not waive segregation by diminishing the amount of 
customer property available to be distributed to customers.
---------------------------------------------------------------------------

    \773\ See paragraph (d)(2)(ii) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment on the special provisions 
for non-cleared security-based swaps in proposed new Rule 18a-4. In 
addition, the Commission requests comment, including empirical data in 
support of comments, in response to the following questions:
    1. Is the requirement to have notice be given in writing prior to 
the execution of the first non-cleared security-based swap transaction 
with the counterparty occurring after the effective date of the rule 
appropriate? If not, explain why not. Should the notice be required on 
a periodic basis such as monthly or annually? If so, explain why. If 
not, explain why not. Should the notice be required before every 
transaction? If so, explain why. If not, explain why not.
    2. Describe the current practices and arrangements for individual 
segregation. For example, are these arrangements based on tri-party 
agreements between the SBSD, counterparty, and independent third-party 
custodian? If so, describe the terms of the these third-party 
agreements. Under these agreements, how would the SBSD perfect its 
security interest in the funds and other property held by the third-
party custodian? What terms would the counterparty require that are 
designed to ensure that funds or property held by the independent 
third-party custodian at the time of a liquidation proceeding of the 
SBSD are not included in the bankruptcy estate of the SBSD?
    3. Is it appropriate to require counterparties electing individual 
segregation to subordinate their claims to security-based swap 
customers? If not, explain why not and describe other measures that 
could be taken to ensure that security-based swap customers whose cash, 
securities, and money market instruments are subject to the omnibus 
segregation requirements have a first priority claim to these assets 
over counterparties whose funds and other property are individually 
segregated at a third party custodian.
    4. Is it appropriate to require counterparties who waive all right 
to segregation to subordinate their claims to security-based swap 
customers? If not, explain why not and describe other measures that 
could be taken to ensure that security-based swap customers whose cash, 
securities, and money market instruments are subject to the omnibus 
segregation requirements have a first priority claim to these assets 
over counterparties who waive all right to segregation.

III. General Request for Comment

    In responding to the specific requests for comment above, 
interested persons are encouraged to provide supporting data and 
analysis and, when appropriate, suggest modifications to proposed rule 
text. Responses that are supported by data and analysis provide great 
assistance to the Commission in considering the practicality and 
effectiveness of proposed new requirements as well as weighing the 
benefits and costs of proposed requirements. In addition, commenters 
are encouraged to identify in their responses a specific request for 
comment by indicating the section number of the release.
    The Commission also seeks comment on the proposals as a whole. In 
this regard, the Commission seeks comment, including empirical data in 
support of comments, on the following:
    1. Are there financial responsibility programs other than the 
broker-dealer financial responsibility program that could serve as a 
better model for establishing financial responsibility requirements for 
SBSDs and MSBSPs? If so, identify the program and explain how it would 
be a better model for implementing the provisions of the Dodd-Frank Act 
mandating capital and margin requirements for nonbank SBSDs and nonbank 
MSBSPs.
    2. Should any of the proposed quantitative requirements (e.g., 
minimum capital thresholds, margin risk factor, standardized haircuts) 
be modified? If so, how? Are there new quantitative requirements that 
should be used? What would be the financial or other consequences for 
individual firms and the financial markets of such modified or new 
quantitative requirements and how would such consequences differ from 
the proposed requirements? Please provide detailed data regarding such 
consequences and describe in detail any econometric or other 
mathematical models, or economic analyses of data, that would

[[Page 70289]]

be relevant for evaluating or modifying any quantitative requirements.
    3. How would the proposals integrate with provisions in other 
titles and subtitles of the Dodd-Frank Act and any regulations or 
proposed regulations under those other titles and subtitles?
    4. How would the proposals integrate with other proposals 
applicable to SBSDs or MSBSPs in the Exchange Act and any applicable 
regulations adopted under authority in the Exchange Act?
    5. As discussed throughout this release, many of the proposed 
amendments are based on dollar amounts that are prescribed in existing 
requirements. Should any of these proposed dollar amounts be adjusted 
to account for inflation?
    6. What should the implementation timeframe be for the proposed 
amendments and new rules? For example, should the compliance date be 
90, 120, 150, 180, or some other number of days after publication? 
Should the proposed requirements have different time frames before 
their compliance dates are triggered? For example, would it take longer 
to come into compliance with certain of these proposals than others? If 
so, rank the requirements in terms of the length of time it would take 
to come into compliance with them and propose a schedule of compliance 
dates.

IV. Paperwork Reduction Act

    Certain provisions of the proposed rule amendments and proposed new 
rules would contain a new ``collection of information'' within the 
meaning of the Paperwork Reduction Act of 1995 (``PRA'').\774\ The 
Commission is submitting the proposed rule amendments and proposed new 
rules to the Office of Management and Budget (``OMB'') for review in 
accordance with the PRA. 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 OMB control number. The titles for 
the collections of information are:
---------------------------------------------------------------------------

    \774\ 44 U.S.C. 3501 et seq.; 5 CFR 1320.11.
---------------------------------------------------------------------------

    (1) Rule 18a-1 and related appendices, Net capital requirements for 
security-based swap dealers for which there is not a prudential 
regulator (a proposed new collection of information);
    (2) Rule 18a-2, Capital requirements for major security-based swap 
participants for which there is not a prudential regulator (a proposed 
new collection of information);
    (3) Rule 18a-3, Non-cleared security-based swap margin requirements 
for security-based swap dealers and major security-based swap 
participants for which there is not a prudential regulator (a proposed 
new collection of information);
    (4) Rule 18a-4, Segregation requirements for security-based swap 
dealers and major security-based swap participants (a proposed new 
collection of information); and
    (5) Rule 15c3-1 Net capital requirements for brokers or dealers 
(OMB Control Number 3235-0200).

The burden estimates contained in this section do not include any other 
possible costs or economic effects beyond the burdens required to be 
calculated for PRA purposes.

A. Summary of Collections of Information Under the Proposed Rules and 
Rule Amendments

1. Proposed Rule 18a-1 and Amendments to Rule 15c3-1
    Section 764 of the Dodd-Frank Act added section 15F to the Exchange 
Act.\775\ Section 15F(e)(1)(B) of the Exchange Act provides that the 
Commission shall prescribe capital and margin requirements for nonbank 
SBSDs and nonbank MSBSPs. Proposed new Rule 18a-1 \776\ would establish 
minimum capital requirements for stand-alone SBSDs and the amendments 
to Rule 15c3-1 \777\ would augment the current capital requirements for 
broker-dealers to address broker-dealers that register as SBSDs and to 
enhance the provisions applicable to ANC broker-dealers (all of which 
the Commission preliminarily estimates would register as SBSDs). The 
proposed new rule and amendments would establish a number of new 
collection of information requirements.
---------------------------------------------------------------------------

    \775\ See Public Law 111-203 Sec.  764; 15 U.S.C. 78o-10.
    \776\ See proposed new Rule 18a-1. See also section II.A. of 
this release.
    \777\ See proposed amendments to Rule 15c3-1. See also section 
II.A. of this release.
---------------------------------------------------------------------------

    First, under proposed Rule 18a-1, a stand-alone SBSD would need to 
apply to the Commission to be authorized to use internal models to 
compute net capital.\778\ As part of the application process, a stand-
alone SBSD would be required to provide the Commission staff with, 
among other things: (1) A comprehensive description of the firm's 
internal risk management control system; (2) a description of the VaR 
models the firm will use to price positions and compute deductions for 
market risk; (3) a description of the firm's internal risk management 
controls over the VaR models, including a description of each category 
of person who may input data into the models; and (4) a description of 
the back-testing procedures that that firm will use to review the 
accuracy of the VaR models.\779\ In addition, under proposed Rule 18a-
1, a stand-alone SBSD authorized to use internal models would review 
and update the models it uses to compute market and credit risk, as 
well as backtest the models.
---------------------------------------------------------------------------

    \778\ See paragraphs (a)(2) and (d) of proposed new Rule 18a-1. 
This collection of information requirement already exists in Rule 
15c3-1 and applies to broker-dealers seeking to become ANC broker-
dealers.
    \779\ See paragraph (d) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

    Second, under proposed Rule 18a-1 and amendments to Rule 15c3-1, 
nonbank SBSDs that are approved to use models to compute deductions for 
market and credit risk under Rule 18a-1 and ANC broker-dealers would be 
required to perform a liquidity stress test at least monthly and, based 
on the results of that test, maintain liquidity reserves to address 
funding needs.\780\ The result of the test must be provided within 10 
business days to senior management that has the responsibility to 
oversee risk management of the nonbank SBSD or ANC broker-dealer. The 
assumptions underlying the liquidity stress test must be reviewed at 
least quarterly by senior management that has responsibility to oversee 
risk management at the nonbank SBSD and at least annually by senior 
management of the nonbank SBSD.\781\ In addition, if such a nonbank 
SBSD or ANC broker-dealer is part of a consolidated entity using 
liquidity stress tests, the nonbank SBSD or ANC broker-dealer would 
need to justify and document any differences in the assumptions used in 
their liquidity stress tests from those used in the liquidity stress 
tests of the consolidated entity.\782\ Furthermore, the nonbank SBSDs 
and ANC broker-dealers would be required to establish a written 
contingency funding plan.\783\ The plan would need to address the 
policies and roles and responsibilities of relevant personnel for 
meeting the liquidity needs of the firm and communications with the 
public and other market participants during a liquidity stress 
event.\784\
---------------------------------------------------------------------------

    \780\ See proposed new paragraph (f) to Rule 15c3-1; paragraph 
(f) of proposed new Rule 18a-1.
    \781\ See proposed new paragraph (f)(1) to Rule 15c3-1; 
paragraph (f)(1) of proposed new Rule 18a-1.
    \782\ See proposed new paragraph (f)(2) of Rule 15c3-1; 
paragraph (f)(2) of proposed new Rule 18a-1.
    \783\ See proposed new paragraph (f)(4) of Rule 15c3-1; 
paragraph (f)(3) of proposed new Rule 18a-1.
    \784\ Id.
---------------------------------------------------------------------------

    Third, nonbank SBSDs, including broker-dealer SBSDs, would be 
required to comply with certain requirements of

[[Page 70290]]

Rule 15c3-4.\785\ Rule 15c3-4 requires OTC derivatives dealers and 
firms subject to its provisions, to establish, document, and maintain a 
system of internal risk management controls to assist the firm in 
managing the risks associated with business activities, including 
market, credit, leverage, liquidity, legal, and operational risks.\786\
---------------------------------------------------------------------------

    \785\ See 17 CFR 240.18a-1(g); 15c3-1(a)(10)(ii). See also 17 
CFR 240.15c3-4.
    \786\ Id.
---------------------------------------------------------------------------

    Fourth, under paragraph (c)(2)(vi)(O)(1)(iii) of Rule 15c3-1 and 
paragraph (c)(1)(vi)(A)(3)(i) of proposed new Rule 18a-1, broker-
dealers, broker-dealers registered as SBSDs, and stand-alone SBSDs not 
using models would be required to use an industry sector classification 
system that is documented and reasonable in terms of grouping types of 
companies with similar business activities and risk characteristics, 
used for credit default swap reference names for purposes of 
calculating ``haircuts'' on security-based swaps under the applicable 
net capital rules.\787\ These firms could use a classification system 
of a third-party or develop their own classification system, subject to 
these limitations, and would need to be able to demonstrate the 
reasonableness of the system they use.\788\
---------------------------------------------------------------------------

    \787\ See paragraph (c)(2)(vi)(O)(1)(iii) of Rule 15c3-1; 
paragraph (c)(1)(vi)(A)(3)(i) of proposed new Rule 18a-1.
    \788\ See proposed new paragraph (c)(2)(vi)(O)(1)(iii)(A) of 
Rule 15c3-1; paragraph (c)(1)(vii)(A)(3)(i) of proposed new Rule 
18a-1.
---------------------------------------------------------------------------

    Fifth, under paragraph (i) of proposed Rule 18a-1, stand-alone 
SBSDs would be required to provide the Commission with certain written 
notices with respect to equity withdrawals.\789\
---------------------------------------------------------------------------

    \789\ See paragraph (i) of proposed new Rule 18a-1.
---------------------------------------------------------------------------

    Finally, under paragraph (c)(5) of Appendix D to proposed Rule 18a-
1, a stand-alone SBSD would be required to file with the Commission two 
copies of any proposed subordinated loan agreement (including 
nonconforming subordinated loan agreements) at least 30 days prior to 
the proposed execution date of the agreement.\790\ The rule would also 
require an SBSD to file with the Commission a statement setting forth 
the name and address of the lender, the business relationship of the 
lender to the SBSD, and whether the SBSD carried an account for the 
lender effecting transactions in security-based swaps at or about the 
time the proposed agreement was filed.\791\
---------------------------------------------------------------------------

    \790\ See paragraph (c)(5) of proposed new Rule 18a-1d.
    \791\ Id.
---------------------------------------------------------------------------

2. Proposed Rule 18a-2
    Proposed new Rule 18a-2 would establish capital requirements for 
nonbank MSBSPs.\792\ In particular, a nonbank MSBSP would be required 
at all times to have and maintain positive tangible net worth.\793\ The 
proposed definition of tangible net worth would allow nonbank MSBSPs to 
include as regulatory capital assets that would be deducted from net 
worth under Rule 15c3-1, such as property, plants, equipment, and 
unsecured receivables. At the same time, it would require the deduction 
of goodwill and other intangible assets.\794\
---------------------------------------------------------------------------

    \792\ See proposed new Rule 18a-2. See also section II.A.3 of 
this release.
    \793\ See paragraph (a) of proposed new Rule 18a-2.
    \794\ The proposed definition of tangible net worth under 
proposed new Rule 18a-2 is consistent with the CFTC's proposed 
definition of tangible net equity. See CFTC Capital Proposing 
Release, 76 FR at 27828 (Defining tangible net equity as ``equity as 
determined under U.S. generally accepted accounting principles, and 
excludes goodwill and other intangible assets.'').
---------------------------------------------------------------------------

    Because MSBSPs, by definition, will be entities that engage in a 
substantial security-based swap business, the Commission is proposing 
that they be required to comply with Rule 15c3-4,\795\ which requires 
OTC derivatives dealers and other firms subject to its provisions to 
establish, document, and maintain a system of internal risk management 
controls to assist the firm in managing the risks associated with their 
business activities, including market, credit, leverage, liquidity, 
legal, and operational risks.\796\
---------------------------------------------------------------------------

    \795\ See paragraph (c) of proposed new Rule 18a-2.
    \796\ See 17 CFR 240.15c3-4.
---------------------------------------------------------------------------

3. Proposed Rule 18a-3
    Proposed new Rule 18a-3 would establish minimum margin requirements 
for non-cleared security-based swap transactions entered into by 
nonbank SBSDs and nonbank MSBSPs.\797\ Proposed Rule 18a-3 would 
prescribe the requirements for nonbank SBSDs or nonbank MSBSPs to 
collect or post collateral with regard to non-cleared security-based 
swap transactions. The provisions of proposed Rule 18a-3 contain a 
collection of information requirement for nonbank SBSDs. Specifically, 
paragraph (e) of proposed Rule 18a-3 would require a nonbank SBSD to 
monitor the risk of each account and establish, maintain, and document 
procedures and guidelines for monitoring the risk of accounts as part 
of the risk management control system required by Rule 15c3-4.\798\ In 
addition, the rule would require a nonbank SBSD to review, in 
accordance with written procedures and at reasonable periodic 
intervals, its non-cleared security-based swap activities for 
consistency with the risk monitoring procedures and guidelines required 
by paragraph (e) of Rule 18a-3. The nonbank SBSD would also be required 
to determine whether information and data necessary to apply the risk 
monitoring procedures and guidelines required by paragraph (e) of Rule 
18a-3 are accessible on a timely basis and whether information systems 
are available to adequately capture, monitor, analyze, and report 
relevant data and information. Finally, the rule would require that the 
risk monitoring procedures and guidelines must include, at a minimum, 
procedures and guidelines for:
---------------------------------------------------------------------------

    \797\ See proposed new Rule 18a-3. See also section II.B. of 
this release for a more detailed description of the proposed rule.
    \798\ See paragraph (e) to proposed new Rule 18a-3.
---------------------------------------------------------------------------

     Obtaining and reviewing account documentation and 
financial information necessary for assessing the amount of current and 
potential future exposure to a given counterparty permitted by the 
SBSD;
     Determining, approving, and periodically reviewing credit 
limits for each counterparty, and across all counterparties;
     Monitoring credit risk exposure to the SBSD from non-
cleared security-based swaps, including the type, scope, and frequency 
of reporting to senior management;
     Using stress tests to monitor potential future exposure to 
a single counterparty and across all counterparties over a specified 
range of possible market movements over a specified time period;
     Managing the impact of credit exposure related to non-
cleared security-based swaps on the SBSD's overall risk exposure;
     Determining the need to collect collateral from a 
particular counterparty, including whether that determination was based 
upon the creditworthiness of the counterparty and/or the risk of the 
specific non-cleared security-based swap contracts with the 
counterparty;
     Monitoring the credit exposure resulting from concentrated 
positions with a single counterparty and across all counterparties, and 
during periods of extreme volatility; and
     Maintaining sufficient equity in the account of each 
counterparty to protect against the largest individual potential future 
exposure of a non-cleared security-based swap carried in the

[[Page 70291]]

account of the counterparty as measured by computing the largest 
maximum possible loss that could result from the exposure.
4. Proposed Rule 18a-4
    Proposed new Rule 18a-4 would establish segregation requirements 
for cleared and non-cleared security-based swap transactions, which 
would apply to all types of SBSDs (i.e., they would apply to bank 
SBSDs, nonbank stand-alone SBSDs, and broker-dealer SBSDs), as well as 
notification requirements for SBSDs and MSBSPs.\799\ The provisions of 
proposed Rule 18a-4 are modeled on Rule 15c3-3, the broker-dealer 
segregation rule.\800\ Paragraph (a) of the proposed new rule would 
define key terms used in the rule.\801\ Paragraph (b) would require an 
SBSD to promptly obtain and thereafter maintain physical possession or 
control of all excess securities collateral (a term defined in 
paragraph (a)) and specify certain locations where excess securities 
collateral could be held and deemed in the SBSD's control.\802\ 
Paragraph (c) would require an SBSD to maintain a special account for 
the exclusive benefit of security-based swap customers and have on 
deposit in that account at all times an amount of cash and/or qualified 
securities (a term defined in paragraph (a)) determined through a 
computation using the formula in Exhibit A to proposed new Rule 18a-
4.\803\
---------------------------------------------------------------------------

    \799\ See proposed new Rule 18a-4. See also section II.C. of 
this release for a more detailed description of the proposal.
    \800\ 17 CFR 240.15c3-3.
    \801\ Compare 17 CFR 240.15c3-3(a), with paragraph (a) of 
proposed new Rule 18a-4.
    \802\ Compare 17 CFR 240.15c3-3(b)-(d), with paragraph (b) of 
proposed new Rule 18a-4.
    \803\ Compare 17 CFR 240.15c3-3(e), with paragraph (c) of 
proposed new Rule 18a-4.
---------------------------------------------------------------------------

    Paragraph (d) of proposed new Rule 18a-4 would contain provisions 
that are not modeled specifically on Rule 15c3-1. First, it would 
require an SBSD and an MSBSP to provide the notice required by section 
3E(f)(1)(A) of the Exchange Act to a counterparty in writing prior to 
the execution of the first non-cleared security-based swap transaction 
with the counterparty.\804\ Second, it would require the SBSD to obtain 
subordination agreements from counterparties that opt out of the 
segregation requirements in proposed new Rule 18a-4 because they either 
elect individual segregation pursuant to the self-executing provisions 
of section 3E(f) of the Exchange Act \805\ or agree that the SBSD need 
not segregate their assets at all.\806\
---------------------------------------------------------------------------

    \804\ See 15 U.S.C. 78c-5(f)(1)(A); proposed paragraph (d)(1) of 
proposed new Rule 18a-4.
    \805\ See 15 U.S.C. 78c-5(f)(1)-(3).
    \806\ See 15 U.S.C. 78c-5(f)(4).
---------------------------------------------------------------------------

    Additionally, paragraph (a)(3) of proposed new Rule 18a-4 would 
define qualified clearing agency account to mean an account of an SBSD 
at a clearing agency established to hold funds and other property in 
order to purchase, margin, guarantee, secure, adjust, or settle cleared 
security-based swaps of the SBSD's security-based swap customers that 
meets the following conditions (which would contain collection of 
information requirements):
     The account is designated ``Special Clearing Account for 
the Exclusive Benefit of the Cleared Security-Based Swap Customers of 
[name of the SBSD]''; \807\
---------------------------------------------------------------------------

    \807\ See paragraph (a)(3)(i) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (e)(1) of Rule 15c3-3, which 
requires a broker-dealer to maintain a ``Special Reserve Bank 
Account for the Exclusive Benefit of Customers.'' Compare 17 CFR 
240.15c3-3(e), with paragraph (a)(3)(i) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

     The clearing agency has acknowledged in a written notice 
provided to and retained by the SBSD that the funds and other property 
in the account are being held by the clearing agency for the exclusive 
benefit of the cleared security-based swap customers of the SBSD in 
accordance with the regulations of the Commission and are being kept 
separate from any other accounts maintained by the SBSD with the 
clearing agency; \808\ and
---------------------------------------------------------------------------

    \808\ See paragraph (a)(3)(ii) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (f) of Rule 15c3-3, which requires 
a broker-dealer to obtain a written notification from a bank where 
it maintains a customer reserve account. Compare 17 CFR 240.15c3-
3(f), with paragraph (a)(3)(ii) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

     The account is subject to a written contract between the 
SBSD and the clearing agency which provides that the funds and other 
property in the account shall be subject to no right, charge, security 
interest, lien, or claim of any kind in favor of the clearing agency or 
any person claiming through the clearing agency, except a right, 
charge, security interest, lien, or claim resulting from a cleared 
security-based swap transaction effected in the account.\809\
---------------------------------------------------------------------------

    \809\ See paragraph (a)(3)(iii) of proposed new Rule 18a-4. This 
provision is modeled on paragraph (f) of Rule 15c3-3, which requires 
a broker-dealer to obtain a contract from a bank where it maintains 
a ``Special Reserve Bank Account for the Exclusive Benefit of 
Customers.'' Compare 17 CFR 240.15c3-3(f), with paragraph (a)(3)(ii) 
of proposed new Rule 18a-4.
---------------------------------------------------------------------------

    Under paragraph (a)(4) of proposed new Rule 18a-4, a qualified SBSD 
account would be defined to mean an account at another SBSD registered 
with the Commission pursuant to section 15F of the Exchange Act that is 
not an affiliate of the SBSD and that meets conditions that are largely 
identical to the conditions for a qualified clearing agency account. 
Finally, paragraph (c)(1) of proposed new Rule 18a-4 would require an 
SBSD, among other things, to maintain a special account for the 
exclusive benefit of security-based swap customers separate from any 
other bank account of the SBSD.\810\ The term special account for the 
exclusive benefit of security-based swap customers would be defined 
under paragraph (a)(7) of proposed new Rule 18a-4 to mean an account at 
a bank that is not an affiliate of the SBSD and that meets conditions 
that are largely identical to the conditions for a qualified clearing 
agency account and qualified SBSD account.\811\
---------------------------------------------------------------------------

    \810\ See paragraph (c) of proposed new Rule 18a-4. The 
provisions of paragraph (c) of proposed new Rule 18a-1 are modeled 
on paragraph (e) of Rule 15c3-3. Compare 17 CFR 240.15c3-3(e), with 
paragraph (c) of proposed new Rule 18a-4.
    \811\ See paragraph (a)(7) of proposed new Rule 18a-4. See also 
Section II.C.1. of this release for a more detailed description of 
the proposed requirements.
---------------------------------------------------------------------------

    Paragraph (c)(1) of proposed new Rule 18a-4 would provide that the 
SBSD must at all times maintain in a Rule 18a-4 Customer Reserve 
Account, through deposits into the account, cash and/or qualified 
securities in amounts computed in accordance with the formula set forth 
in Exhibit A to Rule 18a-4.\812\ The formula in Exhibit A to proposed 
new Rule 18a-4 is modeled on the formula in Exhibit A to Rule 15c3-
3.\813\ Paragraph (c)(3) of proposed new Rule 18a-4 would provide that 
the computations necessary to determine the amount required to be 
maintained in the special bank account must be made daily as of the 
close of the previous business day and any deposit required to be made 
into the account must be made on the next business day following the 
computation no later than 1 hour after the opening of the bank that 
maintains the account.\814\
---------------------------------------------------------------------------

    \812\ See paragraph (c)(1) of proposed new Rule 18a-4; Exhibit A 
to proposed new Rule 18a-4.
    \813\ See 17 CFR 240.15c3-3a.
    \814\ See paragraph (c)(3) of proposed new rule 18a-4.
---------------------------------------------------------------------------

B. Proposed Use of Information

    As discussed more fully above, the Commission and SROs, as 
applicable, would use the information collected under new Rules 18a-1, 
18a-2, 18a-3 and 18a-4, as well as the amendments to Rule 15c3-1 to 
determine whether an SBSD, MSBSP, or ANC broker-dealer, as applicable, 
is in compliance with each applicable rule and to help fulfill their 
oversight responsibilities. The

[[Page 70292]]

collections of information would also help to ensure that SBSD, MSBSPs 
and broker-dealers are meeting their obligations under the proposed 
rules and rule amendments and have the required policies and procedures 
in place.
    Proposed new Rules 18a-1 and 18a-2, as well as the proposed 
amendments to Rule 15c3-1 would be integral parts of the Commission's 
financial responsibility program for SBSDs and MSBSPs, and ANC broker-
dealers, respectively. Proposed Rule 18a-1 and Rule 15c3-1 are designed 
to ensure that nonbank SBSDs and broker-dealers (including broker-
dealer SBSDs), respectively, have sufficient liquidity to meet all 
unsubordinated obligations to customers and counterparties and, 
consequently, if the SBSD or broker-dealer fails, sufficient resources 
to wind-down in an orderly manner without the need for a formal 
proceeding. The collections of information in proposed new Rule 18a-1, 
Rule 18a-2 and the amendments to Rule 15c3-1 would facilitate the 
monitoring of the financial condition of nonbank SBSDs, nonbank MSBSPs 
and broker-dealers by the Commission.
    Proposed new Rule 18a-3 would prescribe, among other things, 
requirements for nonbank SBSDs to collect collateral with regard to 
non-cleared security-based swap transactions. Under proposed Rule 18a-
3, a nonbank SBSD would be required to establish and implement risk 
monitoring procedures with respect to counterparty accounts.\815\ The 
purpose of the proposed rule is to limit risks to individual firms and 
systemic risk arising from non-cleared security-based swaps. The 
collections of information in proposed Rule 18a-3 would assist 
examiners in determining whether SBSDs are in compliance with 
requirements in the rule.
---------------------------------------------------------------------------

    \815\ See paragraph (e) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    Proposed new Rule 18a-4 would establish segregation requirements 
for cleared and non-cleared security-based swap transactions, which 
would apply to all types of SBSDs (i.e., they would apply to bank 
SBSDs, nonbank stand-alone SBSDs, and broker-dealer SBSDs), as well as 
establish notice requirements for SBSDs and MSBSPs. Proposed new Rule 
18a-4 would be an integral part of the Commission's financial 
responsibility program for SBSDs. Its purpose is to protect the rights 
of security-based swap customers and their ability to promptly obtain 
their property from an SBSD. The collection of information requirements 
in the proposed new rule would facilitate the process by which the 
Commission monitors how SBSDs are fulfilling their custodial 
responsibilities to SBSD customers. Proposed Rule 18a-4 also would 
require that an SBSD provide certain notices to counterparties.\816\ 
These notices would alert counterparties to the alternatives available 
to them with respect to segregation of non-cleared security-based 
swaps. The Commission staff would use this new collection of 
information in its examination and oversight program.
---------------------------------------------------------------------------

    \816\ See paragraphs (a) and (c) of proposed new Rule 18a-4.
---------------------------------------------------------------------------

C. Respondents

    Consistent with the Entity Definitions Adopting Release, the 
Commission staff estimates that 50 or fewer entities ultimately may 
have to register with the Commission as SBSDs.\817\ In addition, 
consistent with the Entity Definitions Adopting Release, based on 
available data regarding the single-name credit default swap market--
which the Commission believes will comprise the majority of security-
based swaps--the Commission staff estimates that the number of MSBSPs 
likely will be five or fewer and, in actuality, may be zero.\818\ 
Therefore, to capture the likely number of MSBSPs that may be subject 
to the collections of information for purposes of this PRA, the 
Commission staff estimates for purposes of this PRA that 5 entities 
will register with the Commission as MSBSPs. Accordingly, for the 
purposes of calculating PRA reporting burdens, the Commission staff 
estimates there are 50 SBSDs and 5 MSBSPs respondents.
---------------------------------------------------------------------------

    \817\ Entity Definitions Adopting Release, 77 FR at 30725. This 
estimate--which potentially overstates the number of potential 
entities that ultimately have to register with the Commission as 
SBSDs--is consistent with the data regarding activities and 
positions of participants in the single-name credit default swap 
market summarized in a memorandum of the Commission staff. See 
Memorandum (Mar. 15, 2012), available at http://www.sec.gov/comments/s7-39-10/s73910-154.pdf (``CDS Data Analysis''). Depending 
on the final capital requirements as well as other requirements for 
SBSDs and how businesses choose to respond to such requirements, the 
actual number of SBSDs may be significantly fewer. See Business 
Conduct Standards for Security-Based Swap Dealers and Major-Security 
Based Swap Participants, Exchange Act Release No. 64766 (June 29, 
2011), 76 FR 42396, 42442 (July 18, 2011) (``Business Conduct 
Release''). See also SBSD Registration Proposing Release, 76 FR at 
65808.
    \818\ Entity Definitions Adopting Release, 77 FR at 30727, 
30729. The number of MSBSPs likely will depend on the final capital 
requirements and other requirements for MSBSPs and how businesses 
choose to respond to such requirements. See Business Conduct 
Release, 76 FR at 42442. See also SBSD Registration Proposing 
Release, 76 FR at 65808.
---------------------------------------------------------------------------

    The Commission previously estimated that 16 broker-dealers would 
likely seek to register as SBSDs.\819\ The Commission is retaining this 
estimate for purposes of this release.\820\ Accordingly, for the 
purposes of calculating PRA reporting burdens, the Commission staff 
estimates there are 16 broker-dealer SBSDs.
---------------------------------------------------------------------------

    \819\ See SBSD Registration Proposing Release, 76 FR at 65808. 
No comments were received on this estimate.
    \820\ Id.
---------------------------------------------------------------------------

    Because proposed Rules 18a-1 and 18a-3 would apply only to nonbank 
SBSDs, including nonbank subsidiaries of bank holding companies the 
Federal Reserve regulates, the number of respondents subject to these 
proposed rules would be less than the 50 entities expected to register 
with the Commission as an SBSD, as many of the dealers that currently 
engage in OTC derivative activities are banks, and would therefore be 
``bank SBSDs.'' \821\ Because the Commission staff estimates that 16 
broker-dealers would likely register as SBSDs, there would be an 
estimated maximum of 34 bank SBSDs.\822\ However, because of business 
planning purposes, risk management purposes, potential regulatory 
requirements, or other reasons, some of these entities would likely 
register with the Commission as nonbank stand-alone SBSDs. Therefore, 
as stated above, because many of the dealers that currently engage in 
OTC derivatives activities are banks, the Commission staff estimates 
that approximately 75% of the maximum estimated bank SBSDs will 
register as bank SBSDs, and the remainder (approximately 25%) will 
register as stand-alone nonbank SBSDs. As a result, for purposes of the 
reporting burdens, the Commission staff estimates that approximately 9 
entities will register as stand-alone SBSDs.\823\ Therefore, for 
purposes of the reporting burdens, the Commission staff estimates

[[Page 70293]]

that approximately 25 nonbank SBSDs would be subject to Rules 18a-1 and 
18a-3.\824\
---------------------------------------------------------------------------

    \821\ See, e.g., ISDA Margin Survey 2012 (May 2012), at Appendix 
1, available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/ (``ISDA Margin Survey 2012''). ISDA is a 
global trade association for OTC derivatives. The ISDA margin survey 
is conducted annually to examine the state of collateral use and 
management among derivatives dealers and end-users. See id.; ISDA 
Margin Survey 2011, available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/ (``ISDA Margin Survey 
2011''). Appendix 1 to the survey lists firms that responded to the 
survey including the largest dealer banks. See ISDA Margin Survey 
2012 at Appendix 1; ISDA Margin Survey 2011 at Appendix 1. See also 
Economic Analysis in section V.A. of this release (discussing 
overview of OTC derivatives market).
    \822\ 50 SBSDs-16 broker-dealer SBSDs = 34 maximum estimated 
bank SBSDs.
    \823\ 34 maximum estimated bank SBSDs x 25% = 8.5, rounded to 9 
stand-alone nonbank SBSDs.
    \824\ 16 broker-dealer SBSDs + 9 stand-alone SBSDs = 25 nonbank 
SBSDs.
---------------------------------------------------------------------------

    Of the 9 stand-alone SBSDs, the Commission staff estimates that, 
based on its experience with ANC broker-dealers and OTC derivatives 
dealers, the majority of stand-alone SBSDs would apply to use internal 
models.\825\ Consequently, the Commission is estimating that 6 of the 9 
stand-alone SBSDs would apply to use internal models under Rule 18a-1. 
Because the Commission staff estimates that 6 stand-alone SBSDs would 
apply to the Commission to use internal models, the Commission staff 
estimates that three stand-alone SBSDs would not use models.\826\ For 
purposes of estimating the number of respondents with respect to the 
proposed amendments to Rule 15c3-1, the Commission staff estimates that 
there would be 10 respondents currently subject to the collection of 
information as it relates to Appendix E to Rule 15c3-1.\827\ Finally, 
because the Commission staff estimates that 10 of the broker-dealers 
registered as SBSDs would be ANC broker-dealers, the Commission staff 
estimates that 6 broker-dealers registered as SBSDs would not use 
internal models.\828\
---------------------------------------------------------------------------

    \825\ See section II.A.2.a.iii. of this release (discussing 
minimum capital requirements for stand-alone SBSDs); section 
II.A.2.b.iii. of this release (discussing the use of VaR models). 
VaR models, while more risk sensitive than standardized haircuts, 
tend to substantially reduce the amount of the deductions to 
tentative net capital in comparison to the standardized haircuts 
because the models recognize more offsets between related positions 
than the standardized haircuts. Therefore, the Commission expects 
that stand-alone SBSDs that have the capability to use internal 
models to calculate net capital would chose to do so.
    \826\ 9 stand-alone SBSDs-6 stand-alone SBSDs using internal 
models = 3 stand-alone SBSDs not using models.
    \827\ These 10 broker-dealer respondents likely would also 
register as SBSDs because these entities are expected to engage in a 
broad range of activities.
    \828\ 16 broker-dealers registered as SBSDs-10 ANC broker-dealer 
SBSDs = 6 broker-dealer SBSDs not using internal models.

------------------------------------------------------------------------
                                                              Number of
                    Type of respondent                       respondents
------------------------------------------------------------------------
SBSDs.....................................................            50
Bank SBSDs................................................            25
Nonbank SBSDs.............................................            25
Broker-Dealer SBSDs.......................................            16
Stand-Alone SBSD..........................................             9
ANC Broker-Dealer SBSDs...................................            10
Broker-Dealer SBSDs (Not Using Models)....................             6
Stand-Alone SBSDs (Using Models)..........................             6
Stand-Alone SBSDs (Not Using Models)......................             3
Nonbank MSBSPs............................................             5
------------------------------------------------------------------------

    The Commission generally requests comment on all aspects of these 
estimates of the number of respondents. Commenters should provide 
specific data and analysis to support any comments they submit with 
respect to the number of respondents, including identifying any sources 
of industry information that could be used to estimate the number of 
respondents.

D. Total Initial and Annual Recordkeeping and Reporting Burden

1. Proposed Rule 18a-1 and Amendments to Rule 15c3-1
    Proposed Rule 18a-1 and the proposed amendments to Rule 15c3-1 
would have collection of information requirements that result in one-
time and annual hour burdens for nonbank SBSDs and ANC broker-dealers. 
The estimates in this section are based in part on the Commission's 
experience with burden estimates for similar collections of information 
requirements, including the current collection of information 
requirements for Rule 15c3-1.\829\
---------------------------------------------------------------------------

    \829\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    First, under paragraph (a)(2) of proposed Rule 18a-1, the 
Commission is proposing that a stand-alone SBSD be required to file an 
application for authorization to compute net capital using internal 
models.\830\ The requirements for the application would be set forth in 
paragraph (d) of proposed Rule 18a-1, which is modeled on the 
application requirements of Appendix E to Rule 15c3-1.\831\ ANC broker-
dealers--the number of which would include broker-dealer SBSDs that 
seek to use internal models--currently are subject to this application 
requirement. Consequently, the Commission staff estimates that the 
proposed requirements of paragraph (d) of Rule 18a-1 would result in 
one-time and annual hour burdens for stand-alone SBSDs.\832\
---------------------------------------------------------------------------

    \830\ A broker-dealer SBSD seeking Commission authorization to 
use internal models to compute market and credit risk charges would 
apply under the existing provisions of Appendix E to Rule 15c3-1, 
which apply to ANC broker-dealers. See 17 CFR 240.15c3-1e.
    \831\ See 17 CFR 240.15c3-1e(a) and paragraph (d) of proposed 
Rule 18a-1. Consequently, the Commission is using the current 
collection of information for Appendix E to Rule 15c3-1 as a basis 
for this new collection of information.
    \832\ The requirements that would be imposed on paragraphs (d) 
and (e) of proposed Rule 18a-1 are consistent with the requirements 
of Appendix E to Rule 15c3-1.
---------------------------------------------------------------------------

    Based on its experience with ANC broker-dealers and OTC derivatives 
dealers, the Commission expects that stand-alone SBSDs that apply to 
the Commission to use internal models to calculate net capital will 
already have developed models to calculate market and credit risk and 
will already have developed internal risk management control systems. 
On the other hand, the Commission notes that proposed Rule 18a-1 
contains additional requirements that stand-alone SBSDs may not yet 
have incorporated into their models and control systems.\833\ 
Therefore, stand-alone SBSDs would incur one-time hour burdens and 
start-up costs in order to develop their VaR models in accordance with 
the requirements of proposed Rule 18a-1, as well as to submit such 
models along with its application under paragraph (d) of proposed Rule 
18a-1 to the Commission for approval.
---------------------------------------------------------------------------

    \833\ See sections II.A.2.b.iii., II.A.2.c., and II.A.2.d. of 
this release (describing requirements for VaR models and other 
requirements under proposed Rule 18a-1 for stand-alone SBSDs).
---------------------------------------------------------------------------

    These estimates are based on currently approved PRA estimates for 
the ANC firms and OTC derivatives dealers.\834\ While these estimates 
are averages, the burdens may vary depending on the size and complexity 
of each stand-alone SBSD.
---------------------------------------------------------------------------

    \834\ See OTC Derivatives Dealers, 62 FR 67940; OTC Derivatives 
Dealers, 63 FR 59362; Alternative Net Capital Requirements Adopting 
Release, 69 FR at 34452.
---------------------------------------------------------------------------

    The Commission staff estimates that each of the 6 stand-alone 
nonbank SBSDs that apply to use the internal models would spend 
approximately 1,000 hours to develop and submit its VaR model and the 
description of its risk management control system to the Commission as 
well as to create and compile the various documents to be included with 
the application and to work with the Commission staff through the 
application process.\835\ This includes approximately 100 hours for an 
in-house attorney to complete a review of the application.\836\ 
Consequently, the Commission staff estimates that the total burden 
associated with the application process for the stand-alone SBSDs would 
result in an industry-wide one-time hour burden of approximately 6,000 
hours.\837\ In addition, the Commission staff allocated 75% (4,500 
hours) of these one-time burden hours \838\ to internal burden and the

[[Page 70294]]

remaining 25% (1,500 hours) to external burden to hire outside 
professionals to assist in preparing and reviewing the stand-alone 
SBSD's application for submission to the Commission.\839\ The 
Commission staff estimates $400 per hour for external costs for 
retaining outside consultants, resulting in a one-time industry-wide 
external cost of $600,000.\840\
---------------------------------------------------------------------------

    \835\ This estimate is based on the current hour burdens under 
Appendix E to Rule 15c3-1.
    \836\ Id. See also OTC Derivatives Dealers, 62 FR 67940; 
Alternative Net Capital Requirements Adopting Release, 69 FR at 
34452.
    \837\ 6 stand-alone SBSDs x 1,000 hours = 6,000 hours.
    \838\ The internal hours likely would be performed by an in-
house attorney (1,500 hours), a risk management specialist (1,500 
hours), and compliance manager (1,500 hours). Therefore, the 
estimated internal costs for this hour burden would be calculated as 
follows: ((in-house attorney for 1,500 hours at $378 per hour) + 
(risk management specialist for 1,500 hours at $259 per hour) + 
(compliance manager for 1,500 hours at $279 per hour)) = $1,374,000. 
The hourly rates use for internal professionals used throughout this 
section IV. of the release are taken from SIFMA's Management & 
Professional Earnings in the Securities Industry 2011, modified to 
account for an 1800-hour work-year and multiplied by 5.35 to account 
for bonuses, firm size, employee benefits and overhead.
    \839\ 6,000 hours x .75 = 4,500 hours; 6,000 hours x .25 = 1,500 
hours. This allocation is based on the Commission's experience in 
implementing the ANC rules for broker-dealers. Larger firms tend to 
perform these tasks in-house due to the proprietary nature of these 
models as well as the high fixed-costs in hiring an outside 
consultant. However, smaller firms may need to hire an outside 
consultant to perform certain of these tasks.
    \840\ 1,500 hours x $400 per hour = $600,000. See PRA Analysis 
in Product Definitions Adopting Release, 77 FR at 48334 (providing 
an estimate of $400 an hour to engage an outside attorney). See also 
Nationally Recognized Statistical Rating Organizations, Exchange Act 
Release No. 64514 (May 18, 2011) 76 FR 33430, 33504 (June 8, 2012) 
(providing estimate of $400 per hour to engage outside attorneys and 
outside professionals).
---------------------------------------------------------------------------

    The Commission staff estimates that a stand-alone SBSD approved to 
use internal models would spend approximately 5,600 hours per year to 
review and update the models and approximately 160 hours each quarter, 
or approximately 640 hours per year, to backtest the models.\841\ 
Consequently, the Commission staff estimates that the total burden 
associated with reviewing and back-testing the models for the 6 stand-
alone SBSDs would result in an industry-wide annual hour burden of 
approximately 37,440 hours per year.\842\ In addition, the Commission 
staff has allocated 75% (28,080) \843\ of these burden hours to 
internal burden and the remaining 25% (9,360) to external burden to 
hire outside professionals to assist in reviewing, updating and 
backtesting the models.\844\ The Commission staff estimates $400 per 
hour for external costs for retaining outside professionals, resulting 
in an industry-wide external cost of $3.7 million annually.\845\
---------------------------------------------------------------------------

    \841\ These hour burdens are consistent with the current hour 
burdens under Appendix E to Rule 15c3-1 for ANC broker-dealers.
    \842\ 6 Stand-alone SBSDs x [5,600 hours + 640 hours] = 37,440 
hours.
    \843\ These functions likely would be performed by a risk 
management specialist (14,040 hours) and a senior compliance 
examiner (14,040 hours). Therefore, the estimated internal costs for 
this hour burden would be calculated as follows: ((risk management 
specialist for 14,040 hours at $259 per hour) + (senior compliance 
examiner for 14,040 hours at $230 per hour)) = $6,865,560.
    \844\ 37,440 hours x .75 = 28,080; 37,440 hours x .25 = 9,360 
hours. This allocation is based on the Commission's experience in 
implementing the ANC rules for broker-dealers. Larger firms tend to 
perform these tasks in-house due to the proprietary nature of these 
models as well as the high fixed-costs in hiring an outside 
consultant. However, smaller firms may need to hire an outside 
consultant to perform these tasks.
    \845\ 9,360 hours x $400 per hour = $3,744,000. See PRA Analysis 
in Product Definitions Adopting Release, 77 FR 48334 (providing an 
estimate of $400 an hour to engage an outside attorney). See also 
Nationally Recognized Statistical Rating Organizations, 76 FR at 
33504 (providing estimate of $400 per hour to engage outside 
attorneys and outside professionals).
---------------------------------------------------------------------------

    Stand-alone SBSDs electing to file an application with the 
Commission to use a VaR model will incur start-up costs including 
information technology costs to comply with proposed Rule 18a-1. 
Because each stand-alone SBSD's information technology systems may be 
in varying stages of readiness to enable these firms to meet the 
requirements of the proposed rules, the cost of modifying their 
information technology systems could vary significantly. Based on the 
estimates for the ANC broker-dealers,\846\ it is expected that a stand-
alone SBSD would incur an average of approximately $8.0 million to 
modify its information technology systems to meet the VaR requirements 
of the proposed new Rule 18a-1, for a total one-time industry-wide cost 
of $48 million.\847\
---------------------------------------------------------------------------

    \846\ Alternative Net Capital Requirements Adopting Release, 69 
FR 34428.
    \847\ 6 stand-alone SBSDs x $8 million = $48 million.
---------------------------------------------------------------------------

    Second, under paragraph (f) of proposed Rule 18a-1 and proposed new 
paragraph (f) of Rule 15c3-1, stand-alone SBSDs that are approved to 
use models to compute deductions for market and credit risk under Rule 
18a-1 and ANC broker-dealers would be subject to liquidity stress test 
requirements. The Commission staff estimates that the proposed 
requirements resulting from these provisions would result in a one-time 
burden to applicable stand-alone SBSDs and ANC broker-dealers as they 
would need to develop models for the liquidity stress test, document 
the results of the test to provide to senior management, document 
differences in the assumptions used in the liquidity stress test of the 
firm from those used in a consolidated entity of which the firm is a 
part, and develop a written contingency funding plan.\848\ Based on 
experience supervising ANC broker-dealers,\849\ the Commission staff 
estimates that each of the 6 stand-alone SBSDs and 10 ANC broker-
dealers would spend an average of approximately 200 hours to comply 
with these requirements, resulting in an average industry-wide one-time 
internal hour burden of approximately 3,200 hours.\850\
---------------------------------------------------------------------------

    \848\ See section II.A.2.d. of this release (discussing 
liquidity stress test and written contingency funding plan).
    \849\ Based on Commission staff experience supervising the ANC 
broker-dealers, all of the ANC broker-dealers that are part of a 
holding company generally have a written contingency funding plan, 
generally at the holding company level. This proposed rule would 
require that each ANC broker-dealer and stand-alone SBSD using 
internal models maintain a written contingency funding plan at the 
entity level (in addition to any holding company plan). Therefore, 
the proposed hour burdens are averages for all firms, including the 
ANC broker-dealers, which may already conduct these activities 
within their organizations, and smaller firms, including stand-alone 
broker-dealers which may not currently undertake these proposed 
activities.
    \850\ [10 ANC broker-dealers + 6 stand-alone SBSDs] x 200 hours 
= 3,200 hours. Based on Commission staff experience supervising the 
ANC broker-dealers, the Commission staff expects that these 
functions would likely be performed internally by an in-house 
attorney (1,600 hours) and a risk management specialist (1,600). 
Therefore, the estimated internal costs for this hour burden would 
be calculated as follows: ((in-house attorney for 1,600 hours at 
$378 per hour) + (risk management specialist for 1,600 hours at $259 
per hour)) = $1,019,200.
---------------------------------------------------------------------------

    In terms of annual hour burden, the Commission staff estimates that 
a stand-alone SBSD or ANC broker-dealer would spend an average of 
approximately 50 hours \851\ per month testing and documenting the 
results of its liquidity stress test and reviewing its contingency 
funding plan, resulting in a total industry-wide annual hour burden of 
approximately 9,600 hours.\852\
---------------------------------------------------------------------------

    \851\ This PRA estimate is based, in part, on the 160 hours per 
quarter it would take an ANC broker-dealer to review and backtest 
its models under the current collection of information in Rule 15c3-
1. See Alternative Net Capital Requirements Adopting Release, 69 FR 
at 34452.
    \852\ [6 Stand-alone SBSDs + 10 ANC broker-dealers] x 50 hours x 
12 months = 9,600 hours. These functions would be performed by a 
senior compliance examiner (4,800 hours) and a risk management 
specialist (4,800 hours). Therefore, the estimated internal costs 
for this hour burden would be calculated as follows: ((senior 
compliance examiner for 4,800 hours at $230 per hour) + (risk 
management specialist for 4,800 hours at $259 per hour)) = 
$2,347,200.
---------------------------------------------------------------------------

    Third, under paragraph (g) of proposed new Rule 18a-1, a stand-
alone SBSD would be required to comply with Rule 15c3-4 (except for 
certain provisions of that rule) as if it were an OTC derivatives 
dealer.\853\ ANC broker-dealers currently are required to comply with 
Rule 15c3-4.\854\ Nonbank SBSDs would be required to comply with Rule 
15c3-4, which requires the establishment of a risk management

[[Page 70295]]

control system.\855\ The Commission adopted Rule 15c3-4 in 1998 as part 
of the OTC derivatives dealer oversight program.\856\ The rule requires 
an OTC derivatives dealer to establish, document, and maintain a system 
of internal risk management controls to assist in managing the risks 
associated with its business activities, including market, credit, 
leverage, liquidity, legal, and operational risks.\857\ It also 
requires OTC derivatives dealers to establish, document, and maintain 
procedures designed to prevent the firm from engaging in securities 
activities that are not permitted by OTC derivatives dealers pursuant 
to Rule 15a-1.\858\ Rule 15c3-4 identifies a number of elements that 
must be part of an OTC derivatives dealer's internal risk management 
control system.\859\ These include, for example, that the system have:
---------------------------------------------------------------------------

    \853\ See paragraph (g) to proposed new Rule 18a-1.
    \854\ 17 CFR 240.15c3-1(a)(7)(iii).
    \855\ See proposed new paragraph (a)(10)(ii) of Rule 15c3-1 (17 
CFR 240.15c3-1); paragraph (g) of proposed new Rule 18a-1. See also 
17 CFR 240.15c3-4.
    \856\ See 17 CFR 240.15c3-4; OTC Derivatives Dealers, 63 FR 
59362.
    \857\ See 17 CFR 240.15c3-4.
    \858\ See 17 CFR 240.15c3-4; 17 CFR 240.15a-1.
    \859\ See 17 CFR 240.15c3-4(c).
---------------------------------------------------------------------------

     A risk control unit that reports directly to senior 
management and is independent from business trading units; \860\
---------------------------------------------------------------------------

    \860\ See 17 CFR 240.15c3-4(c)(1).
---------------------------------------------------------------------------

     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; 
\861\
---------------------------------------------------------------------------

    \861\ See 17 CFR 240.15c3-4(c)(2).
---------------------------------------------------------------------------

     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; \862\ and
---------------------------------------------------------------------------

    \862\ See 17 CFR 240.15c3-4(c)(3).
---------------------------------------------------------------------------

     Definitions of risk, risk monitoring, and risk 
management.\863\
---------------------------------------------------------------------------

    \863\ See 17 CFR 240.15c3-4(c)(4).
---------------------------------------------------------------------------

    Rule 15c3-4 further provides that the elements of the internal risk 
management control system must include written guidelines, approved by 
the OTC derivatives dealer's governing body, that discuss a number of 
matters, including for example:
     Quantitative guidelines for managing the OTC derivatives 
dealer's overall risk exposure; \864\
---------------------------------------------------------------------------

    \864\ See 17 CFR 240.15c3-4(c)(5)(iii).
---------------------------------------------------------------------------

     The type, scope, and frequency of reporting by management 
on risk exposures; \865\
---------------------------------------------------------------------------

    \865\ See 17 CFR 240.15c3-4(c)(5)(iv).
---------------------------------------------------------------------------

     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; \866\
---------------------------------------------------------------------------

    \866\ See 17 CFR 240.15c3-4(c)(5)(v).
---------------------------------------------------------------------------

     The process for monitoring risk independent of the 
business or trading units whose activities create the risks being 
monitored; \867\
---------------------------------------------------------------------------

    \867\ See 17 CFR 240.15c3-4(c)(5)(vi).
---------------------------------------------------------------------------

     The performance of the risk management function by persons 
independent from or senior to the business or trading units whose 
activities create the risks; \868\
---------------------------------------------------------------------------

    \868\ See 17 CFR 240.15c3-4(c)(5)(vii).
---------------------------------------------------------------------------

     The authority and resources of the groups or persons 
performing the risk monitoring and risk management functions; \869\
---------------------------------------------------------------------------

    \869\ See 17 CFR 240.15c3-4(c)(5)(viii).
---------------------------------------------------------------------------

     The appropriate response by management when internal risk 
management guidelines have been exceeded; \870\
---------------------------------------------------------------------------

    \870\ See 17 CFR 240.15c3-4(c)(5)(ix).
---------------------------------------------------------------------------

     The procedures to monitor and address the risk that an OTC 
derivatives transaction contract will be unenforceable; \871\
---------------------------------------------------------------------------

    \871\ See 17 CFR 240.15c3-4(c)(5)(x).
---------------------------------------------------------------------------

     The procedures requiring the documentation of the 
principal terms of OTC derivatives transactions and other relevant 
information regarding such transactions; \872\ and
---------------------------------------------------------------------------

    \872\ See 17 CFR 240.15c3-4(c)(5)(xi).
---------------------------------------------------------------------------

     The procedures authorizing specified employees to commit 
the OTC derivatives dealer to particular types of transactions.\873\
---------------------------------------------------------------------------

    \873\ See 17 CFR 240.15c3-4(c)(5)(xii).

Rule 15c3-4 also requires management to periodically review, in 
accordance with the written procedures, the business activities of the 
OTC derivatives dealer for consistency with risk management 
guidelines.\874\
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    \874\ See 17 CFR 240.15c3-4(d).
---------------------------------------------------------------------------

    Based on the nature of the written guidelines described above, the 
Commission staff estimates that the requirement to comply with Rule 
15c3-4 would result in one-time and annual hour burdens to nonbank 
SBSDs. The Commission staff estimates that the average amount of time a 
firm would spend implementing its risk management control system would 
be 2,000 hours,\875\ resulting in an industry-wide one-time hour burden 
of 30,000 hours across the 15 nonbank SBSDs not already subject to Rule 
15c3-4.\876\
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    \875\ This estimates is based on the one-time burden estimated 
for an OTC derivatives dealer to implement is controls under Rule 
15c3-1. See OTC Derivatives Dealers, 62 FR 67940. This also is 
included in the current PRA estimate for Rule 15c3-4.
    \876\ 25 nonbank SBSDs--10 ANC broker-dealer SBSDs = 15 nonbank 
SBSDs. 15 nonbank SBSDs x 2,000 hours = 30,000 hours. This number is 
incremental to the current collection of information for Rule 15c3-1 
with regard to complying with the provisions of Rule 15c3-4 and, 
therefore, excludes the 10 respondents included in the collection of 
information for that rule. These hours would likely be performed by 
a combination of an in-house attorney (10,000 hours), a risk 
management specialist (10,000 hours), and an operations specialist 
(10,000 hours). Therefore, the estimated internal costs for this 
hour burden would be calculated as follows: ((in-house attorney for 
10,000 hours at $378 per hour) + (risk management specialist for 
10,000 hours at $259 per hour) + (operations specialist for 10,000 
hours at $117 per hour)) = $7,540,000.
---------------------------------------------------------------------------

    The proposed rule would require a nonbank SBSD to consider a number 
of issues affecting its business environment when creating its risk 
management control system. For example, a nonbank SBSD would need to 
consider, among other things, the sophistication and experience of 
relevant trading, risk management, and internal audit personnel, as 
well as the separation of duties among these personnel, when designing 
and implementing its internal control system's guidelines, policies, 
and procedures. This would help to ensure that the control system that 
is implemented would adequately address the risks posed by the firm's 
business and the environment in which it is being conducted. In 
addition, this would enable a nonbank SBSD derivatives dealer to 
implement specific policies and procedures unique to its circumstances.
    In implementing its policies and procedures, a nonbank SBSD would 
be required to document and record its system of internal risk 
management controls. In particular, a nonbank SBSD would be required to 
document its consideration of certain issues affecting its business 
when designing its internal controls. A nonbank SBSD would also be 
required to prepare and maintain written guidelines that discuss its 
internal control system, including procedures for determining the scope 
of authorized activities. The Commission staff estimates that each of 
these 15 nonbank SBSDs \877\ would spend approximately 250 hours per 
year reviewing and updating their risk management control systems to 
comply with Rule 15c3-4, resulting in an industry-wide annual hour 
burden of approximately 3,750 hours.\878\
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    \877\ 25 nonbank SBSDs-10 ANC broker-dealer/SBSDs = 15 nonbank 
SBSDs.
    \878\ 15 nonbank SBSDs x 250 hours = 3,750 hours. These hour 
burden estimates are consistent with similar collections of 
information under Appendix E to Rule 15c3-1. These hours likely 
would be performed by a risk management specialist. Therefore, the 
estimated internal costs for this hour burden would be calculated as 
follows: Risk management specialist for 3,750 hours at $259 per hour 
= $971,250.

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[[Page 70296]]

    Nonbank SBSDs may incur start-up costs to comply with the 
provisions of Rule 15c3-4 incorporated into proposed Rule 18a-1, 
including information technology costs. The information technology 
systems of nonbank SBSDs may be in varying stages of readiness to 
enable these firms to meet the requirements of the proposed rules so 
the cost of modifying their information technology systems could vary 
significantly. Based on the estimates for similar collections of 
information,\879\ it is expected that a nonbank SBSDs would incur an 
average of approximately $16,000 for initial hardware and software 
expenses, while the average ongoing cost would be approximately $20,500 
per nonbank SBSD to meet the requirements of the proposed new Rule 18a-
1, for a total industry-wide initial cost of $240,000 and ongoing cost 
of $307,500 per year.\880\
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    \879\ Risk Management Controls for Brokers or Dealers with 
Market Access, Exchange Act Release No. 63421 (Nov. 3, 2010), 75 FR 
69792, 69814 (Nov. 15, 2010).
    \880\ 15 nonbank SBSDs x $16,000 = $240,000; 15 nonbank SBSDs x 
$20,500 =$307,500.
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    Fourth, proposed paragraph (c)(2)(vi)(O)(1)(iii) of Rule 15c3-1 and 
paragraph (c)(1)(vi)(A)(3)(i) of proposed new Rule 18a-1, broker-dealer 
SBSDs and stand-alone SBSDs not using models would be required to use 
an industry sector classification system that is documented and 
reasonable in terms of grouping types of companies with similar 
business activities and risk characteristics used for credit default 
swap reference obligors for purposes of calculating ``haircuts'' on 
security-based swaps under applicable net capital rules.
    As discussed above, the Commission staff estimates that 6 broker-
dealer SBSDs and 3 nonbank SBSDs not using models would utilize the 
credit default swap haircut provisions under the proposed amendments to 
Rule 15c3-1 and proposed new Rule 18a-1, respectively. Consequently, 
these firms would use an industry sector classification system that is 
documented for the credit default swap reference obligors. The 
Commission expects that these firms would utilize external 
classifications systems because of reduced costs and ease of use as a 
result of the common usage of several of these classification systems 
in the financial services industry. The Commission staff estimates that 
nonbank SBSDs not using models would spend approximately 1 hour per 
year documenting these industry sectors, for a total annual hour burden 
of 9 hours.\881\
---------------------------------------------------------------------------

    \881\ (3 nonbank SBSDs not using models x 1 hour) + (6 broker-
dealer SBSDs x 1 hour) = 9 hours. This function would likely be 
performed by an internal compliance attorney. Therefore, the 
estimated internal costs for this hour burden would be calculated as 
follows: Internal compliance attorney for 9 hours at $322 per hour = 
$2,898.
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    Fifth, under paragraph (i) of proposed new Rule 18a-1, a nonbank 
SBSD would be required to file certain notices with the Commission 
relating to the withdrawal of equity capital.\882\ Broker-dealers--
which would include broker-dealer SBSDs--currently are required to file 
these notices under paragraph (e) of Rule 15c3-1.\883\ The Commission 
staff estimates that the notice requirements would result in annual 
hour burdens to stand-alone SBSDs. The Commission staff estimates that 
each of the 9 stand-alone SBSDs would file approximately 2 notices 
annually with the Commission.\884\ In addition, the Commission staff 
estimates that it would take a stand-alone SBSD approximately 30 
minutes to file these notices, resulting in an industry-wide annual 
hour burden of 4.5 hours.\885\
---------------------------------------------------------------------------

    \882\ See proposed new Rule 18a-1(i).
    \883\ 17 CFR 240.15c3-1(e).
    \884\ This estimate is based on the number of notices currently 
filed by broker-dealers under the current collection of information 
under Rule 15c3-1.
    \885\ [9 stand-alone SBSDs x 2 notices] x 30 minutes = 4.5 
hours. This estimate is based on the 30 minutes it is estimated to 
take a broker-dealer to file a similar notice under Rule 15c3-1. The 
Commission believes the stand-alone SBSDs would likely perform these 
functions internally using an internal compliance attorney. 
Therefore, the estimated internal costs for this hour burden would 
be calculated as follows: Internal compliance attorney for 4.5 hours 
at $322 per hour = $1,449.
---------------------------------------------------------------------------

    Finally, under Appendix D to proposed new Rule 18a-1, a nonbank 
SBSD would be required to file a proposed subordinated loan agreement 
with the Commission (including nonconforming subordinated loan 
agreements).\886\ Broker-dealers--which would include broker-dealer 
SBSDs--currently are subject to such a requirement. The Commission 
staff estimates this proposed requirement would result in one-time and 
annual hour burdens for stand-alone SBSDs. Based on staff experience 
with Rule 15c3-1, the Commission staff estimates that each of the 9 
stand-alone SBSDs would spend approximately 20 hours of internal 
employee resources drafting or updating its subordinated loan agreement 
template to comply with the proposed requirement, resulting in an 
industry-wide one-time hour burden of approximately 180 hours.\887\ In 
addition, based on staff experience with Rule 15c3-1, the Commission 
staff estimates that each stand-alone SBSD would file 1 proposed 
subordinated loan agreement with the Commission per year and that it 
would take a firm approximately 10 hours to prepare and file the 
agreement, resulting in an industry-wide annual hour burden of 
approximately 90 hours.\888\
---------------------------------------------------------------------------

    \886\ See proposed new paragraph (c)(5) to proposed Rule 18a-1. 
Broker-dealer SBSDs would be subject to the provisions of Appendix D 
to Rule 15c3-1. 17 CFR 240.15c3-1d.
    \887\ 9 stand-alone SBSDs x 20 hours = 180 hours. This function 
would likely be performed by an in-house attorney. Therefore, the 
estimated internal costs for this hour burden would be calculated as 
follows: in-house attorney for 180 hours at $378 per hour = $68,040.
    \888\ 9 stand-alone SBSDs x 1 loan agreement x 10 hours = 90 
hours. This function would likely be performed by an in-house 
attorney. Therefore, the estimated internal costs for this hour 
burden would be calculated as follows: In-house attorney for 90 
hours at $378 per hour = $34,020.
---------------------------------------------------------------------------

2. Proposed Rule 18a-2
    Proposed new Rule 18a-2 would establish capital requirements for 
nonbank MSBSPs.\889\ In particular, a nonbank MSBSP would be required 
at all times to have and maintain positive tangible net worth.\890\ 
Because MSBSPs, by definition, will be entities that engage in a 
substantial security-based swap business, under the proposed rules, 
they would be required to comply with Rule 15c3-4,\891\ which requires 
OTC derivatives dealers and ANC broker-dealers to establish, document, 
and maintain a system of internal risk management controls to assist in 
managing the risks associated with their business activities, including 
market, credit, leverage, liquidity, legal, and operational risks.\892\ 
The Commission staff estimates that the requirement to comply with Rule 
15c3-4 would result in one-time and annual hour burdens to nonbank 
MSBSPs. The Commission staff estimates that the average amount of time 
a firm would spend implementing its risk management control system 
would be 2,000 hours,\893\ resulting in an industry-wide one-time hour 
burden of 10,000 hours.\894\
---------------------------------------------------------------------------

    \889\ See proposed new Rule 18a-2.
    \890\ See paragraph (a) of proposed new Rule 18a-2.
    \891\ See paragraph (c) of proposed new Rule 18a-2.
    \892\ See 17 CFR 240.15c3-4.
    \893\ This estimate is based on the one-time burden estimated 
for an OTC derivatives dealer to implement is controls under Rule 
15c3-1. OTC Derivatives Dealers, 62 FR 67940. This also is included 
in the current PRA estimate for Rule 15c3-4.
    \894\ 5 MSBSPs x 2,000 hours = 10,000 hours. These hours would 
likely be performed by a combination of an internal compliance 
attorney (3,333.33 hours), a risk management specialist (3,333.33 
hours), and an operations specialist (3,333.33 hours). Therefore, 
the estimated internal costs for this hour burden would be 
calculated as follows: ((internal compliance attorney for 3,333.33 
hours at $322 per hour) + (risk management specialist for 3,333.33 
hours at $259 per hour) + (operations specialist for 3,333.33 hours 
at $117 per hour)) = $2,326,664.34.

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

[[Page 70297]]

    The proposed rule would require a nonbank MSBSP to consider a 
number of issues affecting its business environment when creating its 
risk management control system. For example, a nonbank MSBSP would need 
to consider, among other things, the sophistication and experience of 
relevant trading, risk management, and internal audit personnel, as 
well as the separation of duties among these personnel, when designing 
and implementing its internal control system's guidelines, policies, 
and procedures. This would help to ensure that the control system that 
is implemented would adequately address the risks posed by the firm's 
business and the environment in which it is being conducted. In 
addition, this would enable a nonbank MSBSP to implement specific 
policies and procedures unique to its circumstances.
    In implementing its policies and procedures, a nonbank MSBSP would 
be required to document and record its system of internal risk 
management controls. In particular, a nonbank MSBSP would be required 
to document its consideration of certain issues affecting its business 
when designing its internal controls. A nonbank MSBSP would also be 
required to prepare and maintain written guidelines that discuss its 
internal control system, including procedures for determining the scope 
of authorized activities. The Commission staff estimates that each of 
the 5 MSBSPs would spend approximately 250 hours per year reviewing and 
updating their risk management control systems to comply with Rule 
15c3-4, resulting in an industry-wide annual hour burden of 
approximately 1,250 hours.\895\
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    \895\ 5 MSBSPs x 250 hours = 1,250 hours. These hour burden 
estimates are consistent with similar collections of information 
under Appendix E to Rule 15c3-1. These hours would likely be 
performed by a risk management specialist. Therefore, the estimated 
internal cost for this hour burden would be calculated as follows: 
Risk management specialist for 1,250 hours at $259 per hour = 
$323,750.
---------------------------------------------------------------------------

    Because nonbank MSBSPs may not initially have the systems or 
expertise internally to meet the risk management requirements of 
proposed new Rule 18a-2, these firms would likely hire an outside risk 
management consultant to assist them in implementing their risk 
management systems. The Commission staff estimates that a nonbank MSBSP 
may hire an outside management consultant for approximately 200 hours 
to assist the firm for a total start-up cost to the nonbank MSBSP of 
$80,000 per MSBSP, or a total of $400,000 for all nonbank MSBSPs.\896\
---------------------------------------------------------------------------

    \896\ 5 nonbank MSBSPs x $80,000 = $400,000. See also PRA 
Analysis in Product Definitions Adopting Release, 77 FR at 48344 
(providing an estimate of $400 an hour to engage an outside 
attorney); Nationally Recognized Statistical Rating Organizations, 
76 FR at 33504 (providing estimate of $400 per hour to engage 
outside attorneys and outside professionals).
---------------------------------------------------------------------------

    Nonbank MSBSPs may incur start-up costs to comply with proposed 
Rule 18a-2, including information technology costs. The information 
technology systems of a nonbank MSBSP may be in varying stages of 
readiness to enable these firms to meet the requirements of the 
proposed rules so the cost of modifying their information technology 
systems could vary significantly. Based on the estimates for similar 
collections of information,\897\ the Commission staff expects that a 
nonbank MSBSP would incur an average of approximately $16,000 for 
initial hardware and software expenses, while the average ongoing cost 
would be approximately $20,500 per nonbank MSBSP to meet the 
requirements of the proposed new Rule 18a-2, for a total industry-wide 
initial cost of $80,000 and ongoing cost of $102,500.\898\
---------------------------------------------------------------------------

    \897\ Risk Management Controls for Brokers or Dealers with 
Market Access, 75 FR at 69814.
    \898\ 5 nonbank MSBSPs x $16,000 = $80,000; 5 nonbank MSBSPs x 
$20,500 = $102,500.
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3. Proposed Rule 18a-3
    Proposed paragraph (e) of new Rule 18a-3 would require a nonbank 
SBSD to establish and implement risk monitoring procedures with respect 
to counterparty accounts.\899\ Therefore, paragraph (e) to proposed 
Rule 18a-3 would result in one-time and annual hour burdens for nonbank 
SBSDs. In this regard, nonbank SBSDs would need to develop a 
comprehensive written risk analysis methodology for assessing the 
potential risk to the firm over a specified range of possible market 
movements over a specified time period that would meet the requirements 
of the rule.
---------------------------------------------------------------------------

    \899\ See paragraph (e) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    Because these firms would already be required to comply with Rule 
15c3-4,\900\ the Commission staff estimates that each of the 25 nonbank 
SBSDs would spend an average of approximately 210 hours establishing 
the written risk analysis methodology, resulting in an industry-wide 
one-time hour burden of approximately 5,250 hours.\901\ In addition, 
based on staff experience, the Commission staff estimates that a 
nonbank SBSD would spend an average of approximately 60 hours per year 
reviewing the written risk analysis methodology and updating it as 
necessary, resulting in an average industry-wide annual hour burden of 
approximately 1,500 hours.\902\
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    \900\ See section II.A.2.c. of this release (describing risk 
management provisions of Rule 15c3-4).
    \901\ 25 nonbank SBSDs x 210 hours = 5,250 hours. See generally 
Clearing Agency Standards for Operation and Governance, 76 FR at 
14510 (estimating 210 one-time burden hours and 60 annual hours to 
implement policies and procedures reasonably designed to use margin 
requirements to limit a clearing agency's credit exposures to 
participants in normal market conditions and use risk-based models 
and parameters to set and review margin requirements.). These hours 
would likely be performed internally by an assistant general counsel 
(1,750 hours), a compliance attorney (1,750 hours), and a risk 
management specialist (1,750 hours). Therefore, the estimated 
internal cost for this hour burden would be calculated as follows: 
((assistant general counsel for 1,750 hours at $407 per hour) + 
(risk management specialist for 1,750 hours at $259 per hour) + 
(compliance attorney for 1,750 hours at $322 per hour)) = 
$1,729,000.
    \902\ 25 stand-alone SBSDs x 60 hours = 1,500 hours. These hours 
would likely be performed by a compliance attorney. Therefore, the 
estimated internal cost for this hour burden would be calculated as 
follows: Compliance attorney for 1,500 hours at $322 per hour = 
$483,000.
---------------------------------------------------------------------------

    The 25 respondents subject to the collection of information may 
incur start-up costs in order to comply with this collection of 
information. These costs may vary depending on the size and complexity 
of the nonbank SBSD. In addition, the start-up costs may be less for 
the 16 nonbank SBSD respondents also registered as broker-dealers 
because these firms may already be subject to similar requirements with 
respect to other margin rules.\903\ For the remaining 9 nonbank SBSDs, 
because these written procedures may be novel undertakings for these 
firms, the Commission staff assumes these nonbank SBSDs would have 
their written risk analysis methodology reviewed by outside counsel. As 
a result, the Commission staff estimates that these nonbank SBSDs would 
likely incur $2,000 in legal costs, or $18,000 in the aggregate initial 
burden to review and comment on these materials.\904\
---------------------------------------------------------------------------

    \903\ See, e.g., FINRA Rule 4210 and 4240. See also Business 
Conduct Release, 76 FR at 42445 (noting burden for paragraph (g) of 
proposed Rule 15Fh-3 is based on existing FINRA rules).
    \904\ The Commission staff estimates the review of the written 
risk analysis methodology would require 5 hours of outside counsel 
time at a cost of $400 per hour. See also Business Conduct Release, 
76 FR at 42445.
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4. Proposed Rule 18a-4
    Under proposed new Rule 18a-4, SBSDs would be required to establish 
special accounts with banks and obtain written acknowledgements from, 
and

[[Page 70298]]

enter into written contracts with, the banks. These special accounts 
would include: (1) The qualified clearing agency account under 
paragraph (a)(3); (2) the qualified SDSD account under paragraph 
(a)(4); and the special account for the exclusive benefit of security-
based swap customers under paragraph (a)(7) of proposed new Rule 18a-4, 
(collectively, the ``special accounts''). Based on staff experience 
with Rule 15c3-3, the Commission staff estimates that each of the 50 
SBSDs would establish six special accounts at banks (two for each type 
of special account). Further, based on staff experience with Rule 15c3-
3, the Commission staff estimates that each SBSD would spend 
approximately 30 hours to draft and obtain the written acknowledgement 
and agreement for each account, resulting in an industry-wide one-time 
hour burden of approximately 9,000 hours.\905\ The Commission staff 
estimates that 25% \906\ of the 50 SBSDs or approximately 13 would 
establish a new special account each year because, for example, they 
change their banking relationship, for each type of special account. 
Therefore, the Commission staff estimates an industry-wide annual hour 
burden of approximately 1,170 hours.\907\
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    \905\ 50 SBSDs x 6 special accounts x 30 hours = 9,000 hours. A 
compliance attorney would likely perform this function. Therefore, 
the estimated internal cost for this hour burden would be calculated 
as follows: Compliance attorney for 9,000 hours at $322 per hour = 
$2,898,000.
    \906\ This number is based on the currently approved PRA 
collection for Rule 15c3-3.
    \907\ 13 SBSDs x 3 types of special accounts x 30 hours = 1,170 
hours. A compliance attorney would likely perform this function. 
Therefore, the estimated internal cost for this hour burden would be 
calculated as follows: Compliance attorney for 1,170 hours at $322 
per hour = $376,740.
---------------------------------------------------------------------------

    Paragraph (c)(1) of proposed new Rule 18a-4 would provide that the 
SBSD must at all times maintain in a special account, through deposits 
into the account, cash and/or qualified securities in amounts computed 
in accordance with the formula set forth in Exhibit A to Rule 18a-
4,\908\ modeled on the formula in Appendix A to Rule 15c3-3. Paragraph 
(c)(3) of proposed new Rule 18a-4 would provide that the computations 
necessary to determine the amount required to be maintained in the 
special bank account must be made on a daily basis. Variation in size 
and complexity between these SBSDs would make it very difficult to 
develop a meaningful figure for the amount of time required to 
calculate each reserve computation. Based on experience with the Rule 
15c3-3 reserve computation PRA burden hours and with the OTC 
derivatives industry, the Commission staff estimates that it would take 
between one and five hours to compute each reserve computation, and 
that the average time spent across all the SBSDs would be approximately 
2.5 hours. Accordingly, the Commission staff estimates that the 
resulting annual hour burden for paragraph (c)(3) of proposed new Rule 
18a-3 would be approximately 31,250 hours.\909\
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    \908\ See paragraph (c)(1) of proposed new Rule 18a-4 and 
Exhibit A to proposed new Rule 18a-4.
    \909\ 50 SBSDs x 250 business days x 2.5 hours/day = 31,250 
hours. This task would likely be performed by a financial reporting 
manager. Therefore, the estimated internal cost for this hour burden 
would be calculated as follows: Financial reporting manager for 
31,250 hours at $309 per hour = $9,656,250.
---------------------------------------------------------------------------

    Under paragraph (d)(1) of proposed new Rule 18a-4, an SBSD or an 
MSBSP would be required to provide a notice to a counterparty pursuant 
to section 3E(f) of the Exchange Act prior to the execution of the 
first non-cleared security-based swap transaction with the counterparty 
occurring after the effective date of the proposed rule.\910\ All 50 
SBSDs and 5 MSBSPs would be required to provide these notices to their 
counterparties. The Commission staff estimates that these 55 entities 
would engage outside counsel to draft and review the notice at a cost 
of $400 per hour for an average of 10 hours per respondent, resulting 
in a one-time cost burden of $220,000 for all of these 55 
entities.\911\
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    \910\ See paragraph (d)(1) of proposed new Rule 18a-4.
    \911\ [50 SBSDs + 5 MSBSPs] x $400 per hour x 10 hours = 
$220,000. The Commission expects that these functions would likely 
be performed by outside counsel with an expertise in financial 
services law to help ensure that counterparties are receiving the 
proper notice under the statutory requirement.
---------------------------------------------------------------------------

    The number of notices sent in the first year the rule is effective 
would depend on the number of counterparties with which each SBSD and 
MSBSP engages in security-based swap transactions. The number of 
counterparties an SBSD and MSBSP would have would vary depending on the 
size and complexity of the firm and its operations. The Commission 
staff estimates that each of the 50 SBSDs and 5 MSBSPs would have 
approximately 1,000 counterparties at any given time.\912\ Therefore, 
the Commission staff estimates that approximately 55,000 notices would 
be sent in the first year the rule is effective.\913\ The Commission 
staff estimates that the each of the 50 SBSDs and 5 MSBSPs would spend 
approximately 10 minutes sending out the notice, resulting in an 
industry-wide one-time hour burden of approximately 9,167 hours.\914\ 
The Commission staff further estimates that the 50 SBSDs and 5 MSBSPs 
would establish account relationships with 200 new counterparties per 
year. Therefore, the Commission staff estimates that approximately 
11,000 notices would be sent annually,\915\ resulting in an industry-
wide annual hour burden of approximately 1,833 hours.\916\
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    \912\ The Commission previously estimated that there are 
approximately 8,500 market participants in security-based swap 
transactions. See Business Conduct Release, 76 FR at 42443. Based on 
the 8,500 market participants and Commission staff experience 
relative to the securities and OTC derivatives industry, the 
Commission staff estimates that each SBSD and MSBSP would have 1,000 
counterparties at any given time. The number of counterparties may 
widely vary depending on the size of the SBSD or MSBSP. A large firm 
may have thousands or counterparties at one time, while a smaller 
firm may have substantially less than 1,000. The Commission staff 
also estimates, based on staff experience, that these entities would 
establish account relationships with approximately 200 new 
counterparties a year, or approximately 20% of a firm's existing 
counterparties.
    \913\ [50 SBSDs + 5 MSBSPs] x 1,000 counterparties = 55,000 
notices.
    \914\ (55,000 notices x 10 minutes)/60 minutes = 9,167 hours. A 
compliance clerk would likely send these notices. Therefore, the 
estimated internal cost for this hour burden would be calculated as 
follows: Compliance clerk for 9,167 hours at $60 per hour = 
$550,020. The hourly rates use for internal office employees used 
throughout this section are taken from SIFMA's Office Salaries in 
the Securities Industry 2011, modified by the Commission staff to 
account for an 1800-hour work-year and multiplied by 2.93 to account 
for bonuses, firm size, employee benefits and overhead.
    \915\ [50 SBSDs + 5 MSBSPs] x 200 counterparties = 11,000 
notices.
    \916\ (11,000 notices x 10 minutes)/60 minutes = 1,833 hours. A 
compliance clerk would likely send these notices. Therefore, the 
estimated internal cost for this hour burden would be calculated as 
follows: compliance clerk for 1,833 hours at $60 per hour = 
$109,980.
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    Under proposed new Rule 18a-4(d)(2), an SBSD would be required to 
obtain agreements from counterparties that do not choose to require 
segregation of funds or other property pursuant to Section 3E(f) of the 
Exchange Act or paragraph (c)(3) of Rule 18a-4 in which the 
counterparty agrees to subordinate all of its claims against the SBSD 
to the claims of security-based swap customers of the SBSD.\917\ The 
Commission staff estimates that an SBSD would spend, on average, 
approximately 200 hours to draft and prepare standard subordination 
agreements, resulting in an industry-wide one-time hour burden of 
10,000 hours.\918\ Because the SBSD would enter into these agreements 
with

[[Page 70299]]

security-based swap customers, after the SBSD prepares a standard 
subordination agreement in-house, the Commission staff also estimates 
that an SBSD would have outside counsel a review the standard 
subordination agreements and that the review would take approximately 
20 hours at a cost of approximately $400 per hour. As a result, the 
Commission staff estimates that each SBSD would incur one-time costs of 
approximately $8,000,\919\ resulting in an industry-wide one-time cost 
of approximately $400,000.\920\
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    \917\ See paragraph (d)(2) of proposed new Rule 18a-4.
    \918\ 200 hours x 50 SBSDs = 10,000 hours. An in-house attorney 
would likely draft these agreements because the Commission staff 
expects that drafting contracts would be one of the typical job 
functions of an in-house attorney. Therefore, the estimated internal 
cost for this hour burden would be calculated as follows: In-house 
attorney for 10,000 hours at $378 per hour = $3,780,000.
    \919\ $400 x 20 hours = $8,000.
    \920\ $8,000 x 50 = $400,000.
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    As discussed above, the Commission staff estimates that each of the 
50 SBSDs would have approximately 1,000 counterparties at any given 
time. The Commission staff further estimates that approximately 50% of 
these counterparties would either elect individual segregation or waive 
segregation altogether.\921\ The Commission staff estimates that an 
SBSD would spend 20 hours per counterparty to enter into a written 
subordination agreement, resulting in an industry-wide one-time hour 
burden of approximately 500,000 hours.\922\ Further, as discussed the 
Commission staff estimates that each of the 50 SBSDs would establish 
account relationships with 200 new counterparties per year. The 
Commission staff further estimates that 50% or 100 of these 
counterparties would either elect individual segregation or waive 
segregation altogether. Therefore, the Commission staff estimates an 
industry-wide annual hour burden of approximately 100,000 hours.\923\
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    \921\ Based on discussions with market participants, the 
Commission staff understands that many large buy-side financial end 
users currently ask for individual segregation and the Commission 
staff assumes that many of these end users will continue to do so. 
However, Commission staff believes that some smaller end users may 
not choose to incur additional cost that may come with individual 
segregation. Therefore, the Commission staff estimates that 
approximately 50% of counterparties will either elect individual 
segregation or waiver segregation altogether.
    \922\ 50 SBSDs x 500 counterparties x 20 hours = 500,000 hours. 
These functions would likely be performed by a compliance attorney 
(250,000 hours) and a compliance clerk (250,000 hours). Therefore, 
the estimated internal cost for this hour burden would be calculated 
as follows: ((compliance attorney for 250,000 hours at $322 per 
hour) + (compliance clerk for 250,000 hours at $60 per hour)) = 
$95,500,000.
    \923\ 50 SBSDs x 100 counterparties x 20 hours = 100,000 hours. 
These functions would likely be performed by a compliance attorney 
(50,000 hours) and a compliance clerk 50,000 hours). Therefore, the 
estimated internal cost for this hour burden would be calculated as 
follows: ((compliance attorney for 50,000 hours at $322 per hour) + 
(compliance clerk for 50,000 hours at $60 per hour)) = $19,100,000.
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E. Collection of Information Is Mandatory

    The collections of information pursuant to the proposed amendments 
and new rules are mandatory, as applicable, for ANC broker-dealers, 
SBSDs, and MSBSPs.

F. Confidentiality

    The Commission expects to receive confidential information in 
connection with the proposed collections of information. To the extent 
that the Commission receives confidential information pursuant to these 
collections of information, the Commission is committed to protecting 
the confidentiality of such information to the extent permitted by 
law.\924\
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    \924\ See, e.g., 15 U.S.C. 78 x (governing the public 
availability of information obtained by the Commission); 5 U.S.C. 
552 et seq. (Freedom of Information Act--``FOIA''). See also 
paragraph (d)(1) of proposed new Rule 18a-1(d). FOIA provides at 
least two pertinent exemptions under which the Commission has 
authority to withhold certain information. FOIA Exemption 4 provides 
an exemption for ``trade secrets and commercial or financial 
information obtained from a person and privileged or confidential.'' 
5 U.S.C. 552(b)(4). FOIA Exemption 8 provides an exemption for 
matters that are ``contained in or related to examination, 
operating, or condition reports prepared by, on behalf of, or for 
the use of an agency responsible for the regulation or supervision 
of financial institutions.'' 5 U.S.C. 552(b)(8).
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G. Retention Period for Recordkeeping Requirements

    ANC broker-dealers are required to preserve for a period of not 
less than three years, the first two years in an easily accessible 
place, certain records required under Rule 15c3-4 and certain records 
under Appendix E to Rule 15c3-1.\925\ Rule 17a-4 specifies the required 
retention periods for a broker-dealer.\926\ Many of a broker-dealer's 
records must be retained for three years; certain other records must be 
retained for longer periods.\927\
---------------------------------------------------------------------------

    \925\ See 17 CFR 17a-4(b)(9), (10), and (12).
    \926\ 17 CFR 240.17a-4.
    \927\ Id.
---------------------------------------------------------------------------

    As noted above, the recordkeeping burdens with respect to some 
requirements in proposed new Rules 18a-1 through 18a-4 will be 
addressed in the SBSD and MSBSP recordkeeping requirements, which will 
the subject of a separate release.

H. Request for Comment

    Pursuant to 44 U.S.C. 3306(c)(2)(B), the Commission requests 
comment on the proposed collections of information in order to:
     Evaluate whether the proposed collections of information 
are necessary for the proper performance of the functions of the 
Commission, including whether the information would have practical 
utility;
     Evaluate the accuracy of the Commission's estimates of the 
burden of the proposed collections of information;
     Determine whether there are ways to enhance the quality, 
utility, and clarity of the information to be collected; and
     Evaluate whether there are ways to minimize the burden of 
the collection of information on those who respond, including through 
the use of automated collection techniques or other forms of 
information technology.

Persons submitting comments on the collection of information 
requirements should direct their comments to the Office of Management 
and Budget, Attention: Desk Officer for the Securities and Exchange 
Commission, Office of Information and Regulatory Affairs, Washington, 
DC 20503, and should also send a copy of their comments to Elizabeth M. 
Murphy, Secretary, Securities and Exchange Commission, 100 F Street 
NE., Washington, DC 20549-1090, and refer to File No. S7-08-12. OMB is 
required to make a decision concerning the collections of information 
between 30 and 60 days after publication of this document in the 
Federal Register; therefore, comments to OMB are best assured of having 
full effect if OMB receives them within 30 days of this publication. 
Requests for the materials submitted to OMB by the Commission with 
regard to these collections of information should be in writing, refer 
to File No. S7-08-12, and be submitted to the Securities and Exchange 
Commission, Records Management, Office of Filings and Information 
Services, 100 F Street NE., Washington, DC 20549.

V. Economic Analysis

    The Commission is sensitive to the costs and benefits of its rules. 
Some of these costs and benefits stem from statutory mandates, while 
others are affected by the discretion exercised in implementing the 
mandates. The following economic analysis seeks to identify and 
consider the benefits and costs--including the effects on efficiency, 
competition, and capital formation--that would result from the proposed 
capital, margin, and segregation rules for SBSDs and MSBSPs and from 
the proposed amendments to Rule 15c3-1. The costs and benefits 
considered in proposing these new rules and amendments are discussed 
below and have informed the policy choices described throughout this 
release.

[[Page 70300]]

    The Commission discusses below a baseline against which the rules 
may be evaluated. For the purposes of this economic analysis, the 
baseline is the OTC derivatives markets as they exist today prior to 
the effectiveness of the statutory and regulatory provisions that will 
govern these markets in the future pursuant to the Dodd-Frank Act. With 
respect to the proposed amendments to Rule 15c3-1, the baseline for 
purposes of this economic analysis is the current capital regime for 
broker-dealers under Rule 15c3-1.\928\
---------------------------------------------------------------------------

    \928\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    While the Commission does not have comprehensive information on the 
U.S. OTC derivatives markets, the Commission is using the limited data 
currently available in considering in this economic analysis the 
effects of the proposals, including their intended benefits and 
anticipated possible costs.\929\ Additionally, the Commission requests 
that commenters identify sources of data and information as well as 
provide data and information to assist the Commission in analyzing the 
economic consequences of the proposed rules. More generally, the 
Commission requests comment on all aspects of this initial economic 
analysis, including on whether the analysis has: (1) Identified all 
benefits and costs, including all effects on efficiency, competition, 
and capital formation; (2) given due consideration to each benefit and 
cost, including each effect on efficiency, competition, and capital 
formation; and (3) identified and considered reasonable alternatives to 
the proposed new rules and rule amendments.
---------------------------------------------------------------------------

    \929\ Information that is available for the purposes of this 
economic analysis includes an analysis of the market for single-name 
credit default swaps performed by the Commission's Division of Risk, 
Strategy, and Financial Innovation. See CDS Data Analysis.
---------------------------------------------------------------------------

    If these proposed rules and rule amendments are adopted, their 
benefits and costs would affect competition, efficiency, and capital 
formation in the security-based swap market broadly, with the impact 
not being limited to SBSDs and MSBSPs. Section 3(f) of the Exchange Act 
provides that whenever the Commission engages in rulemaking under the 
Exchange Act and is required to consider or determine whether an action 
is necessary or appropriate in the public interest, the Commission 
shall also consider, in addition to the protection of investors, 
whether the action will promote efficiency, competition, and capital 
formation.\930\ In addition, section 23(a)(2) of the Exchange Act 
requires the Commission, when adopting rules under the Exchange Act, to 
consider the effect such rules would have on competition.\931\ Section 
23(a)(2) of the Exchange Act also prohibits the Commission from 
adopting any rule that would impose a burden on competition not 
necessary or appropriate in furtherance of the purposes of the Exchange 
Act.\932\
---------------------------------------------------------------------------

    \930\ 15 U.S.C. 78c(f).
    \931\ 15 U.S.C. 78w(a)(2).
    \932\ Id.
---------------------------------------------------------------------------

    As discussed more fully in section II. above, the Commission is 
proposing: (1) Rules 18a-1 and 18a-2, and amendments to Rule 15c3-1, to 
establish capital requirements for nonbank SBSDs and nonbank MSBSPs; 
(2) Rule 18a-3 to establish customer margin requirements applicable to 
nonbank SBSDs and nonbank MSBSPs for non-cleared security-based swaps; 
and (3) Rule 18a-4 to establish segregation requirements for SBSDs and 
notification requirements with respect to segregation for SBSDs and 
MSBSPs.\933\ Some of the proposed amendments to Rule 15c3-1 would apply 
to broker-dealers that are not registered as SBSDs or MSBSPs to the 
extent that they hold positions in security-based swaps and swaps. The 
Commission also is proposing to amend Rule 15c3-1 to increase the 
minimum capital requirements for ANC broker-dealers. Finally, the 
Commission is proposing a liquidity requirement for ANC broker-dealers 
and for nonbank stand-alone SBSDs that use internal models to compute 
net capital.
---------------------------------------------------------------------------

    \933\ The Commission is also proposing a conforming amendment to 
Rule 15c3-3 to clarify that broker-dealer SBSDs must comply with 
Rule 15c3-3 and Rule 18a-4, as applicable.
---------------------------------------------------------------------------

    The sections below present an overview of the OTC derivatives 
markets, a discussion of the general costs and benefits of the proposed 
financial responsibility requirements, and a discussion of the costs 
and benefits of each proposed amendment and new rule. The sections that 
follow also incorporate a consideration of the potential effects of the 
proposed amendments and new rules on competition, efficiency, and 
capital formation.

A. Baseline of Economic Analysis

1. Overview of the OTC Derivatives Markets--Baseline for Proposed Rules 
18a-1 Through 18a-4
    As stated above, to assess the costs and benefits of these rules, a 
baseline must be established against which the rules may be evaluated. 
For the purposes of this economic analysis, the baseline is the OTC 
derivatives markets \934\ as they exist today prior to the 
effectiveness of the statutory and regulatory provisions that will 
govern these markets in the future pursuant to the Dodd-Frank Act.\935\ 
The markets as they exist today are dominated, both globally and 
domestically, by a small number of firms, generally entities affiliated 
with or within large commercial banks.\936\
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    \934\ OTC derivatives may include forwards, swaps and options on 
foreign exchange, and interest rate, equity and commodity 
derivatives.
    \935\ The baseline, however, for amendments to Rule 15c3-1 is 
the current financial responsibility regime for broker-dealers under 
this rule.
    \936\ See, e.g., ISDA Margin Survey 2012.
---------------------------------------------------------------------------

    The OTC derivatives markets have been described as opaque because, 
for example, transaction-level data about OTC derivatives trading 
generally is not publicly available.\937\ This economic analysis is 
supported, where possible, by data currently available to the 
Commission from The Depository Trust & Clearing Corporation Trade 
Information Warehouse (``DTCC-TIW''). This evaluation takes into 
account data regarding the security-based swap market and especially 
data regarding the activity--including activity that may be suggestive 
of dealing behavior--of participants in the single-name credit default 
swap market.\938\ While a large segment of the security-based swap 
market is comprised of single-name credit default swaps, these 
derivatives do not comprise the entire security-based swap market.\939\ 
Moreover, credit

[[Page 70301]]

default swaps are a small percentage of the overall OTC derivatives 
market, which, in addition to security-based swaps, includes foreign 
currency swaps and interest rate swaps.
---------------------------------------------------------------------------

    \937\ See Orice M. Williams, GAO, Systemic Risk: Regulatory 
Oversight and Recent Initiatives to Address Risk Posed by Credit 
Default Swaps at 2, 5, 27. See also Robert E. Litan, The Brookings 
Institution, The Derivatives Dealers' Club and Derivatives Market 
Reform: A Guide for Policy Makers, Citizens and Other Interested 
Parties 15-20 (Apr. 7, 2010), available at http://www.brookings.edu/
~/media/research/files/papers/2010/4/07%20derivatives%20litan/0407--
derivatives--litan.pdf; Security-Based Swap Data Repository 
Registration, Duties, and Core Principles, Exchange Act Release No. 
63347 (Nov. 19, 2010), 75 FR 77306, 77354 (Dec. 10, 2010); IOSCO, 
The Credit Default Swap Market, Report FR05/12, (June 2012), 
available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD385.pdf 
(stating although the amount of public information on CDS has 
increased over recent years, the CDS market is still quite opaque).
    \938\ The CDS Data Analysis provides reasonably comprehensive 
information regarding the credit default swap activities and 
positions of U.S. market participants, but the Commission notes that 
the data does not encompass those credit default swaps that both: 
(i) Do not involve U.S. counterparties; and (ii) are based on non-
U.S. reference entities. Reliance on this data should not be 
interpreted to indicate our views as to the nature or extent of the 
application of Title VII to non-U.S. persons; instead, it is 
anticipated that issues regarding the extraterritorial application 
of Title VII will be addressed in a separate release.
    \939\ In addition, it is reasonable to believe that the 
implementation of Title VII itself will change the security-based 
swap market, and, with the full implementation of Title VII--which 
in part is conditioned on the implementation of the proposed 
financial responsibility program--more information will be available 
for this analysis.
---------------------------------------------------------------------------

    Available information about the global OTC derivatives markets 
suggests that swap transactions, in contrast to security-based swap 
transactions, dominate trading activities, notional amounts, and market 
values.\940\ For example, the BIS estimates that the total notional 
amounts outstanding and gross market value of global OTC derivatives 
were over $648 trillion and $27.2 trillion, respectively, as of the end 
of 2011.\941\ Of these totals, the BIS estimates that foreign exchange 
contracts, interest rate contracts, and commodity contracts comprised 
approximately 88% of the total notional amount and 84% of the gross 
market value.\942\ Credit default swaps, including index credit default 
swaps, comprised approximately 4.4% of the total notional amount and 
5.8% of the gross market value. Equity-linked contracts, including 
forwards, swaps and options, comprised approximately an additional 1.0% 
of the total notional amount and 2.5% of the gross market value.\943\
---------------------------------------------------------------------------

    \940\ See BIS, Statistical Release: OTC derivatives statistics 
at end-December 2011, 5 (May 2012), available at http://www.bis.org/publ/otc_hy1205.pdf (reflecting data reported by central banks in 
14 countries: Belgium, Canada, France, Germany, England, Italy, 
Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, the 
United States, Australia, and Spain).
    \941\ Id. at 12 (``Nominal or notional amounts outstanding are 
defined as the gross nominal or notional value of all deals 
concluded and not yet settled on the reporting date * * * Gross 
market values are defined as the sums of the absolute values of all 
open contracts with either positive or negative replacement values 
evaluated at market prices prevailing on the reporting date * * * 
gross market values supply information about the potential scale of 
market risk in derivatives transactions. Furthermore, gross market 
value at current market prices provides a measure of economic 
significance that is readily comparable across markets and 
products.'').
    \942\ Id.
    \943\ Id. Similarly, the OCC has found that interest rate 
products comprised 81% of the total notional amount of OTC 
derivatives held by bank dealers whereas credit derivative contracts 
comprised 6.4% and equity contracts comprised 1% of that notional 
amount. See OCC, Quarterly Report on Bank Trading and Derivatives 
Activities, Fourth Quarter 2011, available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq411.pdf.
---------------------------------------------------------------------------

    Because the financial responsibility program for SBSDs and MSBSPs 
would apply to dealers and participants in the security-based swap 
markets, they are expected to affect a substantially smaller portion of 
the U.S. OTC derivatives markets than the proposed financial 
responsibility rules for swap dealers and major swap participants 
proposed by the CFTC and prudential regulators.\944\ In addition, 
though the proposed capital, segregation and margin rules apply to all 
security-based swaps, not just single-name credit default swaps, the 
data on single-name credit default swaps are currently sufficiently 
representative of the market to help inform this economic analysis 
because currently an estimated 95% of all security-based swap 
transactions appear likely to be single-name credit default swaps.\945\ 
The majority of these single-name credit default swaps, both in terms 
of aggregate total notional amount and total volume by product type, 
are based on corporate and sovereign reference entities.\946\
---------------------------------------------------------------------------

    \944\ See CFTC Margin Proposing Release, 76 FR 27802; Prudential 
Regulator Margin and Capital Proposing Release, 76 FR 27564.
    \945\ See Entity Definitions Adopting Release, 77 FR at 30636. 
See also Product Definitions Adopting Release, 77 FR 48205 (defining 
the term security-based swap).
    \946\ Data compiled by the Commission's Division of Risk, 
Strategy, and Financial Innovation on credit default transactions 
from the DTCC-TIW between January 1, 2011 and December 31, 2011.
---------------------------------------------------------------------------

    While the number of transactions is larger in single-name credit 
default swaps than in index credit default swaps, the aggregate total 
notional amount of the latter exceeds that of single-name credit 
default swaps.\947\ For example, the total aggregate notional amount 
for single-name credit default swaps was $6.2 trillion, while the 
aggregate total notional amount for index credit default swaps was 
$16.8 trillion over the sample period of January 1, 2011 to December 
31, 2011. For the same sample period, however, single-name credit 
default swaps totaled 69% of transactional volume, while index credit 
default swaps comprised 31% of the total transactional volume.\948\ The 
majority of trades in both notional amount and volume for both single-
name and index credit default swaps over the 2011 sample period were 
new trades in contrast to assignments, increases, terminations or 
exits.\949\ The analysis of the 2011 data further shows that by total 
notional amount and total volume the majority of single-name and index 
credit default contracts have a tenor of 5 years.\950\ In addition, the 
data from the sample period indicates that the geographical 
distribution of counterparties' parent country domiciles in single name 
contracts are concentrated in the United States, United Kingdom, and 
Switzerland.\951\
---------------------------------------------------------------------------

    \947\ Id. This data also shows the average mean and median 
single-name and index credit default swap notional transaction size 
in millions is 6.47 and 4.12, and 39.22 and 14.25, respectively.
    \948\ Id.
    \949\ Id.
    \950\ Id.
    \951\ Id.
---------------------------------------------------------------------------

    As described more fully in the CDS Data Analysis,\952\ based on 
2011 transaction data, Commission staff identified entities currently 
transacting in the credit default swap market that may register as 
SBSDs by analyzing various criteria of their dealing activity. The 
results suggest that there is currently a high degree of concentration 
of potential dealing activity in the single-name credit default swap 
market. For example, using the criterion that dealers are likely to 
transact with many counterparties who themselves are not dealers, the 
analysis of the 2011 data show that only 28 out of 1,084 market 
participants have three or more counterparties that themselves are not 
recognized as dealers by ISDA.\953\ In addition, the analysis suggests 
that dealers appear, based on the percentage of trades between buyer 
and seller principals, in the majority of all trades on either one or 
both sides in single-name and index credit default swaps.\954\
---------------------------------------------------------------------------

    \952\ See CDS Data Analysis.
    \953\ Id. at Table 3c. The analysis of this transaction data is 
imperfect as a tool for identifying dealing activity, given that the 
presence or absence of dealing activity ultimately turns upon the 
relevant facts and circumstances of an entity's security-based swap 
transactions, as informed by the dealer-trader distinction. Criteria 
based on the number of an entity's counterparties that are not 
recognized as dealers nonetheless appear to be useful for 
identifying apparent dealing activity in the absence of full 
analysis of the relevant facts and circumstances, given that 
engaging in security-based swap transactions with non-dealers would 
be consistent with the conduct of seeking to profit by providing 
liquidity to others, as anticipated by the dealer-trader 
distinction.
    \954\ Data compiled by the Commission's Division of Risk, 
Strategy, and Financial Innovation on credit default transactions 
from the DTCC-TIW between January 1, 2011 and December 31, 2011. 
Additionally, according to the OCC, at the end of the first quarter 
of 2012, derivatives activity in the U.S. banking system continues 
to be dominated by a small group of large financial institutions. 
Four large commercial banks represent 93% of the total banking 
industry notional amounts and 81% of industry net current credit 
exposure. See OCC, Quarterly Report on Bank Trading and Derivatives 
Activities, First Quarter 2012, available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq112.pdf.
---------------------------------------------------------------------------

    This concentration to a large extent appears to reflect the fact 
that those larger entities are well-capitalized and therefore possess 
competitive advantages in engaging in OTC security-based swap dealing 
activities by providing potential counterparties with adequate 
assurances of financial performance.\955\ As such, it is

[[Page 70302]]

reasonable to conclude that currently there likely are high barriers to 
entry in terms of capitalization in connection with security-based swap 
dealing activity.\956\
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    \955\ See, e.g., Craig Pirrong, Rocket Science, Default Risk and 
The Organization of Derivatives Markets, Working Paper 17-18 (2006), 
available at http://www.cba.uh.edu/spirrong/Derivorg1.pdf (noting 
that counterparties seek to reduce risk of default by engaging in 
credit derivative transactions with well-capitalized firms). See 
also Entity Definitions Adopting Release, 77 FR at 30739-30742.
    \956\ See id. at 18-19 (noting lack of success among new 
entrants into derivatives dealing market due to perception that AAA 
rating for subsidiary is less desirable than a slightly lower rating 
for a larger entity, and suggesting that there are ``economies of 
scale in bearing default risk'' that may induce ``substantial 
concentration in dealer activities''). See also Entity Definitions 
Adopting Release, 77 FR at 30739-30742.
---------------------------------------------------------------------------

    Other than OTC derivatives dealers, which are subject to 
significant limitations on their activities, broker-dealers 
historically have not participated in a significant way in security-
based swap trading for at least two reasons. First, because the 
Exchange Act has not previously defined security-based swaps as 
``securities,'' they have not been required to be traded through 
registered broker-dealers.\957\ And second, a broker-dealer engaging in 
security-based swap activities is currently subject to existing 
regulatory requirements with respect to those activities, including 
capital, margin, segregation, and recordkeeping requirements. 
Specifically, the existing broker-dealer capital requirements make it 
relatively costly to conduct these activities in broker-dealers, as 
discussed in section II.A.2. of this release. As a result, security-
based swap activities are currently mostly concentrated in entities 
that are affiliated with the parent companies of broker-dealers, but 
not in broker-dealers themselves.\958\
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    \957\ See definition of ``security'' in section 3(a)(10) of the 
Exchange Act and ``security-based swap'' in section 3(a)(68) of the 
Exchange Act.
    \958\ See ISDA Margin Survey 2012.
---------------------------------------------------------------------------

    End users enter into OTC derivatives transactions to take 
investment positions or to hedge commercial and financial risk. These 
non-dealer end users of OTC derivatives are, for example, commercial 
companies, governmental entities, financial institutions, investment 
vehicles, and individuals. Available data suggests that the largest end 
users of credit default swaps are, in descending order, hedge funds, 
asset managers, and banks, which may have a commercial need to hedge 
their credit exposures to a wide variety of entities or may take an 
active view on credit risk.\959\ Based on the available data, the 
Commission further estimates that commercial end users currently 
participate in the security-based swap markets on a very limited 
basis.\960\
---------------------------------------------------------------------------

    \959\ This information is based on available market data from 
DTCC-TIW compiled by the Commission's Division of Risk, Strategy, 
and Financial Innovation. For example, data compiled by the 
Commission's Division of Risk, Strategy, and Financial Innovation on 
credit default transactions from the DTCC-TIW between January 1, 
2011 and December 31, 2011 suggests that for single-name credit 
default swap transactions, dealer to dealer transactions composed 
68.26% of trades between buyer and seller principals over the sample 
period.
    \960\ For example, data compiled by the Commission's Division of 
Risk, Strategy, and Financial Innovation on credit default 
transactions from the DTCC-TIW between January 1, 2011 and December 
31, 2011 suggest that the total percentage of trades between buyer 
and seller principals over the sample period for single-name credit 
default swaps was only 0.03% of the total trade counterparty 
distribution for non-financial end users, which are composed of non-
financial companies and family trusts.
---------------------------------------------------------------------------

    Finally, this baseline for proposed new Rules 18a-1 through 18a-4 
will be further discussed in the applicable sections of the release 
below.
Request for Comment
    The Commission generally requests comment about its preliminary 
estimates of the scale and composition of the OTC derivatives market, 
including the relative size of the security-based swap segment of that 
market. In addition, the Commission requests that commenters provide 
data and sources of data to quantify:
    1. The average daily and annual volume of OTC derivatives 
transactions;
    2. The volume of transactions in each class of OTC derivatives 
(e.g., interest rate swaps, index credit default swaps, single-name 
credit default swaps, currency swaps, commodity swaps, and equity-based 
swaps);
    3. The total notional amount of all pending swap transactions;
    4. The total current exposure of all pending swap transactions;
    5. The total notional amount of all pending security-based swap 
transactions;
    6. The total current exposure of all pending security-based swap 
transactions;
    7. The types and numbers of dealers in OTC derivatives (e.g., 
banks, broker-dealers, unregulated entities);
    8. The capital levels of dealers, particularly those not subject to 
regulatory capital requirements;
    9. The types and numbers of dealers in OTC derivatives dealers that 
engage in both a swap and security-based swap business;
    10. The types and numbers of dealers in OTC derivatives that engage 
only in a swap business;
    11. The types and numbers of dealers in OTC derivatives that engage 
only in a security-based swaps business;
    12. The classes of end users (e.g., commercial end users, financial 
end users, and others) and the number of end users in each class;
    13. The types of OTC derivatives transactions that each class of 
end user commonly engages in;
    14. The amount of assets posted for OTC derivatives to 
collateralize current exposure;
    15. The amount of assets posted for OTC derivatives to 
collateralize potential future exposure;
    16. The type of assets used as collateral; and
    17. The amount of assets that are held under the different types of 
collateral arrangements (e.g., held by the dealer but not segregated, 
held by the dealer in omnibus segregation, held by a third-party 
custodian).
2. Baseline for Amendments to Rule 15c3-1
    As discussed in more detail above, the Commission is proposing 
amendments to Rule 15c3-1.\961\ These amendments would establish 
minimum net capital requirements for broker-dealers that register as 
SBSDs, increase the minimum net capital requirements for ANC broker-
dealers, narrow the current treatment of credit risk charges for ANC 
broker-dealers to apply only to uncollateralized receivables from 
commercial end users arising from security-based swaps, and establish 
liquidity requirements for ANC broker-dealers and nonbank SBSDs using 
internal models. Some of those proposed amendments to Rule 15c3-1 would 
also apply to broker-dealers not registering as SBSDs or MSBSPs to the 
extent they hold security-based swap positions or non-security-based 
swap positions.
---------------------------------------------------------------------------

    \961\ See section II.B. of this release.
---------------------------------------------------------------------------

    As discussed in section II.A.1. of this release, the existing 
broker-dealer capital requirements are contained in Rule 15c3-1 \962\ 
and seven appendices to Rule 15c3-1.\963\ The baseline for this 
economic analysis with respect to the proposed amendments to Rule 15c3-
1 is

[[Page 70303]]

the broker-dealer capital regime as it exists today.
---------------------------------------------------------------------------

    \962\ 17 CFR 240.15c3-1.
    \963\ 17 CFR 240.15c3-1a (Options); 17 CFR 240.15c3-1b 
(Adjustments to net worth and aggregate indebtedness for certain 
commodities transactions); 17 CFR 240.15c3-1c (Consolidated 
computations of net capital and aggregate indebtedness for certain 
subsidiaries and affiliates; 17 CFR 240.15c3-1d (Satisfactory 
subordination agreements); 17 CFR 240.15c3-1e (Deductions for market 
and credit risk for certain brokers or dealers); 17 CFR 240.15c3-1f 
(Optional market and credit risk requirements for OTC derivatives 
dealers); 17 CFR 240.15c3-1g (Conditions for ultimate holding 
companies of certain brokers or dealers).
---------------------------------------------------------------------------

    Specifically, current Rule 15c3-1 requires broker-dealers to 
maintain a minimum level of net capital (meaning highly liquid capital) 
at all times.\964\ The rule requires that a broker-dealer perform two 
calculations: (1) A computation of the minimum amount of net capital 
the broker-dealer must maintain; \965\ and (2) a computation of the 
amount of net capital the broker-dealer is maintaining.\966\ The 
minimum net capital requirement is the greater of a fixed-dollar amount 
specified in the rule and an amount determined by applying one of two 
financial ratios: the 15-to-1 aggregate indebtedness to net capital 
ratio or the 2% of aggregate debit items ratio.\967\
---------------------------------------------------------------------------

    \964\ See 17 CFR 240.15c3-1.
    \965\ See 17 CFR 240.15c3-1(a).
    \966\ See 17 CFR 240.15c3-1(c)(2). The computation of net 
capital is based on the definition of ``net capital'' in paragraph 
(c)(2) of Rule 15c3-1. Id.
    \967\ See 17 CFR 240.15c3-1(a).
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    In computing net capital, the broker-dealer must, among other 
things, make certain adjustments to net worth such as deducting 
illiquid assets and taking other capital charges and adding qualifying 
subordinated loans.\968\ ``Tentative net capital'' is defined as the 
amount remaining after these deductions.\969\ The final step in 
computing net capital is to deduct from the mark-to-market values of 
the proprietary positions (e.g. in securities, money market 
instruments, and commodities) that are included in its tentative net 
capital prescribed percentages (``standardized haircuts'').\970\ The 
standardized haircuts are designed to account for the market risk 
inherent in these proprietary positions and to create a buffer of 
liquidity to protect against other risks associated with the securities 
business.\971\ With Commission approval, ANC broker-dealers and OTC 
derivative dealers are permitted to calculate deductions for market 
risk and credit risk from tentative net capital using internal models 
in lieu of the standardized haircuts.\972\ Because the use of internal 
models to compute net capital generally can substantially reduce the 
deductions for proprietary positions compared to standardized haircuts 
and only certain risks are addressed by these internal models, current 
Rule 15c3-1 imposes substantially higher minimum capital requirements 
for ANC broker-dealers and OTC derivatives dealers as compared to other 
types of broker-dealers.\973\ For example, under current Rule 15c3-1, 
ANC broker-dealers are required to at all times maintain tentative net 
capital of not less than $1 billion and net capital of not less than 
$500,000,\974\ and they are required to provide notice to the 
Commission if their tentative net capital falls below $5 billion.\975\ 
The current rule requires that a broker-dealer must ensure that its net 
capital exceeds its minimum net capital requirement at all times.\976\
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    \968\ See 17 CFR 240.15c3-1(c)(2)(i)-(xiii).
    \969\ See 17 CFR 240.15c3-1(c)(15).
    \970\ See 17 CFR 240.15c3-1(c)(2)(vi).
    \971\ See, e.g., Uniform Net Capital Rule, 42 FR 31778 
(``[Haircuts] are intended to enable net capital computations to 
reflect the market risk inherent in the positioning of the 
particular types of securities enumerated in [the rule]'').
    \972\ See 17 CFR 240.15c3-1(a)(5) and (a)(7); 17 CFR 240.15c3-
1e; 17 CFR 240.15c3-1f. As part of the application to use internal 
models, an entity seeking to become an ANC broker-dealer or an OTC 
derivatives dealer must identify the types of positions it intends 
to include in its model calculation. See 17 CFR 240.15c3-
3e(a)(1)(iii); 17 CFR 240.15c3-1f(a)(1)(ii). After approval, the ANC 
broker-dealer or OTC derivatives dealer must obtain Commission 
approval to make a material change to the model, including a change 
to the types of positions included in the model. See 17 CFR 
240.15c3-1e(a)(8); 17 CFR 240.15c3-f(a)(3).
    \973\ See 17 CFR 240.15c3-1(a)(5) and (a)(7).
    \974\ 17 CFR 240.15c3-1(a)(7)(i).
    \975\ 17 CFR 240.15c3-1(a)(7)(ii).
    \976\ 17 CFR 240.15c3-1(a).
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    Finally, the baseline of the current capital regime will be further 
discussed in the applicable sections of the release below.

B. Analysis of the Proposals and Alternatives

1. Overview--The Proposed Financial Responsibility Program
    Generally, the financial responsibility requirements the Commission 
is proposing today are intended to enhance the financial integrity of 
SBSDs and MSBSPs. As discussed more fully below, in proposing these 
requirements, the Commission is seeking to appropriately consider both 
the potential benefits of minimizing the risk that the failure of one 
firm will cause financial distress to other firms and disrupt financial 
markets and the U.S. financial system and the potential costs to that 
firm, the financial markets, and the U.S. financial system if SBSDs and 
MSBPs are required to comply with overly restrictive capital, margin 
and segregation requirements. This introductory section reviews at a 
general level certain considerations regarding the economic analysis of 
the proposed rules that is set forth in greater detail below.
    As discussed in section I. of the release, the current broker-
dealer financial responsibility requirements serve as the template for 
the proposals for several reasons. First, the financial markets in 
which SBSDs and MSBSPs are expected to operate are similar to the 
financial markets in which broker-dealers operate in the sense that 
they are driven in significant part by dealers that buy and sell on a 
regular basis and that take principal risk. Second, like nonbank 
dealers in securities but unlike bank SBSDs, nonbank SBSDs will not be 
able to rely on a backstop provider of liquidity but rather need to be 
able to liquidate assets quickly in the event of a counterparty 
default. Third, the broker-dealer financial responsibility requirements 
have existed for many years and have facilitated the prudent operation 
of broker-dealers.\977\ Fourth, some broker-dealers likely will be 
registered as nonbank SBSDs so as to be able to offer customers a 
broader range of services than would be permitted as a stand-alone 
SBSD. Therefore, establishing consistent financial responsibility 
requirements would avoid potential competitive disparities between 
stand-alone SBSDs and broker-dealer SBSDs. And fifth, by placing an 
emphasis on maintaining liquid assets and requiring the segregation of 
customer funds, the current broker-dealer financial responsibility 
requirements have generally been successful in limiting losses to 
customers due to broker-dealer defaults.\978\ Consequently, the current 
broker-dealer financial responsibility requirements provide a 
reasonable template for building a financial responsibility program for 
SBSDs and MSBSPs.
---------------------------------------------------------------------------

    \977\ For example, one of the objectives of the broker-dealer 
financial responsibility requirements is to protect customers from 
the consequences of the financial failure of a broker-dealer in 
terms of safeguarding customer securities and funds held by the 
broker-dealer. In this regard, SIPC, since its inception in 1971, 
has initiated customer protection proceedings for only 324 broker-
dealers, which is less than 1% of the approximately 39,200 broker-
dealers that have been members of SIPC during that timeframe. During 
the same period, only $1.1 billion of the $117.5 billion of cash and 
securities distributed for accounts of customers came from the SIPC 
fund rather than debtors' estates. See SIPC 2011 Annual Report.
    \978\ For example, of the more than 625,200 claims satisfied in 
completed or substantially completed cases since SIPC's inception in 
1971, as of December 31, 2011, a total of 351 were for cash and 
securities whose value was greater than the limits of protection 
afforded by SIPA. The 351 claims, unchanged during 2011, represent 
less than one-tenth of one percent of all claims satisfied. The 
unsatisfied portion of claims, $47.2 million, is unchanged in 2011. 
These remaining claims approximate three-tenths of one percent of 
the total value of securities and cash distributed for accounts of 
customers in those cases. See SIPC 2011 Annual Report. These figures 
do not include the SIPA liquidations of Bernard L. Madoff Investment 
Securities LLC and Lehman Brothers Inc., which are not complete.
---------------------------------------------------------------------------

    However, the Commission recognizes that there may be other 
appropriate

[[Page 70304]]

approaches to establishing financial responsibility requirements--
including, for example, requirements based on the Basel Standard in the 
case of entities that are part of a bank holding company, as has been 
proposed by the CFTC.\979\ Generally, the bank capital model requires 
the holding of specified levels of capital as a percentage of ``risk 
weighted assets.'' \980\ In general, it does not require a full capital 
deduction for unsecured receivables, given that banks, as lending 
entities, are in the business of extending credit to a range of 
counterparties.
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    \979\ CFTC Capital Proposing Release, 76 FR 27802.
    \980\ The prudential regulators also have proposed capital rules 
that would require a covered swap entity to comply with the 
regulatory capital rules already made applicable to that covered 
swap entity as part of its prudential regulatory regime. Prudential 
Regulator Margin and Capital Proposing Release, 76 FR at 27568. The 
prudential regulators note that they have ``had risk-based capital 
rules in place for banks to address over-the-counter derivatives 
since 1989 when the banking agencies implemented their risk-based 
capital adequacy standards * * * based on the first Basel Accord.'' 
Id.
---------------------------------------------------------------------------

    This approach could promote a consistent view and management of 
capital within a bank holding company structure. However, it would not 
be a net liquid assets standard. In addition, applying capital rules 
designed for banks to a non-bank entity would raise various practical 
and policy issues that are not directly implicated by the proposed 
approach. First, it would need to be clear whether a regulator with 
primary responsibility for the non-bank entity would defer to bank 
regulators with respect to the interpretation of Basel standards as 
applied to the entity, or instead develop its own interpretation of 
those standards. Further, it would need to be clear how trading and 
other risks of the non-bank entity and its bank affiliate or affiliates 
would be expected to be managed, whether such risks would be managed 
holistically at the holding company level or separately at the entity 
level, and what limitations, if any, would apply to transfers of risks 
from a bank to its non-bank entity affiliate, or vice versa. In 
addition, to the extent that bank capital standards would permit the 
non-bank entity to hold more illiquid assets as regulatory capital, an 
additional liquidity standard might be required at the entity level in 
order to assure that the entity maintained sufficient liquidity to 
support its trading activity. Similarly, if the non-bank entity were an 
SBSD that held assets for customers, the impact of any reduced 
liquidity associated with the application of bank capital standards on 
the ability of the entity to quickly wind down operations and 
distribute assets to customers would need to be considered. The 
Commission specifically seeks comment as to whether to adapt Basel 
capital standards to non-bank affiliates of banks, and how such a 
regime would work in practice--including how it would address the 
issues described above and similar challenges.
    The Commission also recognizes that in determining appropriate 
financial responsibility requirements--whether based on current broker-
dealer rules or other alternative approaches described above--it must 
assess and consider a number of different costs and benefits, and the 
determinations it ultimately makes can have a variety of economic 
consequences for the relevant firms, markets, and the financial system 
as a whole. On the one hand, the capital and margin requirements in 
particular are broadly intended to work in tandem to strengthen the 
financial system by reducing the potential for default to an acceptable 
level and limiting the amount of leverage that can be employed by SBSDs 
and other market participants. Requiring particular firms to hold more 
capital or exchange more margin may reduce the risk of default by one 
or more market participants and reduce the amount of leverage employed 
in the system generally, which in turn may have a number of important 
benefits. The failure of an SBSD could result in immediate financial 
loss to its counterparties or customers, particularly those that are 
not able to avoid losses by liquidating collateral or those that have 
delivered assets for custody by the SBSD. Since the primary benefit of 
the capital and margin requirements is to reduce the probability of a 
SBSD failure, potential counterparties may be more willing to transact 
when they have greater assurance that they will be paid following a 
credit event. Depending on the size of the SBSD and its 
interconnectedness with other market participants, such a default also 
could have adverse spillover or contagion effects that could create 
instability for the financial markets more generally, such as limiting 
the willingness of healthy market participants to extend credit to each 
other, and thus substantially reduce liquidity and valuations for 
particular types of financial instruments.\981\ Further, to the extent 
that market participants generally perceive that the prudential 
requirements are sufficient to protect them from losses due to a 
counterparty's default, the security-based swap market may experience 
increased trading activity, reduced transaction costs, improved 
liquidity, enhanced capital formation, and an improved ability to 
manage risk.
---------------------------------------------------------------------------

    \981\ See, e.g., Markus K. Brunnermeier and Lasse Heje Pedersen, 
Market Liquidity and Funding Liquidity, Review of Financial Studies, 
22 Review of Financial Studies 2201 (2009); Denis Gromb and Dimitri 
Vayanos, A Model of Financial Market Liquidity Based on Intermediary 
Capital, 8 Journal of the European Economic Association 456 (2010).
---------------------------------------------------------------------------

    On the other hand, as described below, higher financial 
responsibility requirements for individual firms also give rise to 
direct costs for the firms involved and potentially significant 
collective costs for the markets and the financial system as a whole. 
For example, overly restrictive requirements that increase the cost of 
trading by individual firms could reduce their willingness to engage in 
such trading, adversely affecting liquidity in the security-based swaps 
markets and increasing transaction costs for market participants. 
Similarly, capital requirements that are set high enough to limit or 
restrict the willingness or ability of new firms to enter the market 
may impair or reduce competition in the markets, which in turn could 
also adversely affect liquidity and price discovery and increase 
transaction costs. Any such reduction in liquidity or price discovery, 
or increase in transaction costs, could adversely affect efficiency and 
impose direct costs on those market participants who rely on security-
based swaps to manage or hedge the risks arising from their business 
activities that may support or promote capital formation. Even if the 
cost of overly restrictive financial responsibility requirements were 
shouldered only by those market participants that are subject to them, 
the excess amount of capital or margin tied up as a result of those 
requirements would not be available for potentially more efficient 
uses, which thereby could impair effective capital allocation and 
formation.
    Although, in establishing appropriate financial responsibility 
requirements that are neither insufficient nor excessive, the 
Commission must seek to consider these and other potential benefits and 
costs, the Commission notes that it is difficult to quantify such 
benefits and costs. For example, although the adverse spillover effects 
of defaults on liquidity and valuations were evident during the 
financial crisis,\982\ it is difficult to quantify the

[[Page 70305]]

effects of measures intended to reduce the default probability of the 
individual intermediary, the ensuing prevention of contagion, and the 
adverse effects on liquidity and valuation. More broadly, it is 
difficult to quantify the costs and benefits that may be associated 
with steps to mitigate or avoid a future financial crisis. Similarly, 
although capital, margin, or segregation requirements may, among other 
things, affect liquidity and transaction costs in the security-based 
swap markets, and result in a different allocation of capital than may 
otherwise occur, it is difficult to quantify the extent of these 
effects, or the resulting effect on the financial system more 
generally.
---------------------------------------------------------------------------

    \982\ See aggregate derivatives claims on Lehman Brothers 
Special Finance initially filed by the top 30 financial institution 
counterparties was estimated to be approximately $22 billion, 
available at http://chapter11.epiqsystems.com/LBH/document/GetDocument.aspx?DocumentId=1386611 and http://chapter11.epiqsystems.com/LBH/document/GetDocument.aspx?DocumentId=1430484.
---------------------------------------------------------------------------

    These difficulties are further aggravated by the fact that only 
limited public data related to the security-based swap market, in 
general, and to security-based swap market participants in particular, 
exist, all of which could assist in quantifying certain benefits and 
costs. It also is difficult to demonstrate empirically that the 
customer protections associated with the proposed financial 
responsibility requirements would alter the likelihood that any 
specific market participant would suffer injury, or the degree to which 
the participant would suffer injury, from participating in an under- or 
over-regulated security-based swap market.
    In light of these challenges, much of the discussion of the 
proposed rules in this economic analysis will remain qualitative in 
nature, although where possible the economic analysis attempts to 
quantify these benefits and costs. The inability to quantify these 
benefits and costs, however, does not mean that the benefits and costs 
of the proposals are any less significant. In addition, as noted above, 
the proposed rules include a number of specific quantitative 
requirements--such as numerical thresholds, limits, deductions and 
ratios. The Commission recognizes that the specificity of each such 
quantitative requirement could be read by some to imply a definitive 
conclusion based on quantitative analysis of that requirement and its 
alternatives. These quantitative requirements have not been derived 
directly from econometric or mathematical models. Instead, they reflect 
a preliminary assessment by the Commission, based on qualitative 
analysis, regarding the appropriate financial standard for an 
identified issue, drawing (as noted above) from the Commission's long-
term experience in administering its existing broker-dealer financial 
responsibility regime as well as its general experience in regulating 
broker-dealers and markets and from comparable quantitative 
requirements in its own rules and those of other regulators. 
Accordingly, the discussion generally describes in a qualitative way 
the primary costs, benefits and other economic effects that the 
Commission has identified and taken into account in developing these 
specific quantitative requirements. The Commission emphasizes that it 
invites comment, including relevant data and analysis, regarding all 
aspects of the various quantitative requirements reflected in the 
proposed rules.
    Finally, the Commission notes that the proposals ultimately 
adopted, like other requirements under the Dodd-Frank Act, could have a 
substantial impact on international commerce and the relative 
competitive position of intermediaries operating in various, or 
multiple, jurisdictions. U.S. or foreign firms could be advantaged or 
disadvantaged depending on how the rules ultimately adopted by the 
Commission compare with corresponding requirements in other 
jurisdictions. Such differences could in turn affect cross-border 
capital flows and the ability of global firms to most efficiently 
allocate capital among legal entities to meet the demands of their 
counterparties. The Commission intends to address the potential 
international implications of the proposed capital, margin and 
segregation requirements, together with the full spectrum of other 
issues relating to the application of Title VII to cross-border 
security-based swap transactions, in a separate proposal.
a. Nonbank SBSDs
    In addition to fulfilling a statutory requirement, it is expected 
that the proposed capital, margin and segregation rules should be 
beneficial to market participants by advancing market transparency, 
risk reduction and counterparty protection as Title VII of the Dodd-
Frank Act intended.\983\ It can be further expected that these benefits 
manifest themselves over the long-term and benefit the market as a 
whole. To the extent that the proposed rules increase the safety and 
soundness of entities that register as nonbank SBSDs and not just 
codify current practice, the proposals should specifically reduce the 
likelihood of default by an intermediary with substantial positions in 
security-based swaps and possible negative spillover effects. This 
would further imply that without the proposed rules in place, such an 
event could result in significant losses to counterparties whose 
exposures to the defaulting dealer are not sufficiently secured, which, 
depending on the size of individual counterparty exposures, could lead 
to defaults of those counterparties. Such events could then deter 
intermediaries from entering into financing transactions,\984\ even 
with creditworthy counterparties, which could ultimately adversely 
affect valuation and liquidity in the broader financial markets.\985\
---------------------------------------------------------------------------

    \983\ See section I. of this release.
    \984\ See, e.g., Markus K. Brunnermeier and Lasse Heje Pedersen, 
Market Liquidity and Funding Liquidity, Review of Financial Studies 
at 22; Denis Gromb and Dimitri Vayanos, A Model of Financial Market 
Liquidity Based on Intermediary Capital at 8.
    \985\ See aggregate derivatives claims on Lehman Brothers 
Special Finance initially filed by the top 30 financial institution 
counterparties was estimated to be approximately $22 billion, 
available at http://chapter11.epiqsystems.com/LBH/document/GetDocument.aspx?DocumentId=1386611 and http://chapter11.epiqsystems.com/LBH/document/GetDocument.aspx?DocumentId=1430484.
---------------------------------------------------------------------------

    Apart from the positive impact on the safety and soundness of the 
security-based swap market, the proposed new rules and rule amendments 
could create the potential for regulatory arbitrage to the extent that 
they differ from corresponding rules other regulators adopt. As noted 
above in section I. of this release, the Commission is proposing 
capital and margin requirements for nonbank SBSDs that differ in some 
respects from the prudential regulators' proposed capital and margin 
requirements for bank SBSDs.\986\ Depending on the final rules the 
Commission adopts, the financial responsibility requirements could make 
it more or less costly to conduct security-based swaps trading in banks 
as compared to nonbank SBSDs. For example, if the application of the 
proposed 8% margin risk factor substantially increases capital 
requirements for nonbank SBSDs compared to the risk-based capital 
requirements imposed by the prudential regulators on the same activity, 
bank holding companies could be incentivized to conduct these 
activities in their bank affiliates.\987\ On the other hand, if the 
Commission does not require nonbank SBSDs to collect initial margin in 
their transactions with each other, as is generally current market 
practice,\988\ while the prudential regulators require the collection 
of initial margin for the same trades as their proposed rules suggest, 
intermediaries could have an incentive

[[Page 70306]]

to conduct business through nonbank entities.\989\ These differences 
could create competitive inequalities and affect the allocation of 
trading activities within a holding company structure.
    The proposed financial responsibility requirements for SBSDs would 
also result in costs to individual market participants and may affect 
the amount of capital available to support security-based swap 
transactions generally.\990\ As described in section V.B.1 immediately 
above, if SBSDs are required to maintain an excessive amount of 
capital, that amount may result in certain costs for the markets and 
the financial system, including the potential for the reduced 
availability of security-based swaps for market participants who would 
otherwise use such transactions to hedge the risks of their business, 
or engage in other activities that would promote capital formation. In 
addition, in some cases, these costs may include costs to financial 
conglomerates to restructure their security-based swap activities or 
move them into affiliates that register as SBSDs.\991\ Nonbank SBSDs as 
well as other market participants would also incur costs to hire 
compliance personnel and to establish internal systems, procedures and 
controls designed to ensure compliance with the new requirements. Some 
of these costs were discussed in the PRA analysis in section IV of this 
release. Finally, the full cost impact of the proposed financial 
responsibility requirements will depend to some extent on other rules 
related to SBSDs (e.g., registration) that the Commission has not yet 
adopted.\992\
---------------------------------------------------------------------------

    \986\ See section I. of this release.
    \987\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564.
    \988\ See generally ISDA Margin Survey 2011.
    \989\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564.
    \990\ See section II. of this release.
    \991\ See SBSD Registration Proposing Release, 76 FR 65784.
    \992\ Id.
---------------------------------------------------------------------------

    Costs related to specific sections of the proposed new rules and 
rule amendments are discussed below. Some of these costs may be largely 
fixed in nature; other costs (such as minimum capital requirements and 
margin costs) may be variable as they reflect the level of the nonbank 
SBSD's security-based swap activity. End users also may incur increased 
transaction costs in connection with the proposals as SBSDs are likely 
to pass on the financial burden of any increased capital, margin or 
segregation requirements to customers.\993\
---------------------------------------------------------------------------

    \993\ If the rules succeed in improving competition among 
dealers in the security-based swap market rules this pass-through 
behavior should be less of a concern.
---------------------------------------------------------------------------

    This economic analysis considers the overall benefits and costs of 
the proposed new rules and amendments, keeping in mind that the 
benefits may be distributed across market participants, accrue over the 
long-term, and are difficult to quantify or to measure as easily as 
certain costs.
Request for Comment
    The Commission generally requests comment about its analysis of the 
general costs and benefits of the proposed rules. The Commission 
requests data to quantify and estimates of the costs and the value of 
the benefits of the proposals described above. The Commission also 
requests data to quantify the impact of the proposals against the 
baseline. In addition, the Commission requests comment in response to 
the following questions:
    1. In general terms, how effectively would the proposed rules limit 
systemic risk arising from security-based swap transactions? Please 
explain.
    2. In general, how would the proposed rules and rule amendments 
impact the capital of entities that would need to register as nonbank 
SBSDs? For example, would they require these entities to hold more 
capital? If so, what would be the impact of the availability of sources 
of funding to these entities?
    3. How important is parity of treatment between nonbank SBSDs and 
bank SBSDs in terms of regulatory requirements, and how should parity 
be understood? For example, should nonbank SBSDs and bank SBSDs be 
required to hold the same amounts of capital to support a certain level 
of security-based swaps business?
    4. To what extent would the proposed regulatory requirements impact 
the amount of liquidity provided for or required by security-based swap 
market participants, and to what extent will that affect the funding 
cost for the financial sector in particular and the economy in general? 
Please quantify.
b. Nonbank MSBSPs
    As with their application to nonbank SBSDs, in addition to 
fulfilling a statutory requirement, it is expected that the proposed 
capital, margin and notification requirements under the segregation 
rules for MSBSPs will advance market transparency, risk reduction and 
counterparty protection as Title VII of the Dodd-Frank Act 
intended.\994\ However, in contrast to capital and margin requirements 
for nonbank SBSDs, the proposed rules for nonbank MSBSPs are intended 
to limit the impact on counterparties of a potential default by a 
nonbank MSBSP, rather than to create prudential standards that would 
render the possibility of its failure more remote. Capital standards of 
the type that would apply to SBSDs \995\ may not be practical for 
nonbank MSBSPs, depending on their individual business models and 
whether they are subject to any other prudential requirements. 
Accordingly, the proposals are intended to ensure that nonbank MSBSPs 
meet a minimum capital standard by maintaining a positive tangible net 
worth,\996\ collateralize their current exposures to end users, and 
post collateral to counterparties that covers at least the amount of 
the current exposure of those counterparties to them.\997\
---------------------------------------------------------------------------

    \994\ See section I. of this release.
    \995\ See proposed new Rule 18a-1.
    \996\ See proposed new Rule 18a-2.
    \997\ See proposed new Rule 18a-3.
---------------------------------------------------------------------------

    These proposed requirements are expected to have a relatively 
smaller aggregate effect than the proposed financial responsibility 
requirements for nonbank SBSDs because they are likely to affect 
relatively fewer entities. The Commission expects that only 5 or fewer 
entities will register as nonbank MSBSPs with the Commission.\998\ 
Another approach, discussed further below, would subject MSBSPs to a 
capital regime similar to that proposed for nonbank SBSDs.
---------------------------------------------------------------------------

    \998\ See section IV.C. of this release.
---------------------------------------------------------------------------

    The proposed financial responsibility requirements for MSBSPs would 
also result in costs to individual market participants and may affect 
the amount of capital available to support security-based swap 
transactions overall and the financial markets generally. To the extent 
that the proposed capital and margin requirements are too restrictive, 
it could limit capital formation and the use of security-based swaps to 
hedge risks associated with the MSBSP's business activities.\999\
---------------------------------------------------------------------------

    \999\ See section II. of this release.
---------------------------------------------------------------------------

    The proposed requirements may also impose more limited compliance 
burdens on MSBSPs. For example, nonbank MSBSPs as well as other market 
participants would also incur costs to hire compliance personnel and to 
establish internal systems, procedures and controls designed to ensure 
compliance with the new requirements.\1000\ Some of these costs are 
discussed in the PRA analysis in section IV. of this release. Finally, 
the full cost impact of the proposed financial responsibility 
requirements will depend to some extent on other rules related to 
MSBSPs (e.g., registration) that the Commission has not yet 
adopted.\1001\
---------------------------------------------------------------------------

    \1000\ See section V.C. of this release.
    \1001\ See SBSD Registration Proposing Release, 76 FR 65784.

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[[Page 70307]]

    Costs related to specific sections of the proposed new rules and 
rule amendments are discussed below. Some of these costs may be largely 
fixed in nature; other costs (such as minimum capital requirements and 
margin costs) may be variable as they reflect the level of the nonbank 
MSBSP's security-based swap activity.
Request for Comment
    The Commission generally requests comment about its analysis of the 
general costs and benefits of the proposed rules on MSBSPs. The 
Commission requests data to quantify and estimates of the costs and the 
value of the benefits of the proposals for MSBSPs described above.
2. The Proposed Capital Rules
a. Nonbank SBSDs and ANC Broker-Dealers
    As discussed above in section II.A. of this release, proposed new 
Rule 18a-1 would prescribe capital requirements for stand-alone SBSDs, 
and proposed amendments to Rule 15c3-1 would prescribe capital 
requirements for broker-dealer SBSDs and increase existing capital 
requirements for ANC broker-dealers.\1002\ The proposed amendments to 
Rule 15c3-1 would apply to broker-dealers that are not registered as 
SBSDs to the extent they hold positions in security-based swaps and 
swaps. In addition, the Commission is proposing liquidity requirements 
for ANC broker-dealers and stand-alone SBSDs that use internal models 
to compute net capital.\1003\ Finally, the Commission is proposing to 
require that all nonbank SBSDs comply with Rule 15c3-4, which requires 
the establishment of a risk management control system.\1004\
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    \1002\ See proposed new Rule 18a-1.
    \1003\ See proposed paragraph (f) to Rule 15c3-1; paragraph (f) 
of proposed new Rule 18a-1.
    \1004\ See proposed new paragraph (a)(10)(ii) of Rule 15c3-1; 
paragraph (g) of proposed new Rule 18a-1. See also 17 CFR 240.15c3-
4.
---------------------------------------------------------------------------

    As described above, the capital and other financial responsibility 
requirements for broker-dealers generally provide a reasonable template 
for crafting the corresponding requirements for nonbank SBSDs. For 
example, among other considerations, the objectives of capital 
standards for both types of entities are similar. Rule 15c3-1 is a net 
liquid assets test that is designed to require a broker-dealer to 
maintain sufficient liquid assets to meet all obligations to customers 
and counterparties and have adequate additional resources to wind-down 
its business in an orderly manner without the need for a formal 
proceeding if it fails financially. The objective of the proposed 
capital standards for nonbank SBSDs is the same.
    In addition, as discussed in section II.A.1. above, the Dodd-Frank 
Act divided responsibility for SBSDs and MSBSPs by providing the 
prudential regulators with authority to prescribe the capital and 
margin requirements for bank SBSDs and the Commission with authority to 
prescribe capital and margin requirements for nonbank SBSDs.\1005\ This 
division also suggests it may be appropriate to model the capital 
requirements for nonbank SBSDs on the capital standards for broker-
dealers, while the capital requirements for bank SBSDs are modeled on 
capital standards for banks (as reflected in the proposal by the 
prudential regulators).\1006\
---------------------------------------------------------------------------

    \1005\ See 15 U.S.C. 78o-10, in general; 15 U.S.C. 78o-
10(e)(2)(A)-(B), in particular.
    \1006\ The prudential regulators have proposed capital 
requirements for bank SBSDs and bank swap dealers that are based on 
the capital requirements for banks. See Prudential Regulator Margin 
and Capital Proposing Release, 76 FR at 27582.
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    As discussed in section II.A.1. above, certain differences in the 
activities of securities firms, banks, and commodities firms, 
differences in the products at issue, or the balancing of relevant 
policy choices and considerations, appear to support this distinction 
between nonbank SBSDs and bank SBSDs. First, based on the Commission 
staff's understanding of the activities of nonbank dealers in OTC 
derivatives, nonbank SBSDs are expected to engage in a securities 
business with respect to security-based swaps that is more similar to 
the dealer activities of broker-dealers than to the activities of 
banks; indeed, some broker-dealers likely will be registered as nonbank 
SBSDs.\1007\ Second, existing capital standards for banks and broker-
dealers reflect, in part, differences in their funding models and 
access to certain types of financial support, and those same 
differences also will exist between bank SBSDs and nonbank SBSDs. For 
example, banks obtain funding through customer deposits and can obtain 
liquidity through the Federal Reserve's discount window; whereas 
broker-dealers do not--and nonbank SBSDs will not--have access to these 
sources of funding and liquidity. Third, Rule 15c3-1 currently contains 
provisions designed to address dealing in OTC derivatives by broker-
dealers and, therefore, to some extent already can accommodate this 
type of activity (although, as discussed below, proposed amendments to 
Rule 15c3-1 would be designed to more specifically address the risks of 
security-based swaps and the potential for increased involvement of 
broker-dealers in the security-based swaps markets).\1008\ For these 
reasons, the proposed capital standard for nonbank SBSDs is a net 
liquid assets test modeled on the broker-dealer capital standard in 
Rule 15c3-1.
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    \1007\ Id.
    \1008\ See 17 CFR 240.15c3-1f and 17 CFR 240.15c3-1e. See also 
Alternative Net Capital Requirements Adopting Release, 69 FR 34428; 
OTC Derivatives Dealers, 63 FR 59362.
---------------------------------------------------------------------------

    The net liquid assets test is designed to allow a broker-dealer to 
engage in activities that are part of conducting a securities business 
(e.g., taking securities into inventory) but in a manner that places 
the firm in the position of holding at all times more than one dollar 
of highly liquid assets for each dollar of unsubordinated liabilities 
(e.g., money owed to customers, counterparties, and creditors). For 
example, Rule 15c3-1 allows securities positions to count as allowable 
net capital, subject to standardized or internal model-based 
haircuts.\1009\ The rule, however, does not permit most unsecured 
receivables to count as allowable net capital.\1010\
---------------------------------------------------------------------------

    \1009\ See 17 CFR 240.15c3-1(c)(2)(vi); 17 CFR 240.15c3-1e; 17 
CFR 240.15c3-1f.
    \1010\ See 17 CFR 240.15c3-1(c)(2)(iv).
---------------------------------------------------------------------------

    This aspect of the rule severely limits the ability of broker-
dealers to engage in activities, such as unsecured lending, that 
generate unsecured receivables. The rule also does not permit fixed 
assets or other illiquid assets to count as allowable net capital, 
which creates disincentives for broker-dealers to own real estate and 
other fixed assets that cannot be readily converted into cash. For 
these reasons, Rule 15c3-1 incentivizes broker-dealers to confine their 
business activities and devote capital to activities such as 
underwriting, market making, and advising on and facilitating customer 
securities transactions.
    Proposed new Rule 18a-1 and the proposed amendments to Rule 15c3-1 
would provide a number of benefits, as well as impose certain costs on 
nonbank SBSDs, broker-dealer SBSDs, and broker-dealers, which are 
described below. In considering costs, in cases where the Commission is 
proposing amendments to Rule 15c3-1, the baseline is the current 
broker-dealer capital regime under Rule 15c3-1.\1011\ The proposed rule 
also will have possible effects on competition, efficiency, and capital 
formation, which will be discussed further below.
---------------------------------------------------------------------------

    \1011\ 17 CFR 240.15c3-1.

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[[Page 70308]]

i. Minimum Capital Requirements
    The following table provides a summary of the proposed minimum 
capital requirements under the proposed new Rule 18a-1 and proposed 
amendments to Rule 15c3-1:
[GRAPHIC] [TIFF OMITTED] TP23NO12.001

    Stand-alone SBSDs and broker-dealer SBSDs that are not approved to 
use internal models, that is, are neither ANC broker-dealers nor OTC 
derivatives dealers, would be required to maintain net capital of the 
larger of $20 million or 8% of the firm's margin factor. The proposed 
$20 million fixed-dollar minimum requirement would be consistent with 
the fixed-dollar minimum requirement applicable to OTC derivatives 
dealers and already familiar to existing market participants.\1012\ OTC 
derivatives dealers are limited purpose broker-dealers that are 
authorized to trade in certain derivatives, including security-based 
swaps, use internal models to calculate net capital, and they are 
required to maintain minimum tentative net capital of $100 million and 
minimum net capital of $20 million.\1013\ These current fixed-dollar 
minimums have been the minimum capital standards for OTC derivative 
dealers for over a decade and to date, there have been no indications 
that these minimums are not adequately meeting the objective of 
requiring OTC derivatives dealers to maintain sufficient levels of 
regulatory capital to account for the risks inherent in their 
activities.
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    \1012\ See 17 CFR 240.15c3-1(a)(5). The CFTC proposed a $20 
million fixed-dollar minimum net capital requirement for FCMs that 
are registered as swap dealers, regardless of whether the firm is 
approved to use internal models to compute regulatory capital. See 
CFTC Capital Proposing Release, 76 FR 27802. Further, the CFTC 
proposed a $20 million fixed-dollar ``tangible net equity'' minimum 
requirement for swap dealers and major swap participants that are 
not FCMs and are not affiliated with a U.S. bank holding company. 
Finally, the CFTC proposed a $20 million fixed-dollar Tier 1 capital 
minimum requirement for swap dealers and major swap participants 
that are not FCMs and are affiliated with a U.S. bank holding 
company (the term ``Tier 1 capital'' refers to the regulatory 
capital requirement for U.S. banking institutions). Id.
    \1013\ See 17 CFR 240.15c3-1(a)(5).
---------------------------------------------------------------------------

    However, the proposed $20 million fixed-dollar minimum requirement 
for stand-alone SBSDs not using internal models to calculate net 
capital would be substantially higher than the fixed-dollar minimums in 
Rule 15c3-1 currently applicable to broker-dealers that do not use 
internal models.\1014\ The proposed more stringent minimum capital 
requirement of $20 million for stand-alone SBSDs not approved to use 
models reflects the facts that these firms: (1) Unlike broker-dealers, 
will be able to deal in security-based swaps, which, in general, pose 
risks that are different from, and in some respects greater than, those 
arising from dealing in securities; but (2) unlike OTC derivative 
dealers have direct customer relationships and have custody of customer 
funds.\1015\ Therefore, without the increased requirements, a failure 
of a stand-alone SBSD would, ceteris paribus, be more likely than a 
failure of an OTC derivatives dealer and, as a consequence of the 
relationships with customers, would have a broader adverse impact on a 
larger number of market participants, including customers and 
counterparties.\1016\ Consequently, these heightened requirements 
should enhance the safety and soundness of the nonbank SBSDs, and 
thereby reduce systemic risk, as well as increase market participants' 
confidence in the security-based swap markets. Stand-alone SBSDs not 
approved to use internal models would not, however, be subject to a 
minimum tentative net capital requirement, which is applied to only 
firms that use internal models to account for risks not fully captured 
by the models.\1017\
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    \1014\ For example, a broker-dealer that carries customer 
accounts has a fixed-dollar minimum requirement of $250,000; a 
broker-dealer that does not carry customer accounts but engages in 
proprietary securities trading (defined as more than ten trades a 
year) has a fixed-dollar minimum requirement of $100,000; and a 
broker-dealer that does not carry accounts for customers or 
otherwise receive or hold securities and cash for customers, and 
does not engage in proprietary trading activities, has a fixed-
dollar minimum requirement of $5,000. See 17 CFR 240.15c3-1(a)(2).
    \1015\ See 17 CFR 240.3b-12; 17 CFR 240.15a-1.
    \1016\ The proposal is consistent with the CFTC's proposed 
capital requirements for nonbank swap dealers, which impose $20 
million fixed-dollar minimum requirements regardless of whether the 
firm is approved to use internal models to compute regulatory 
capital. See CFTC Capital Proposing Release, 76 FR 27802.
    \1017\ OTC derivatives dealers are subject to a $100 million 
minimum tentative net capital requirement. ANC broker-dealers are 
currently subject to a $1 billion minimum tentative net capital 
requirement. The minimum tentative net capital requirements are 
designed to address risks that may not be captured when using 
internal models rather than standardized haircuts to compute net 
capital. See OTC Derivatives Dealers, 63 FR at 59384; Alternative 
Net Capital Requirements for Broker-Dealers That Are Part of 
Consolidated Supervised Entities; Proposed Rule, Exchange Act 
Release No. 48690 (Oct. 24, 2003), 68 FR 62872, 62875 (Nov. 6, 
2003).
---------------------------------------------------------------------------

    Stand-alone SBSDs using models would be required to maintain 
minimum net capital of the higher of $20 million or the 8% margin 
factor, as well as a minimum tentative net capital of $100 million, a 
requirement that also applies to OTC derivatives dealers. Models to 
calculate deductions from tentative net capital for proprietary 
positions take only market and credit risk into account and therefore 
generally lead to lower deductions and higher levels of net 
capital.\1018\ The minimum

[[Page 70309]]

tentative net capital requirement for firms using models is intended to 
provide an additional assurance of adequate capital to reflect this 
concern.
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    \1018\ See, e.g., Alternative Net Capital Requirements Adopting 
Release, 69 FR at 34455 (describing benefits of alternative net 
capital requirements for broker-dealers using models stating a 
``major benefit for the broker-dealer will be lower deductions from 
net capital for market and credit risk that we expect will result 
from the use of the alternative method.''). Therefore, it is likely 
that for new entrants to capture substantial volume in security-
based swaps they will need to use VaR models. See also OTC 
Derivatives Dealer Release, 63 FR 59362 (discussing benefits of 
minimum capital requirements as an additional measure of 
protection).
---------------------------------------------------------------------------

    However, because the tentative net capital calculation does not 
take account of market risk deductions, the minimum $100 million 
tentative net capital requirement might be a less effective standard in 
cases where a dealer maintains a substantial amount of less liquid 
positions that require relatively large deductions for market risk. As 
an alternative, the Commission could impose a minimum requirement that 
increases according to the nature and size of the positions held, for 
example, 25% of the market risk deductions that are required to be 
taken in determining actual net capital. This approach could better 
scale the tentative net capital requirement according to the risk of 
the proprietary positions held by an SBSD. On the other hand, a 
variable tentative net capital test would not serve as an accurate 
measure of risk if the model did not appropriately capture all material 
risks of the positions or the assumptions underlying the use of the 
model were no longer appropriate. The variable tentative net capital 
test also could increase the tentative net capital requirement in some 
cases to a level that could limit or discourage the entry of firms that 
do not presently compete in the security-based swap markets. Further, 
as noted above, the minimum net capital requirement in each case would 
increase in accordance with an increase in the amount of business 
conducted as a result of the 8% margin factor. The Commission is 
specifically seeking comment on this alternative in section II.A.1. of 
this release.
    Under the proposed amendments to Rule 15c3-1, ANC broker-dealers 
would be required to maintain: (1) Tentative net capital of not less 
than $5 billion; and (2) net capital of not less than the greater of $1 
billion or the financial ratio amount required pursuant to paragraph 
(a)(1) of Rule 15c3-1 plus the 8% margin factor.\1019\ These relatively 
high minimum capital requirements for ANC dealers (as compared with the 
requirements for other types of broker-dealers) reflect the substantial 
and diverse range of business activities engaged in by ANC broker-
dealers and their importance as intermediaries in the securities 
markets.\1020\ Further, the heightened capital requirements reflect the 
fact that, as noted above, VaR models are more risk sensitive but also 
generally permit substantially reduced deductions to tentative net 
capital as compared to the standardized haircuts as well as the fact 
that VaR models may not capture all risks.\1021\
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    \1019\ See proposed amendments to paragraph (a)(7)(i) of Rule 
15c3-1.
    \1020\ As noted above, the six ANC broker-dealers collectively 
hold in excess of one trillion dollars' worth of customer 
securities.
    \1021\ See Alternative Net Capital Requirements Adopting 
Release, 69 FR 34428.
---------------------------------------------------------------------------

    Based on financial information reported by the ANC broker-dealers 
in their monthly FOCUS Reports filed with the Commission, the six 
current ANC broker-dealers maintain capital levels in excess of these 
proposed increased minimum requirements. For example, at the end of 
2011, the interquartile range of net capital and tentative net capital 
levels among the six ANC broker-dealers were from $1.11 billion to 
$7.77 billion and from $1.32 billion to $9.69 billion, respectively. 
Further, ANC broker-dealers are currently required to notify the 
Commission if their tentative net capital falls below $5 billion.\1022\ 
This notification provision is used by the Commission to trigger 
increased supervision of the firm's operations and to take any 
necessary corrective action and is similar to corollary ``early 
warning'' requirements for OTC derivatives dealers.\1023\ Consequently, 
this $5 billion ``early warning'' level currently acts as the de facto 
minimum tentative net capital requirement since the ANC broker-dealers 
seek to avoid providing this regulatory notice that their tentative net 
capital has fallen below the early warning level.\1024\
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    \1022\ 17 CFR 240.15c3-1(a)(ii).
    \1023\ OTC derivatives dealers are required to provide 
notification promptly (but within 24 hours) if their tentative net 
capital falls below 120% of the firm's required minimum tentative 
net capital amount. See 17 CFR 240.17a-11(c)(3). Rule 17a-11 also 
requires ANC broker-dealers and OTC derivatives dealers to provide 
same day notification if their tentative net capital falls below 
required minimums. See 17 CFR 240.17a-11(b)(2).
    \1024\ See 17 CFR 240.15c3-1(a)(7)(i).
---------------------------------------------------------------------------

    Although increases to minimum tentative and minimum net capital 
requirements are being proposed, the proposals may not present a 
material cost to the current ANC broker-dealers, because they already 
hold more than the proposed minimum requirements in the amendments to 
Rule 15c3-1. The more relevant number is the proposed increase in the 
early warning notification threshold from $5 billion to $6 billion. The 
existing early warning requirement for OTC derivatives dealers triggers 
a notice when the firm's tentative net capital falls below an amount 
that is 120% of the firm's required minimum tentative net capital 
amount of $100 million ($120 million = 1.2 x $100 million).\1025\ The 
proposed new ``early warning'' threshold for ANC broker-dealers of $6 
billion (= 1.2 x $5 billion) in tentative net capital is modeled on 
this requirement. In general, because the amount of actual net capital 
is subject to volatility commensurate with market volatility in 
proprietary instruments, the Commission expects ANC broker-dealers to 
maintain a reasonable cushion in excess of the minimum. Since, based on 
the Commission staff's supervision of the ANC broker-dealers, the 
current ANC broker-dealers report tentative net capital levels 
generally well in excess of $6 billion, the costs to the ANC broker-
dealers to comply with this new requirement are not expected to be 
material.\1026\ However, these costs may be prohibitive to new entrants 
that wish to register as broker-dealer SBSDs using internal models if 
they currently do not, or cannot, maintain these proposed capital 
levels. As noted below, such barriers to entry may prevent or reduce 
competition among SBSDs, which in turn can lead to higher transaction 
costs and less liquidity than would otherwise exist.
---------------------------------------------------------------------------

    \1025\ See 17 CFR 240.17a-11(c)(3).
    \1026\ Id.
---------------------------------------------------------------------------

    In addition to the proposed minimum fixed tentative and minimum net 
capital requirements, the proposed 8% margin factor would be part of 
determining a nonbank SBSD's minimum net capital requirement.\1027\ The 
8% margin factor is intended to establish a minimum capital requirement 
that scales with the level of a nonbank SBSD's security-based swap 
activity and to limit the amount of leverage a nonbank SBSD can employ 
by requiring an increase in capital commensurate with the amount of 
leverage extended.
---------------------------------------------------------------------------

    \1027\ Since the 8% margin factor would be additive to the 
minimum capital requirements for ANC broker-dealers conducting a 
security-based swap business, the cost impact to an ANC broker-
dealer using its current minimum capital requirements under Rule 
15c3-1 and 15c3-1e as a baseline, would at minimum, increase by the 
8% margin factor.
---------------------------------------------------------------------------

    The 8% margin factor ratio requirement also is similar to an 
existing requirement in the CFTC's net capital rule for FCMs,\1028\ and 
the CFTC has proposed a similar requirement for swap dealers and major 
swap participants registered as FCMs.\1029\

[[Page 70310]]

Under the CFTC's proposal, an FCM would be required to maintain 
adjusted net capital \1030\ that is equal to or greater than 8% of the 
risk margin required for customer and non-customer exchange-traded 
futures and swaps positions that are cleared by a DCO.\1031\ Because 
exchange-traded futures, however, are generally more liquid and give 
rise to lower margins than non-cleared security-based swaps with the 
same notional amount, the proposed 8% margin factor (which includes 
margin for both cleared and non-cleared swaps) would require allocating 
substantially more capital to support a non-cleared security-based swap 
contract compared to a futures contract. Requiring such additional 
capital could impose the types of costs on these firms and the markets 
more generally that are described above in section V.B.1. of this 
release. On the other hand, applying the 8% margin factor to non-
cleared security-based swaps (rather than just cleared security-based 
swaps) would permit the nonbank SBSD's minimum capital requirement to 
vary based on this aspect of its business, which can entail similar 
leverage and present greater credit risk than cleared security-based 
swaps. This would have the benefit of further promoting the goals of 
the financial responsibility rules described above in section V.B.1. of 
this release.
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    \1028\ See 17 CFR 1.17(a)(1)(i)(B).
    \1029\ See CFTC Capital Proposing Release, 76 FR 27802. The 8% 
calculation under the CFTC's proposal relates to cleared swaps or 
futures transactions, whereas the 8% margin factor proposed in new 
Rule 18a-1 would be based on cleared and non-cleared security-based 
swaps.
    \1030\ The CFTC has proposed that swap dealers and major swap 
participants that are also FCMs would be required to meet the 
existing FCM requirement to hold minimum levels of adjusted net 
capital, and also would be required to calculate the required 
minimum level as the greatest of the following: (1) A fixed dollar 
amount which under the CFTC's proposed rules would be $20 million; 
(2) the amount required for FCMs that also act as retail foreign 
exchange dealers; (3) 8% of the proposed risk margin; (4) the amount 
required by a registered futures association of which the FCM is a 
member; or (4) for an FCM, that is also a broker-dealer, the amount 
required by Commission rules. See CFTC Capital Proposing Release, 76 
FR 27802.
    \1031\ See CFTC Capital Proposing Release, 76 FR 27802. The 
CFTC's proposed 8% margin requirement is intended to establish a 
minimum capital requirement that corresponds to the level of risk 
arising from the FCM's swap activity. Id. at 27807. One commenter 
objected to the inclusion of the 8% test in the CFTC's capital 
proposal, noting that margin and capital are complementary concepts 
in that both incorporate counterparty risk, and accordingly, the 
higher the initial margin requirement for a particular swap, the 
less regulatory capital a swap dealer should need to carry the 
client's position. The commenter believed that the CFTC's 8% charge 
would lead to allocations of dealer and client funding and capital 
to client portfolios in amounts disproportionately large in 
comparison to the risks of the relevant transactions. This commenter 
recommended to the CFTC that the CFTC defer incorporating swaps into 
the 8% margin multiplier for capital until after margin and capital 
requirements are finalized and the CFTC and market participants have 
had an opportunity to evaluate margin levels and the 
interrelationship between swap margin and capital. Letter from John 
M. Damgard, President, Futures Industry Association, Robert G. 
Pickel, Chief Executive Officer, ISDA and Kenneth E. Bentsen, Jr., 
Executive Vice President, Public Policy and Advocacy, SIFMA, to the 
CFTC (July 7, 2011) (``FIA/ISDA/SIFMA Comment Letter to the CFTC'').
---------------------------------------------------------------------------

    Based on FOCUS Report information as of year-end 2011, 
approximately ten broker-dealers, including the current ANC broker-
dealers, maintain tentative net capital in excess of $5 billion,\1032\ 
approximately 31 broker-dealers maintain net capital in excess of $1 
billion, approximately 145 broker-dealers maintain tentative net 
capital in excess of $100 million, and approximately 270 broker-dealers 
maintain net capital in excess of $20 million.
---------------------------------------------------------------------------

    \1032\ These 10 broker-dealers also maintain tentative net 
capital in excess of $6.0 billion based on FOCUS Report information 
as of year-end 2011.
---------------------------------------------------------------------------

    Although the proposed increase in minimum capital and early warning 
requirements for ANC broker-dealers will not affect firms that already 
have this classification, it would reduce the number of additional 
firms (from 31 to 4, according to FOCUS Report data) that would 
currently qualify for this designation and hence represents a 
significant potential cost for additional registrants. As noted above, 
these costs may be prohibitive to new entrants that wish to register as 
ANC broker-dealer SBSDs using internal models. If these additional 
costs were not imposed or were lower, there might be greater 
opportunities for more competition in the security-based swap markets, 
which in turn could lower transaction costs and increase liquidity in 
these markets. However, setting capital levels that allow new entrants 
that do not have sufficient capital to engage in the diverse business 
of ANC broker dealers could be disruptive to the market. In addition, 
to the extent that potential new entrants are able to operate 
effectively in these markets as stand-alone SBSDs (i.e., swap dealers 
that are not registered as broker-dealers), they would be eligible for 
lower minimum capital requirements and competition could further 
increase without compromising the heightened requirements for ANC 
broker-dealers.
    With respect to the derivatives markets in particular, it is 
difficult to quantify the impact of the proposed capital requirements 
against the baseline of the OTC derivatives markets as they exist today 
because prior to the adoption of Title VII, swaps and security-based 
swaps were by and large unregulated.\1033\ As discussed above in 
section V.A. of this release, however, most trading in security-based 
swaps and other derivatives is currently conducted by large banks and 
their affiliates. Among these entities are the current ANC broker-
dealers. Other broker-dealers affiliated with firms presently 
conducting business in security-based swaps may be among the 270 
broker-dealers that maintain net capital in excess of $20 million. 
Consequently, broker-dealers presently trading in security-based swaps 
may not need to raise significant new amounts of capital in order to 
register as nonbank SBSDs. At the same time, the proposed minimum 
capital requirements could discourage entry by entities other than the 
approximately 270 broker-dealers that already have capital in excess of 
the required minimums.
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    \1033\ See Product Definitions Adopting Release, 77 FR 48207.
---------------------------------------------------------------------------

    As discussed above in section II.A.1. of this release, the 
Commission is seeking comment on possible modifications to the capital 
requirements in ways that may lessen potential compliance costs. First, 
to the extent that a nonbank SBSD that is approved to use models may be 
required to register as a broker-dealer solely to conduct certain 
brokerage activity, e.g., sending customer orders for execution to a 
security-based swap execution facility, the Commission could modify the 
capital requirements by setting lower minimum capital requirements for 
such firms than apply to ANC broker-dealers. Further, the requirements 
for OTC derivatives dealers could be amended to allow these firms to 
conduct a broader range of activities. This modification could increase 
the ability of firms that are not capitalized at minimum capital 
requirements proposed for the ANC firms to use models and compete for 
business in security-based swaps.
    The Commission also could consider modifications that would 
increase the flexibility for a broader group of firms to conduct a 
derivatives business that extends beyond security-based swaps. For 
example, the Commission could determine to allow a firm to register 
jointly as an OTC derivatives dealer and SBSD. This modification could 
allow the registrant to conduct a broader range of derivatives 
activities than dealing only in security-based swaps, and to be able to 
use internal models for capital purposes without being subject to much 
higher capital requirements that apply to ANC broker-dealers. On the 
other hand, there could be practical difficulties in merging the 
registration regimes. For example, because OTC derivatives dealers are 
prohibited from having custody of customers' assets, while nonbank 
SBSDs would be

[[Page 70311]]

permitted to do so, subject to compliance with new Rule 18a-4, dual 
registrants could be required to maintain separate sets of compliance 
processes and procedures, based on product type.
    Alternatively, the Commission could provide conditional relief on a 
case-by-case basis to allow a firm that is registered as an SBSD to 
conduct dealing activity in derivatives other than security-based 
swaps. This also could provide a means for an entity to do business in 
a broad set of derivative instruments, subject to the basic capital 
standards that would apply to SBSDs. This approach also could allow the 
Commission to fashion exemptive relief on a case-by-case basis, pending 
further consideration of how and whether to reconcile the SBSD and OTC 
derivatives dealer regimes. On the other hand, allowing SBSDs to deal 
in products that OTC derivatives dealers can deal in, without the 
restrictions that apply to their activities, could undermine the 
purpose for the restrictions. The Commission is specifically soliciting 
comment on these potential approaches above in section II.A.1.
ii. Standardized Haircuts
    As discussed in section II.A.2.b.ii. of this release, under 
proposed new Rule 18a-1 and the amendments to Rule 15c3-1, a nonbank 
SBSD would be required to apply standardized haircuts to its 
proprietary positions, unless the Commission approved it to use 
internal models for specific positions. In general, all haircut regimes 
are intended to be conservative estimates of risk as they tend to 
overcompensate for the actual risks and hence generally impose higher 
costs in terms of capital compared to VaR models.\1034\
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    \1034\ Commenters to the proposed CFTC capital rule for swap 
dealers stated that they believe that model-based approaches are 
generally superior to grid-based approaches. One commenter argued 
that grid-based approaches are generally insufficiently risk 
sensitive, are not part of integrated risk management systems, and 
are hard to keep up-to-date to include innovative product and 
trading strategies. FIA/ISDA/SIFMA Comment Letter to the CFTC. Grid-
based approaches, however, provide alternatives to firms that are 
unable to or chose not to use models.
---------------------------------------------------------------------------

    As discussed in section II.A.2.b.ii. of this release, for positions 
that are not security-based swaps, broker-dealer SBSDs and stand-alone 
SBSDs also would be required to apply the standardized haircuts 
currently set forth in Rule 15c3-1.\1035\ Standardized ``haircuts'' for 
credit default swaps would be based on a maturity grid approach. 
Modeled after similar ``haircut'' approaches currently employed under 
Rule 15c3-1, the proposed approach for credit default swaps is designed 
to be more risk-sensitive than a haircut approach that determines 
market deductions based on the type of each position without 
recognizing offsets among securities with similar risk characteristics 
(the proposed rules also permit firms to reduce the required haircut 
for certain netted positions). The number of maturity and spread 
categories in the proposed grid for credit default swaps is based on 
staff experience with the maturity grids for other securities in Rule 
15c3-1 and, in part, on FINRA Rule 4240.\1036\ While the haircut grid 
design takes into account that positions in credit defaults swaps with 
larger spreads or longer tenors are riskier and hence should be 
supported by larger haircuts, the Commission is specifically seeking 
comment on the design of the grid and particularly whether the haircuts 
appropriately reflect the risk inherent in long and short positions of 
credit defaults swaps across the spread and tenor spectrum.
---------------------------------------------------------------------------

    \1035\ See 17 CFR 240.15c3-1(c)(2)(vi); paragraph (c)(1)(vii) of 
proposed new Rule 18a-1. See also section II.A.2.b.vi. of this 
release (discussing the treatment of swaps).
    \1036\ See Notice of Filing and Order Granting Accelerated 
Approval of Proposed Rule Change to Amend FINRA Rule 4240 (Margin 
Requirements for Credit Default Swaps), Exchange Act Release No. 
66527 (Mar. 7, 2012) (File No. SR-FINRA-2012-015) (in which FINRA 
amended the maturity grid in Rule 4240 in the interest of regulatory 
clarity and efficiency, and based upon FINRA's experience in the 
administration of the rule). While FINRA Rule 4240 is one reference 
point, the maturity grid it specifies does not appear to have been 
widely used by market participants, in part because a significant 
amount of business in the current credit default swap market is 
conducted by entities that are not members of FINRA.
---------------------------------------------------------------------------

    Security-based swaps that are not credit default swaps can be 
divided into two broad categories: Those that reference equity 
securities and those that reference debt instruments. Since each type 
of security-based swap can be viewed as being equivalent to a highly-
levered synthetic position in the referenced instrument and therefore 
has the same price volatility as the referenced instrument, the 
standardized haircut for these categories of security-based swaps would 
be the deduction currently prescribed in Rule 15c3-1 applicable to the 
instrument referenced by the security-based swap multiplied by the 
contract's notional amount.\1037\ It is likely that a nonbank SBSD that 
maintains substantial positions in such instruments would maintain 
portfolios of multiple instruments in such categories with offsetting 
long and short positions to hedge its risk.
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    \1037\ See proposed new paragraph (c)(2)(vi)(O)(2) of Rule 15c3-
1; paragraph (c)(1)(vi)(B) of proposed new Rule 18a-1. For example, 
if a dealer maintained a position in a security-based swap with a 
notional amount of $1 million that provided the dealer with long 
exposure to a nonconvertible debt security maturing in 2\1/2\ years 
(assuming no offsetting short positions), the dealer would look to 
Rule 15c3-1(c)(2)(vi)(F) to find the applicable haircut percentage 
(5%) and the firm would be required to take a capital deduction of 
$50,000.
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    Under the Commission's proposed standardized haircuts for these 
categories of security-based swaps, nonbank SBSDs would also be able to 
recognize the offsets currently permitted under Rule 15c3-1.\1038\ In 
particular, as discussed below, nonbank SBSDs would be permitted to 
treat equity security-based swaps under the provisions of Appendix A to 
Rule 15c3-1, which produces a single haircut for portfolios of equity 
options and related positions.\1039\ This method would permit a nonbank 
SBSD to compute deductions for a portfolio of equity security-based 
swaps using a comprehensive risk perspective by accounting for the risk 
of the entire portfolio, rather than the risk of each position within 
the portfolio.\1040\ Appendix A provides a relatively less costly 
mechanism for a nonbank SBSD to calculate haircuts (in contrast to the 
standardized haircuts) since it is used for other equity derivatives 
and generally may reduce haircuts for a nonbank SBSD by allowing a swap 
referencing an equity security to be considered as part of a related 
portfolio. This, in turn, may permit a nonbank SBSD to more efficiently 
deploy this capital savings in other areas of its operations, as well 
as enhance operational efficiencies.
---------------------------------------------------------------------------

    \1038\ See proposed new paragraph (c)(2)(vi)(O)(2) of Rule 15c3-
1; paragraph (c)(1)(vi)(B) of proposed new Rule 18a-1.
    \1039\ See 17 CFR 240.15c3-1a; Appendix A to proposed new Rule 
18a-1.
    \1040\ See section II.A.2.b.ii. of this release.
---------------------------------------------------------------------------

    Similarly, nonbank SBSDs would be permitted to treat a debt 
security-based swap in the same manner as debt instruments are treated 
in the Rule 15c3-1 grids in terms of allowing offsets between long and 
short positions where the instruments are in the same maturity 
categories, subcategories, and in some cases, adjacent 
categories.\1041\ Consequently, nonbank SBSDs could recognize the 
offsets and hedges that those provisions permit to reduce the 
deductions on portfolios of debt security-based swaps, and thereby 
reduce their capital costs. This, in turn, may permit a nonbank SBSD to 
more efficiently deploy this capital savings in other areas of its 
operations.
---------------------------------------------------------------------------

    \1041\ See 17 CFR 240.15c3-1(c)(2)(vi).
---------------------------------------------------------------------------

    The proposed approaches, like other types of standardized haircuts, 
likely will require a higher amount of capital to conduct security-
based swaps

[[Page 70312]]

business, in contrast to a VaR model. While the standardized haircuts 
and proposed CDS grid recognize certain offsets, standardized haircuts 
generally result in higher costs of capital because the standardized 
approaches do not recognize other ways in which a nonbank SBSD may 
mitigate its exposures, including unwinding unprofitable trades, 
entering into certain hedges that would not be recognized under the 
proposed capital rules, and portfolio diversification. The higher 
amounts that may result from using the standardized haircut and a grid-
based approach \1042\ may be acceptable for nonbank SBSDs that 
occasionally trade in security-based swaps but not in a substantial 
enough volume to justify the initial and ongoing systems and personnel 
costs to develop, implement, and monitor the performance of internal 
models. On the other hand, firms that conduct a substantial business in 
securities-based swaps in general will need to use the more cost-
efficient models to measure and manage the risks of their positions 
over time.
---------------------------------------------------------------------------

    \1042\ See section II.A.2.b.2. of this release.
---------------------------------------------------------------------------

    The benefit of the standardized haircut approach of measuring 
market risk, besides its inherent simplicity, is that it may reduce the 
likelihood of default or failure by nonbank SBSDs that have not 
demonstrated that they have the risk management capabilities, of which 
VaR models are an integral part, or capital levels to support the use 
of VaR models. Therefore, the standardized haircut approach, in turn, 
may improve customer protections and reduce systemic risk. In addition, 
a standardized haircut approach may reduce costs for the nonbank SBSD 
related to the risk of failing to observe or correct a problem with the 
use of VaR models that could adversely impact the firm's financial 
condition, because the use of VaR models would require the allocation 
by the nonbank SBSD of additional firm resources and personnel.
    Conversely, if the proposed standardized haircuts are too 
conservative, they could make the conduct of security-based swaps 
business too costly, preventing or impairing the ability of firms to 
engage in security-based swaps, increasing transaction costs, reducing 
liquidity, and reducing the availability of security-based swaps for 
risk mitigation by end users.
iii. Capital Charge in Lieu of Margin Collateral
    As discussed in section II.A.2.b.v. of this release, the Commission 
is proposing certain capital charges in lieu of margin. Generally, 
margin collateral is designed to serve as a buffer to account for a 
decrease in the market value of the counterparty's positions between 
the time of default and liquidation. If the amount of the margin 
collateral is insufficient to make up the difference, the nonbank SBSD 
will incur losses. The proposal requires the nonbank SBSD to hold 
sufficient net capital to enable it to, first, withstand such losses 
and to cover counterparty exposures that are not sufficiently secured 
with liquid collateral, and, second, to create a strong incentive for 
dealers to collateralize these exposures. Consequently, this proposed 
capital charge may serve as an alternative to margin collateral, 
enhance the financial soundness of the nonbank SBSD and, in turn, 
ultimately reduce systemic risk.
    With respect to cleared security-based swaps, the rules would 
impose a capital charge if a nonbank SBSD collects margin collateral 
from a counterparty in an amount that is less than the deduction that 
would apply to the security-based swap if it were a proprietary 
position of the nonbank SBSD (i.e., less than an amount determined by 
using the standardized haircuts in Rule 15c3-1, as proposed to be 
amended, and in proposed new Rule 18a-1 or a VaR model, as 
applicable).\1043\ As discussed in section II.A.2.b.v. of this release, 
the proposed capital charge, therefore, is designed to protect the 
nonbank SBSDs against this risk, and thereby, serves to increase the 
safety and soundness of the nonbank SBSD.
---------------------------------------------------------------------------

    \1043\ See proposed paragraph (c)(2)(xiv)(A) of Rule 15c3-1; 
paragraph (c)(1)(viii)(A) of proposed Rule 18a-1.
---------------------------------------------------------------------------

    This proposed charge, however, could impose additional capital 
costs on cleared transactions where the amount of the additional costs 
would depend on the differences between amounts required under Rule 
18a-1 and margin amounts the clearing agency sets. It is difficult to 
estimate the cost impact of this proposal because there is currently a 
lack of trading for customers in cleared security-based swaps that 
could be used for comparative purposes.\1044\ In addition, requiring 
nonbank SBSDs to take a capital charge equal to the difference between 
the haircut amount and the clearing agency margin could reduce 
incentives to use cleared security-based swap contracts, which would be 
inconsistent with the goal of reducing systemic risk. However, 
incentives to clear security-based swaps will be substantially affected 
by a variety of other factors, including the amount of margin required 
for non-cleared contracts, and clearing volume will also be affected by 
mandatory clearing determinations by the Commission under Section 
763(a) of the Dodd-Frank Act. In general, it is unclear whether the 
additional costs to conduct business on a cleared basis would 
materially affect the volume of business that SBSDs conduct on an 
uncleared basis when they have the choice to do so.
---------------------------------------------------------------------------

    \1044\ See Process for Submissions of Security-Based Swaps, 77 
FR 41602 (although the volume of interdealer CDS cleared to date is 
quite large, many security-based swap transactions are still 
ineligible for central clearing, and many transactions in security-
based swaps eligible for clearing at a CCP continue to settle 
bilaterally. Voluntary clearing of security-based swaps in the U.S. 
is currently limited to CDS products. Central clearing of security-
based swaps began in March 2009 for index CDS products, in December 
2009 for single-name corporate CDS products, and in November 2011 
for single-name sovereign CDS products. At present, there is no 
central clearing in the U.S. for security-based swaps that are not 
CDS products, such as those based on equity securities.). Id.
---------------------------------------------------------------------------

    As discussed in section II.A.2.b.v. of the release, with respect to 
non-cleared security-based swaps, the Commission is proposing capital 
charges to address three exceptions in proposed new Rule 18a-3 (nonbank 
SBSD margin rule), including margin not collected from commercial end 
users, margin collateral collected but segregated pursuant to section 
3E(f) of the Exchange Act, and margin that has not been collected for a 
legacy swap.\1045\ The rule is designed to reduce systemic risk by 
requiring capital to cover counterparty exposures, because the capital 
levels will serve in lieu of margin as a buffer in case of counterparty 
defaults. If the nonbank SBSD did not hold capital in lieu of margin, a 
counterparty default could lead to the default of the nonbank SBSD 
itself. This capital charge should have the benefit of reducing the 
likelihood of default of the nonbank SBSD due to under-margined 
counterparty exposure. Conversely it will increase the cost of capital 
for nonbank SBSDs that engage in non-cleared security-based swaps 
because they must use their own capital to support the counterparty's 
transaction, which in turn could reduce the liquidity of such security-
based swaps. However, the proposed rule imposes a charge only if a firm 
fails to collect margin under Rule 18a-3, and thus no additional costs 
would be imposed on a nonbank SBSDs that

[[Page 70313]]

collects margin. Therefore, the proposed rule is designed to create a 
strong incentive for nonbank SBSDs to collect margin and collateralize 
counterparty exposures.
---------------------------------------------------------------------------

    \1045\ This proposed rule also provides the nonbank SBSDs 
certain flexibility in determining whether to collect margin from 
certain counterparties exempt from certain requirements of proposed 
Rule 18a-3 and thus attempts to appropriately consider both the 
concerns of commercial end users and other entities/transactions 
exempt from proposed new Rule 18a-3 and the need to enhance the 
financial soundness of the nonbank SBSD.
---------------------------------------------------------------------------

    The charge for collateral segregated in individual accounts under 
Section 3E(f) of the Exchange Act reflects the potential that 
collateral collected by an SBSD but held in a third-party custodian 
account may not be readily liquidated immediately following a 
counterparty's default. Accordingly, this aspect of the rule would 
create an additional capital cost to SBSDs that hold collateral in 
independent third-party accounts.\1046\ If these costs are passed on to 
counterparties electing an independent segregation option, they could 
deter counterparties from electing the option and reduce their 
flexibility in determining the optimal way to hold their collateral.
---------------------------------------------------------------------------

    \1046\ See discussion above in section II.A.2.b.v. of this 
release. See also discussion above in section V.B.1. of this release 
(discussing quantification of costs).
---------------------------------------------------------------------------

    The third proposed capital charge would apply to margin not 
collected in the case of legacy non-cleared security-based swaps. This 
proposal should benefit nonbank SBSDs and their counterparties in that 
it is designed to avoid the difficulties of requiring a nonbank SBSD to 
renegotiate security-based swap contracts to come into compliance with 
the new margin collateral requirements, which would be a complex and 
costly task. Based on discussions with market participants, this 
proposal, however, may impose substantial costs in the form of capital 
charges on firms that have legacy contracts.\1047\ Because broker-
dealers, however, currently do not conduct significant business in 
security-based swaps, and any newly-registered SBSDs may not enter into 
security-based swap transactions before the effectiveness of these 
proposed rules and, therefore, not have any legacy security-based 
swaps, this cost of capital may be immaterial. However, the costs could 
be significant if legacy security-based swaps are assigned to a 
security-based swap dealer.
---------------------------------------------------------------------------

    \1047\ As discussed above in section II.B.2. of this release, 
this exception would be designed to address the impracticality of 
renegotiating contracts governing security-based swap transactions 
that predate the effectiveness of proposed new Rule 18a-3 in order 
to come into compliance with the account equity requirements in the 
rule. See discussion above in section V.A.1. of this release 
(discussing quantification of costs).
---------------------------------------------------------------------------

iv. Credit Risk Charge
    As discussed in section II.A.2.b.iv. of this release, consistent 
with existing rules affecting broker-dealers,\1048\ proposed Rule 18a-1 
and the amendments to Rule 15c3-1 rule would require firms to take a 
100% charge for the amount of any unsecured receivable, including any 
uncollateralized receivable currently owed under a security-based swap. 
As an alternative to taking this capital charge in lieu of margin to a 
commercial end user, as discussed in section II.A.2.b.iv. of the 
release, ANC broker-dealers and stand-alone SBSDs using internal models 
would be permitted instead to take a credit risk charge using a 
methodology in Appendix E to Rule 15c3-1 for uncollateralized 
receivables arising from security-based swaps with (and only with) 
commercial end users in lieu of the 100% deduction otherwise required 
by the rules.\1049\
---------------------------------------------------------------------------

    \1048\ See 17 CFR 240.15c3-1(c)(2)(iv)(B)-(D); proposed new Rule 
18a-1(c)(1)(iii)(B)-(D).
    \1049\ See paragraph (e)(2) of proposed new Rule 18a-1. 
Paragraph (c)(1) of Appendix E to Rule 15c3-1 requires an ANC 
broker-dealer to take a counterparty exposure charge in an amount 
equal to: (i) The net replacement value in the account of each 
counterparty that is insolvent, or in bankruptcy, or that has senior 
unsecured long-term debt in default; and (ii) for a counterparty not 
otherwise described in paragraph (c)(1)(i) of Appendix E, the credit 
equivalent amount of the broker's or dealer's exposure to the 
counterparty, as defined in paragraph (c)(4)(i) of this Appendix E, 
multiplied by the credit risk weight of the counterparty, as defined 
in paragraph (c)(4)(vi) of Appendix E, multiplied by 8%. 17 CFR 
240.15c3-1e(c)(1).
---------------------------------------------------------------------------

    The proposed rule is designed to provide an alternative, less 
costly way (in lieu of the 100% deduction otherwise required by the 
rules) to recognize credit exposure incurred in transactions with 
commercial end users for those nonbank SBSDs approved to use internal 
models. Nonbank SBSDs would be permitted to use this approach because 
they are required to implement processes for analyzing credit risk to 
OTC derivative counterparties and to develop mathematical models for 
estimating credit exposures arising from OTC derivatives transactions 
and determining risk-based capital charges for those exposures.\1050\
---------------------------------------------------------------------------

    \1050\ See Appendix E to Rule 15c3-1 and proposed new Rule 18a-
1.
---------------------------------------------------------------------------

    The rule, however, will increase costs \1051\ for nonbank SBSDs 
that do substantial trading with commercial end users and do not 
collect margin for transactions in non-cleared security-based swaps 
from them. Available data suggests that commercial end users presently 
do not conduct substantial trading in non-cleared security-based 
swaps.\1052\ Therefore, the proposed credit risk charge may not have an 
immediate cost impact on nonbank SBSDs when compared to the baseline of 
the OTC derivatives markets as they exist today. However, costs, in 
terms of higher capital charges and opportunity costs, could become 
significant if commercial end users begin to trade security-based swaps 
in greater volume and exposures to the nonbank SBSDs remain 
uncollateralized.
---------------------------------------------------------------------------

    \1051\ See section V.B.1. of this release (discussing 
quantification of costs).
    \1052\ See generally CDS Data Analysis; ISDA Margin Survey 2012.
---------------------------------------------------------------------------

    To the extent that commercial end users do trade in security-based 
swaps, the ability of a nonbank SBSD to use internal models likely 
would give it a significant cost advantage over nonbank SBSDs not using 
models once the initial infrastructure investment to use the models has 
been made. In addition, ANC broker-dealers currently are permitted to 
add back to net worth uncollateralized receivables from counterparties 
arising from OTC derivatives transactions (i.e., they can add back the 
amount of the uncollateralized current exposure).\1053\ This treatment 
would be narrowed under the proposed capital requirements for nonbank 
SBSDs as well as for ANC broker-dealers to the extent that it would 
apply only to uncollateralized receivables from commercial end users 
arising from security-based swaps. In contrast, uncollateralized 
receivables from other types of counterparties would be subject to a 
100% deduction from net worth to limit the potential that the rules 
would permit a substantial amount of unsecured exposures for ANC 
broker-dealers and nonbank SBSDs.\1054\
---------------------------------------------------------------------------

    \1053\ See 17 CFR 240.15c3-1e(c). OTC derivatives dealers are 
permitted to treat such uncollateralized receivables in a similar 
manner. See 17 CFR 240.15c3-1f.
    \1054\ See proposed amendments to paragraphs (a) and (c) of Rule 
15c3-1e. See section II.A.2.b.iv. of this release (discussing credit 
risk charges).
---------------------------------------------------------------------------

    According to FOCUS Reports and staff experience supervising the ANC 
broker-dealers, ANC broker-dealers have not engaged in a large volume 
of OTC derivatives transactions since the rules were adopted in 2004. 
Therefore, they have not had significant amounts of unsecured 
receivables that would be subject to the credit risk charge provisions 
in Appendix E to Rule 15c3-1. However, when the Dodd-Frank OTC 
derivatives reforms are implemented, ANC broker-dealers could 
significantly increase their holdings of OTC derivatives. An increase 
in derivatives exposure that is uncollateralized would increase the 
exposure of the ANC broker-dealers to their derivatives counterparties. 
In turn, however, this proposed amendment should strengthen the capital 
position of the ANC broker-

[[Page 70314]]

dealers, and thereby reduce the likelihood of default of one of these 
entities. Because ANC broker-dealers currently do not trade in 
significant amounts of OTC derivatives, and therefore, do not currently 
have significant amounts of unsecured receivables related to OTC 
derivatives transactions, the cost impact as compared to the baseline 
of the current capital regime for broker-dealers should not be material 
for these firms.
v. Funding Liquidity Stress Test Requirement
    As discussed in section II.A.2.d. of this release, the Commission 
is proposing a funding liquidity stress requirement \1055\ to be 
conducted by the ANC broker-dealers and stand-alone SBSDs that use 
internal models at least monthly that takes into account certain 
assumed conditions lasting for 30 consecutive days. These required 
assumed conditions would be:
---------------------------------------------------------------------------

    \1055\ Compare BCBS, Basel III: International framework for 
liquidity risk measurement, standards and monitoring (Dec. 2010), 
available at http://www.bis.org/publ/bcbs188.pdf.
---------------------------------------------------------------------------

     A stress event that includes a decline in creditworthiness 
of the firm severe enough to trigger contractual credit-related 
commitment provisions of counterparty agreements; \1056\
---------------------------------------------------------------------------

    \1056\ See Federal Reserve Enhanced Prudential Standards and 
Early Remediation Requirements for Covered Companies, 77 FR 594, 608 
(Jan. 5, 2012) (noting that effective liquidity stress testing 
should be conducted over a variety of time horizons to adequately 
capture rapidly developing events, and other conditions and outcomes 
that may materialize in the near or long term).
---------------------------------------------------------------------------

     The loss of all existing unsecured funding at the earlier 
of its maturity or put date and an inability to acquire a material 
amount of new unsecured funding, including intercompany advances and 
unfunded committed lines of credit;
     The potential for a material net loss of secured funding;
     The loss of the ability to procure repurchase agreement 
financing for less liquid assets;
     The illiquidity of collateral required by and on deposit 
at clearing agencies or other entities which is not deducted from net 
worth or which is not funded by customer assets;
     A material increase in collateral required to be 
maintained at registered clearing agencies of which the firm is a 
member; and
     The potential for a material loss of liquidity caused by 
market participants exercising contractual rights and/or refusing to 
enter into transactions with respect to the various businesses, 
positions, and commitments of the firm, including those related to 
customer businesses of the firm.\1057\
---------------------------------------------------------------------------

    \1057\ See proposed new paragraph (f)(1) to Rule 15c3-1 and 
paragraph (f)(1) of proposed new Rule 18a-1.

These proposed minimum elements are designed to ensure that ANC broker-
dealers and stand-alone SBSDs using internal models employ a stress 
test that is severe enough to produce an estimate of a potential 
funding loss of a magnitude that might be expected in a severely 
stressed market.
    The benefit of the proposed liquidity stress test requirement is an 
additional level of protection against disruptions in the ability to 
obtain funding for a firm with significant proprietary positions in 
securities or derivatives.\1058\ The proposed liquidity requirement is 
intended to increase the likelihood that a firm could withstand a 
general loss of confidence in the firm itself, or the markets more 
generally and stay solvent for up to 30 days, during which time it 
could either regain the ability to obtain funding in the ordinary 
course or else better position itself for resolution, with less 
collateral impact on other market participants and the financial 
system. As such, this proposal may reduce the likelihood and severity 
of a fire sale and, therefore, mitigate spillover effects and lower 
systemic risk.\1059\ This, in turn, may increase confidence in the 
security-based swap markets and may lead to an increase in trading in 
this market.
---------------------------------------------------------------------------

    \1058\ See letter from Christopher Cox, Chairman, Commission, to 
Dr. Nout Wellink, Chairman, BCBS (Mar. 20, 2008), available at 
http://www.sec.gov/news/press/2008/2008-48_letter.pdf (highlighting 
importance of liquidity management in meeting obligations during 
stressful market conditions). See also Enhanced Prudential Standards 
and Early Remediation Requirements for Covered Companies, 77 FR 594, 
608 (Jan. 5, 2012) (proposing that liquidity stress testing must be 
tailored to reflect a covered company's capital structure, risk 
profile, complexity, activities, size and other appropriate risk-
related factors stating that stress testing will be directly tied to 
the covered company's business profile and the regulatory 
environment in which it operates.). The minimum factors described 
above are intended to specifically address factors relevant to the 
regulatory environment in which ANC broker-dealers and stand-alone 
SBSD using internal models operate.
    \1059\ See Andrei Shleifer and Robert Vishny, Fire Sales in 
Finance and Macroeconomics, 25 Journal of Economic Perspectives 29-
48 (Winter 2011) (surveying literature on fire sales, which implies 
that if financial institutions are not liquidity restraints during 
fire sales, price and liquidity spirals should less likely occur).
---------------------------------------------------------------------------

    This proposal, however, would impose additional opportunity costs 
of capital, and other costs on ANC broker-dealers and nonbank SBSDs 
directly related to the amount of the required liquidity reserve 
because a nonbank SBSD would be unable to deploy the assets that are 
maintained for the liquidity reserve in other, potentially more 
efficient ways.
    In addition, smaller firms may incur more implementation costs, 
because, in general, large firms already run stress tests and maintain 
a liquidity reserve based on those tests.\1060\ In addition, the 
required assumed conditions are designed to be consistent with the 
liquidity stress tests performed by ANC broker-dealers (based on staff 
experience in supervising the ANC broker-dealers) and to address the 
types of outflows experienced by ANC broker-dealers and other broker-
dealers in times of stress. Therefore, while the opportunity cost of 
the liquidity requirements might be substantial, they are not expected 
to impose liquidity standards that are materially different from what 
is observed now among the ANC broker-dealers and thus should not 
represent an undue burden at this time.
---------------------------------------------------------------------------

    \1060\ See 17 CFR 240.15c3-4.
---------------------------------------------------------------------------

    Finally, under the proposals, an ANC broker-dealer and a stand-
alone SBSD using internal models would be required to establish a 
written contingency funding plan. The plan would need to clearly set 
out the strategies for addressing liquidity shortfalls in emergency 
situations,\1061\ and would need to address the policies, roles, and 
responsibilities for meeting the liquidity needs of the firm and 
communicating with the public and other market participants during a 
liquidity stress event.\1062\
---------------------------------------------------------------------------

    \1061\ See proposed new paragraph (f)(4) of Rule 15c3-1; 
paragraph (f)(4) of proposed Rule 18a-1.
    \1062\ See proposed new paragraph (f)(4) of Rule 15c3-1; 
paragraph (f)(4) of proposed Rule 18a-1.
---------------------------------------------------------------------------

    This proposal may reduce the likelihood of default of a nonbank 
SBSD that uses internal models or an ANC broker-dealer, and thus, in 
turn, reduce systemic risk. Based on staff experience supervising ANC 
broker-dealers and monitoring the ultimate holding companies of these 
firms, most of these entities have a written contingency funding plan, 
generally, at the holding company level. To the extent that these firms 
are required to implement a written contingency funding plan at the 
nonbank SBSD level or ANC level, these firms may incur personnel, 
technology or other operational costs to develop and implement such a 
plan.\1063\
---------------------------------------------------------------------------

    \1063\ See section V.C. of this release.
---------------------------------------------------------------------------

vi. Risk Management Procedures
    As discussed in section II.A.2.c. above, nonbank SBSDs would be 
required to comply with the risk management provisions of Rule 15c3-4, 
as if they were OTC derivatives dealers, because the risks of trading 
by nonbank SBSDs in security-based swaps,

[[Page 70315]]

including market, credit, operational, and legal risks, are similar to 
the risks faced by OTC derivatives dealers in trading other types of 
OTC derivatives.\1064\ These requirements may reduce the risk of 
significant losses by nonbank SBSDs. The internal risk management 
control system requirements also should reduce the risk that the 
problems of one firm will spread because each nonbank SBSD should have 
a better understanding of the nonbank's exposures and the risks of 
those exposures. The nonbank SBSDs may incur costs in better modifying 
documents and their information technology systems to meet these 
requirements, but these costs could vary significantly among nonbank 
SBSDs depending on the degree to which their risk management systems 
are documented and on size of each firm and the types of business it 
engages in.\1065\
---------------------------------------------------------------------------

    \1064\ For example, individually negotiated OTC derivative 
products, including security-based swaps, generally are not very 
liquid. Market participants face risks associated with the financial 
and legal ability of counterparties to perform under the terms of 
specific transactions. The additional exposure to credit risk, 
liquidity risk, and other risks makes it necessary for OTC 
derivatives market participants to implement a risk management 
control system.
    \1065\ See section V.C. of this release.
---------------------------------------------------------------------------

b. Capital Requirements for MSBSPs
    As discussed in section II.A.3. of the release, proposed new Rule 
18a-2 would require nonbank MSBSPs to have and maintain positive 
tangible net worth at all times.\1066\ Entities that may need to 
register as MSBSPs may engage in a diverse range of business activities 
very different from, and broader than, the securities activities 
conducted by broker-dealers (otherwise they would be required to 
register as an SBSD and/or broker-dealer). Because nonbank MSBSPs, by 
definition, will be entities that have substantial exposure to 
security-based swaps, they would also be required to comply with Rule 
15c3-4,\1067\ which requires OTC derivatives dealers and ANC broker-
dealers to establish, document, and maintain a system of internal risk 
management.\1068\ This proposal is designed to promote sound risk 
management practices with respect to the risks associated with trading 
in OTC derivatives. Nonbank MSBSPs may incur implementation costs, such 
as technology costs to comply with the risk management practices 
proposed by the rule. These are discussed in section V.C. below.
---------------------------------------------------------------------------

    \1066\ See paragraph (a) of proposed new Rule 18a-2.
    \1067\ See paragraph (c) of proposed new Rule 18a-2.
    \1068\ See 17 CFR 240.15c3-4.
---------------------------------------------------------------------------

    Risk management controls at nonbank MSBSPs may promote the 
stability of these firms and, consequently, the stability of the entire 
financial system. This, in turn, may protect the financial industry 
from systemic risk.
    The Commission could instead impose capital requirements that are 
the same as, or modeled on, those that are being proposed for nonbank 
SBSDs, which could more effectively reduce the risk of failure of 
MSBSPs and thereby reduce systemic risk. In general, nonbank SBSDs and 
MSBSPs can be expected to differ in terms of the range and types of 
their counterparty relationships and, by definition, MSBSPs will not 
maintain two-sided exposure to a range of instruments that is 
characteristic of dealer activity. The systemic impact of the failure 
of an MSBSP will depend on various factors, including the ability of 
its counterparties to readily liquidate assets posted by the MSBSP as 
collateral, without suffering a loss. Although the Commission is 
proposing to require MSBSPs to post collateral to eliminate their 
current exposure to counterparties in security-based swaps, the 
collateral may not be sufficient to avoid losses during a period of 
market volatility. At the same time, imposing a capital regime on 
MSBSPs that is based on a net liquid assets test could impact the 
ability of an MSBSP to pursue business activities and strategies 
unrelated to its activities involving financial instruments. For 
example, these entities may engage in commercial activities that 
require them to have substantial fixed assets to support manufacturing 
and/or result in them having significant assets comprised of unsecured 
receivables. Requiring them to adhere to a net liquid assets test could 
result in their having to obtain significant additional capital or 
engage in costly restructurings. The Commission is specifically seeking 
comment on this approach in section II.A.3. of this release.
    As stated above, at present, entities that may be required to be 
registered as MSBSPs are expected to be companies that engage in a 
diverse range of business. For these reasons, it would be difficult to 
quantify how much additional capital, if any, or costs the capital 
requirements under proposed new Rule 18a-3 would require these entities 
to maintain or incur and compare these amounts against the current 
baseline of the OTC derivatives market as it exists today.\1069\ Given 
that proposed new Rule 18a-2 would only require that a nonbank MSBSP 
maintain a positive tangible net worth at all times, and 5 or fewer 
entities are expected to register as nonbank MSBSPs,\1070\ these costs 
are not expected to be material because it is not expected that these 
firms would have to alter their existing business practice in any 
substantial way to comply with the proposed positive tangible net worth 
test.
---------------------------------------------------------------------------

    \1069\ See section V.A.1. of this release.
    \1070\ See section IV. of this release.
---------------------------------------------------------------------------

c. Consideration of Burden on Competition, and Promotion of Efficiency, 
Competition, and Capital Formation
    The proposed financial responsibility requirements should reduce 
the risk of a failure of any major market participant in the security-
based swap market, which in turn reduces the possibility of a general 
market failure, and thus promotes confidence for market participants to 
transact in security-based swaps for investment and hedging purposes. 
The proposed capital requirements are designed to promote confidence in 
nonbank SBSDs among customers, counterparties, and the entities that 
provide financing to nonbank SBSDs and, thereby, lessen the potential 
that these market participants may seek to rapidly withdraw assets and 
financing from SBSDs during a time of market stress. This heightened 
confidence is expected to increase trading activity and promote 
competition among dealers. The proposed financial responsibility 
requirements, in significant part, will affect efficiency and capital 
formation through their impact on competition.\1071\ Specifically, 
markets that are competitive can, ceteris paribus, be expected to 
promote a more efficient allocation of capital.
---------------------------------------------------------------------------

    \1071\ See also Entity Definitions Adopting Release, 77 FR at 
30742.
---------------------------------------------------------------------------

    Any new entrant will increase the number of competing entities, and 
the extent to which competition increases will depend on the number of 
additional entrants and their success in attracting business from 
established market participants. As discussed in section IV. of this 
release, the Commission expects up to 50 entities to register as SBSDs. 
The number of registered firms will depend, among other factors, on 
whether potential new entrants determine that the cost impact of the 
proposed financial responsibility requirements would allow them to 
compete effectively for business. To the extent that costs associated 
with the proposed rules are high however, they

[[Page 70316]]

may negatively affect competition within the security-based swap 
markets. This may, for example, lead smaller dealers or entities for 
whom dealing is not a core business to exit the market because 
compliance with the proposed minimum capital requirements is not 
feasible because of cost considerations. The same costs might also 
deter the entry of new SBSDs or MSBSPs into the market, and if 
sufficiently high, increase concentration among nonbank SBSDs.
    The possibility of using VaR to calculate haircuts may permit a 
nonbank SBSD to more efficiently deploy capital in other parts of its 
operations (because VaR models could reduce capital charges and thereby 
could make additional capital available), which should be a factor in 
the decision to enter the security-based swap markets in general and 
through which type of registrant in particular. Because of the reduced 
charges for market and credit risk, a nonbank SBSD may be able to 
reallocate capital from the nonbank SBSD to affiliates that may receive 
a higher return than the nonbank SBSD.\1072\ Therefore, the success of 
new entrants in competing for security-based swap business also will 
likely depend on the extent to which they obtain the Commission's 
approval to use a VaR model.\1073\ Hence, the Commission expects a 
positive impact on competition especially among SBSDs that use internal 
models, whether they are stand-alone SBSDs or ANC broker-dealers.
---------------------------------------------------------------------------

    \1072\ See Alternative Net Capital Requirements Adopting 
Release, 69 FR 34428.
    \1073\ See, e.g., Alternative Net Capital Requirements Adopting 
Release, 69 FR at 34455 (describing benefits of alternative net 
capital requirements for broker-dealers using models stating a 
``major benefit for the broker-dealer will be lower deductions from 
net capital for market and credit risk that we expect will result 
from the use of the alternative method.'') Therefore, it is likely 
that for new entrants to capture substantial volume in security-
based swaps they will need to use VaR models. See also OTC 
Derivatives Dealer Release, 63 FR 59362 (discussing benefits of 
minimum capital requirements as an additional measure of 
protection).
---------------------------------------------------------------------------

    However, some of the entities that presently compete in the market 
may opt to conduct these activities in registered broker-dealer 
affiliates; this development would not increase the number of 
competitors. But other firms that currently do not deal in security-
based swaps or do not do so in any significant degree, may choose to 
compete either as a stand-alone SBSD or as a broker-dealer SBSD. This 
may increase the number of competing firms.
    The proposals ultimately adopted, like other requirements 
established under the Dodd-Frank Act, could have a substantial impact 
on international commerce and the relative competitive position of 
intermediaries operating in various, or multiple, jurisdictions. In 
particular, intermediaries operating in the U.S. and in other 
jurisdictions could be advantaged or disadvantaged if corresponding 
requirements are not established in other jurisdictions or if the 
Commission's rules are substantially more or less stringent than 
corresponding requirements in other jurisdictions. This could, among 
other potential impacts, affect the ability of intermediaries and other 
market participants based in the U.S. to participate in non-U.S. 
markets, the ability of non-U.S.-based intermediaries and other market 
participants to participate in U.S. markets, and whether and how 
international firms make use of global ``booking entities'' to 
centralize risks related to security-based swaps. As discussed in 
section I. of this release, these issues have been the focus of 
numerous comments to the Commission and other regulators, Congressional 
inquiries, and other public dialogue.
    Accordingly, substantial differences between the U.S. and foreign 
jurisdictions in the costs of complying with the financial 
responsibility requirements for security-based swaps between U.S. and 
foreign jurisdictions could reduce cross-border capital flows and 
hinder the ability of global firms to most efficiently allocate capital 
among legal entities to meet the demands of their counterparties. As 
discussed in section I. of this release, the potential international 
implications of the proposed capital, margin, and segregation 
requirements warrant further consideration.\1074\ The Commission 
intends to publish a comprehensive release seeking public comment on 
the full spectrum of issues relating to the application of Title VII to 
cross-border security-based swap transactions and non-U.S. persons that 
act in capacities regulated under the Dodd-Frank Act.
---------------------------------------------------------------------------

    \1074\ See BCBS, IOSCO, Margin Requirements for Non-centrally-
cleared Derivatives (July 2012), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD387.pdf (consultative document seeking 
comment on a paper on margin requirements for non-centrally-cleared 
derivatives).
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    The willingness of end users to trade with a nonbank SBSD dealer 
will depend on their evaluation of the risks of trading with that 
particular firm compared to more established firms, and their ability 
to negotiate favorable price and other terms. As discussed in section 
V.A. of this release, end users of security-based swaps are mostly 
comprised of hedge funds and other asset management and financial 
firms. Many of these entities are sophisticated participants that trade 
in substantial volume and generally post collateral for their security-
based swap positions.\1075\ These end users are relatively well-
positioned to negotiate price and other terms with competing dealers 
and to take advantage of greater choice of nonbank SBSD counterparties. 
These same participants, when transacting in the securities markets, 
often trade with a variety of competing dealers, including through 
prime brokerage relationships. To the extent that the proposals result 
in increased competition, participants in the security-based swap 
markets should be able to take advantage of this increased competition 
and negotiate improved terms, resulting generally in narrower spreads 
and better prices.
---------------------------------------------------------------------------

    \1075\ See, e.g., Independent Amounts at 6.
---------------------------------------------------------------------------

    In addition, benefits may be expected to also arise from the 
ability of nonbank SBSDs, which now conduct substantial business in 
security-based swaps, to consolidate those operations within their 
affiliated U.S. broker-dealers. This flexibility may yield efficiencies 
for clients conducting business in securities and security-based swaps, 
including netting benefits,\1076\ a reduction in the number of account 
relationships required with affiliated entities, and a reduction in the 
number of governing agreements. These potential benefits are at some 
tension with benefits from an increase in the number of competitors, to 
the extent that netting benefits will be maximized by holding a large 
portfolio of positions at the same entity,\1077\ rather than trading 
with a variety of competing dealers. Further, because the proposals 
would permit the conduct of a security-based swap business in an entity 
jointly registered as a broker-dealer SBSD,\1078\ they would facilitate 
the potential for those firms to offer portfolio margin for a variety 
of positions. From the standpoint of a holding company with multiple 
financial affiliates, aggregating security-based swaps business in a 
single entity,

[[Page 70317]]

such as a broker-dealer SBSD, could help to simplify and streamline 
risk management, allow more efficient use of capital, as well as 
operational efficiencies, and avoid the need for multiple netting and 
other agreements.
---------------------------------------------------------------------------

    \1076\ See, e.g., paragraph (c)(5) of proposed new Rule 18a-
3(c)(5). See letter from Stuart J. Kaswell, Executive Vice 
President, Managing Director and General Counsel, Managed Funds 
Association, to David A. Stawick, Secretary of the CFTC (July 11, 
2011) (``Effective netting agreements lower systemic risk by 
reducing both the aggregate requirement to deliver margin and 
trading costs for market participants.'').
    \1077\ See Darrell Duffie and Haoxiang Zhu, Does a Central 
Clearing Party Reduce Counterparty Risk, Stanford University Working 
Paper (Mar. 6, 2010) (showing that netting in the context of CCPs 
results in significant reductions in counterparty exposures).
    \1078\ See, e.g., amendments to Rule 15c3-1 (proposing minimum 
net capital requirements for broker-dealers engaging in a security-
based swap business).
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    While these arguments generally suggest the possibility of positive 
effects of the proposed rules on competition, efficiency and capital 
formation, financial responsibility requirements that impose too many 
competitive burdens pose the risk of imposing excessive regulatory 
costs that could deter the efficient allocation of capital. Such rules 
also may be expected to reduce the capital formation benefits that 
otherwise would be associated with security-based swaps. Specifically, 
financial responsibility requirements that are overly stringent may 
prevent entries in the security-based swap markets and thereby may 
either increase spreads and trading costs or even reduce the 
availability of security-based swaps. In both instances, end users 
would face higher cost to meet their business needs.
    Apart from their impact on the extent of dealer competition and 
efficiencies for end users, the proposed new rules and rule amendments 
could create the potential for regulatory arbitrage to the extent that 
they differ from corresponding rules other regulators adopt. As noted 
above in section I. of this release, the proposals of the prudential 
regulators and the CFTC were considered in developing the Commission's 
proposed capital, margin, and segregation requirements for SBSDs and 
MSBSPs. The Commission's proposals differ in some respects from 
proposals of the prudential regulators and the CFTC. While some 
differences are based on differences in the activities of securities 
firms, banks, and commodities firms, or differences in the products at 
issue, other differences may reflect an alternative approach to 
balancing the relevant policy choices and considerations. Depending on 
the final rules the Commission adopts, the financial responsibility 
requirements could make it more or less costly to conduct security-
based swaps trading in banks as compared to nonbank SBSDs. For example, 
high capital requirements may discourage certain entities from 
participating in the security-based swap markets, particularly if the 
regulatory costs for nonbank SBSDs are high. Likewise, if the 
application of the proposed 8% margin risk factor substantially 
increases capital requirements for nonbank SBSDs compared to risk-based 
capital requirements imposed by the prudential regulators on the same 
activity, bank holding companies could be incentivized to conduct these 
activities in their bank affiliates.\1079\ These differences could 
create competitive inequalities and affect the allocation of trading 
activities within a holding company structure.
---------------------------------------------------------------------------

    \1079\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564.
---------------------------------------------------------------------------

    Finally, in significant part, the effect of the proposals for 
nonbank MSBSPs on efficiency and capital formation will also be linked 
to the effect of these requirements on competition,\1080\ as 
competitive markets, ceteris paribus, can be expected to promote a more 
efficient allocation of capital.
---------------------------------------------------------------------------

    \1080\ See also Entity Definitions Adopting Release, 77 FR at 
30742.
---------------------------------------------------------------------------

    Conversely, if the proposals for MSBSPs are accompanied by too many 
competitive burdens, the proposals risk the imposition of excessive 
regulatory costs that could deter the efficient allocation of capital. 
Such rules also may be expected to reduce the capital formation 
benefits that otherwise would be associated with security-based swaps. 
Requirements for nonbank MSBSPs that are overly stringent may prevent 
entries in the security-based swap markets and thereby may reduce the 
availability of security-based swaps, forcing end users to use less 
effective financial instruments to meet their business needs.
Request for Comment
    The Commission generally requests comment about its analysis of the 
general costs and benefits of the proposed capital rules for SBSDs and 
MSBSPs. In addition, the Commission requests comment in response to the 
following questions:
    1. Would the minimum capital requirements represent a barrier to 
entry to firms that may otherwise seek to trade security-based swaps as 
SBSDs? If so, which types of firms would be foreclosed?
    2. Is it correct to assume that firms that have the risk management 
capability to act as a dealer in security-based swaps generally would 
also meet or be readily able to meet the proposed capital minimums?
    3. To what extent will firms that receive approval to use VaR 
models be able to dominate trading in security-based swaps, whether 
because of costs to other firms in applying a haircut methodology to 
security-based swaps or for other reasons?
    4. What would be the impact of market concentration on reduction in 
systemic risk? For example, would concentration of positions in a 
relatively few firms exacerbate systemic risk by exaggerating the 
impact of the failure of a single firm? Conversely, would high capital 
requirements better protect against systemic risk by reducing the risk 
of failure of a nonbank SBSD?
    5. Do the proposed capital requirements for nonbank SBSDs 
proportionately reflect the increased risk associated with the use of 
internal models and trading in a portfolio of instruments, including 
securities, security-based swaps, and other derivatives?
    6. The Commission requests comment on how much additional capital 
would be required, if any, as a result of the proposed 8% margin factor 
based on a sample portfolio of security-based swaps and how the result 
compares to the amount these firms currently hold against the same 
risk.
    7. Under the proposed 8% margin factor, the relation between 
exposure and capital is linear. Is this type of formal approach 
appropriate for risks associated with security-based swaps? Should the 
risk margin factor be increased at higher levels of exposure, or should 
it increase on some other basis?
    8. How would firms' current risk management practices for 
calculating their exposures to counterparties compare to the proposed 
8% margin factor, if nonbank SBSDs were only required to comply with a 
fixed minimum net capital standard?
    9. From a systemic risk perspective, should the proposed capital 
rules for nonbank SBSDs encourage the conduct of security-based swaps 
trading outside of broker-dealer affiliates?
    10. From a systemic risk perspective, are the proposed increases in 
the minimum net capital (from $500 million to $1 billion) and minimum 
tentative net capital ($1 billion to $5 billion) requirements for ANC 
broker-dealers adequate? From a systematic risk perspective, is the 
proposed increase in the ``early warning'' level from $5 billion to $6 
billion for ANC broker-dealers adequate?
    11. Would the proposed CDS grid impose any additional costs on 
nonbank SBSDs in comparison to the current haircut charges for similar 
debt securities under Rule 15c3-1?
    12. Would a nonbank SBSD incur additional costs resulting from the 
proposed liquidity stress test based on current practice? The 
Commission requests that commenters quantify the extent of the 
additional cost the proposed stress test would yield based on 
hypothetical firm portfolios, and provide the Commission with such 
data.
    13. Are the factors proposed in the liquidity funding stress test 
adequate? If

[[Page 70318]]

not, are there other factors that should be included?
    14. How would proposed new Rule 18a-2 impact entities that may be 
required to register as MSBSPs?
    15. Would proposed new Rule 18a-2 require nonbank MSBSPs to hold 
additional capital, in comparison to current capital levels maintained 
at these firms? If yes, please quantify the amount.
    16. What additional costs, if any, would a nonbank MSBSP incur in 
making adjustments to risk management practices to conform to the 
specific provisions of Rule 15c3-4?
    17. If stand-alone SBSDs would not be able to claim flow-through 
capital benefits for consolidated subsidiaries or affiliates under Rule 
18a-1c, in contrast to Appendix C of existing Rule 15c3-1, would stand-
alone SBSDs be competitively disadvantaged? If yes, please explain.
    18. Would the Commission's proposals lead to greater competition 
among intermediaries for security-based swaps business, greater 
concentration, or neither? How important are the goals of reduction in 
systemic risk versus promotion of competition in crafting rules in this 
area, and to what extent are they competing goals? If they are not 
competing goals, how should the achievement of both goals inform the 
Commission's overall approach?
    19. Will the Commission's proposals affect the competitive position 
of U.S. firms in the global security-based swaps market? How in general 
would they impact global trading in these products? How could the 
Commission best address any anti-competitive effects? For example, 
should the Commission permit U.S. firms trading with off-shore 
counterparties to collect margin based on the rules of the jurisdiction 
where the counterparty is located, provided the Commission determines 
that those rules are comparable to the U.S. regime? How would 
comparability be determined?
    20. The Commission specifically requests comment on the potential 
impact of interagency differences in specific aspects of capital and 
margin requirements. Which specific aspects of the proposed rules could 
have the most impact in determining the type of legal entity in which 
trading is conducted? What would be the market or economic effects?
3. The Proposed Margin Rule--Rule 18a-3
    As discussed in section II.B. of this release, pursuant to section 
15F(e) of the Exchange Act, proposed new Rule 18a-3 would establish 
margin requirements for nonbank SBSDs and nonbank MSBSPs with respect 
to transactions with counterparties in non-cleared security-based 
swaps.\1081\ As discussed in more detail below, the proposed rule would 
require nonbank SBSDs to collect collateral from their counterparties 
to non-cleared security-based swaps to cover both current exposure and 
potential future exposure to the counterparty (i.e., the rule would 
require the account to have prescribed minimum levels of equity); 
however, there would be exceptions to these requirements for certain 
types of counterparties. Proposed new Rule 18a-3 would have a number of 
benefits as well as impose certain costs on nonbank SBSDs, nonbank 
MSBSPs, as well as other market participants, including commercial end 
users. The proposed rule also would have possible effects on 
competition, efficiency, and capital formation, which will be discussed 
further below.
---------------------------------------------------------------------------

    \1081\ See proposed new Rule 18a-3.
---------------------------------------------------------------------------

    The two types of credit exposure arising from OTC derivatives are 
current exposure and potential future exposure. The current exposure is 
the amount that the counterparty would be obligated to pay the dealer 
if all the OTC derivatives contracts with the counterparty were 
terminated (i.e., it is the amount of the current receivable from the 
counterparty). This form of credit risk arises from the potential that 
the counterparty may default on the obligation to pay the current 
receivable. The potential future exposure is the amount that the 
current exposure may increase in the favor of the dealer in the future. 
This form of credit risk arises from the potential that the 
counterparty may default before providing the dealer with additional 
collateral to cover the incremental increase in the current exposure or 
the current exposure will increase after a default when the 
counterparty has ceased to provide additional collateral to cover such 
increases and before the dealer can liquidate the position.
    Rule 18a-3 is intended to support a goal of the Dodd-Frank Act by 
promoting centralized clearing of sufficiently standardized 
products,\1082\ which, in turn, may help to mitigate credit risk.\1083\ 
Specifically, Rule 18a-3, by creating stringent margin requirements for 
non-cleared contracts, is meant to create incentives for participants 
to clear security-based swaps, where available and appropriate for 
their needs.\1084\ Central clearing can provide systemic benefits by 
limiting systemic leverage and aggregating and managing risks by a 
central counterparty.\1085\ At the same time, realization of these 
benefits assumes that central counterparties are appropriately 
capitalized and sufficiently collateralize their exposures to their 
clearing members. Under the proposed rule, the market will benefit from 
the required collateralization of non-cleared security-based swaps. 
Specifically, the required collateralization should improve 
counterparty risk management, reduce the risk of contagion from a 
defaulting counterparty, and ultimately reduce systemic risk.
---------------------------------------------------------------------------

    \1082\ The Dodd-Frank Act seeks to ensure that, wherever 
possible and appropriate, derivatives contracts formerly traded 
exclusively in the OTC market be cleared. See, e.g., Senate 
Committee on Banking, Housing, and Urban Affairs, The Restoring 
American Financial Stability Act of 2010, S. Rep. No. 111-176, 34 
(stating that ``[s]ome parts of the OTC market may not be suitable 
for clearing and exchange trading due to individual business needs 
of certain users. Those users should retain the ability to engage in 
customized, non-cleared contracts while bringing in as much of the 
OTC market under the centrally cleared and exchange-traded framework 
as possible.'').
    \1083\ For example, when an OTC derivatives contract between two 
counterparties that are members of a CCP is executed and submitted 
for clearing, it is typically replaced by two new contracts--
separate contracts between the CCP and each of the two original 
counterparties. At that point, the original counterparties are no 
longer counterparties to each other. Instead, each acquires the CCP 
as its counterparty, and the CCP assumes the counterparty credit 
risk of each of the original counterparties that are members of the 
CCP. See Stephen Cecchetti, Jacob Gyntelberg, and Mark Hollanders, 
Central counterparties for over-the-counter derivatives, BIS 
Quarterly Review (Sept. 2009), available at http://www.bis.org/publ/qtrpdf/r_qt0909f.pdf. Structured and operated appropriately, CCPs 
may improve the management of counterparty risk and may provide 
additional benefits such as multilateral netting of trades. See also 
Process for Submissions of Security-Based Swaps, 77 FR at 41603.
    \1084\ See Daniel Heller and Nicholas Vause, Expansion of 
Central Clearing, BIS Quarterly Review (June 2011) (arguing 
expansion of central clearing within or across segments of the 
derivatives markets could economize both on margin and non-margin 
resources).
    \1085\ See Process for Submissions of Security-Based Swaps, 77 
FR 41602.
---------------------------------------------------------------------------

    While available data suggests that clearing of security-based swaps 
has been increasing, significant segments of the security-based swap 
markets remain uncleared, even where a CCP is available to clear the 
product in question on a voluntary basis.\1086\ The mandatory clearing 
determinations made pursuant to Exchange Act section 3C(a)(1) will 
alter current clearing practices at the time such determinations are 
made. The Commission has not yet made any mandatory clearing 
determinations under the authority of section 3C(a)(1) of the Exchange 
Act and cannot estimate

[[Page 70319]]

at this time how much of the security-based swap markets may ultimately 
be subject to such determinations.
---------------------------------------------------------------------------

    \1086\ See Process for Submissions of Security-Based Swaps, 77 
FR 41602.
---------------------------------------------------------------------------

    Other costs resulting from proposed new Rule 18a-3 may result from 
reducing the availability of liquid assets for purposes other than 
posting collateral. Data available to the Commission suggests that 
existing collateral practices vary widely by type of market participant 
and counterparty.\1087\ For example, the ISDA Margin Survey 2012, which 
provides global estimates regarding the use of collateral in the OTC 
derivatives business based on a survey of ISDA members as of the end of 
2011,\1088\ stated that 71% of all OTC derivatives transactions were 
subject to collateral agreements; the average percentage was 96% for 
the largest dealers responding to the survey.\1089\ The percent of 
trades subject to collateral agreements was higher, however, for credit 
derivatives (93.4% of all trades) and about the same as the general 
average for equity derivatives (72.7%).\1090\
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    \1087\ See, e.g., ISDA Margin Survey 2012. Proposed new Rule 
18a-3 would distinguish by counterparty type in that the rule would 
provide specific exemptions from the rule for certain 
counterparties, such as commercial end users. See section II.B. of 
this release.
    \1088\ ISDA Margin Survey 2012. The ISDA Margin Survey 2012 also 
states that the estimated amount of collateral in circulation in the 
non-cleared OTC derivatives market at the end of 2011 was 
approximately $3.6 trillion, which is up 24% from last year's 
estimated amount of $2.9 trillion.
    \1089\ Id. The threshold for classification as a ``large'' 
program under the ISDA survey is more than 3,000 agreements. 
Overall, 84% of all OTC derivatives transactions executed by the 
largest dealers were subject to collateral agreements. Hedge fund 
exposures tend to be the most highly collateralized of all types of 
counterparty exposures with average collateralization levels 
exceeding 100% of net exposures, a figure that reflects 
``Independent Amounts'' (initial margin) posted by such firms. ISDA 
Margin Survey 2011 at Table 3.3.
    \1090\ ISDA Margin Survey 2012 at Table 3.2. The fourteen 
largest reporting firms reported an average 96.1% of credit 
derivatives trades were subject to collateral arrangements during 
2011, and 85.5% of equity derivatives trades were subject to 
collateral agreements. Id.
---------------------------------------------------------------------------

    The ISDA Margin Survey 2011 reported on the extent of 
collateralization (percentage of net exposures) by type of 
counterparty.\1091\ The amount reported for all counterparties and all 
OTC derivatives was 73.1%.\1092\ The ISDA Margin Survey 2011 also 
indicates that the collateralization levels by large dealers of their 
net exposures to their bank and broker-dealer dealer counterparties was 
88.6%.\1093\ For hedge funds, the average collateralization levels were 
178%, reflecting a greater tendency to collect initial margin from 
those participants.\1094\ Finally, exposures to non-financial 
corporations (37.3%) and sovereign governments (17.6%) had much lower 
levels of coverage.\1095\
---------------------------------------------------------------------------

    \1091\ See ISDA Margin Survey 2011. This information was not 
reported in the ISDA Margin Survey 2012.
    \1092\ Id.
    \1093\ Id.
    \1094\ Id.
    \1095\ Id.
---------------------------------------------------------------------------

    The data from the ISDA Margin Survey 2011 and the ISDA Margin 
Survey 2012 support the premises that margin practices widely vary, 
that larger dealers tend to collateralize their net exposures, that 
exposures to financial end users tend to be collateralized with both 
variation (current exposure) and initial margin (potential future 
exposure), and that much of the exposure to non-financial end users 
generally is not collateralized.\1096\
---------------------------------------------------------------------------

    \1096\ See generally ISDA Margin Survey 2011; ISDA Margin Survey 
2012. The results of the survey, however, could be substantially 
different if limited only to U.S. participants, because the data 
contained in the ISDA Margin Survey 2011 and ISDA Margin Survey 2012 
is global. Id. For example, 47% of the institutions responding to 
the ISDA Margin Survey 2012 were based in Europe, the Middle East, 
or Africa, and 31% were based in the Americas. ISDA Margin Survey 
2012 at Chart 1.1.
---------------------------------------------------------------------------

    Rule 18a-3 is generally modeled on the broker-dealer margin rules 
in terms of establishing an account equity requirement; requiring 
nonbank SBSDs to collect collateral to meet the requirement; and, 
subject to haircuts, allowing a range of securities for which there is 
a ready market to be used as collateral.\1097\ The goals of modeling 
proposed new Rule 18a-3 on the broker-dealer margin rules are to create 
a framework that will limit counterparty exposure of nonbank SBSDs 
while promoting consistency with existing rules. This consistency may 
also facilitate the ability to provide portfolio margining of security-
based swaps with other types of securities, and in particular single 
name credit default swaps along with bonds that serve as reference 
obligations for the credit default swaps.
---------------------------------------------------------------------------

    \1097\ Broker-dealers are subject to margin requirements in 
Regulation T promulgated by the Federal Reserve (12 CFR 220.1, et 
seq.), in rules promulgated by the SROs (see, e.g., FINRA Rules 
4210-4240), and with respect to security futures, in rules jointly 
promulgated by the Commission and the CFTC (17 CFR 242.400-406).
---------------------------------------------------------------------------

    In the securities markets, margin rules have been set by relevant 
regulatory authorities (the Federal Reserve and the SROs) since the 
1930s.\1098\ The requirement that an SRO file proposed margin rules 
with the Commission has promoted the establishment of consistent margin 
levels across the SROs, which mitigates the risk that SROs (as well as 
their member firms) will compete by implementing lower margin levels 
and helps ensure that margin levels are set at sufficiently prudent 
levels to reduce systemic risk.\1099\ Basing proposed Rule 18a-3 on the 
broker-dealer margin rules is intended to achieve these same objectives 
in the market for security-based swaps. This consistency between margin 
requirements for securities and security-based swaps should ultimately 
benefit participants in the securities markets, reduce the potential 
for regulatory arbitrage, and lead to consistent interpretation and 
enforcement of applicable regulatory requirements across U.S. 
securities markets.
---------------------------------------------------------------------------

    \1098\ The Federal Reserve originally adopted Regulation T 
pursuant to section 7 of the Exchange Act shortly after the 
enactment of the Exchange Act. See 1934 Fed. Res. Bull. 675. The 
purposes of the Federal Reserve's margin rules include: (1) 
Regulation of the amount of credit directed into securities 
speculation and away from other uses; (2) protection of the 
securities markets from price fluctuations and disruptions caused by 
excessive margin credit; (3) protection of investors against losses 
arising from undue leverage in securities transactions; and (4) 
protection of broker-dealers from the financial exposure involved in 
excessive margin lending to customers. See Charles F. Rechlin, 
Securities Credit Regulation Sec.  1:3 (2d ed. 2008).
    \1099\ Pursuant to Section 19(b)(1) of the Exchange Act, each 
SRO must file with the Commission any proposed change in, addition 
to, or deletion from the rules of the exchange electronically on a 
Form 19b-4 through the Electronic Form 19b-4 Filing System, which is 
a secure Web site operated by the Commission. 15 U.S.C. 78s(b)(1) 
and 17 CFR 240.19b-4.
---------------------------------------------------------------------------

    The discussion below focuses on the impact of specific provisions 
of proposed new Rule 18a-3 and their potential benefits and costs. With 
respect to certain provisions, the Commission has identified 
alternatives to the proposed approach and is seeking comment on the 
relative costs and benefits of adopting the alternatives, in comparison 
to the proposed approach. As to whether nonbank SBSDs should be 
required to collect initial margin in transactions with each other, the 
Commission is expressly proposing alternative formulations of the rule.
a. Calculation of Margin Amount
    Proposed new Rule 18a-3 would require a nonbank SBSD to perform two 
calculations (and a nonbank MSBSP to perform one calculation) as of the 
close of each business day with respect to each account carried by the 
firm for a counterparty to a non-cleared security-based swap 
transaction.\1100\ Even if the counterparty is not required to deliver 
collateral, the calculation(s) would assist the nonbank SBSD or the 
nonbank MSBSPs in managing its credit risk (and determining how much 
needs to be

[[Page 70320]]

collateralized) and understanding the extent of its uncollateralized 
credit exposure to the counterparty and across all counterparties. 
These required calculations also would provide examiners with enhanced 
information about non-cleared security-based swaps, allowing the 
Commission and other appropriate regulators to gain ``snapshot'' 
information at a point in time for examination purposes.
---------------------------------------------------------------------------

    \1100\ See paragraphs (c)(1)(i)(A), (B), and (c)(2)(i) of 
proposed new Rule 18a-3.
---------------------------------------------------------------------------

    As described in section II.B. of the release, paragraph (d) of 
proposed new Rule 18a-3 would prescribe a standardized method for 
calculating the margin amount as well as a model-based method if the 
non-bank SBSD is approved to use internal models.\1101\ The benefits of 
consistent treatment of the standardized haircut and internal models as 
between the proposed capital rules and proposed new Rule 18a-3 may 
increase operational efficiencies and reduce costs at the nonbank SBSD 
by permitting the use of congruent systems and processes to comply with 
both capital and margin requirements.\1102\
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    \1101\ See paragraph (d) of proposed new Rule 18a-3. ``Margin 
amount'' is generally initial margin or potential future exposure. 
These terms may be used interchangeably throughout this section.
    \1102\ See proposed new Rule 18a-1; proposed new Rule 18a-3; 
proposed amendments to Rule 15c3-1.
---------------------------------------------------------------------------

    As is the case with the impact of standardized haircuts on 
regulatory capital, as described in section II.B. of the release, 
nonbank SBSDs required to use standardized haircuts under Rule 18a-3(d) 
to determine the margin amount generally will be required to collect 
higher margin amounts from counterparties for non-cleared security-
based swap transactions than nonbank SBSDs that are approved to use 
internal models will need to collect, because VaR models generally 
result in lower charges than the standardized haircut provisions.\1103\
---------------------------------------------------------------------------

    \1103\ See Alternative Net Capital Requirements Adopting 
Release, 69 FR 34428.
---------------------------------------------------------------------------

    In addition, this proposed requirement would impose additional 
operational and technology costs to install or upgrade systems needed 
to perform daily calculations under proposed new Rule 18a-3. These 
costs may vary because broker-dealers registering as nonbank SBSDs may 
already have systems in place, as current margin rules \1104\ for 
securities require daily margin calculations for customer accounts, 
while new entrants may incur higher operational or other systems costs 
to comply with this requirement. Finally, secondary costs (such as 
reduced profits) could arise if commercial end users or other 
counterparties reduce trading in non-cleared security-based swaps 
because of the increased collateral requirements required by Rule 18a-
3, or if these entities determine to trade instead with non-U.S. 
entities.
---------------------------------------------------------------------------

    \1104\ See, e.g., FINRA Rule 4220 (Daily Record of Required 
Margin); 12 CFR 220.4.
---------------------------------------------------------------------------

b. Account Equity Requirements
    As described in section II.B. to this release, a nonbank SBSD and 
nonbank MSBSP generally would need to collect cash and/or securities to 
meet the account equity requirements in proposed new Rule 18a-3.\1105\ 
This proposal recognizes that counterparties may engage in a wide range 
of trading strategies that include security-based swaps. Because of the 
relation between security-based swaps and other securities positions, 
permitting various types of securities to count as collateral may be 
more practical for margin arrangements involving security-based swaps 
than for other types of derivatives. This flexibility to accept a broad 
range of securities, along with consistency with existing margin 
requirements,\1106\ takes advantage of efficiencies that result from 
correlations between securities and security-based swaps.\1107\ 
However, it may increase the risk that SBSDs will incur a shortfall if, 
as a result, they hold less liquid collateral that cannot be quickly 
sold for an amount that covers the nonbank SBSD's exposure to the 
counterparty.\1108\ This risk may be mitigated by the collateral 
haircut and other requirements regarding the liquidity of collateral 
under the proposed rule.\1109\
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    \1105\ By requiring most counterparties to deliver collateral, 
the proposed margin requirements are intended to prevent 
counterparties from employing undue leverage in their portfolios of 
security-based swaps, which can exacerbate the magnitude of losses 
in relation to the financial resources of the counterparty in the 
case of default.
    \1106\ See the Federal Reserve's Regulation T, 12 CFR 220.1, et 
seq. and SRO margin rules, such as FINRA Rule 4210 and CBOE Rule 
12.3. The consideration in adopting final rules will be informed by 
the comments received.
    \1107\ The ISDA Margin Survey 2012 states with regard to the 
types of assets used as collateral, that the use of cash and 
government securities as collateral remains predominant, 
constituting 90.4% of collateral received and 96.8% of collateral 
delivered. ISDA Margin Survey 2012 at 8, Table 2.1.
    \1108\ Gary Gorton and Guillermo Ordo[ntilde]ez, Collateral 
Crises, Yale University Working Paper (Mar. 2012) (arguing that 
during normal times collateral values are less precise, but during 
volatile times are reassessed). This reassessment can possibly lead 
to large negative shocks in their values, which by deduction can 
lead to market disruptions if collateral needs to be liquidated.
    \1109\ See paragraphs (c)(3)-(c)(4) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    As an alternative, the Commission could limit eligible collateral 
to the most highly liquid categories, as proposed by the prudential 
regulators and the CFTC and described in section II.B.2.c. of this 
release.\1110\ This alternative could limit the potential that an SBSD 
would incur a loss following default of a counterparty based on changes 
in market values of less liquid collateral that occur before the SBSD 
is able to sell the collateral, and therefore could limit the potential 
for a default by the SBSD to other counterparties. On the other hand, 
if Rule 18a-3 required a counterparty to deliver additional collateral 
beyond assets already held in the counterparty's account because the 
existing assets did not qualify as eligible collateral, the rule could 
have the effect of increasing the counterparty's exposure to the SBSD 
and draining liquidity from the counterparty in a way that may not be 
necessary to account for the nonbank SBSD's potential future exposure 
to the counterparty, and may increase costs for both the nonbank SBSD 
and its counterparties.\1111\ Also, granting counterparties the 
flexibility to post a variety of collateral types to meet margin 
requirements may result in reduced costs for end users and could 
encourage increased trading of security-based swaps, thereby increasing 
competition. The extent of increased trading of non-cleared security-
based swaps, however, may depend on the extent to which portfolio 
margin treatment would materially increase the amount of net equity 
that counterparties would have available to serve as collateral, 
compared to the amount that would result if they were limited to very 
highly liquid securities, such as U.S. Treasury securities.
---------------------------------------------------------------------------

    \1110\ Commenters argued that the scope of eligible collateral 
should be significantly expanded by arguing that there are other 
assets that are highly liquid and suitable for credit support if a 
counterparty fails and if eligible collateral remains narrowly 
defined, the liquidity of eligible assets could be highly affected 
and sourcing of adequate margin could become difficult. See, e.g., 
CFTC SIFMA/ISDA Letter.
    \1111\ This alternative may also increase demand for highly 
liquid collateral and potentially cause shortages in the supply of 
cash and government bonds. See IMF, Global Financial Stability 
Report: The Quest for Lasting Stability 96 and 120 (Apr. 2012), 
available at http://www.imf.org/External/Pubs/FT/GFSR/2012/01/pdf/
text.pdf.
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i. Commercial End Users
    As discussed in section II.B.2.c.i. of this release, under proposed 
new Rule 18a-3, a nonbank SBSD would not be required to collect cash or 
securities to cover the negative equity (current exposure) or margin 
amount (potential future exposure) in the account of a counterparty 
that is a commercial end user.\1112\
---------------------------------------------------------------------------

    \1112\ See paragraph (b)(2) of proposed new Rule 18a-3 (defining 
the term commercial end user).

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

[[Page 70321]]

    As discussed above in section II.A.2.b.v. of this release, this 
proposed exception to the requirement to collect collateral is intended 
to benefit commercial end users in order to address concerns that have 
been expressed by them and others that the imposition of margin 
requirements on commercial companies that use derivatives to mitigate 
the risk of business activities that are not financial in nature could 
unduly disrupt their ability to enter into such hedging transactions. 
The proposed exception for commercial end users also is intended to 
account for the different risk profiles of commercial end users as 
compared with financial end users.\1113\ This exception may increase 
efficiencies by allowing such end users to more cost efficiently manage 
business risks and thereby better compete in their respective 
industries.
---------------------------------------------------------------------------

    \1113\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27571 (``Among end users, financial end users are 
considered more risky than nonfinancial end users because the 
profitability and viability of financial end users is more tightly 
linked to the health of the financial system than nonfinancial end 
users. Because financial counterparties are more likely to default 
during a period of financial stress, they pose greater systemic risk 
and risk to the safety and soundness of the covered swap entity.''). 
See also CFTC Margin Proposing Release, 76 FR at 27735 (``The 
Commission believes that financial entities, which are generally not 
using swaps to hedge or mitigate commercial risk, potentially pose 
greater risk to CSEs than non-financial entities.'').
---------------------------------------------------------------------------

    At the same time, to the extent of any dealer exposure to 
commercial end users, the proposed exception for commercial end users 
could lead to uncollateralized exposure by nonbank SBSDs to commercial 
end users. To address this concern and because collecting collateral is 
an important means of mitigating risk, Rule 18a-1 would require nonbank 
SBSDs not approved to use internal models to take a capital charge 
equal to the margin amount calculated for the commercial end user to 
the extent the firm does not collect cash or securities equal to that 
amount.\1114\ Requiring a firm to hold capital in lieu of margin \1115\ 
in these cases is designed to reflect both the needs of commercial end 
users and concerns that permitting nonbank SBSDs to assume credit 
exposure without the protection of margin could lead to the assumption 
of inappropriate risks. In this way the proposal is intended to ensure 
the safety and soundness of nonbank SBSDs and be proportionate to the 
amount of uncollateralized exposures to commercial end users.\1116\
---------------------------------------------------------------------------

    \1114\ See proposed paragraph (c)(2)(xiv) of Rule 15c3-1; 
paragraph (c)(1)(xiv) of proposed Rule 18a-1.
    \1115\ See section II.A.2.b.v. of this release (discussing 
proposed charge capital in lieu of margin collateral).
    \1116\ As discussed above in section II.A. of this release, 
nonbank SBSDs that have been approved to use internal models for 
credit risk would take a much smaller capital charge, i.e., 8% of 
net replacement value multiplied by the counterparty factor. These 
firms also would be permitted to take a smaller charge with respect 
to the unsecured receivables from commercial end user 
counterparties, which may provide a competitive advantage for 
nonbank SBSDs that are capable of and have received approval to 
model credit risk.
---------------------------------------------------------------------------

    The extent of the impact of the intended benefit to commercial end 
users, however, would depend on whether nonbank SBSDs choose to trade 
with commercial end user counterparties on an uncollateralized basis, 
notwithstanding the capital charges under Rule 18a-1. In addition, 
nonbank SBSDs subject to this capital charge are expected to, at least 
partially, pass the increased cost of capital through to commercial end 
users in the form of increased transaction pricing.\1117\ Accordingly, 
any potential economic benefit associated with an exception from Rule 
18a-3 for commercial end users in non-cleared security-based swaps may 
be offset to the extent that nonbank SBSDs determine to pass on any 
costs incurred as a result of the additional capital charges.\1118\ In 
summary, the Commission does not expect those costs will be material, 
unless commercial end users begin to account for meaningful volume in 
non-cleared security-based swap trading.
---------------------------------------------------------------------------

    \1117\ Even under these conditions, a nonbank SBSD still retains 
the option to collect margin from its counterparties.
    \1118\ See Antonio S. Mello and John E. Parsons, Margins, 
Liquidity and the Cost of Hedging, MIT Center for Energy and 
Environmental Policy Research Working Paper 2012-005 (May 2012) 
(presenting a replication argument to show that a non-margined swap 
is equivalent to a package of (1) a margined swap, plus (2) a 
contingent line of credit). The paper concludes that a mandate to 
clear and therefore to margin derivatives trades forces dealers to 
market these two components separately, but otherwise makes no 
additional demand on non-financial corporations, and therefore, a 
clearing and margin mandate does not add any real costs to a non-
financial corporation seeking to hedge its commercial risk). Id.
---------------------------------------------------------------------------

    As an alternative, the Commission could limit this proposed 
exception for commercial end users and require nonbank SBSDs to collect 
collateral from commercial end users with regard to their transactions 
in non-cleared security-based swaps. This alternative would protect the 
nonbank SBSDs by requiring that transactions with commercial end users 
be collateralized. However, in contrast to the Commission's proposal, 
this alternative would limit the flexibility of nonbank SBSDs and 
commercial end users to negotiate the terms of their non-cleared 
security-based swap transactions. In considering this approach, the 
Commission would need to consider the benefit of any additional 
protections to SBSDs against losses in transactions with commercial end 
users in light of increased costs to such end users or less 
accessibility to them of hedging instruments.
ii. SBSDs--Alternatives A and B
    As described in section II.B. to the release, the Commission is 
proposing specific alternative margin requirements with respect to 
counterparties that are nonbank SBSDs. Under Alternative A, which would 
create an exception from proposed new Rule 18a-3, a nonbank SBSD would 
need collateral only to cover the current exposure (negative equity) in 
the account of a counterparty that is another SBSD. Under Alternative 
B, a nonbank SBSD would be required to collect collateral to cover both 
the current exposure (negative equity) and the potential future 
exposure (margin amount) in the account of a counterparty that is 
another SBSD \1119\ and further segregate the margin amount in an 
account carried by an independent third-party custodian pursuant to the 
requirements of Section 3E(f) of the Exchange Act.\1120\ Alternative B 
is consistent with the proposals of the prudential regulators and the 
CFTC.\1121\
---------------------------------------------------------------------------

    \1119\ Alternative B is not an exception to the account equity 
requirements in proposed new Rule 18a-3 because it would require the 
nonbank SBSD to collect collateral to cover the negative equity and 
margin amount in an account of another SBSD.
    \1120\ See 15 U.S.C. 78c-5(f).
    \1121\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564; CFTC Margin Proposing Release, 76 FR 23732.
---------------------------------------------------------------------------

    As discussed in section V.A. above, the baseline of this economic 
analysis is the OTC derivatives markets as they exist today. The CDS 
Data Analysis suggests there is currently a high degree of 
concentration of potential dealing activity in the single-name credit 
default swap market. Based on discussions with market participants, the 
Commission staff understands that dealers in security-based swaps 
presently collect variation margin covering current exposure but 
generally do not collect initial margin covering potential future 
exposure from other dealers.\1122\ Accordingly, relative to the 
existing market for security-based swaps, Alternative A would not 
create additional costs for dealers resulting from transactions with 
other dealers in security-based swaps. Alternative B would impose 
substantially greater costs

[[Page 70322]]

to inter-dealer transactions compared to the baseline.
---------------------------------------------------------------------------

    \1122\ See generally ISDA Margin Survey 2011; ISDA Margin Survey 
2012.
---------------------------------------------------------------------------

    Alternatives A and B would both require the exchange of variation 
margin; the difference between the alternatives therefore is, first and 
foremost, whether to require nonbank SBSD counterparties to exchange 
initial margin. The cost impact would depend on how significant initial 
margin is in relation to variation margin, which will vary by type of 
contract, extent of market volatility, and other factors. The goal for 
either alternative is to reduce systemic risk without imposing undue 
additional cost to the extent that the ability of counterparties to 
trade security-based swaps is severely compromised. However, the 
benefit of collecting the margin amount under Alternative B would be 
the further protection of a nonbank SBSD from market exposure during 
the period of unwinding a position from a defaulting counterparty when 
that counterparty, by definition, would not be able to post additional 
variation margin.
    Requiring a nonbank SBSD to post initial margin, however, could 
significantly impact its liquidity and therefore limit the ability of 
the nonbank SBSD to trade in security-based swaps. Permitting a firm to 
retain a pool of liquid assets that would not otherwise be used to post 
initial margin could permit the nonbank SBSD to use this capital more 
efficiently, for example by increasing its investment in information 
technology or increasing its investments that offer a higher rate of 
return. The potential benefit of Alternative B is that it would limit 
the aggregate amount of leverage in the financial system associated 
with security-based swaps. A principal purpose of Title VII of the 
Dodd-Frank Act, including those provisions that apply to capital and 
margin requirements for dealers, is to reduce systemic risk, 
particularly risks associated with relatively opaque bilateral, non-
cleared derivative transactions. Requiring dealers to collateralize 
their potential future exposure to each other by exchanging both 
initial and variation margin may further reduce systemic risk by 
reducing leverage and the potential that a default by a single large 
dealer could translate to defaults of counterparty dealers with 
potential ripple effects throughout the system.
    On the other hand, the requirement to exchange initial margin would 
not only impose costs to the extent that it would result in 
substantially less capital available to support the security-based swap 
business or other dealer activity, but also it could contribute to the 
instability of a nonbank SBSD. The instability stems from the 
possibility that assets posted to the custodian account might in the 
case of a counterparty default not be immediately returned to a nonbank 
SBSD to absorb losses or meet other liquidity demands. In this regard, 
the ability of a dealer counterparty to demand and obtain the return of 
initial margin held by a third-party custodian could be subject to 
various uncertainties, including the potential for counterparty 
disputes that might be subject to court resolution. During periods of 
general market instability or loss of confidence, even a brief delay in 
being able to access liquid assets could prove decisive.\1123\
---------------------------------------------------------------------------

    \1123\ See Manmohan Singh, Velocity of Pledged Collateral: 
Analysis and Implications, IMF Working Paper, WP/11/256 (Nov. 2011) 
(stating that the decline in leverage and re-use of collateral may 
be viewed positively from a financial stability perspective, but 
from a monetary policy perspective, however, the lubrication in the 
global financial markets is now lower as the velocity of money-type 
instruments has declined.). Singh argues that the ``velocity of 
collateral,'' analogous to the concept of the ``velocity of money'' 
indicates the liquidity impact of collateral. A security that is 
owned by an economic agent and can be pledged as re-usable 
collateral leads to chains. Therefore, Singh argues that a shortage 
of acceptable collateral would have a negative cascading impact on 
lending similar to the impact on the money supply of a reduction in 
the monetary base. Id. at 16. See also Manmohan Singh and James 
Aitken, The (sizable) Role of Rehypothecation in the Shadow Banking 
System, IMF Working Paper WP/10/172 (July 2010).
---------------------------------------------------------------------------

    The prudential regulators and the CFTC have received comment 
letters regarding the liquidity impact of their proposed rules, as well 
as public research reports attempting to estimate the liquidity 
impact.\1124\ Each of these commenters used different methods, data and 
assumptions to arrive at a liquidity impact estimate and respond to the 
amount of initial margin required by the prudential regulators' and 
CFTC's proposed margin rules. Overall, each of these commenters 
concluded that the liquidity impact of the proposed initial margin 
rules proposed by the CFTC and the prudential regulators was 
significant.\1125\ One such estimate, however, noted that the numbers 
should be viewed as an ``order of magnitude estimate'' and that ``[o]ne 
cannot predict which entities will use derivatives in the future nor 
the amounts and types of products that will be used.'' \1126\ 
Consequently, while it is difficult to estimate the costs imposed by 
requiring dealers to post initial margin, commenters to the CFTC and 
prudential regulators' proposed margin rules and others have estimated 
that the cost would be significant. These estimates are discussed in 
detail below.\1127\
---------------------------------------------------------------------------

    \1124\ See OCC Economics Department, Unfunded Mandates Reform 
Act--Impact Analysis for Swaps Margin and Capital Rule, (Apr. 15, 
2011) (``OCC Unfunded Mandates Report''); SIFMA/ISDA Comment Letter 
to the Prudential Regulators; J.P. Morgan Letter; Bank of America-
Merrill Lynch, No Margin for Error, Part 3: Dodd-Frank Implements 
QE3, Credit Derivatives Strategist (Nov. 5, 2011) (``BAML Report'').
    \1125\ See Manmohan Singh, Collateral, Netting and Systemic Risk 
in the OTC Derivatives Market, IMF Working Paper WP 10/99 (1999) (a 
study by the IMF arguing that moving OTC derivatives to centralized 
clearing would require between $170 and $220 billion in initial 
margin collateral).
    \1126\ SIFMA/ISDA Comment Letter to the Prudential Regulators at 
38.
    \1127\ See BCBS, IOSCO, Margin Requirements for Non-centrally-
cleared Derivatives. The Working Group on Margin Requirements is 
conducting a Quantitative Impact Study to better quantify the impact 
of the proposed margin requirements set forth in the consultative 
paper. See id. at Part C.
---------------------------------------------------------------------------

    One commenter to the prudential regulators' proposed margin rule 
stated that imposing segregated initial margin requirements on trades 
between swap entities would result in a tremendous cost to the 
financial system in the form of a massive liquidity drain.\1128\ This 
commenter estimated that the effect of the proposed rule would result 
in a cost of $428 billion in initial margin for swap dealers.\1129\ 
Another commenter predicted that the initial margin requirements will 
result in a huge drain of liquid assets from the U.S. economy because 
they would require very large amounts of collateral to be posted as 
initial margin and placed in segregated custodial accounts.\1130\ This 
commenter attempted to quantify this amount by calculating the amounts 
of initial margin that the firm would have to collect from 34 of its 
largest professional dealer counterparties by reference to the ``Lookup 
Table'' percentages of notional approach set forth in Appendix A to the 
prudential regulators' margin rulemaking.\1131\ Application of this 
approach to the commenter's existing portfolio with those 34 
counterparties yielded an estimated amount of initial margin that the 
firm would have to collect equal to $1.4 trillion.\1132\ The commenter 
noted that since the interdealer initial margin requirements are 
reciprocal, it would also be obligated to post $1.4 trillion.\1133\
---------------------------------------------------------------------------

    \1128\ SIFMA/ISDA Comment Letter to the Prudential Regulators.
    \1129\ Id. at 36.
    \1130\ J.P. Morgan Letter.
    \1131\ J.P. Morgan Letter; Prudential Regulator Margin and 
Capital Proposing Release, 76 FR at 27592.
    \1132\ J.P. Morgan Letter at 5.
    \1133\ Id. In the J.P. Morgan Letter, however, it was noted that 
it is likely that most swap dealers would use the model based 
approach, and not the ``lookup table'', to calculate initial margin 
which would likely produce smaller initial margin amounts. In the 
letter, it was argued that there is substantial uncertainty about 
the model approval process and timing and accordingly the large 
amounts resulting from application of the lookup table are relevant. 
Id.

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[[Page 70323]]

    In addition, the OCC Unfunded Mandates Report estimated that the 
initial margin collected under the prudential regulators' proposed 
margin rule in one year could total $2.56 trillion.\1134\ The report 
pointed out, however, that several factors are likely to reduce the 
impact of the proposed rule, including a move to central clearing and 
the fact that dealers are likely to use internal models that permit 
netting. The report estimated that currently roughly 20% of swap 
contracts trade through clearing houses.\1135\ Assuming that the 
proportion of cleared to non-cleared swaps will at a minimum remain at 
one in five, the report further estimated the required funds to cover 
the initial margin requirement under the proposed rule to be $2.05 
trillion (0.80 x $2.56 trillion).\1136\
---------------------------------------------------------------------------

    \1134\ OCC Unfunded Mandates Report at 5. The report also used 
the ``lookup table'' to estimate the initial margin impact of the 
prudential regulators' proposed margin rule, and noted the proposed 
rule would apply to any swap that is a national bank, a federally 
chartered branch or agency of a foreign bank, or a federal savings 
association. Id. at 2.
    \1135\ OCC Unfunded Mandates Report at 5.
    \1136\ Id. The report also estimated that the actual cost of the 
initial margin requirement is the opportunity cost of collateral 
that under the prudential regulators' rule must be segregated into a 
custodial account with a presumably lower rate of return.
---------------------------------------------------------------------------

    Finally, the BAML Report stated that its calculations suggested 
that the regulatory changes may eventually result in initial margin 
requirements of $200 billion to $600 billion for US banks, as current 
derivatives portfolios turn over.\1137\
---------------------------------------------------------------------------

    \1137\ BAML Report at 5.
---------------------------------------------------------------------------

    In summary, as stated above, commenters concluded that the 
liquidity impact of the initial margin rules proposed by the CFTC and 
the prudential regulators was significant.\1138\ However, one commenter 
acknowledged that the numbers should be viewed as an ``order of 
magnitude estimate'' and that ``[o]ne cannot predict which entities 
will use derivatives in the future nor the amounts and types of 
products that will be used.'' \1139\ The Commission seeks comment on 
the liquidity impact of its proposals below and in section II.B. of 
this release.
---------------------------------------------------------------------------

    \1138\ See also Manmohan Singh, Collateral, Netting and Systemic 
Risk in the OTC Derivatives Market.
    \1139\ SIFMA/ISDA Comment Letter to the CFTC at 38.
---------------------------------------------------------------------------

c. Margin Requirements for Nonbank-MSBSPs
    As described in section II.B. of this release, a nonbank MSBSP 
would be required to calculate as of the close of each business day the 
amount of equity in the account of each counterparty to a non-cleared 
security-based swap.\1140\ On the next business day following the 
calculation, the nonbank MSBSP would be required to either collect or 
deliver cash, securities, and/or money instruments to the counterparty 
depending on whether there was negative or positive equity in the 
account of the counterparty.\1141\ Specifically, if the account had 
negative equity on the previous business day, the nonbank MSBSP would 
be required to collect cash, securities, and or money market 
instruments in an amount equal to the negative equity.\1142\ 
Conversely, if the account had positive equity on the previous business 
day, the nonbank MSBSP would be required to deliver cash, securities, 
and/or money market instruments to the counterparty in an amount equal 
to the positive equity.\1143\
---------------------------------------------------------------------------

    \1140\ See paragraph (c)(2)(i) of proposed new Rule 18a-3.
    \1141\ See paragraph (c)(2)(ii) of proposed new Rule 18a-3. As 
indicated, the nonbank MSBSP would need to deliver cash, securities, 
and/or money market instruments and, consequently, other types of 
assets would not be eligible as collateral.
    \1142\ See paragraph (c)(2)(ii)(A) of proposed new Rule 18a-3. 
In this case, the nonbank MSBSP would have current exposure to the 
counterparty in an amount equal to the negative equity.
    \1143\ See paragraph (c)(2)(ii)(B) of proposed new Rule 18a-3.
---------------------------------------------------------------------------

    Nonbank MSBSPs are not expected to maintain two-sided markets or 
otherwise engage in activities that would require them to register as 
an SBSD.\1144\ They will, however, by definition, maintain substantial 
positions in particular categories of security-based swaps.\1145\ These 
positions could create significant risk to counterparties to the extent 
the counterparties have uncollateralized current exposure to the 
nonbank SBSD. In addition, they could pose significant risk to the 
nonbank MSBSP to the extent it has uncollateralized current exposure to 
its counterparties. The proposed account equity requirements for 
nonbank MSBSPs seek to address these risks by imposing a requirement 
that nonbank MSBSPs on a daily basis must ``neutralize'' the credit 
risk between the nonbank MSBSP and the counterparty either by 
collecting or delivering cash, securities, and/or money market 
instruments in an amount equal to the positive or negative equity in 
the account.
---------------------------------------------------------------------------

    \1144\ See Entity Definitions Adopting Release, 77 FR 30596.
    \1145\ See 15 U.S.C. 78c(a)(67); Entity Definitions Adopting 
Release, 77 FR 30596.
---------------------------------------------------------------------------

    The collection of collateral from counterparties would strengthen 
the liquidity of the nonbank MSBSP by collateralizing its current 
exposure to counterparties. The delivery of collateral to 
counterparties to collateralize their current exposure to the nonbank 
MSBSP would lessen the impact on the counterparties if the nonbank 
MSBSP failed.
    The requirement for nonbank MSBSPs to post current exposure to 
certain counterparties under proposed new Rule 18a-3 would impose an 
incremental opportunity cost for these nonbank MSBSPs only to the 
extent that they do not currently post collateral to cover current 
exposure. The requirement that nonbank MSBSPs collect variation margin 
from certain counterparties also would represent an incremental cost to 
those counterparties users to the extent they do not currently post 
such margin.
    As stated above, proposed new Rule 18a-3 contains an exception for 
trades between nonbank MSBSPs and commercial end users, so those end 
users would not face additional costs because of this exception.
    Instead of the proposed approach, the Commission could adopt margin 
requirements for nonbank MSBSPs that are consistent with those proposed 
for nonbank SBSDs, by requiring them to collect initial margin from all 
non-dealer counterparties. This approach could better protect the MSBSP 
from loss in the event of a counterparty default, and thereby lessen 
the possibility of a default by the MSBSP. On the other hand, such a 
requirement would increase the credit exposure of counterparties to the 
MSBSP by the amount of the initial margin that they provide to the 
MSBSP and could increase their risk of loss if the MSBSP were to fail 
and they were unsuccessful in obtaining the return of amounts owed to 
them. The Commission is seeking comment on this alternative.
d. Consideration of Burden on Competition, and Promotion of Efficiency, 
Competition, and Capital Formation
    The proposed margin requirements to collect collateral from their 
counterparties to non-cleared security-based swaps to cover both 
current exposure and potential future exposure are designed to insulate 
security-based swap market participants from the negative fallout of a 
defaulting counterparty. Basing proposed Rule 18a-3 on the broker-
dealer margin rules is intended to achieve those objectives in the 
market for security-based swaps. Moreover, the consistency between 
margin requirements for securities and security-based swaps should 
ultimately promote efficiency in the securities

[[Page 70324]]

markets, and in turn, enhance competition in the security-based swap 
markets.
    The proposed rule offers built-in flexibilities that should enhance 
the efficiency in the application of the rule. For example, granting 
counterparties the flexibility to post a variety of collateral types to 
meet margin requirements may result in increased efficiencies for end 
users, and could encourage increased trading of security-based swaps 
and thereby increase competition. Furthermore, the proposed exception 
for commercial end users is intended to account for the different risk 
profiles of commercial end users as compared with financial end 
users.\1146\ This exception may increase efficiencies by allowing SBSDs 
to optimally choose to collect collateral or take a capital charge, 
which in turn might allow end users to more cost efficiently manage 
business risks and thereby better compete in their respective 
industries.
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    \1146\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR at 27571 (``Among end users, financial end users are 
considered more risky than nonfinancial end users because the 
profitability and viability of financial end users is more tightly 
linked to the health of the financial system than nonfinancial end 
users. Because financial counterparties are more likely to default 
during a period of financial stress, they pose greater systemic risk 
and risk to the safety and soundness of the covered swap entity.''). 
See also CFTC Margin Proposing Release, 76 FR at 27735 (``The 
Commission believes that financial entities, which are generally not 
using swaps to hedge or mitigate commercial risk, potentially pose 
greater risk to CSEs than non-financial entities.'').
---------------------------------------------------------------------------

    However, the flexibility to use models to calculate margins instead 
of applying the standard haircuts could have an adverse impact on 
competition if the differences in these margin amounts are sufficiently 
large. If this was the case, a nonbank SBSD not approved to use models 
will find it difficult to compete with an SBSD approved to use models. 
However, it is conceivable that SBSDs not approved to use models would 
tend to do business only in cleared security-based swaps and SBSDs that 
use models would compete in both cleared and non-cleared security-based 
swaps. This separation could have a negative impact on competition in 
non-cleared security-based swaps. If, however, SBSDs that are approved 
to use models manage counterparty risk more efficiently, the market for 
non-cleared security-based swaps might be systemically less risky than 
it would be if SBSDs not using models participated actively in that 
market. It is unclear whether the benefit from the reduction in 
systemic risk would outweigh the potential cost of the reduced 
competition.
    There also is a trade-off between Alternatives A and B for SBSDs. 
Under Alternative A the reduced demand on posting and collecting 
collateral should lead to more efficient allocation of capital and 
hence improve competition, but it comes at the cost of being less 
resilient to counterparty defaults and hence might overall increase 
systemic risk. In addition, if the Commission does not require nonbank 
SBSDs to collect initial margin in their transactions with each other, 
as is generally current market practice,\1147\ while the prudential 
regulators require the collection of initial margin for the same trades 
as their proposed rules suggest, intermediaries could have an incentive 
to conduct business through nonbank entities.\1148\ Under Alternative 
B, the requirement to exchange initial margin would impose costs on the 
nonbank SBSD in the form of a capital charge to the extent the nonbank 
SBSD must post initial margin. This could result in substantially less 
liquidity available to the nonbank SBSD to support its security-based 
swap business or other dealer activity, but to the extent it limits the 
amount of uncleared SBSD transactions among nonbank SBSDs as a whole, 
it could lead to lower systemic risk. Moreover, if this requirement 
results in a significant increase in costs because of the required 
capital charge, nonbank SBSDs could be motivated to conduct trading 
either in bank SBSDs or offshore because they would not need to take 
the capital charge. Especially in the latter case, this may not only 
adversely affect domestic competition if the only dealers able to 
absorb the increased expenses are the ones currently participating in 
the market, it also could increase systemic risk worldwide if the 
regulatory environment in foreign jurisdictions are less stringent.
---------------------------------------------------------------------------

    \1147\ See generally ISDA Margin Survey 2011.
    \1148\ See Prudential Regulator Margin and Capital Proposing 
Release, 76 FR 27564.
---------------------------------------------------------------------------

Request for Comment
    The Commission generally requests comment about its analysis of the 
costs and benefits of proposed Rule 18a-3. In addition, the Commission 
requests comment in response to the following questions:
    1. In many respects, the proposed rules reflect an interplay 
between capital and margin requirements. How should each set of rules 
take account of the other? For example, does the proposed alternative 
capital charge in lieu of collecting margin from commercial end users 
appropriately account for the increased exposure to the dealer? Does it 
over-state the exposure?
    2. What would be the general market impact of requiring that 
dealers post both variation and initial margin in transactions with 
each other? Commenters are asked to supply data on the volume of 
interdealer transactions in security-based swaps and the aggregate 
dollar impact of this proposal. How does the impact of requiring 
dealers to exchange both variation and initial margin compare with the 
aggregate dollar impact of requiring that nonbank SBSDs collect only 
variation margin?
    3. With regard to Alternatives A and B regarding interdealer 
margin, the Commission requests that commenters provide the following 
data points to the Commission:
     The relative amounts of variation and initial margin for 
sample dealer portfolios of security-based swaps;
     The industry dollar impact and liquidity impact of 
requiring lock up of initial margin for dealer portfolios; and
     How the amount of initial margin would compare to overall 
dealer capital.
    4. The Commission also requests comment on the potential legal 
limitations involved in obtaining a return of collateral that has been 
posted to a third party custodian, the costs involved, and whether 
there are ways to overcome these limitations.
    5. The Commission requests comment on the costs and benefits, if 
the Commission, as an alternative to proposed new Rule 18a-3, permitted 
nonbank SBSDs to apply to the Commission to use internal models solely 
to compute the margin amount in paragraph (d) to Rule 18a-3 (without 
seeking approval to use internal models for capital purposes). Would 
this alternative impact the Commission's oversight responsibility of 
nonbank SBSDs?
    6. What is the cost impact, if any, of permitting nonbank SBSDs to 
accept securities as collateral that may be less liquid than Treasury 
securities in the case of severe market disruptions? Would this cost be 
mitigated by the haircut and collateral requirements in proposed Rule 
18a-3?
    7. What would be the costs and benefits of an initial margin 
requirement between nonbank SBSDs counterparties dependent on the 
firm's minimum net capital requirement (e.g., based on firm size)?
    8. Proposed Rule 18a-3(d) would require that firms approved to use 
VaR models calculate margin amount using a 99%, 10 business-day period. 
How would this proposal affect sample portfolios of security-based 
swaps based on existing internal firm models and current market 
practices, including margin practices at registered clearing

[[Page 70325]]

agencies? The Commission requests data from market participants to 
assist it in evaluating this proposal.
    9. Would the margin requirements under proposed new Rule 18a-3 
incentivize counterparties to trade in cleared security-based swaps? If 
certain security-based swaps cannot be cleared, would the proposed 
margin requirements render the use of these non-cleared contracts 
inefficient?
    10. Will nonbank MSBSPs incur operational, technology or other 
costs to calculate the amount of equity in the account of a 
counterparty, as required under paragraph (c)(2)(i) of proposed new 
Rule 18a-3?
4. Proposed Segregation Rule--Rule 18a-4
    Proposed new Rule 18a-4 would establish segregation requirements 
for cleared and non-cleared security-based swap transactions, which 
would apply to bank SBSDs, nonbank stand-alone SBSDs, and broker-dealer 
SBSDs.\1149\ The goal of proposed new Rule 18a-4 is to protect customer 
assets by ensuring that cash and securities that SBSDs hold for 
security-based swap customers are isolated from the proprietary assets 
of the SBSD and identified as property of such customers.\1150\ This 
approach would facilitate the prompt return of customer property to 
customers either before or during liquidation proceedings if the firm 
fails,\1151\ and is therefore expected to provide market participants 
who enter into security-based swap transactions with an SBSD the 
confidence that their accounts will remain separate from the SBSD in 
the event of bankruptcy.\1152\ As such, proposed new Rule 18a-4 will 
have a number of benefits as well as impose certain costs on SBSDs and 
MSBSPs, as well as other market participants. The proposed rules are 
expected to have possible effects on competition, efficiency, and 
capital formation, which are discussed below.
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    \1149\ See proposed new Rule 18a-4. See also section II.C. of 
this release for a more detailed description of the proposal. The 
provisions of proposed new Rule 18a-4 are modeled on the broker-
dealer segregation rule, Rule 15c3-3. 17 CFR 240.15c3-3.
    \1150\ See proposed new Rule 18a-4.
    \1151\ See generally Michael P. Jamroz, The Customer Protection 
Rule, 57 Bus. Law. 1069 (May 2002). See also section II.C. of this 
release for a more detailed description of the proposal.
    \1152\ See 15 U.S.C. 78c-5.
---------------------------------------------------------------------------

    As discussed earlier in this release, Rule 18a-4 is in substantial 
part modeled on provisions of Rule 15c3-3 that require a carrying 
broker-dealer to take two primary steps to safeguard these assets. The 
first step required by Rule 15c3-3 is that a carrying broker-dealer 
must maintain physical possession or control over customers' fully paid 
and excess margin securities.\1153\ The second step is that a carrying 
broker-dealer must maintain a reserve of funds or qualified securities 
in a customer reserve account at a bank that is equal in value to the 
net cash owed to customers, computed in accordance with the Exhibit A 
formula.\1154\ The corollary provisions of Rule 18a-4 are likewise 
intended to require that customer funds are adequately protected from 
loss in the event of the SBSD's failure. Further, this protection would 
be provided to customers who have not affirmatively elected to require 
individual account segregation of their assets under section 3E(f) of 
the Exchange Act.
---------------------------------------------------------------------------

    \1153\ See 17 CFR 240.15c3-3(d).
    \1154\ 17 CFR 240.15c3-3(e). The term ``qualified security'' is 
defined in Rule 15c3-3 to mean a security issued by the United 
States or a security in respect of which the principal and interest 
are guaranteed by the United States. See 17 CFR 240.15c3-3(a)(6).
---------------------------------------------------------------------------

    Paragraph (a) of the proposed new rule would define key terms used 
in the rule.\1155\ Paragraph (b) would require an SBSD to promptly 
obtain and thereafter maintain physical possession or control of all 
excess securities collateral (a term defined in paragraph (a)) and 
specify certain locations where excess securities collateral could be 
held and deemed in the SBSD's control.\1156\ Paragraph (c) would 
require an SBSD to maintain a special account for the exclusive benefit 
of security-based swap customers and have on deposit in that account at 
all times an amount of cash and/or qualified securities (a term defined 
in paragraph (a)) determined through a computation using the formula in 
Exhibit A to proposed new Rule 18a-4.\1157\
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    \1155\ Compare 17 CFR 240.15c3-3(a), with paragraph (a) of 
proposed new Rule 18a-4.
    \1156\ Compare 17 CFR 240.15c3-3(b)-(d), with paragraph (b) of 
proposed new Rule 18a-4.
    \1157\ Compare 17 CFR 240.15c3-3(e), with paragraph (e) of 
proposed new Rule 18a-4.
---------------------------------------------------------------------------

    Paragraph (d) of proposed new Rule 18a-4 would contain provisions 
that are designed to implement the individual account segregation 
requirements of section 3E(f) of the Exchange Act, and therefore, are 
not modeled specifically on Rule 15c3-3. First, it would require an 
SBSD and an MSBSP to provide the notice required by section 3E(f)(1)(A) 
of the Exchange Act prior to the execution of the first non-cleared 
security-based swap transaction with the counterparty.\1158\ Second, it 
would require the SBSD to obtain subordination agreements from 
counterparties that opt out of the segregation requirements in proposed 
new Rule 18a-4 because they either elect individual segregation 
pursuant to the self-executing provisions of section 3E(f) of the 
Exchange Act \1159\ or agree that the SBSD need not segregate their 
assets at all.\1160\
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    \1158\ See 15 U.S.C. 78c-5(f)(1)(A); paragraph (d)(1) of 
proposed new Rule 18a-4.
    \1159\ See 15 U.S.C. 78c-5(f)(1)-(3).
    \1160\ See 15 U.S.C. 78c-5(f)(4).
---------------------------------------------------------------------------

    Available information suggests that customer assets related to OTC 
derivatives are currently not consistently segregated from dealer 
proprietary assets. With respect to non-cleared derivatives, available 
information suggests that there is no uniform segregation practice but 
that collateral for most accounts is not segregated.\1161\ According to 
the ISDA Margin Survey 2012, where independent amounts (initial margin) 
is collected, ISDA members reported that most (approximately 72.2%) was 
commingled with variation margin and not segregated, and only 4.8% of 
the amount received was segregated with a third party custodian.\1162\
---------------------------------------------------------------------------

    \1161\ See generally ISDA Margin Survey 2012.
    \1162\ ISDA Margin Survey 2012. The survey also notes that while 
the holding of the independent amounts and variation margin together 
continues to be the industry standard both contractually and 
operationally, it is interesting to note that the ability to 
segregate has been made increasingly available to counterparties 
over the past three years on a voluntary basis, and has led to 
adoption of 26% of independent amount received and 27.8% of 
independent amount delivered being segregated in some respects. Id. 
at 10. See also Independent Amounts.
---------------------------------------------------------------------------

    In the absence of a segregation requirement, the likelihood that 
security-based swap customers would suffer losses upon a dealer default 
may substantially increase. The proposed segregation requirements would 
limit for security-based swap customers these potential losses if an 
SBSD fails.\1163\ The extent to which assets are in fact protected by 
proposed Rule 18a-4 would depend on how effective they are in practice 
in allowing assets to be readily returned to customers.
---------------------------------------------------------------------------

    \1163\ CFTC and Commission, Statement on MF Global about the 
deficiencies in customer futures segregated accounts held at the 
firm (Oct. 31, 2011).
---------------------------------------------------------------------------

    It is difficult to measure these benefits against the current 
baseline of the OTC derivatives market as it exists today, as discussed 
in section V.A.1. of this release. Rule 15c3-3, on which proposed Rule 
18a-4 is modeled, however, may generally provide a reasonable template 
for crafting the corresponding requirements for nonbank SBSDs.\1164\ 
Furthermore, the ensuing increased confidence of market participants 
when transacting in

[[Page 70326]]

security-based swaps, as compared to the OTC derivatives market as it 
exists today, should enhance liquidity and generally benefit market 
participants.
---------------------------------------------------------------------------

    \1164\ See 17 CFR 240.15c3-3. See SIPC 2011 Annual Report.
---------------------------------------------------------------------------

    Further, modeling the provisions of Rule 18a-4 on existing Rule 
15c3-3 will generally promote consistent treatment of collateral in 
circumstances where a broker-dealer SBSD conducts business in 
securities and security-based swaps with the same counterparty, and in 
these cases it will facilitate the ability of firms to offer portfolio 
margin treatment. In addition, ``omnibus segregation'' requirements of 
proposed Rule 18a-4 are intended to reduce costs for SBSDs and their 
customers by providing a less expensive segregation alternative to 
individual account segregation.\1165\
---------------------------------------------------------------------------

    \1165\ See section 3E(f)(1)(B) of the Exchange Act.
---------------------------------------------------------------------------

    Currently, because of a lack of trading in cleared security-based 
swaps for customers,\1166\ there is no definitive baseline against 
which to measure the various costs associated with segregation 
requirements for those trades. Further, overall costs of segregating 
collateral for cleared security-based swaps will be heavily affected by 
the clearing agency rules, which will govern how margin required by, 
and held at, a clearing agency with respect to customer positions must 
be segregated.\1167\
---------------------------------------------------------------------------

    \1166\ See Process for Submissions of Security-Based Swaps, 77 
FR 41602.
    \1167\ See Clearing Agency Standards for Operation and 
Governance, 76 FR 14472.
---------------------------------------------------------------------------

    As stated above, proposed new Rule 18a-4 also is intended to 
provide SBSDs and their counterparties a less expensive segregation 
alternative to individual account segregation. Higher costs for 
individual segregation derive from, among other things, higher fees 
charged by custodians to monitor individual account assets and to 
account for potentially greater legal risks and liabilities of 
custodians to account beneficiaries or dealers, as well as higher 
operational costs to account for collateral on an individual customer 
basis. A commenter to the CFTC raised concerns with the length of time 
and the costs to comply with an individual segregation mandate. 
Specifically, the commenter raised concerns regarding the number of 
collateral arrangements that would be required. The commenter 
estimated, based on discussion with its members, that ``a rough 
estimate of the time it would take to establish the necessary 
collateral arrangements is 1 year and eleven months, with an associated 
cost of $141.8 million, per covered swap entity.'' \1168\ To account 
for these higher costs, SBSDs likely may increase fees for customers 
that choose individual rather than omnibus segregation. If higher fees 
make it prohibitively expensive for some counterparties to elect 
individual segregation, the proposed omnibus segregation scheme under 
Rule 18a-4 could be a more cost-effective solution.
---------------------------------------------------------------------------

    \1168\ SIFMA/ISDA Comment Letter to the Prudential Regulators.
---------------------------------------------------------------------------

    Rule 18a-4 will impose on SBSDs operational costs, as well as costs 
related to the use of customer funds, compared to the baseline, given 
that dealers in general do not presently segregate customer collateral 
for security-based swaps, and to the extent collateral is segregated, 
it is not done so on the terms that would be required by proposed new 
Rule 18a-4. The operational costs include costs to establish qualifying 
bank accounts and to perform the calculations required to determine the 
amount that is required at any one time to be maintained in the reserve 
account.\1169\ In cases where an SBSD is jointly registered as a 
broker-dealer, the costs of adapting existing systems to account for 
security-based swap transactions may not be material in light of the 
similarities between the systems and procedures required by Rule 15c3-3 
and those that would be required by proposed new Rule 18a-4.
---------------------------------------------------------------------------

    \1169\ See proposed new Rule 18a-4. See section V.C. of this 
release for a discussion of implementation costs. See also section 
V.B. of this release.
---------------------------------------------------------------------------

    A further cost would be imposed on SBSDs to the extent that 
collateral they hold that could otherwise be rehypothecated would no 
longer be eligible for this purpose.\1170\ An SBSD would incur a cost 
of funds equal to the borrowing cost of the dealer if the dealer was 
unable to use customer collateral to finance its business activities. 
The extent of this cost would depend on how much collateral associated 
with security-based swaps and held by dealers today consists of initial 
margin that they can rehypothecate, i.e., that is not now segregated as 
would be required under Rule 18a-4 (the rule would not require the 
segregation of variation margin).\1171\
---------------------------------------------------------------------------

    \1170\ See SIFMA/ISDA Comment Letter to the Prudential 
Regulators (``First, because the collateral cannot be 
rehypothecated, and because the collateral amounts will be very 
large, CSEs will be limited to investing very large amounts of 
eligible collateral in assets that generate low returns.'').
    \1171\ See Manmohan Singh, Velocity of Pledged Collateral: 
Analysis and Implications; Manmohan Singh and James Aitken, The 
(sizable) Role of Rehypothecation in the Shadow Banking System.
---------------------------------------------------------------------------

a. Consideration of Burden on Competition, and Promotion of Efficiency, 
Competition, and Capital Formation
    The proposed segregation requirements for SBSDs are designed to 
protect and preserve counterparty collateral held at SBSDs. More 
specifically, the goal of proposed new Rule 18a-4 is to protect 
customer assets by ensuring that cash and securities that SBSDs hold 
for security-based swap customers are isolated from the proprietary 
assets of the SBSD and identified as property of such customers.\1172\ 
These protections may provide market participants who enter into 
security-based swap transactions with an SBSD the assurance that their 
accounts will remain separate from the SBSD in the event of 
bankruptcy.\1173\ These proposed protections could reduce the risk of 
loss of collateral to individual counterparties and, thereby, promote 
participation in the security-based swap markets. This may result in 
enhanced competition and more efficient price discovery.
---------------------------------------------------------------------------

    \1172\ See proposed new Rule 18a-4.
    \1173\ See 15 U.S.C. 78c-5.
---------------------------------------------------------------------------

    Therefore, proposed segregation rules that promote, or do not 
unduly restrict, competition may be accompanied by regulatory benefits 
that minimize the risk of market failure and thus promote efficiency 
within the market. Such competitive markets would increase the 
efficiency with which market participants could transact in security-
based swaps for speculative, trading, hedging and other purposes. 
Conversely, increased costs associated with the proposed segregation 
rules could result in high barriers to entry and negatively affect 
competition for SBSDs in the security-based swap markets.
    Further, modeling the provisions of Rule 18a-4 on existing Rule 
15c3-3 will generally promote consistent treatment of collateral in 
circumstances where a broker-dealer SBSD conducts business in 
securities and security-based swaps with the same counterparty, 
increasing efficiencies for counterparties. Finally, the proposed 
``omnibus segregation'' requirements of proposed Rule 18a-4 are 
intended to provide a less expensive segregation alternative to 
individual account segregation.\1174\ This proposed requirement could 
also result in increased efficiencies, and, in turn, facilitate capital 
formation through the availability of additional capital for 
counterparties as a result of decreased costs.
---------------------------------------------------------------------------

    \1174\ See 15 U.S.C. 78c(f)(1)(B).

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[[Page 70327]]

Request for Comment
    The Commission generally requests comment about its analysis of the 
costs and benefits of the proposed segregation rules. In addition, the 
Commission requests comment in response to the following questions:
    1. To what extent do counterparties presently require that their 
assets associated with security-based swaps be independently 
segregated?
    2. What would be the overall market impact of a right by customers 
to demand individual segregation? How would costs to end users be 
impacted? Would those costs differ depending on the type of end user or 
size of its positions with the SBSD?
    3. How would the existence of omnibus versus independent accounts 
factor into the ability easily to resolve a defaulting SBSD?
    4. Would the proposed segregation requirements prove to be 
difficult to implement for existing contracts?

C. Implementation Considerations

    As discussed above, proposed Rules 18a-1 through 18a-4, as well as 
the proposed amendments to Rule 15c3-1, would impose certain costs on 
SBSDs and MSBSPs. The Commission expects that the highest economic cost 
impact as a result of the proposed new rules and rule amendments would 
likely result from the additional capital nonbank SBSDs and nonbank 
SBSDs may have to hold as a result of the proposed capital rules, and 
the additional margin that SBSDs, MSBSPs, and other market participants 
may have to post and/or collect as a result of proposed margin 
requirements.
    The proposed new rules and rule amendments, however, as discussed 
above, would impose certain implementation burdens and related costs on 
SBSDs, MSBSPs and other market participants. These costs may include 
start-up costs, including personnel and other costs, such as technology 
costs, to comply with the proposed new rules and rule amendments. As 
discussed in section IV.D. of this release, the Commission has 
estimated the burdens and related costs of these implementation 
requirements for SBSDs and MDBSPs.\1175\ These costs are summarized 
below.
---------------------------------------------------------------------------

    \1175\ See section IV.D. of this release (discussing total 
initial and annual recordkeeping and reporting burden of the 
proposed rules and rule amendments).
---------------------------------------------------------------------------

    A stand-alone SBSD that applies to use internal models would be 
required under proposed new Rule 18a-1 to create and compile various 
documents to be included with the application, including documents 
related to the development of its VaR models, and to provide additional 
documentation to, and respond to questions from, Commission staff 
throughout the application process.\1176\ These firms also would be 
required to review and backtest these models annually. The requirements 
are estimated to impose one-time and annual costs in the aggregate of 
approximately $1.97 million \1177\ and $10.6 million, 
respectively.\1178\ These firms would also incur technology costs of 
$48.0 million in the aggregate.\1179\
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    \1176\ See section IV.A.1. of this release.
    \1177\ This consists of external costs of $600,000, plus 
internal costs of $1.37 million. See section IV.D.1. of this 
release.
    \1178\ This consists of external costs of $3.7 million, plus 
internal costs of $6.9 million. See section IV.D.1. of this release.
    \1179\ See section IV.D.1. of this release.
---------------------------------------------------------------------------

    Stand-alone SBSDs that use internal models and ANC broker-dealers 
would be required to develop a liquidity stress test and a written 
contingency plan under proposed new Rule 18a-1 and proposed amendments 
to Rule 15c3-1, and periodically review them.\1180\ These requirements 
would impose one-time and annual costs in the aggregate of 
approximately $1.0 million \1181\ and $2.3 million,\1182\ respectively.
---------------------------------------------------------------------------

    \1180\ See section IV.A.1. of this release.
    \1181\ See section IV.D.1. of this release.
    \1182\ Id.
---------------------------------------------------------------------------

    Rule 18a-1 also would require stand-alone SBSDs to establish, 
document, and maintain a system of internal risk management controls 
required under Rule 15c3-4, as well as to review and update these 
controls.\1183\ This requirement would impose one-time and annual costs 
in the aggregate of $7.5 million \1184\ and $971,000, 
respectively.\1185\ These firms also may incur aggregate initial and 
ongoing information technology costs of $240,000 and $307,500, 
respectively.\1186\
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    \1183\ See section IV.A.1. of this release.
    \1184\ See section IV.D.1. of this release.
    \1185\ Id.
    \1186\ Id.
---------------------------------------------------------------------------

    Finally, nonbank SBSDs and broker-dealers, as applicable, may incur 
one-time and ongoing costs related to filing notices and subordination 
agreements and documenting industry sector classifications under 
proposed new Rule 18a-1, and amendments to Rule 15c3-1.\1187\ These 
requirements would impose one-time and annual costs in the aggregate of 
$68,040 \1188\ and $38,367, respectively.\1189\
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    \1187\ See section IV.A.1. of this release.
    \1188\ See section IV.D.1 of this release (one-time cost to 
draft subordinated loan agreement template under Appendix D to 
proposed new Rule 18a-1).
    \1189\ Id. (annual costs of $2,898, $1,449 and $34,020 related 
to documenting industry sector classifications for credit default 
swap haircuts under Rule 18a-1, equity withdrawal notices under 
paragraph (i) under Rule 18a-1, and preparing and filing proposed 
subordinated loan agreements with the Commission under Appendix D to 
Rule 18a-1).
---------------------------------------------------------------------------

    Rule 18a-2 also would require nonbank MSBSPs to establish, 
document, and maintain a system of internal risk management controls 
required under Rule 15c3-4, as well as to review and update these 
controls.\1190\ This requirement would impose one-time and annual costs 
in the aggregate of $2.7 million \1191\ and $324,000 \1192\ for nonbank 
MSBSPs, respectively. These nonbank MSBSPs also may incur initial and 
ongoing information technology costs of $80,000 and $102,500, 
respectively.\1193\
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    \1190\ See section IV.A.2. of this release.
    \1191\ This consists of external costs of $400,000, plus 
internal costs of $2.3 million. See section IV.D.2. of this release.
    \1192\ See section IV.D.2. of this release.
    \1193\ Id.
---------------------------------------------------------------------------

    Rule 18a-3 would require nonbank SBSDs to establish a written risk 
analysis methodology, which would need to be reviewed and 
updated.\1194\ This requirement would impose one-time and annual costs 
in the aggregate of $1.7 million \1195\ and $483,000, 
respectively.\1196\
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    \1194\ See section IV.A.3. of this release.
    \1195\ See section IV.D.3. of this release. This consists of 
external costs of $18,000, plus internal costs of $1.7 million.
    \1196\ Id.
---------------------------------------------------------------------------

    Finally, SBSDs and MSBSPs would incur various one-time and ongoing 
costs in the aggregate in order to comply with the segregation and 
notification requirements of proposed new Rule 18a-4.\1197\ Each SBSD 
would incur one-time and annual costs in establishing special bank 
accounts required by the rule. This requirement would impose one-time 
and annual costs of $2.9 million \1198\ and $377,000 \1199\ in the 
aggregate on SBSDs, respectively. In addition, SBSDs would be required 
to perform a reserve computation required by Appendix A to proposed new 
Rule 18a-4, which would impose on these firms annual costs in the 
aggregate of $9.7 million.\1200\
---------------------------------------------------------------------------

    \1197\ See section IV.A.4. of this release.
    \1198\ See section IV.D.4. of this release.
    \1199\ Id.
    \1200\ Id.
---------------------------------------------------------------------------

    In addition, both SBSDs and MSBSPs would be required to prepare and 
send to their counterparties segregation-related notices pursuant to 
section 3E(f)

[[Page 70328]]

of the Exchange Act.\1201\ This requirement would impose one-time and 
annual costs in the aggregate to SBSDs and MSBSPs of $770,000 \1202\ 
and $110,000, respectively.\1203\
---------------------------------------------------------------------------

    \1201\ See section IV.A.4. of this release.
    \1202\ See section IV.D.4. of this release. This consists of 
external costs of $220,000, plus internal costs of $550,020.
    \1203\ Id.
---------------------------------------------------------------------------

    Finally, proposed new Rule 18a-4 would require each SBSD to draft, 
prepare, and enter into subordination agreements with certain 
counterparties.\1204\ This requirement would impose on these firms one-
time and annual costs in the aggregate of $99.7 million \1205\ and 
$19.1 million,\1206\ respectively.
---------------------------------------------------------------------------

    \1204\ See section IV.A.4. of this release.
    \1205\ See section IV.D.4. of this release. This consists of 
external costs of $400,000, plus internal costs of $3,780,000 and 
$95,580,000.
    \1206\ Id.
---------------------------------------------------------------------------

D. General Request for Comment

    The Commission requests data to quantify, and estimates of, the 
costs and the value of the benefits of the proposed rules described 
above. Commenters should provide estimates of these costs and benefits, 
as well as any costs and benefits not already defined, that may result 
from the adoption of the proposed rules. Commenters should provide 
analysis and empirical data to support their views on the costs and 
benefits associated with the proposals. The Commission requests comment 
on any effect the proposed new rules and rule amendments may have on 
efficiency, competition, and capital formation, including the 
competitive or anticompetitive effects the proposals may have on market 
participants. In addition, the Commission requests comment on whether 
other provisions of the Dodd-Frank Act for which Commission rulemaking 
is required are likely to have an effect on the costs and benefits of 
the proposed rules. Commenters should provide analysis and empirical 
data to support their views on the costs and benefits associated with 
the proposed rules.

VI. Regulatory Flexibility Act Certification

    The Regulatory Flexibility Act (``RFA'') \1207\ requires Federal 
agencies, in promulgating rules, to consider the impact of those rules 
on small entities. Section 603(a) \1208\ of the Administrative 
Procedure Act,\1209\ as amended by the RFA, generally requires the 
Commission to undertake a regulatory flexibility analysis of all 
proposed rules, or proposed rule amendments, to determine the impact of 
such rulemaking on ``small entities.'' \1210\ Section 605(b) of the RFA 
states that this requirement shall not apply to any proposed rule or 
proposed rule amendment, which, if adopted, would not have a 
significant economic impact on a substantial number of small 
entities.\1211\
---------------------------------------------------------------------------

    \1207\ 5 U.S.C. 601 et seq.
    \1208\ 5 U.S.C. 603(a).
    \1209\ 5 U.S.C. 551 et seq.
    \1210\ Although section 601(b) of the RFA defines the term 
``small entity,'' the statute permits agencies to formulate their 
own definitions. The Commission has adopted definitions for the term 
``small entity'' for the purposes of Commission rulemaking in 
accordance with the RFA. Those definitions, as relevant to this 
proposed rulemaking, are set forth in Rule 0-10, 17 CFR 240.0-10. 
See Statement of Management on Internal Accounting Control, Exchange 
Act Release No. 18451 (Jan. 28, 1982), 47 FR 5215 (Feb. 4, 1982).
    \1211\ See 5 U.S.C. 605(b).
---------------------------------------------------------------------------

    For purposes of Commission rulemaking in connection with the RFA, a 
small entity includes: (1) When used with reference to an ``issuer'' or 
a ``person,'' other than an investment company, an ``issuer'' or 
``person'' that, on the last day of its most recent fiscal year, had 
total assets of $5 million or less,\1212\ or (2) a broker-dealer with 
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) under the 
Exchange Act,\1213\ or, if not required to file such statements, a 
broker-dealer with 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 is not affiliated with any person (other than a natural person) 
that is not a small business or small organization.\1214\ Under the 
standards adopted by the Small Business Administration, small entities 
in the finance and insurance industry include the following: (1) For 
entities in credit intermediation and related activities,\1215\ firms 
with $175 million or less in assets; (2) for non-depository credit 
intermediation and certain other activities,\1216\ firms with $7 
million or less in annual receipts; (3) for entities in financial 
investments and related activities,\1217\ firms with $7 million or less 
in annual receipts; (4) for insurance carriers and entities in related 
activities,\1218\ firms with $7 million or less in annual receipts; and 
(5) for funds, trusts, and other financial vehicles,\1219\ firms with 
$7 million or less in annual receipts.\1220\
---------------------------------------------------------------------------

    \1212\ See 17 CFR 240.0-10(a).
    \1213\ See 17 CFR 240.17a-5(d).
    \1214\ See 17 CFR 240.0-10(c).
    \1215\ Including commercial banks, savings institutions, credit 
unions, firms involved in other depository credit intermediation, 
credit card issuing, sales financing, consumer lending, real estate 
credit, and international trade financing.
    \1216\ Including firms involved in secondary market financing, 
all other non-depository credit intermediation, mortgage and 
nonmortgage loan brokers, financial transactions processing, reserve 
and clearing house activities, and other activities related to 
credit intermediation.
    \1217\ Including firms involved in investment banking and 
securities dealing, securities brokerage, commodity contracts 
dealing, commodity contracts brokerage, securities and commodity 
exchanges, miscellaneous intermediation, portfolio management, 
providing investment advice, trust, fiduciary and custody 
activities, and miscellaneous financial investment activities.
    \1218\ Including direct life insurance carriers, direct health 
and medical insurance carriers, direct property and casualty 
insurance carriers, direct title insurance carriers, other direct 
insurance (except life, health and medical) carriers, reinsurance 
carriers, insurance agencies and brokerages, claims adjusting, third 
party administration of insurance and pension funds, and all other 
insurance related activities.
    \1219\ Including pension funds, health and welfare funds, other 
insurance funds, open-end investment funds, trusts, estates, and 
agency accounts, real estate investment trusts, and other financial 
vehicles.
    \1220\ See 13 CFR 121.201 (Jan. 1, 2010).
---------------------------------------------------------------------------

    Based on available information about the security-based swap 
market,\1221\ the market, while broad in scope, is largely dominated by 
entities such as those that would be covered by the SBSD and MSBSP 
definitions. Subject to certain exceptions, section 3(a)(71)(A) of the 
Exchange Act defines security-based swap dealer to mean any person who: 
(1) Holds itself out as a dealer in security-based swaps; (2) makes a 
market in security-based swaps; (3) regularly enters into security-
based swaps with counterparties as an ordinary course of business for 
its own account; or (4) engages in any activity causing it to be 
commonly known in the trade as a dealer or market maker in security-
based swaps. Section 3(a)(67)(A) of the Exchange Act defines major 
security-based swap participant to be any person: (1) Who is not an 
SBSD; and (2) who maintains a substantial position in security-based 
swaps for any of the major security-based swap categories, as such 
categories are determined by the Commission, excluding both positions 
held for hedging or mitigating commercial risk and positions maintained 
by any employee benefit plan (or any contract held by such a plan) as 
defined in paragraphs (3) and (32) of section 3 of the Employee 
Retirement Income Security Act of 1974 (29 U.S.C. 1002) for the primary 
purpose of hedging or mitigating any risk directly associated with the 
operation of the plan; whose outstanding security-based swaps create 
substantial

[[Page 70329]]

counterparty exposure that could have serious adverse effects on the 
financial stability of the United States banking system or financial 
markets; or that is a financial entity that is highly leveraged 
relative to the amount of capital such entity holds and that is not 
subject to capital requirements established by an appropriate Federal 
banking regulator; and maintains a substantial position in outstanding 
security-based swaps in any major security-based swap category, as such 
categories are determined by the Commission.\1222\
---------------------------------------------------------------------------

    \1221\ See CDS Data Analysis.
    \1222\ See also Entity Definitions Adopting Release, 77 FR 30596 
(``The SEC continues to believe that the types of entities that 
would engage in more than a de minimis amount of dealing activity 
involving security-based swaps--which generally would be major 
banks--would not be `small entities' for purposes of the RFA. 
Similarly, the SEC continues to believe that the types of entities 
that may have security-based swap positions above the level required 
to be a `major security-based swap participant' would not be a 
`small entity' for purposes of the RFA. Accordingly, the SEC 
certifies that the final rules defining `security-based swap dealer' 
or `major security-based swap participant' would not have a 
significant economic impact on a substantial number of small 
entities for purposes of the RFA.''). Id. at 30743.
---------------------------------------------------------------------------

    Based on feedback from industry participants about the security-
based swap markets, entities that will qualify as SBSDs and MSBSPs, 
whether registered broker-dealers or not, will likely exceed the 
thresholds defining ``small entities'' set out above. Thus, it is 
unlikely that proposed Rules 18a-1 to 18a-4 and the amendments to Rule 
15c3-1 would have a significant economic impact on any small entity.
    The Commission estimates that there are approximately 808 broker-
dealers that were ``small'' for the purposes Rule 0-10. The amendments 
to Rule 15c3-1 relating to the standardized haircuts for swaps and 
security-based swaps, as well as the proposed CDS maturity grid would 
apply to all broker-dealers with such proprietary positions. These 
proposed amendments, therefore, would apply to all ``small'' broker-
dealers in that they would be subject to the requirements in the 
proposed amendments. It is likely, however, that these proposed 
amendments would have no, or little, impact on ``small'' broker-
dealers, since most, if not all, of these firms generally would not 
hold these types of positions.
    For the foregoing reasons, the Commission certifies that the 
proposed new Rules 18a-1 through 18a-4, amendments to Rule 15c3-1, and 
amendments to Rule 15c3-3 would not have a significant economic impact 
on any small entity for purposes of the RFA.
    The Commission encourages written comments regarding this 
certification. The Commission requests that commenters describe the 
nature of any impact on small entities and provide empirical data to 
illustrate the extent of the impact.

VII. Statutory Basis and Text of the Proposed Amendments

    Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and 
particularly, sections 3(b), 3E, 15, 15F, 23(a), and 36 (15 U.S.C. 
78c(b), 78c-5, 78o, 78o-10, 78w(a), and 78mm), thereof, the Commission 
is proposing to amend Sec. Sec.  240.15c3-1, 240.15c3-1a, 240.15c3-1b, 
240.15c3-1d, 240.15c3-1e, and 240.15c3-3, and proposing Sec. Sec.  
240.18a-1, 240.18a-1a, 240.18a-1b, 240.18a-1c, 240.18a-1d, 240.18a-2, 
240.18a-3, 240.18a-4, and 240.18a-4a under the Exchange Act.

List of Subjects in 17 CFR Parts 240

    Brokers, Fraud, Reporting and recordkeeping requirements, 
Securities.

Text of Amendment

    In accordance with the foregoing, Title 17, Chapter II of the Code 
of Federal Regulations is proposed to be amended as follows:

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

    1. The general authority citation for part 240 is revised, the 
sectional authorities for Sec. Sec.  240.15c3-1 and 240.15c3-3 are 
revised, add sectional authorities for Sec. Sec.  240.15c3-1a, 
240.15c3-1e, 240.15c3-3, 240.18a-1, 240.18a-1a, 240.18a-1b, 240.18a-1c, 
240.18a-1d, 240-18a-2, 240.18a-3 and 240.18a-4 in numerical order to 
read as follows.

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f, 
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-10 
78o-4, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 
80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et seq.; 12 U.S.C. 
5221(e)(3), 15 U.S.C. 8302, and 18 U.S.C. 1350, unless otherwise 
noted.
* * * * *
    Section 240.15c3-1 is also issued under 15 U.S.C. 78o(c)(3), 
78o-10(d), and 78o-10(e).
    Section 240.15c3-3 is also issued under 15 U.S.C. 78c-5, 
78o(c)(2), 78(c)(3), 78q(a), 78w(a); sec. 6(c), 84 Stat. 1652; 15 
U.S.C. 78fff.
* * * * *
    Sections 240.18a-1, 240.18a-1a, 240.18a-1b, 240.18a-1c, 240.18a-
1d, 240.18a-2, and 240.18a-3 are also issued under 15 U.S.C. 78o-
10(d) and 78o-10(e).
    Section 240.18a-4 is also issued under 15 U.S.C. 78c-5(f).
* * * * *
    2. Section 240.15c3-1 is amended by:
    a. Revising the center heading above paragraph (a)(7);
    b. In paragraph (a)(7) removing the phrase ``and using the credit 
risk standards of Appendix E to compute a deduction for credit risk on 
certain credit exposures arising from transactions in derivatives 
instruments, instead of the provisions of paragraph (c)(2)(iv) of this 
section'' and in its place adding the phrase ``and using the credit 
risk standards of Appendix E to compute a deduction for credit risk for 
security-based swap transactions with commercial end users as defined 
in Sec.  240.18a-3(b)(2), instead of the provisions of paragraphs 
(c)(2)(iv) and (c)(2)(xiv)(B)(1) of this section'';
    c. Revising paragraph (a)(7)(i);
    d. In paragraph (a)(7)(ii), remove ``$5 billion'' and in its place 
add ``$6 billion'';
    e. Adding a center heading and paragraph (a)(10);
    f. Adding paragraph (c)(2)(vi)(O);
    g. Re-designating paragraph (c)(2)(xii) as paragraph (c)(2)(xii)(A) 
and adding new paragraph (c)(2)(xii)(B);
    h. Adding paragraph (c)(2)(xiv);
    i. Adding paragraph (c)(16); and
    j. Adding paragraph (f).
    The revisions and additions read as follows:


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

* * * * *
    (a) * * *

Alternative Net Capital Computation For Broker-Dealers Authorized To 
Use Models

    (7) * * *
    (i) At all times maintain tentative net capital of not less than $5 
billion and net capital of not less than the greater of $1 billion or 
the sum of the ratio requirement under paragraph (a)(1) of this section 
and eight percent (8%) of the risk margin amount;
* * * * *

Broker-Dealers Registered as Security-Based Swap Dealers

    (10) A broker or dealer registered with the Commission as a 
security-based swap dealer, other than a broker or dealer subject to 
the provisions of (a)(7) of this section, must:
    (i) At all times maintain net capital of not less than the greater 
of $20 million or the sum of the ratio requirement under paragraph 
(a)(1) of this section and eight percent (8%) of the risk margin 
amount; and
    (ii) Comply with Sec.  240.15c3-4 as though it were an OTC 
derivatives dealer with respect to all of its business

[[Page 70330]]

activities, except that paragraphs (c)(5)(xiii), (c)(5)(xiv), (d)(8), 
and (d)(9) of Sec.  240.15c3-4 shall not apply.
* * * * *
    (c) * * *
    (2) * * *
    (vi)(O) Security-based swaps. (1) Credit default swaps. (i) Short 
positions (selling protection). In the case of a security-based swap 
that is a short credit default swap, deducting the percentage of the 
notional amount based upon the current basis point spread of the credit 
default swap and the maturity of the credit default swap in accordance 
with the following table:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                Basis point spread
                                                         -----------------------------------------------------------------------------------------------
       Length of time to maturity of  CDS contract          100 or less
                                                                (%)           101-300         301-400         401-500         501-699       700 or more
--------------------------------------------------------------------------------------------------------------------------------------------------------
12 months or less.......................................            1.00            2.00            5.00            7.50           10.00           15.00
13 months to 24 months..................................            1.50            3.50            7.50           10.00           12.50           17.50
25 months to 36 months..................................            2.00            5.00           10.00           12.50           15.00           20.00
37 months to 48 months..................................            3.00            6.00           12.50           15.00           17.50           22.50
49 months to 60 months..................................            4.00            7.00           15.00           17.50           20.00           25.00
61 months to 72 months..................................            5.50            8.50           17.50           20.00           22.50           27.50
73 months to 84 months..................................            7.00           10.00           20.00           22.50           25.00           30.00
85 months to 120 months.................................            8.50           15.00           22.50           25.00           27.50           40.00
121 months and longer...................................           10.00           20.00           25.00           27.50           30.00           50.00
--------------------------------------------------------------------------------------------------------------------------------------------------------

     (ii) Long positions (purchasing protection). In the case of a 
security-based swap that is a long credit default swap, deducting 50% 
of the deduction that would be required by paragraph 
(c)(2)(vi)(O)(1)(i) of this section if the security-based swap was a 
short credit default swap.
    (iii) Long and short positions. (A) Long and short credit default 
swaps. In the case of security-based swaps that are long and short 
credit default swaps referencing the same entity (in the case of credit 
default swap securities-based swaps referencing a corporate entity) or 
obligation (in the case of credit default swap securities-based swaps 
referencing an asset-backed security), that have the same credit events 
which would trigger payment by the seller of protection, that have the 
same basket of obligations which would determine the amount of payment 
by the seller of protection upon the occurrence of a credit event, that 
are in the same or adjacent spread category, and that are in the same 
or adjacent maturity category and have a maturity date within three 
months of the other maturity category, deducting the percentage of the 
notional amount specified in the higher maturity category under 
paragraph (c)(2)(vi)(O)(1)(i) or (ii) on the excess of the long or 
short position. In the case of security-based swaps that are long and 
short credit default swaps referencing corporate entities in the same 
industry sector and the same spread and maturity categories prescribed 
in paragraph (c)(2)(vi)(O)(1)(i) of this section, deducting 50% of the 
amount required by paragraph (c)(2)(vi)(O)(1)(i) of this section on the 
short position plus the deduction required by paragraph 
(c)(2)(vi)(O)(1)(ii) of this section on the excess long position, if 
any. For the purposes of this section, the broker or dealer must use an 
industry sector classification system that is reasonable in terms of 
grouping types of companies with similar business activities and risk 
characteristics and the broker-dealer must document the industry sector 
classification system used pursuant to this section.
    (B) Long security and long credit default swap. In the case of a 
security-based swap that is a long credit default swap referencing a 
debt security and the broker or dealer is long the same debt security, 
deducting 50% of the amount specified in paragraph (c)(2)(vi) or (vii) 
of this section for the bond, provided that the broker or dealer can 
deliver the debt security to satisfy the obligation of the broker or 
dealer on the credit default swap.
    (C) Short security and short credit default swap. In the case of a 
security-based swap that is a short credit default swap referencing a 
bond or a corporate entity, and the broker or dealer is short the bond 
or a bond issued by the corporate entity, deducting the amount 
specified in paragraph (c)(2)(vi) or (vii) of this section for the 
bond. In the case of a security-based swap that is a short credit 
default swap referencing an asset-backed security and the broker or 
dealer is short the asset-backed security, deducting the amount 
specified in paragraph (c)(2)(vi) or (vii) of this section for the 
asset-backed security.
    (2) Security-based swaps that are not credit default swaps. In the 
case of any security-based swap that is not a credit default swap, 
deducting the amount calculated by multiplying the notional amount of 
the security-based swap and the percentage specified in paragraph 
(c)(2)(vi) of this section applicable to the reference security. A 
broker or dealer may reduce the deduction under this paragraph 
(c)(2)(vi)(O)(2) by an amount equal to any reduction recognized for a 
comparable long or short position in the reference security under 
paragraph (c)(2)(vi) of this section and, in the case of a security-
based swap referencing an equity security, the method specified in 
Sec.  240.15c3-1a.
* * * * *
    (xii) * * *
    (B) Deducting the amount of cash required in the account of each 
security-based swap customer to meet the margin requirements of a 
clearing agency, Examining Authority, or the Commission, after 
application of calls for margin, marks to the market, or other required 
deposits which are outstanding one business day or less.
* * * * *
    (xiv) Deduction from net worth in lieu of collecting margin amounts 
for security-based swaps. (A) Cleared security-based swap transactions. 
Deducting the amount of the margin difference for each account carried 
by the broker or dealer for another person that holds cleared security-
based swap transactions. The margin difference is the amount of the 
deductions that the positions in the account would incur pursuant to 
paragraph (c)(2)(vi)(O) of this section if owned by the broker or 
dealer less the margin value of collateral held in the account.
    (B) Non-cleared security-based swap transactions. (1) Commercial 
end users. Deducting, with respect to a counterparty that is a 
commercial end user as that term is defined in Sec.  240.18a-3(b)(2), 
the margin amount calculated pursuant to Sec.  240.18a-3(c)(1)(i)(B) 
for the account of the counterparty at the broker or dealer less any 
positive equity in that account as that term is defined in Sec.  
240.18a-3(b)(7).
    (2) Margin collateral held by third-party custodian. Deducting, 
with

[[Page 70331]]

respect to a counterparty that is not a commercial end user as that 
term is defined in Sec.  240.18a-3(b)(2) and that elects to have 
collateral segregated in an account at an independent third-party 
custodian pursuant to section 3E(f) of the Act (15 U.S.C. 78c-5(f)), 
the margin amount calculated pursuant to Sec.  240.18a-3(c)(1)(i)(B) 
for the account of the counterparty less any positive equity in the 
account as that term is defined in Sec.  240.18a-3(b)(7).
    (3) Security-based swap legacy accounts. Deducting, with respect to 
a security-based swap legacy account as that term is defined in Sec.  
240.18a-3(b)(9) of a counterparty that is not a commercial end user as 
that term is defined in Sec.  240.18a-3(b)(2), the margin amount 
calculated pursuant Sec.  240.18a-3(c)(1)(i)(B) for the account less 
any positive equity in the account as that term is defined in Sec.  
240.18a-3(b)(7).
* * * * *
    (16) The term risk margin amount means the sum of:
    (i) The greater of the total margin required to be delivered by the 
broker or dealer with respect to security-based swap transactions 
cleared for security-based swap customers at a clearing agency or the 
amount of the deductions that would apply to the cleared security-based 
swap positions of the security-based swap customers pursuant to 
paragraph (c)(2)(vi)(O) of this section; and
    (ii) The total margin amount calculated by the broker or dealer 
with respect to non-cleared security-based swaps pursuant to Sec.  
240.18a-3(c)(1)(i)(B).
* * * * *
    (f) Liquidity requirements. (1) Liquidity stress test. A broker or 
dealer whose application, including amendments, has been approved, in 
whole or in part, to calculate net capital under Appendix E of this 
section must run a liquidity stress test at least monthly, the results 
of which must be provided within ten business days to senior management 
that has responsibility to oversee risk management at the broker or 
dealer. The assumptions underlying the liquidity stress test must be 
reviewed at least quarterly by senior management that has 
responsibility to oversee risk management at the broker or dealer and 
at least annually by senior management of the broker or dealer. The 
liquidity stress test must include, at a minimum, the following assumed 
conditions lasting for 30 consecutive days:
    (i) A stress event that includes a decline in creditworthiness of 
the broker or dealer severe enough to trigger contractual credit-
related commitment provisions of counterparty agreements;
    (ii) The loss of all existing unsecured funding at the earlier of 
its maturity or put date and an inability to acquire a material amount 
of new unsecured funding, including intercompany advances and unfunded 
committed lines of credit;
    (iii) The potential for a material net loss of secured funding;
    (iv) The loss of the ability to procure repurchase agreement 
financing for less liquid assets;
    (v) The illiquidity of collateral required by and on deposit at 
registered clearing agencies or other entities which is not deducted 
from net worth or which is not funded by customer assets;
    (vi) A material increase in collateral required to be maintained at 
registered clearing agencies of which it is a member; and
    (vii) The potential for a material loss of liquidity caused by 
market participants exercising contractual rights and/or refusing to 
enter into transactions with respect to the various businesses, 
positions, and commitments of the broker or dealer, including those 
related to customer businesses of the broker or dealer.
    (2) Stress test of consolidated entity. The broker or dealer must 
justify and document any differences in the assumptions used in the 
liquidity stress test of the broker or dealer from those used in the 
liquidity stress test of the consolidated entity of which the broker or 
dealer is a part.
    (3) Liquidity reserves. The broker or dealer must maintain at all 
times liquidity reserves based on the results of the liquidity stress 
test. The liquidity reserves used to satisfy the liquidity stress test 
must be:
    (i) Cash, obligations of the United States, or obligations fully 
guaranteed as to principal and interest by the United States; and
    (ii) Unencumbered and free of any liens at all times. Securities in 
the liquidity reserve can be used to meet delivery requirements as long 
as cash or other acceptable securities of equal or greater value are 
moved into the liquidity pool contemporaneously.
    (4) Contingency funding plan. The broker or dealer must have a 
written contingency funding plan that addresses the broker's or 
dealer's policies and the roles and responsibilities of relevant 
personnel for meeting the liquidity needs of the broker or dealer and 
communications with the public and other market participants during a 
liquidity stress event.
* * * * *
    3. Section 240.15c3-1a is amended by:
    a. In paragraph (a)(4), revising the first and last sentences; and
    b. Adding paragraph (b)(1)(v)(C)(5).
    The addition to read as follows:


Sec.  240.15c3-1a  Options (Appendix A to 17 CFR 240.15c3-1).

    (a) * * *
    (4) The term underlying instrument refers to long and short 
positions, as appropriate, covering the same foreign currency, the same 
security, security future, or security-based swap, or a security which 
is exchangeable for or convertible into the underlying security within 
a period of 90 days. * * * The term underlying instrument shall not be 
deemed to include securities options, futures contracts, options on 
futures contracts, qualified stock baskets, or unlisted instruments 
(other than security-based swaps).
* * * * *
    (b) * * *
    (1) * * *
    (v) * * *
    (C) * * *
    (5) In the case of portfolio types involving security futures and 
equity options on the same underlying instrument and positions in that 
underlying instrument, there will be a minimum charge of 25% times the 
multiplier for each security-future and equity option.
* * * * *
    4. Section 240.15c3-1b is amended by adding a paragraph (b) to read 
as follows:


Sec.  240.15c3-1b  Adjustments to net worth and aggregate indebtedness 
for certain commodities transactions (Appendix B to 17 CFR 240.15c3-1).

* * * * *
    (b) Every broker or dealer in computing net capital pursuant to 
Sec.  240.15c3-1 must comply with the following:
    (1) Swaps. In the case of any swap for which the deductions in 
Appendix E of this section do not apply:
    (i) Credit default swaps referencing broad-based securities 
indices. (A) Short positions (selling protection). In the case of a 
swap that is a short credit default swap referencing a broad-based 
securities index, deducting the percentage of the notional amount based 
upon the current basis point spread of the credit default swap and the 
maturity of the credit default swap in accordance with the following 
table:

[[Page 70332]]



--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                Basis point spread
                                                         -----------------------------------------------------------------------------------------------
       Length of time to maturity of  CDS contract          100 or less                                                                     700 or more
                                                                (%)         101-300 (%)     301-400 (%)     401-500 (%)     501-699 (%)         (%)
--------------------------------------------------------------------------------------------------------------------------------------------------------
12 months or less.......................................            0.67            1.33            3.33            5.00            6.67           10.00
13 months to 24 months..................................            1.00            2.33            5.00            6.67            8.33           11.67
25 months to 36 months..................................            1.33            3.33            6.67            8.33           10.00           13.33
37 months to 48 months..................................            2.00            4.00            8.33           10.00           11.67           15.00
49 months to 60 months..................................            2.67            4.67           10.00           11.67           13.33           16.67
61 months to 72 months..................................            3.67            5.67           11.67           13.33           15.00           18.33
73 months to 84 months..................................            4.67            6.67           13.33           15.00           16.67           20.00
85 months to 120 months.................................            5.67           10.00           15.00           16.67           18.33           26.67
121 months and longer...................................            6.67           13.33           16.67           18.33           20.00           33.33
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (B) Long positions (purchasing protection). In the case of a swap 
that is a long credit default swap referencing a broad-based securities 
index, deducting 50% of the deduction that would be required by 
paragraph (b)(1)(i)(A) of this Appendix B if the swap was a short 
credit default swap.
    (C) Long and short positions. (1) Long and short credit default 
swaps. In the case of swaps that are long and short credit default 
swaps referencing the same broad-based security index, have the same 
credit events which would trigger payment by the seller of protection, 
have the same basket of obligations which would determine the amount of 
payment by the seller of protection upon the occurrence of a credit 
event, that are in the same or adjacent spread category, and that are 
in the same or adjacent maturity category and have a maturity date 
within three months of the other maturity category, deducting the 
percentage of the notional amount specified in the higher maturity 
category under paragraph (b)(1)(i)(A) or (b)(1)(i)(B) of this Appendix 
B on the excess of the long or short position.
    (2) Long basket of obligors and long credit default swap. In the 
case of a swap that is a long credit default swap referencing a broad-
based securities index and the broker or dealer is long a basket of 
debt securities comprising all of the components of the securities 
index, deducting 50% of the amount specified in Sec.  240.15c3-
1(c)(2)(vi) for the component securities, provided the broker or dealer 
can deliver the component securities to satisfy the obligation of the 
broker or dealer on the credit default swap.
    (3) Short basket of obligors and short credit default swap. In the 
case of a swap that is a short credit default swap referencing a broad-
based securities index and the broker or dealer is short a basket of 
debt securities comprising all of the components of the securities 
index, deducting the amount specified in Sec.  240.15c3-1(c)(2)(vi) for 
the component securities.
    (2) All other swaps. (i) In the case of any swap that is not a 
credit default swap, deducting the amount calculated by multiplying the 
notional value of the swap by the percentage specified in:
    (A) Section 240.15c3-1 applicable to the reference asset if Sec.  
240.15c3-1 specifies a percentage deduction for the type of asset;
    (B) 17 CFR 1.17 applicable to the reference asset if 17 CFR 1.17 
specifies a percentage deduction for the type of asset and Sec.  
240.15c3-1 does not specify a percentage deduction for the type of 
asset; or
    (C) In the case of an interest rate swap, Sec.  240.15c3-
1(c)(2)(vi)(A) based on the maturity of the swap, provided that the 
percentage deduction must be no less than 0.5%.
    (ii) A security-based swap dealer may reduce the deduction under 
this paragraph (b)(2)(ii) by an amount equal to any reduction 
recognized for a comparable long or short position in the reference 
asset or interest rate under Sec.  240.15c3-1 or 17 CFR 1.17.


Sec.  240.15c3-1d  [Amended]

    5. Section 240.15c3-1d is amended by:
    a. Adding to the end of the second sentence of paragraph (b)(7) the 
phrase ``, or if, in the case of a broker or dealer operating pursuant 
to paragraph (a)(10) of Sec.  240.15c3-1, its net capital would be less 
than either $24 million or 10% of the risk margin amount under Sec.  
240.15c3-1'';
    b. In the first sentence of paragraph (b)(8)(i), adding after the 
phrase ``if greater, or'' the phrase ``, in the case of a broker or 
dealer operating pursuant to paragraph (a)(10) of Sec.  240.15c3-1, its 
net capital would be less than either $24 million or 10% of the risk 
margin amount under Sec.  240.15c3-1, or'';
    c. In paragraph (b)(10)(ii)(B), adding after the phrase ``if 
greater,'' the phrase ``or, in the case of a broker or dealer operating 
pursuant to paragraph (a)(10) of Sec.  240.15c3-1, its net capital is 
less than either $20 million or 8% of the risk margin amount under 
Sec.  240.15c3-1,'';
    d. In paragraph (c)(2), adding at the end of the sentence the 
phrase ``, or, in the case of a broker or dealer operating pursuant to 
paragraph (a)(10) of Sec.  240.15c3-1, its net capital would be less 
than either $24 million or 10% of the risk margin amount under Sec.  
240.15c3-1''; and
    e. In paragraph (c)(5)(i)(B), adding after the phrase ``if greater, 
or less than 120 percent of the minimum dollar amount required by 
paragraph (a)(1)(ii) of this section,'' the phrase ``, or, in the case 
of a broker or dealer operating pursuant to paragraph (a)(10) of Sec.  
240.15c3-1, its net capital would be less than either $24 million or 
10% of the risk margin amount under Sec.  240.15c3-1,''.


Sec.  240.15c3-1e  [Amended]

    6. Section 240.15c3-1e is amended by:
    a. In the first sentence of paragraph (a) before the first ``:'', 
removing the phrase ``transactions in derivatives instruments'' and 
adding in its place the phrase ``security-based swap transactions with 
commercial end users as defined in Sec.  240.18a-3(b)(2)'';
    b. In the first sentence of paragraph (c) before the first ``:'', 
removing the phrase ``transactions in derivatives instruments'' and 
adding in its place the phrase ``security-based swap transactions with 
commercial end users as defined in Sec.  240.18a-3(b)(2)'';
    c. In paragraph (c)(2)(ii), removing the phrase ``$5 billion'' and 
adding in its place the phrase ``$6 billion''; and
    d. In paragraph (e)(1), removing the phrase ``$5 billion'' and 
adding in its place the phrase ``$6 billion''.
    7. Section 240.15c3-3 is amended by adding new paragraph (p) to 
read as follows:


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

* * * * *
    (p) Security-based swaps. A broker or dealer that is registered as 
a security-based swap dealer pursuant to section 15F of the Act (15 
U.S.C. 78o-8) must

[[Page 70333]]

also comply with the provisions of Sec.  240.18a-4.
    8. Section 240.18a-1 is added to read as follows:


Sec.  240.18a-1  Net capital requirements for security-based swap 
dealers for which there is not a prudential regulator.

    Note to Sec.  240.18a-1:  Rule 18a-1 and its appendices do not 
apply to a security-based swap dealer that has a prudential 
regulator as such a security-based swap dealer is subject to the 
capital requirement of the prudential regulator. In addition, Rule 
18a-1 and its appendices do not apply to a security-based swap 
dealer that also is registered as a broker or dealer pursuant to 
section 15(b) of the Act (15 U.S.C. 78o(b)) as such a security-based 
swap dealer is subject to the net capital requirements in Sec.  
240.15c3-1 and its appendices.

    (a) Minimum requirements. Every registered security-based swap 
dealer must at all times have and maintain net capital no less than the 
greater of the highest minimum requirements applicable to its business 
under paragraphs (a)(1) or (2) of this section, and tentative net 
capital no less than the minimum requirement under paragraph (a)(2) of 
this section.
    (1) A security-based swap dealer must at all times maintain net 
capital of not less than the greater of $20 million or eight percent 
(8%) of the risk margin amount.
    (2) In accordance with paragraph (d) of this section, the 
Commission may approve, in whole or in part, an application or an 
amendment to an application by a security-based swap dealer to 
calculate net capital using the market risk standards of paragraph (d) 
to compute a deduction for market risk on some or all of its positions, 
instead of the provisions of paragraphs (c)(1)(iv), (vi), and (vii) of 
this section, and using the credit risk standards of paragraph (d) to 
compute a deduction for credit risk for security-based swap 
transactions with commercial end users as defined in Sec.  240.18a-
3(b)(2), instead of the provisions of paragraphs (c)(1)(iii) and 
(c)(1)(viii)(B)(1) of this section, subject to any conditions or 
limitations on the security-based swap dealer the Commission may 
require as necessary or appropriate in the public interest or for the 
protection of investors. A security-based swap dealer that has been 
approved to calculate its net capital under paragraph (d) of this 
section must at all times maintain tentative net capital of not less 
than $100 million and net capital of not less than the greater of $20 
million or eight percent (8%) of the risk margin amount; and
    (b) A security-based swap dealer must at all times maintain net 
capital in addition to the amounts required under paragraph (a)(1) or 
(2) of this section, as applicable, in an amount equal to 10 percent 
of:
    (1) The excess of the market value of United States Treasury Bills, 
Bonds and Notes subject to reverse repurchase agreements with any one 
party over 105 percent of the contract prices (including accrued 
interest) for reverse repurchase agreements with that party;
    (2) The excess of the market value of securities issued or 
guaranteed as to principal or interest by an agency of the United 
States or mortgage related securities as defined in section 3(a)(41) of 
the Act subject to reverse repurchase agreements with any one party 
over 110 percent of the contract prices (including accrued interest) 
for reverse repurchase agreements with that party; and
    (3) The excess of the market value of other securities subject to 
reverse repurchase agreements with any one party over 120 percent of 
the contract prices (including accrued interest) for reverse repurchase 
agreements with that party.
    (c) Definitions. For purpose of this section:
    (1) The term net capital shall be deemed to mean the net worth of a 
security-based swap dealer, adjusted by:
    (i) Adjustments to net worth related to unrealized profit or loss 
and deferred tax provisions. (A) Adding unrealized profits (or 
deducting unrealized losses) in the accounts of the security-based swap 
dealer;
    (B)(1) In determining net worth, all long and all short positions 
in listed options shall be marked to their market value and all long 
and all short securities and commodities positions shall be marked to 
their market value.
    (2) In determining net worth, the value attributed to any unlisted 
option shall be the difference between the option's exercise value and 
the market value of the underlying security. In the case of an unlisted 
call, if the market value of the underlying security is less than the 
exercise value of such call it shall be given no value and in the case 
of an unlisted put if the market value of the underlying security is 
more than the exercise value of the unlisted put it shall be given no 
value.
    (C) Adding to net worth the lesser of any deferred income tax 
liability related to the items in paragraphs (c)(1)(i)(C)(1), (2), and 
(3) of this section, or the sum of paragraphs (c)(1)(i)(C)(1), (2), and 
(3) of this section;
    (1) The aggregate amount resulting from applying to the amount of 
the deductions computed in accordance with paragraphs (c)(1)(vii) and 
(viii) of this section and Appendices A and B, Sec.  240.18a-1a and 
Sec.  240.18a-1b, the appropriate Federal and State tax rate(s) 
applicable to any unrealized gain on the asset on which the deduction 
was computed.
    (2) Any deferred tax liability related to income accrued which is 
directly related to an asset otherwise deducted pursuant to this 
section;
    (3) Any deferred tax liability related to unrealized appreciation 
in value of any asset(s) which has been otherwise deducted from net 
worth in accordance with the provisions of this section; and
    (D) Adding, in the case of future income tax benefits arising as a 
result of unrealized losses, the amount of such benefits not to exceed 
the amount of income tax liabilities accrued on the books and records 
of the security-based swap dealer, but only to the extent such benefits 
could have been applied to reduce accrued tax liabilities on the date 
of the capital computation, had the related unrealized losses been 
realized on that date.
    (E) Adding to net worth any actual tax liability related to income 
accrued which is directly related to an asset otherwise deducted 
pursuant to this section.
    (ii) Subordinated liabilities. Excluding liabilities of the 
security-based swap dealer that are subordinated to the claims of 
creditors pursuant to a satisfactory subordinated loan agreement, as 
defined in Appendix D (Sec.  240.18a-1d).
    (iii) Assets not readily convertible into cash. Deducting fixed 
assets and assets which cannot be readily converted into cash, 
including, among other things:
    (A) Fixed assets and prepaid items. Real estate; furniture and 
fixtures; exchange memberships; prepaid rent, insurance and other 
expenses; goodwill, organization expenses;
    (B) Certain unsecured and partly secured receivables. All unsecured 
advances and loans; deficits in customers' and non-customers' unsecured 
and partly secured notes; deficits in customers' and non-customers' 
unsecured and partly secured accounts after application of calls for 
margin, marks to the market or other required deposits that are 
outstanding for more than one business day; and the market value of 
stock loaned in excess of the value of any collateral received 
therefore.
    (C) Insurance claims. Insurance claims that, after seven (7) 
business days from the date the loss giving rise to the claim is 
discovered, are not covered by an opinion of outside counsel that the 
claim is valid and is covered by insurance policies presently in 
effect; insurance claims that after twenty (20)

[[Page 70334]]

business days from the date the loss giving rise to the claim is 
discovered and that are not accompanied by an opinion of outside 
counsel described above, have not been acknowledged in writing by the 
insurance carrier as due and payable; and insurance claims acknowledged 
in writing by the carrier as due and payable outstanding longer than 
twenty (20) business days from the date they are so acknowledged by the 
carrier; and
    (D) Other deductions. All other unsecured receivables; all assets 
doubtful of collection less any reserves established therefore; the 
amount by which the market value of securities failed to receive 
outstanding thirty (30) calendar days exceeds the contract value of 
such fails to receive, and the funds on deposit in a ``segregated trust 
account'' in accordance with 17 CFR 270.27d-1 under the Investment 
Company Act of 1940, but only to the extent that the amount on deposit 
in such segregated trust account exceeds the amount of liability 
reserves established and maintained for refunds of charges required by 
sections 27(d) and 27(f) of the Investment Company Act of 1940; 
Provided, That any amount deposited in the ``special account for the 
exclusive benefit of security-based swap customers'' established 
pursuant to Sec.  240.18a-4 and clearing deposits shall not be so 
deducted.
    (E)(1) For purposes of this paragraph:
    (i) The term reverse repurchase agreement deficit shall mean the 
difference between the contract price for resale of the securities 
under a reverse repurchase agreement and the market value of those 
securities (if less than the contract price).
    (ii) The term repurchase agreement deficit shall mean the 
difference between the market value of securities subject to the 
repurchase agreement and the contract price for repurchase of the 
securities (if less than the market value of the securities).
    (iii) As used in paragraph (c)(1)(iii)(E)(1) of this section, the 
term contract price shall include accrued interest.
    (iv) Reverse repurchase agreement deficits and the repurchase 
agreement deficits where the counterparty is the Federal Reserve Bank 
of New York shall be disregarded.
    (2)(i) In the case of a reverse repurchase agreement, the deduction 
shall be equal to the reverse repurchase agreement deficit.
    (ii) In determining the required deductions under paragraph 
(c)(1)(iii)(E)(2)(i) of this section, the security-based swap dealer 
may reduce the reverse repurchase agreement deficit by:
    (A) Any margin or other deposits held by the security-based swap 
dealer on account of the reverse repurchase agreement;
    (B) Any excess market value of the securities over the contract 
price for resale of those securities under any other reverse repurchase 
agreement with the same party;
    (C) The difference between the contract price for resale and the 
market value of securities subject to repurchase agreements with the 
same party (if the market value of those securities is less than the 
contract price); and
    (D) Calls for margin, marks to the market, or other required 
deposits that are outstanding one business day or less.
    (3)(i) In the case of repurchase agreements, the deduction shall 
be:
    (A) The excess of the repurchase agreement deficit over 5 percent 
of the contract price for resale of United States Treasury Bills, Notes 
and Bonds, 10 percent of the contract price for the resale of 
securities issued or guaranteed as to principal or interest by an 
agency of the United States or mortgage related securities as defined 
in section 3(a)(41) of the Act and 20 percent of the contract price for 
the resale of other securities; and
    (B) The excess of the aggregate repurchase agreement deficits with 
any one party over 25 percent of the security-based swap dealer's net 
capital before the application of paragraphs (c)(1)(vii) and (viii) of 
this section (less any deduction taken with respect to repurchase 
agreements with that party under paragraph (c)(1)(iii)(E)(3)(i)(A) of 
this section) or, if greater;
    (C) The excess of the aggregate repurchase agreement deficits over 
300 percent of the security-based swap dealer's net capital before the 
application of paragraphs (c)(1)(vii) and (viii) of this section.
    (ii) In determining the required deduction under paragraph 
(c)(1)(iii)(E)(3)(i) of this section, the security-based swap dealer 
may reduce a repurchase agreement by:
    (A) Any margin or other deposits held by the security-based swap 
dealer on account of a reverse repurchase agreement with the same party 
to the extent not otherwise used to reduce a reverse repurchase 
agreement deficit;
    (B) The difference between the contract price and the market value 
of securities subject to other repurchase agreements with the same 
party (if the market value of those securities is less than the 
contract price) not otherwise used to reduce a reverse repurchase 
agreement deficit; and
    (C) Calls for margin, marks to the market, or other required 
deposits that are outstanding one business day or less to the extent 
not otherwise used to reduce a reverse repurchase agreement deficit.
    (F) Securities borrowed. One percent of the market value of 
securities borrowed collateralized by an irrevocable letter of credit.
    (G) Any receivable from an affiliate of the security-based swap 
dealer (not otherwise deducted from net worth) and the market value of 
any collateral given to an affiliate (not otherwise deducted from net 
worth) to secure a liability over the amount of the liability of the 
security-based swap dealer unless the books and records of the 
affiliate are made available for examination when requested by the 
representatives of the Commission in order to demonstrate the validity 
of the receivable or payable. The provisions of this subsection shall 
not apply where the affiliate is a registered security-based swap 
dealer, registered broker or dealer, registered government securities 
broker or dealer, bank as defined in section 3(a)(6) of the Act, 
insurance company as defined in section 3(a)(19) of the Act, investment 
company registered under the Investment Company Act of 1940, federally 
insured savings and loan association, or futures commission merchant or 
swap dealer registered pursuant to the Commodity Exchange Act.
    (iv) Non-marketable securities. Deducting 100 percent of the 
carrying value in the case of securities or evidence of indebtedness in 
the proprietary or other accounts of the security-based swap dealer, 
for which there is no ready market, as defined in paragraph (c)(4) of 
this section, and securities, in the proprietary or other accounts of 
the security-based swap dealer, that cannot be publicly offered or sold 
because of statutory, regulatory or contractual arrangements or other 
restrictions.
    (v) Deducting from the contract value of each failed to deliver 
contract that is outstanding five business days or longer (21 business 
days or longer in the case of municipal securities) the percentages of 
the market value of the underlying security that would be required by 
application of the deduction required by paragraph (c)(1)(vii) of this 
section. Such deduction, however, shall be increased by any excess of 
the contract price of the failed to deliver contract over the market 
value of the underlying security or reduced by any excess of the market 
value of the underlying security

[[Page 70335]]

over the contract value of the failed to deliver contract, but not to 
exceed the amount of such deduction. The Commission may, upon 
application of the security-based swap dealer, extend for a period up 
to 5 business days, any period herein specified when it is satisfied 
that the extension is warranted. The Commission upon expiration of the 
extension may extend for one additional period of up to 5 business 
days, any period herein specified when it is satisfied that the 
extension is warranted.
    (vi) Security-based swaps. Deducting the percentages specified in 
paragraphs (c)(1)(vi)(A) and (B) of this section (or the deductions 
prescribed in Sec.  240.18a-1a) of the notional amount of any security-
based swaps in the proprietary account of the security-based swap 
dealer.
    (A) Credit default swaps. (1) Short positions (selling protection). 
In the case of a security-based swap that is a short credit default 
swap, deducting the percentage of the notional amount based upon the 
current basis point spread of the credit default swap and the maturity 
of the credit default swap in accordance with the following table:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                Basis point spread
                                                         -----------------------------------------------------------------------------------------------
       Length of time to maturity of  CDS contract          100 or less                                                                     700 or more
                                                                (%)        101-300  (%)    301-400  (%)    401-500  (%)    501-699  (%)         (%)
--------------------------------------------------------------------------------------------------------------------------------------------------------
12 months or less.......................................            1.00            2.00            5.00            7.50           10.00           15.00
13 months to 24 months..................................            1.50            3.50            7.50           10.00           12.50           17.50
25 months to 36 months..................................            2.00            5.00           10.00           12.50           15.00           20.00
37 months to 48 months..................................            3.00            6.00           12.50           15.00           17.50           22.50
49 months to 60 months..................................            4.00            7.00           15.00           17.50           20.00           25.00
61 months to 72 months..................................            5.50            8.50           17.50           20.00           22.50           27.50
73 months to 84 months..................................            7.00           10.00           20.00           22.50           25.00           30.00
85 months to 120 months.................................            8.50           15.00           22.50           25.00           27.50           40.00
121 months and longer...................................           10.00           20.00           25.00           27.50           30.00           50.00
--------------------------------------------------------------------------------------------------------------------------------------------------------

     (2) Long positions (purchasing protection). In the case of a 
security-based swap that is a long credit default swap, deducting 50% 
of the deduction that would be required by paragraph (c)(1)(vi)(A)(1) 
of this section if the security-based swap was a short credit default 
swap.
    (3) Long and short positions. (i) Long and short credit default 
swaps. In the case of security-based swaps that are long and short 
credit default swaps referencing the same obligor or obligation, that 
are in the same spread category, and that are in the same maturity 
category or are in the next maturity category and have a maturity date 
within three months of the other maturity category, deducting the 
percentage of the notional amount specified in the higher maturity 
category under paragraphs (c)(1)(vi)(A)(1) or (2) on the excess of the 
long or short position. In the case of security-based swaps that are 
long and short credit default swaps referencing obligors or obligations 
of obligors in the same industry sector and the same spread and 
maturity categories prescribed in paragraph (c)(1)(vi)(A)(1) of this 
section, deducting 50% of the amount required by paragraph 
(c)(1)(vi)(A)(1) of this section on the short position plus the 
deduction required by paragraph (c)(1)(vi)(A)(2) of this section on the 
excess long position, if any. For the purposes of this section, the 
security-based swap dealer must use an industry sector classification 
system that is reasonable in terms of grouping types of companies with 
similar business activities and risk characteristics and document the 
industry sector classification system used pursuant to this section.
    (ii) Long security and long credit default swap. In the case of a 
security-based swap that is a long credit default swap referencing a 
debt security and the security-based swap dealer is long the same debt 
security, deducting 50% of the amount specified in Sec.  240.15c3-
1(c)(2)(vi) or (vii) for the bond, provided that the security-based 
swap dealer can deliver the bond to satisfy the obligation of the 
security-based swap dealer on the credit default swap.
    (iii) Short security and short credit default swap. In the case of 
a security-based swap that is a short credit default swap referencing a 
bond or a corporate entity and the security-based swap dealer is short 
the bond or a bond issued by the corporate entity, deducting the amount 
specified in Sec.  240.15c3-1(c)(2)(vi) or (vii) for the bond. In the 
case of a security-based swap that is a short credit default swap 
referencing an asset-backed security and the security-based swap dealer 
is short the asset-backed security, deducting the amount specified in 
Sec.  240.15c3-1(c)(2)(vi) or (vii) for the asset-backed security.
    (B) All other security-based swaps. In the case of any security-
based swap that is not a credit default swap, deducting the amount 
calculated by multiplying the notional amount of the security-based 
swap and the percentage specified in Sec.  240.15c3-1(c)(2)(vi) 
applicable to the reference security. A security-based swap dealer may 
reduce the deduction under this paragraph (c)(1)(vi)(B) by an amount 
equal to any reduction recognized for a comparable long or short 
position in the reference security under Sec.  240.15c3-1(c)(2)(vi) 
and, in the case of a security-based swap referencing an equity 
security, the method specified in Sec.  240.18a-1a.
    (vii) All other securities, money market instruments or options. 
Deducting the percentages specified in Sec.  240.15c3-1(c)(2)(vi) of 
the market value of all securities, money market instruments, and 
options in the proprietary accounts of the security-based swap dealer.
    (viii) Deduction from net worth in lieu of collecting margin 
amounts for security-based swaps. (A) Cleared security-based swap 
transactions. Deducting the amount of the margin difference for each 
account carried by the security-based swap dealer for another person 
that holds cleared security-based swap transactions. The margin 
difference is the amount of the deductions that the positions in the 
account would incur pursuant to paragraph (c)(1)(vi) of this section if 
owned by the security-based swap dealer less the margin value of 
collateral held in the account.
    (B) Non-cleared security-based swap transactions. (1) Commercial 
end users. Deducting, with respect to a counterparty that is a 
commercial end user as that term is defined in Sec.  240.18a-3(b)(2), 
the margin amount calculated pursuant to Sec.  240.18a-3(c)(1)(i)(B) 
for the account of the counterparty less any positive equity in the 
account as that term is defined in Sec.  240.18a-3(b)(7).

[[Page 70336]]

    (2) Margin collateral held by third-party custodian. Deducting, 
with respect to a counterparty that is not a commercial end user as 
that term is defined in Sec.  240.18a-3(b)(2) and that elects to have 
collateral segregated in an account at an independent third-party 
custodian pursuant to section 3E(f) of the Act (15 U.S.C. 78c-5(f)), 
the margin amount calculated pursuant to Sec.  240.18a-3(c)(1)(i)(B) 
for the account of the counterparty at the security-based swap dealer 
less any positive equity in that account as that term is defined in 
Sec.  240.18a-3(b)(7).
    (3) Security-based swap legacy accounts. Deducting, with respect to 
a security-based swap legacy account as that term is defined in Sec.  
240.18a-3(b)(9) of a counterparty that is not a commercial end user as 
that term is defined in Sec.  240.18a-3(b)(2), the margin amount 
calculated pursuant Sec.  240.18a-3(c)(1)(i)(B) for the account less 
any positive equity in the account as that term is defined in Sec.  
240.18a-3(b)(7).
    (ix) Deduction from net worth for certain undermargined accounts. 
Deducting the amount of cash required in the account of each security-
based swap customer to meet the margin requirements of a clearing 
agency or the Commission, after application of calls for margin, marks 
to the market, or other required deposits which are outstanding one 
business day or less.
    (2) The term exempted securities shall mean those securities deemed 
exempted securities by section 3(a)(12) of the Securities Exchange Act 
of 1934 and the rules thereunder.
    (3) Customer. The term customer shall mean any person from whom, or 
on whose behalf, a security-based swap dealer has received, acquired or 
holds funds or securities for the account of such person, but shall not 
include a security-based swap dealer, a broker or dealer, a registered 
municipal securities dealer, or a general, special or limited partner 
or director or officer of the security-based swap dealer, or any person 
to the extent that such 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 security-based swap dealer.
    (4) Ready market. The term ready market shall include a recognized 
established securities market in which there exists independent bona 
fide offers to buy and sell so that a price reasonably related to the 
last sales price or current bona fide competitive bid and offer 
quotations can be determined for a particular security almost 
instantaneously and where payment will be received in settlement of a 
sale at such price within a relatively short time conforming to trade 
custom.
    (5) The term tentative net capital means the net capital of the 
security-based swap dealer before deductions for market and credit risk 
computed pursuant to this section and increased by the balance sheet 
value (including counterparty net exposure) resulting from transactions 
in derivative instruments which would otherwise be deducted. Tentative 
net capital shall include securities for which there is no ready 
market, as defined in paragraph (c)(4) of this section, if the use of 
mathematical models has been approved for purposes of calculating 
deductions from net capital for those securities pursuant to paragraph 
(d) of this section.
    (6) The term risk margin amount means the sum of:
    (i) The greater of the total margin required to be delivered by the 
security-based swap dealer with respect to security-based swap 
transactions cleared for security-based swap customers at a clearing 
agency or the amount of the deductions that would apply to the cleared 
security-based swap positions of the security-based swap customers 
pursuant to paragraph (c)(1)(vi) of this section; and
    (ii) The total margin amount calculated by the security-based swap 
dealer with respect to non-cleared security-based swaps pursuant to 
Sec.  240.18a-3(c)(1)(i)(B).
    (d) Application to use models to compute deductions for market and 
credit risk. (1) A security-based swap dealer may apply to the 
Commission for authorization to compute deductions for market risk 
under this paragraph (d) in lieu of computing deductions pursuant to 
paragraphs (c)(1)(iv), (vi), and (vii) of this section and to compute 
deductions for credit risk pursuant to this paragraph (d) on credit 
exposures arising from transactions in derivatives instruments (if this 
paragraph (d) is used to calculate deductions for market risk on these 
instruments) in lieu of computing deductions pursuant to paragraph 
(c)(1)(iii) of this section.
    (i) A security-based swap dealer shall submit the following 
information to the Commission with its application:
    (A) An executive summary of the information provided to the 
Commission with its application and an identification of the ultimate 
holding company of the security-based swap dealer;
    (B) A comprehensive description of the internal risk management 
control system of the security-based swap dealer and how that system 
satisfies the requirements set forth in Sec.  240.15c3-4;
    (C) A list of the categories of positions that the security-based 
swap dealer holds in its proprietary accounts and a brief description 
of the methods that the security-based swap dealer will use to 
calculate deductions for market and credit risk on those categories of 
positions;
    (D) A description of the mathematical models to be used to price 
positions and to compute deductions for market risk, including those 
portions of the deductions attributable to specific risk, if 
applicable, and deductions for credit risk; a description of the 
creation, use, and maintenance of the mathematical models; a 
description of the security-based swap dealer's internal risk 
management controls over those models, including a description of each 
category of persons who may input data into the models; if a 
mathematical model incorporates empirical correlations across risk 
categories, a description of the process for measuring correlations; a 
description of the backtesting procedures the security-based swap 
dealer will use to backtest the mathematical models used to calculate 
maximum potential exposure; a description of how each mathematical 
model satisfies the applicable qualitative and quantitative 
requirements set forth in this paragraph (d); and a statement 
describing the extent to which each mathematical model used to compute 
deductions for market risk and credit risk will be used as part of the 
risk analyses and reports presented to senior management;
    (E) If the security-based swap dealer is applying to the Commission 
for approval to use scenario analysis to calculate deductions for 
market risk for certain positions, a list of those types of positions, 
a description of how those deductions will be calculated using scenario 
analysis, and an explanation of why each scenario analysis is 
appropriate to calculate deductions for market risk on those types of 
positions;
    (F) A description of how the security-based swap dealer will 
calculate current exposure;
    (G) A description of how the security-based swap dealer will 
determine internal credit ratings of counterparties and internal credit 
risk weights of counterparties, if applicable;
    (H) For each instance in which a mathematical model to be used by 
the security-based swap dealer to calculate a deduction for market risk 
or to calculate maximum potential exposure for a particular product or 
counterparty differs from the mathematical model used by the ultimate 
holding company to calculate an allowance for market risk or to 
calculate maximum potential

[[Page 70337]]

exposure for that same product or counterparty, a description of the 
difference(s) between the mathematical models; and
    (I) Sample risk reports that are provided to management at the 
security-based swap dealer who are responsible for managing the 
security-based swap dealer's risk.
    (ii) [Reserved].
    (2) The application of the security-based swap dealer shall be 
supplemented by other information relating to the internal risk 
management control system, mathematical models, and financial position 
of the security-based swap dealer that the Commission may request to 
complete its review of the application;
    (3) The application shall be considered filed when received at the 
Commission's principal office in Washington, DC A person who files an 
application pursuant to this section for which it seeks confidential 
treatment may clearly mark each page or segregable portion of each page 
with the words ``Confidential Treatment Requested.'' All information 
submitted in connection with the application will be accorded 
confidential treatment, to the extent permitted by law;
    (4) If any of the information filed with the Commission as part of 
the application of the security-based swap dealer is found to be or 
becomes inaccurate before the Commission approves the application, the 
security-based swap dealer must notify the Commission promptly and 
provide the Commission with a description of the circumstances in which 
the information was found to be or has become inaccurate along with 
updated, accurate information;
    (5) The Commission may approve the application or an amendment to 
the application, in whole or in part, subject to any conditions or 
limitations the Commission may require if the Commission finds the 
approval to be necessary or appropriate in the public interest or for 
the protection of investors, after determining, among other things, 
whether the security-based swap dealer has met the requirements of this 
paragraph (d) and is in compliance with other applicable rules 
promulgated under the Act;
    (6) A security-based swap dealer shall amend its application to 
calculate certain deductions for market and credit risk under this 
paragraph (d) and submit the amendment to the Commission for approval 
before it may change materially a mathematical model used to calculate 
market or credit risk or before it may change materially its internal 
risk management control system;
    (7) As a condition for the security-based swap dealer to compute 
deductions for market and credit risk under this paragraph (d), the 
security-based swap dealer agrees that:
    (i) It will notify the Commission 45 days before it ceases to 
compute deductions for market and credit risk under this paragraph (d); 
and
    (ii) The Commission may determine by order that the notice will 
become effective after a shorter or longer period of time if the 
security-based swap dealer consents or if the Commission determines 
that a shorter or longer period of time is necessary or appropriate in 
the public interest or for the protection of investors; and
    (8) Notwithstanding paragraph (d)(7) of this section, the 
Commission, by order, may revoke a security-based swap dealer's 
exemption that allows it to use the market risk standards of this 
paragraph (d) to calculate deductions for market risk, and the 
exemption to use the credit risk standards of this paragraph (d) to 
calculate deductions for credit risk on certain credit exposures 
arising from transactions in derivatives instruments if the Commission 
finds that such exemption is no longer necessary or appropriate in the 
public interest or for the protection of investors. In making its 
finding, the Commission will consider the compliance history of the 
security-based swap dealer related to its use of models, the financial 
and operational strength of the security-based swap dealer and its 
ultimate holding company, and the security-based swap dealer's 
compliance with its internal risk management controls.
    (9) VaR models. To be approved, each value-at-risk (``VaR'') model 
must meet the following minimum qualitative and quantitative 
requirements:
    (i) Qualitative requirements. (A) The VaR model used to calculate 
market or credit risk for a position must be integrated into the daily 
internal risk management system of the security-based swap dealer;
    (B) The VaR model must be reviewed both periodically and annually. 
The periodic review may be conducted by the security-based swap 
dealer's internal audit staff, but the annual review must be conducted 
by a registered public accounting firm, as that term is defined in 
section 2(a)(12) of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7201 et 
seq.); and
    (C) For purposes of computing market risk, the security-based swap 
dealer must determine the appropriate multiplication factor as follows:
    (1) Beginning three months after the security-based swap dealer 
begins using the VaR model to calculate market risk, the security-based 
swap dealer must conduct backtesting of the model by comparing its 
actual daily net trading profit or loss with the corresponding VaR 
measure generated by the VaR model, using a 99 percent, one-tailed 
confidence level with price changes equivalent to a one business-day 
movement in rates and prices, for each of the past 250 business days, 
or other period as may be appropriate for the first year of its use;
    (2) On the last business day of each quarter, the security-based 
swap dealer must identify the number of backtesting exceptions of the 
VaR model using clean profit and loss, that is, the number of business 
days in the past 250 business days, or other period as may be 
appropriate for the first year of its use, for which the actual net 
trading loss, if any, exceeds the corresponding VaR measure; and
    (3) The security-based swap dealer must use the multiplication 
factor indicated in Table 1 of this paragraph (d) in determining its 
market risk until it obtains the next quarter's backtesting results;

    Table 1--Multiplication Factor Based on the Number of Backtesting
                       Exceptions of the VaR Model
------------------------------------------------------------------------
                                                         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
------------------------------------------------------------------------

     (4) For purposes of incorporating specific risk into a VaR model, 
a security-based swap dealer must demonstrate that it has methodologies 
in place to capture liquidity, event, and default risk adequately for 
each position. Furthermore, the models used to calculate deductions for 
specific risk must:
    (i) Explain the historical price variation in the portfolio;
    (ii) Capture concentration (magnitude and changes in composition);
    (iii) Be robust to an adverse environment;
    (iv) Capture name-related basis risk;
    (v) Capture event risk; and
    (vi) Be validated through backtesting.
    (5) For purposes of computing the credit equivalent amount of the 
security-based swap dealer's exposures

[[Page 70338]]

to a counterparty, the security-based swap dealer must determine the 
appropriate multiplication factor as follows:
    (i) Beginning three months after it begins using the VaR model to 
calculate maximum potential exposure, the security-based swap dealer 
must conduct backtesting of the model by comparing, for at least 80 
counterparties with widely varying types and sizes of positions with 
the firm, the ten business day change in its current exposure to the 
counterparty based on its positions held at the beginning of the ten-
business day period with the corresponding ten-business day maximum 
potential exposure for the counterparty generated by the VaR model;
    (ii) As of the last business day of each quarter, the security-
based swap dealer must identify the number of backtesting exceptions of 
the VaR model, that is, the number of ten-business day periods in the 
past 250 business days, or other period as may be appropriate for the 
first year of its use, for which the change in current exposure to a 
counterparty exceeds the corresponding maximum potential exposure; and
    (iii) The security-based swap dealer will propose, as part of its 
application, a schedule of multiplication factors, which must be 
approved by the Commission based on the number of backtesting 
exceptions of the VaR model. The security-based swap dealer must use 
the multiplication factor indicated in the approved schedule in 
determining the credit equivalent amount of its exposures to a 
counterparty until it obtains the next quarter's backtesting results, 
unless the Commission determines, based on, among other relevant 
factors, a review of the security-based swap dealer's internal risk 
management control system, including a review of the VaR model, that a 
different adjustment or other action is appropriate.
    (ii) Quantitative requirements.
    (A) For purposes of determining market risk, the VaR model must use 
a 99 percent, one-tailed confidence level with price changes equivalent 
to a ten business-day movement in rates and prices;
    (B) For purposes of determining maximum potential exposure, the VaR 
model must use a 99 percent, one-tailed confidence level with price 
changes equivalent to a one-year movement in rates and prices; or based 
on a review of the security-based swap dealer's procedures for managing 
collateral and if the collateral is marked to market daily and the 
security-based swap dealer has the ability to call for additional 
collateral daily, the Commission may approve a time horizon of not less 
than ten business days;
    (C) The VaR model must use an effective historical observation 
period of at least one year. The security-based swap dealer must 
consider the effects of market stress in its construction of the model. 
Historical data sets must be updated at least monthly and reassessed 
whenever market prices or volatilities change significantly; and
    (D) The VaR model must take into account and incorporate all 
significant, identifiable market risk factors applicable to positions 
in the accounts of the security-based swap dealer, including:
    (1) Risks arising from the non-linear price characteristics of 
derivatives and the sensitivity of the market value of those positions 
to changes in the volatility of the derivatives' underlying rates and 
prices;
    (2) Empirical correlations with and across risk factors or, 
alternatively, risk factors sufficient to cover all the market risk 
inherent in the positions in the proprietary or other trading accounts 
of the security-based swap dealer, including interest rate risk, equity 
price risk, foreign exchange risk, and commodity price risk;
    (3) Spread risk, where applicable, and segments of the yield curve 
sufficient to capture differences in volatility and imperfect 
correlation of rates along the yield curve for securities and 
derivatives that are sensitive to different interest rates; and
    (4) Specific risk for individual positions.
    (iii) Additional conditions. (A) As a condition for the security-
based swap dealer to use this paragraph (d) to calculate certain of its 
capital charges, the Commission may impose additional conditions on the 
security-based swap dealer, which may include, but are not limited to 
restricting the security-based swap dealer's business on a product-
specific, category-specific, or general basis; submitting to the 
Commission a plan to increase the security-based swap dealer's net 
capital or tentative net capital; filing more frequent reports with the 
Commission; modifying the security-based swap dealer's internal risk 
management control procedures; or computing the security-based swap 
dealer's deductions for market and credit risk in accordance with 
paragraphs (c)(1) (iii), (iv), (vii), or (viii) as appropriate. If the 
Commission finds it is necessary or appropriate in the public interest 
or for the protection of investors, the Commission may impose 
additional conditions on the security-based swap dealer, if:
    (1) The security-based swap dealer is required by Sec.  240.18a-8 
to provide notice to the Commission that the security-based swap 
dealer's tentative net capital is less than $100 million;
    (2) The security-based swap dealer fails to meet the reporting 
requirements set forth in Sec.  240.18a-8;
    (3) Any event specified in Sec.  240.18a-8 occurs;
    (4) There is a material deficiency in the internal risk management 
control system or in the mathematical models used to price securities 
or to calculate deductions for market and credit risk or allowances for 
market and credit risk, as applicable, of the security-based swap 
dealer;
    (5) The security-based swap dealer fails to comply with this 
paragraph (d); or
    (6) The Commission finds that imposition of other conditions is 
necessary or appropriate in the public interest or for the protection 
of investors.
    (e) Models to compute deductions for market risk and credit risk. 
(1) Market risk. A security-based swap dealer whose application, 
including amendments, has been approved under paragraph (d) of this 
section, shall compute a deduction for market risk in an amount equal 
to the sum of the following:
    (i) For positions for which the Commission has approved the 
security-based swap dealer's use of VaR models, the VaR of the 
positions multiplied by the appropriate multiplication factor 
determined according to paragraph (d) of this section, except that the 
initial multiplication factor shall be three, unless the Commission 
determines, based on a review of the security-based swap dealer's 
application or an amendment to the application under paragraph (d) of 
this section, including a review of its internal risk management 
control system and practices and VaR models, that another 
multiplication factor is appropriate;
    (ii) For positions for which the VaR model does not incorporate 
specific risk, a deduction for specific risk to be determined by the 
Commission based on a review of the security-based swap dealer's 
application or an amendment to the application under paragraph (d) of 
this section and the positions involved;
    (iii) For positions for which the Commission has approved the 
security-based swap dealer's application to use scenario analysis, the 
greatest loss resulting from a range of adverse movements in relevant 
risk factors, prices, or spreads designed to represent a negative 
movement greater than, or equal to, the worst ten-day movement of

[[Page 70339]]

the four years preceding calculation of the greatest loss, or some 
multiple of the greatest loss based on the liquidity of the positions 
subject to scenario analysis. If historical data is insufficient, the 
deduction shall be the largest loss within a three standard deviation 
movement in those risk factors, prices, or spreads over a ten-day 
period, multiplied by an appropriate liquidity adjustment factor. 
Irrespective of the deduction otherwise indicated under scenario 
analysis, the resulting deduction for market risk must be at least $25 
per 100 share equivalent contract for equity positions, or one-half of 
one percent of the face value of the contract for all other types of 
contracts, even if the scenario analysis indicates a lower amount. A 
qualifying scenario must include the following:
    (A) A set of pricing equations for the positions based on, for 
example, arbitrage relations, statistical analysis, historic 
relationships, merger evaluations, or fundamental valuation of an 
offering of securities;
    (B) Auxiliary relationships mapping risk factors to prices; and
    (C) Data demonstrating the effectiveness of the scenario in 
capturing market risk, including specific risk; and
    (iv) For all remaining positions, the deductions specified in Sec.  
240.15c3-1(c)(2)(vi), Sec.  240.15c3-1(c)(2)(vii), and applicable 
appendices to Sec.  240.15c3-1.
    (2) Credit risk. A security-based swap dealer whose application, 
including amendments, has been approved under paragraph (d) of this 
section with respect to positions in security-based swaps may compute a 
deduction for credit risk on security-based swap transactions with 
commercial end users as defined in Sec.  240.18a-3(b)(2) in an amount 
equal to the sum of the following:
    (i) A counterparty exposure charge in an amount equal to the sum of 
the following:
    (A) The net replacement value in the account of each counterparty 
that is insolvent, or in bankruptcy, or that has senior unsecured long-
term debt in default; and
    (B) For a counterparty not otherwise described in paragraph 
(e)(2)(i)(A) of this section, the credit equivalent amount of the 
security-based swap dealer's exposure to the counterparty, as defined 
in paragraph (e)(2)(iv)(A) of this section, multiplied by the credit 
risk weight of the counterparty, as determined in accordance with 
paragraph (e)(2)(iv)(F) of this section, multiplied by 8%;
    (ii) A concentration charge by counterparty in an amount equal to 
the sum of the following:
    (A) For each counterparty with a credit risk weight of 20% or less, 
5% of the amount of the current exposure to the counterparty in excess 
of 5% of the tentative net capital of the security-based swap dealer;
    (B) For each counterparty with a credit risk weight of greater than 
20% but less than 50%, 20% of the amount of the current exposure to the 
counterparty in excess of 5% of the tentative net capital of the 
security-based swap dealer; and
    (C) For each counterparty with a credit risk weight of greater than 
50%, 50% of the amount of the current exposure to the counterparty in 
excess of 5% of the tentative net capital of the security-based swap 
dealer; and
    (iii) A portfolio concentration charge of 100% of the amount of the 
security-based swap dealer's aggregate current exposure for all 
counterparties in excess of 50% of the tentative net capital of the 
security-based swap dealer.
    (iv) Terms. (A) The credit equivalent amount of the security-based 
swap dealer's exposure to a counterparty is the sum of the security-
based swap dealer's maximum potential exposure to the counterparty, as 
defined in paragraph (e)(2)(iv)(B) of this section, multiplied by the 
appropriate multiplication factor, and the security-based swap dealer's 
current exposure to the counterparty, as defined in paragraph 
(e)(2)(iv)(C) of this section. The security-based swap dealer must use 
the multiplication factor determined according to paragraph 
(d)(9)(i)(C)(5) of this section, except that the initial multiplication 
factor shall be one, unless the Commission determines, based on a 
review of the security-based swap dealer's application or an amendment 
to the application approved under paragraph (d) of this section, 
including a review of its internal risk management control system and 
practices and VaR models, that another multiplication factor is 
appropriate;
    (B) The maximum potential exposure is the VaR of the counterparty's 
positions with the security-based swap dealer, after applying netting 
agreements with the counterparty meeting the requirements of paragraph 
(e)(2)(iv)(D) of this section, taking into account the value of 
collateral from the counterparty held by the security-based swap dealer 
in accordance with paragraph (e)(2)(iv)(E) of this section, and taking 
into account the current replacement value of the counterparty's 
positions with the security-based swap dealer;
    (C) The current exposure of the security-based swap dealer to a 
counterparty is the current replacement value of the counterparty's 
positions with the security-based swap dealer, after applying netting 
agreements with the counterparty meeting the requirements of paragraph 
(e)(2)(iv)(D) of this section and taking into account the value of 
collateral from the counterparty held by the security-based swap dealer 
in accordance with paragraph (e)(2)(iv)(E) of this section;
    (D) Netting agreements. A security-based swap dealer may include 
the effect of a netting agreement that allows the security-based swap 
dealer to net gross receivables from and gross payables to a 
counterparty upon default of the counterparty if:
    (1) The netting agreement is legally enforceable in each relevant 
jurisdiction, including in insolvency proceedings;
    (2) The gross receivables and gross payables that are subject to 
the netting agreement with a counterparty can be determined at any 
time; and
    (3) For internal risk management purposes, the security-based swap 
dealer monitors and controls its exposure to the counterparty on a net 
basis.
    (E) Collateral. When calculating maximum potential exposure and 
current exposure to a counterparty, the fair market value of collateral 
pledged and held may be taken into account provided:
    (1) The collateral is marked to market each day and is subject to a 
daily margin maintenance requirement;
    (2) The security-based swap dealer maintains physical possession or 
sole control of the collateral;
    (3) The collateral is liquid and transferable;
    (4) The collateral may be liquidated promptly by the firm without 
intervention by any other party;
    (5) The collateral agreement is legally enforceable by the 
security-based swap dealer against the counterparty and any other 
parties to the agreement;
    (6) The collateral does not consist of securities issued by the 
counterparty or a party related to the security-based swap dealer or to 
the counterparty;
    (7) The Commission has approved the security-based swap dealer's 
use of a VaR model to calculate deductions for market risk for the type 
of collateral in accordance with paragraph (d) of this section; and
    (8) The collateral is not used in determining the credit rating of 
the counterparty.
    (F) Credit risk weights of counterparties. A security-based swap

[[Page 70340]]

dealer that computes its deductions for credit risk pursuant to 
paragraph (e)(2) of this section shall apply a credit risk weight for 
transactions with a counterparty of either 20%, 50%, or 150% based on 
an internal credit rating the security-based swap dealer determines for 
the counterparty.
    (1) As part of its initial application or in an amendment, the 
security-based swap dealer may request Commission approval to apply a 
credit risk weight of either 20%, 50%, or 150% based on internal 
calculations of credit ratings, including internal estimates of the 
maturity adjustment. Based on the strength of the security-based swap 
dealer's internal credit risk management system, the Commission may 
approve the application. The security-based swap dealer must make and 
keep current a record of the basis for the credit risk weight of each 
counterparty;
    (2) As part of its initial application or in an amendment, the 
security-based swap dealer may request Commission approval to determine 
credit risk weights based on internal calculations, including internal 
estimates of the maturity adjustment. Based on the strength of the 
security-based swap dealer's internal credit risk management system, 
the Commission may approve the application. The security-based swap 
dealer must make and keep current a record of the basis for the credit 
risk weight of each counterparty; and
    (3) As part of its initial application or in an amendment, the 
security-based swap dealer may request Commission approval to reduce 
deductions for credit risk through the use of credit derivatives.
    (f) Liquidity requirements. (1) Liquidity stress test. A security-
based swap dealer that computes net capital under paragraph (a)(2) of 
this Rule 18a-1 must perform a liquidity stress test at least monthly, 
the results of which must be provided within ten business days to 
senior management that has responsibility to oversee risk management at 
the security-based swap dealer. The assumptions underlying the 
liquidity stress test must be reviewed at least quarterly by senior 
management that has responsibility to oversee risk management at the 
security-based swap dealer and at least annually by senior management 
of the security-based swap dealer. The liquidity stress test must 
include, at a minimum, the following assumed conditions lasting for 30 
consecutive days:
    (i) A stress event includes a decline in creditworthiness of the 
broker or dealer severe enough to trigger contractual credit-related 
commitment provisions of counterparty agreements;
    (ii) The loss of all existing unsecured funding at the earlier of 
its maturity or put date and an inability to acquire a material amount 
of new unsecured funding, including intercompany advances and unfunded 
committed lines of credit;
    (iii) The potential for a material net loss of secured funding;
    (iv) The loss of the ability to procure repurchase agreement 
financing for less liquid assets;
    (v) The illiquidity of collateral required by and on deposit at 
clearing agencies or other entities which is not deducted from net 
worth or which is not funded by customer assets;
    (vi) A material increase in collateral required to be maintained at 
registered clearing agencies of which it is a member; and
    (vii) The potential for a material loss of liquidity caused by 
market participants exercising contractual rights and/or refusing to 
enter into transactions with respect to the various businesses, 
positions, and commitments of the security-based swap dealer, including 
those related to customer businesses of the security-based swap dealer.
    (2) Stress test of consolidated entity. The security-based swap 
dealer must justify and document any differences in the assumptions 
used in the liquidity stress test of the security-based swap dealer 
from those used in the liquidity stress test of the consolidated entity 
of which the security-based swap dealer is a part.
    (3) Liquidity reserves. The security-based swap dealer must 
maintain at all times liquidity reserves based on the results of the 
liquidity stress test. The liquidity reserves used to satisfy the 
liquidity stress test must be:
    (i) Cash, obligations of the United States, or obligations fully 
guaranteed as to principal and interest by the United States; and
    (ii) Unencumbered and free of any liens at all times.
    Securities in the liquidity reserve can be used to meet delivery 
requirements as long as cash or other acceptable securities of equal or 
greater value are moved into the liquidity pool contemporaneously.
    (4) Contingency funding plan. The security-based swap dealer must 
have a written contingency funding plan that addresses the security-
based swap dealer's policies and the roles and responsibilities of 
relevant personnel for meeting the liquidity needs of the security-
based swap dealer and communications with the public and other market 
participants during a liquidity stress event.
    (g) Internal risk management control systems. A security-based swap 
dealer must comply with Sec.  240.15c3-4 as if it were an OTC 
derivatives dealer with respect to all of its business activities, 
except that paragraphs (c)(5)(xiii) and (xiv) and (d)(8) and (9) of 
Sec.  240.15c3-4 shall not apply.
    (h) Debt-equity requirements. No security-based swap dealer shall 
permit the total of outstanding principal amounts of its satisfactory 
subordination agreements (other than such agreements which qualify 
under this paragraph (h) as equity capital) to exceed 70 percent of its 
debt-equity total, as hereinafter defined, for a period in excess of 90 
days or for such longer period which the Commission may, upon 
application of the security-based swap dealer, grant in the public 
interest or for the protection of investors. In the case of a 
corporation, the debt-equity total shall be the sum of its outstanding 
principal amounts of satisfactory subordination agreements, par or 
stated value of capital stock, paid in capital in excess of par, 
retained earnings, unrealized profit and loss or other capital 
accounts. In the case of a partnership, the debt-equity total shall be 
the sum of its outstanding principal amounts of satisfactory 
subordination agreements, capital accounts of partners (exclusive of 
such partners' securities accounts) subject to the provisions of 
paragraph (i) of this section, and unrealized profit and loss. 
Provided, however, that a satisfactory subordinated loan agreement 
entered into by a partner or stockholder which has an initial term of 
at least three years and has a remaining term of not less than 12 
months shall be considered equity for the purposes of this paragraph 
(h) if:
    (1) It does not have any of the provisions for accelerated maturity 
provided for by paragraphs (b)(8)(i), (9)(i), or (9)(ii) of Appendix D 
of this section and is maintained as capital subject to the provisions 
restricting the withdrawal thereof required by paragraph (i) of this 
section; or
    (2) The partnership agreement provides that capital contributed 
pursuant to a satisfactory subordination agreement as defined in 
Appendix D of this section shall in all respects be partnership capital 
subject to the provisions restricting the withdrawal thereof required 
by paragraph (i) of this section.
    (i) Notice provisions relating to limitations on the withdrawal of 
equity capital. (1) No equity capital of the security-based swap dealer 
or a

[[Page 70341]]

subsidiary or affiliate consolidated pursuant to Appendix C of this 
section may be withdrawn by action of a stockholder or a partner or by 
redemption or repurchase of shares of stock by any of the consolidated 
entities or through the payment of dividends or any similar 
distribution, nor may any unsecured advance or loan be made to a 
stockholder, partner, employee or affiliate without written notice 
given in accordance with paragraph (i)(1)(iv) of this section:
    (i) Two business days prior to any withdrawals, advances or loans 
if those withdrawals, advances or loans on a net basis exceed in the 
aggregate in any 30 calendar day period, 30 percent of the security-
based swap dealer's excess net capital. A security-based swap dealer, 
in an emergency situation, may make withdrawals, advances or loans that 
on a net basis exceed 30 percent of the security-based swap dealer's 
excess net capital in any 30 calendar day period without giving the 
advance notice required by this paragraph, with the prior approval of 
the Commission. Where a security-based swap dealer makes a withdrawal 
with the consent of the Commission, it shall in any event comply with 
paragraph (i)(1)(ii) of this section; or
    (ii) Two business days after any withdrawals, advances or loans if 
those withdrawals, advances or loans on a net basis exceed in the 
aggregate in any 30 calendar day period, 20 percent of the security-
based swap dealer's excess net capital.
    (iii) This paragraph (i)(1) does not apply to:
    (A) Securities or commodities transactions in the ordinary course 
of business between a security-based swap dealer and an affiliate where 
the security-based swap dealer makes payment to or on behalf of such 
affiliate for such transaction and then receives payment from such 
affiliate for the securities or commodities transaction within two 
business days from the date of the transaction; or
    (B) Withdrawals, advances or loans which in the aggregate in any 
thirty calendar day period, on a net basis, equal $500,000 or less.
    (iv) Each required notice shall be effective when received by the 
Commission in Washington, DC, the regional office of the Commission for 
the region in which the security-based swap dealer has its principal 
place of business, and the Commodity Futures Trading Commission if such 
security-based swap dealer is registered with that Commission.
    (2) Limitations on withdrawal of equity capital. No equity capital 
of the security-based swap dealer or a subsidiary or affiliate 
consolidated pursuant to Appendix C of this section may be withdrawn by 
action of a stockholder or a partner or by redemption or repurchase of 
shares of stock by any of the consolidated entities or through the 
payment of dividends or any similar distribution, nor may any unsecured 
advance or loan be made to a stockholder, partner, employee or 
affiliate, if after giving effect thereto and to any other such 
withdrawals, advances or loans and any Payments of Payments Obligations 
(as defined in Appendix D of this section) under satisfactory 
subordinated loan agreements which are scheduled to occur within 180 
days following such withdrawal, advance or loan if:
    (i) The security-based swap dealer's net capital would be less than 
120 percent of the minimum dollar amount required by paragraph (a) of 
this section; and
    (ii) The total outstanding principal amounts of satisfactory 
subordinated loan agreements of the security-based swap dealer and any 
subsidiaries or affiliates consolidated pursuant to Appendix C of this 
section (other than such agreements which qualify as equity under 
paragraph (h) of this section) would exceed 70% of the debt-equity 
total as defined in paragraph (h) of this section.
    (3) Temporary restrictions on withdrawal of net capital. (i) The 
Commission may by order restrict, for a period up to twenty business 
days, any withdrawal by the security-based swap dealer of equity 
capital or unsecured loan or advance to a stockholder, partner, member, 
employee or affiliate under such terms and conditions as the Commission 
deems necessary or appropriate in the public interest or consistent 
with the protection of investors if the Commission, based on the 
information available, concludes that such withdrawal, advance or loan 
may be detrimental to the financial integrity of the security-based 
swap dealer, or may unduly jeopardize the security-based swap dealer's 
ability to repay its customer claims or other liabilities which may 
cause a significant impact on the markets or expose the customers or 
creditors of the security-based swap dealer to loss.
    (ii) An order temporarily prohibiting the withdrawal of capital 
shall be rescinded if the Commission determines that the restriction on 
capital withdrawal should not remain in effect. A hearing on an order 
temporarily prohibiting withdrawal of capital will be held within two 
business days from the date of the request in writing by the security-
based swap dealer.
    (4) Miscellaneous provisions. (i) Excess net capital is that amount 
in excess of the amount required under paragraph (a) of this section. 
For the purposes of paragraphs (i)(1) and (2) of this section, a 
security-based swap dealer may use the amount of excess net capital and 
deductions required under paragraphs (c)(1)(vii) and (viii) and 
Appendix A of this section reported in its most recently required filed 
Form X-18A-7 for the purposes of calculating the effect of a projected 
withdrawal, advance or loan relative to excess net capital or 
deductions. The security-based swap dealer must assure itself that the 
excess net capital or the deductions reported on the most recently 
required filed Form X-18A-7 have not materially changed since the time 
such report was filed.
    (ii) The term equity capital includes capital contributions by 
partners, par or stated value of capital stock, paid-in capital in 
excess of par, retained earnings or other capital accounts. The term 
equity capital does not include securities in the securities accounts 
of partners and balances in limited partners' capital accounts in 
excess of their stated capital contributions.
    (iii) Paragraphs (i)(1) and (2) of this section shall not preclude 
a security-based swap dealer from making required tax payments or 
preclude the payment to partners of reasonable compensation, and such 
payments shall not be included in the calculation of withdrawals, 
advances, or loans for purposes of paragraphs (i)(1) and (2) of this 
section.
    (iv) For the purpose of this paragraph (i), any transactions 
between a security-based swap dealer and a stockholder, partner, 
employee or affiliate that results in a diminution of the security-
based swap dealer's net capital shall be deemed to be an advance or 
loan of net capital.
    9. Section 240.18a-1a is added to read as follows:


Sec.  240.18a-1a  Options (Appendix A to 17 CFR 240.18a-1).

    (a)(1) Definitions. The term unlisted option means any option not 
included in the definition of listed option provided in Sec.  240.15c3-
1(c)(2)(x).
    (2) The term option series refers to listed option contracts of the 
same type (either a call or a put) and exercise style, covering the 
same underlying security with the same exercise price, expiration date, 
and number of underlying units.
    (3) The term related instrument within an option class or product 
group refers to futures contracts and options

[[Page 70342]]

on futures contracts covering the same underlying instrument. In 
relation to options on foreign currencies, a related instrument within 
an option class also shall include forward contracts on the same 
underlying currency.
    (4) The term underlying instrument refers to long and short 
positions, as appropriate, covering the same foreign currency, the same 
security, security future, or security-based swap, or a security which 
is exchangeable for or convertible into the underlying security within 
a period of 90 days. If the exchange or conversion requires the payment 
of money or results in a loss upon conversion at the time when the 
security is deemed an underlying instrument for purposes of this 
Appendix A, the security-based swap dealer will deduct from net worth 
the full amount of the conversion loss. The term underlying instrument 
shall not be deemed to include securities options, futures contracts, 
options on futures contracts, qualified stock baskets, or unlisted 
instruments (other than security-based swaps).
    (5) The term options class refers to all options contracts covering 
the same underlying instrument.
    (6) The term product group refers to two or more option classes, 
related instruments, underlying instruments, and qualified stock 
baskets in the same portfolio type (see paragraph (b)(1)(ii) of this 
section) for which it has been determined that a percentage of 
offsetting profits may be applied to losses at the same valuation 
point.
    (b) The deduction under this Appendix A must equal the sum of the 
deductions specified in paragraph (b)(1)(iv)(C) of this section.

Theoretical Pricing Charges

    (1)(i) Definitions. (A) The terms theoretical gains and losses mean 
the gain and loss in the value of individual option series, the value 
of underlying instruments, related instruments, and qualified stock 
baskets within that option's class, at 10 equidistant intervals 
(valuation points) ranging from an assumed movement (both up and down) 
in the current market value of the underlying instrument equal to the 
percentage corresponding to the deductions otherwise required under 
Sec.  240.15c3-1 for the underlying instrument (see paragraph 
(b)(1)(iii) of this section). Theoretical gains and losses shall be 
calculated using a theoretical options pricing model that satisfies the 
criteria set forth in paragraph (b)(1)(i)(B) of this section.
    (B) The term theoretical options pricing model means any 
mathematical model, other than a security-based swap dealer's 
proprietary model, the use of which has been approved by the 
Commission. Any such model shall calculate theoretical gains and losses 
as described in paragraph (b)(1)(i)(A) of this section for all series 
and issues of equity, index and foreign currency options and related 
instruments, and shall be made available equally and on the same terms 
to all security-based swap dealers. Its procedures shall include the 
arrangement of the vendor to supply accurate and timely data to each 
security-based swap dealer with respect to its services, and the fees 
for distribution of the services. The data provided to security-based 
swap dealers shall also contain the minimum requirements set forth in 
paragraphs (b)(1)(iv)(C) of this section and the product group offsets 
set forth in paragraphs (b)(1)(iv)(B) of this section. At a minimum, 
the model shall consider the following factors in pricing the option:
    (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.
    (C) The term major market foreign currency means the currency of a 
sovereign nation for which there is a substantial inter-bank forward 
currency market.
    (D) The term qualified stock basket means a set or basket of stock 
positions which represents no less than 50% of the capitalization for a 
high-capitalization or non-high-capitalization diversified market 
index, or, in the case of a narrow-based index, no less than 95% of the 
capitalization for such narrow-based index.
    (ii) With respect to positions involving listed option positions in 
its proprietary or other account, the security-based swap dealer shall 
group long and short positions into the following portfolio types:
    (A) Equity options on the same underlying instrument and positions 
in that underlying instrument;
    (B) Options on the same major market foreign currency, positions in 
that major market foreign currency, and related instruments within 
those options' classes;
    (C) High-capitalization diversified market index options, related 
instruments within the option's class, and qualified stock baskets in 
the same index;
    (D) Non-high-capitalization diversified index options, related 
instruments within the index option's class, and qualified stock 
baskets in the same index; and
    (E) Narrow-based index options, related instruments within the 
index option's class, and qualified stock baskets in the same index.
    (iii) Before making the computation, each security-based swap 
dealer shall obtain the theoretical gains and losses for each option 
series and for the related and underlying instruments within those 
options' class in the proprietary or other accounts of that security-
based swap dealer. For each option series, the theoretical options 
pricing model shall calculate theoretical prices at 10 equidistant 
valuation points within a range consisting of an increase or a decrease 
of the following percentages of the daily market price of the 
underlying instrument:
    (A) +(-)15% for equity securities with a ready market, narrow-based 
indexes, and non-high-capitalization diversified indexes;
    (B) +(-)6% for major market foreign currencies;
    (C) +(-)20% for all other currencies; and
    (D) +(-)10% for high-capitalization diversified indexes.
    (iv)(A) The security-based swap dealer shall multiply the 
corresponding theoretical gains and losses at each of the 10 
equidistant valuation points by the number of positions held in a 
particular option series, the related instruments and qualified stock 
baskets within the option's class, and the positions in the same 
underlying instrument.
    (B) In determining the aggregate profit or loss for each portfolio 
type, the security-based swap dealer will be allowed the following 
offsets in the following order, provided, that in the case of qualified 
stock baskets, the security-based swap dealer may elect to net 
individual stocks between qualified stock baskets and take the 
appropriate deduction on the remaining, if any, securities:
    (1) First, a security-based swap dealer is allowed the following 
offsets within an option's class:
    (i) Between options on the same underlying instrument, positions 
covering the same underlying instrument, and related instruments within 
the option's class, 100% of a position's gain shall offset another 
position's loss at the same valuation point;

[[Page 70343]]

    (ii) Between index options, related instruments within the option's 
class, and qualified stock baskets on the same index, 95%, or such 
other amount as designated by the Commission, of gains shall offset 
losses at the same valuation point;
    (2) Second, a security-based swap dealer is allowed the following 
offsets within an index product group:
    (i) Among positions involving different high-capitalization 
diversified index option classes within the same product group, 90% of 
the gain in a high-capitalization diversified market index option, 
related instruments, and qualified stock baskets within that index 
option's class shall offset the loss at the same valuation point in a 
different high-capitalization diversified market index option, related 
instruments, and qualified stock baskets within that index option's 
class;
    (ii) Among positions involving different non-high-capitalization 
diversified index option classes within the same product group, 75% of 
the gain in a non-high-capitalization diversified market index option, 
related instruments, and qualified stock baskets within that index 
option's class shall offset the loss at the same valuation point in 
another non-high-capitalization diversified market index option, 
related instruments, and qualified stock baskets within that index 
option's class or product group;
    (iii) Among positions involving different narrow-based index option 
classes within the same product group, 90% of the gain in a narrow-
based market index option, related instruments, and qualified stock 
baskets within that index option's class shall offset the loss at the 
same valuation point in another narrow-based market index option, 
related instruments, and qualified stock baskets within that index 
option's class or product group;
    (iv) No qualified stock basket should offset another qualified 
stock basket; and
    (3) Third, a security-based swap dealer is allowed the following 
offsets between product groups: Among positions involving different 
diversified index product groups within the same market group, 50% of 
the gain in a diversified market index option, a related instrument, or 
a qualified stock basket within that index option's product group shall 
offset the loss at the same valuation point in another product group;
    (C) For each portfolio type, the total deduction shall be the 
larger of:
    (1) The amount for any of the 10 equidistant valuation points 
representing the largest theoretical loss after applying the offsets 
provided in paragraph (b)(1)(iv)(B) if this section; or
    (2) A minimum charge equal to 25% times the multiplier for each 
equity and index option contract and each related instrument within the 
option's class or product group, or $25 for each option on a major 
market foreign currency with the minimum charge for futures contracts 
and options on futures contracts adjusted for contract size 
differentials, not to exceed market value in the case of long positions 
in options and options on futures contracts; plus
    (3) In the case of portfolio types involving index options and 
related instruments offset by a qualified stock basket, there will be a 
minimum charge of 5% of the market value of the qualified stock basket 
for high-capitalization diversified and narrow-based indexes; and
    (4) In the case of portfolio types involving index options and 
related instruments offset by a qualified stock basket, there will be a 
minimum charge of 7\1/2\% of the market value of the qualified stock 
basket for non-high-capitalization diversified indexes.
    (5) In the case of portfolio types involving security futures and 
equity options on the same underlying instrument and positions in that 
underlying instrument, there will be a minimum charge of 25% times the 
multiplier for each security-future and equity option.
    10. Section 240.18a-1b is added to read as follows:


Sec.  240.18a-1b  Adjustments to net worth for certain commodities 
transactions (Appendix B to 17 CFR 240.18a-1).

    (a) Every registered security-based swap dealer in computing net 
capital pursuant to Sec.  240.18a-1 shall comply with the following:
    (1) Where a security-based swap dealer has an asset or liability 
which is treated or defined in paragraph Sec.  240.18a-1, the inclusion 
or exclusion of all or part of such asset or liability for net capital 
shall be in accordance with Sec.  240.18a-1, except as specifically 
provided otherwise in this Appendix B. Where a commodity related asset 
or liability is specifically treated or defined in 17 CFR 1.17 and is 
not generally or specifically treated or defined in Sec.  240.18a-1 or 
this Appendix B, the inclusion or exclusion of all or part of such 
asset or liability for net capital shall be in accordance with 17 CFR 
1.17.
    (2) In computing net capital as defined in paragraph (c)(1) of 
Sec.  240.18a-1, the net worth of a security-based swap dealer shall be 
adjusted as follows with respect to commodity-related transactions:
    (i) Unrealized profit or loss for certain commodities transactions. 
(A) Unrealized profits shall be added and unrealized losses shall be 
deducted in the commodities accounts of the security-based swap dealer, 
including unrealized profits and losses on fixed price commitments and 
forward contracts; and
    (B) The value attributed to any commodity option which is not 
traded on a contract market shall be the difference between the 
option's strike price and the market value for the physical or futures 
contract which is the subject of the option. In the case of a long call 
commodity option, if the market value for the physical or futures 
contract which is the subject of the option is less than the strike 
price of the option, it shall be given no value. In the case of a long 
put commodity option, if the market value for the physical commodity or 
futures contract which is the subject of the option is more than the 
striking price of the option, it shall be given no value.
    (ii) Deduct any unsecured commodity futures or option account 
containing a ledger balance and open trades, the combination of which 
liquidates to a deficit or containing a debit ledger balance only: 
Provided, however, Deficits or debit ledger balances in unsecured 
customers', non-customers' and proprietary accounts, which are the 
subject of calls for margin or other required deposits need not be 
deducted until the close of business on the business day following the 
date on which such deficit or debit ledger balance originated;
    (iii) Deduct all unsecured receivables, advances and loans except 
for:
    (A) Management fees receivable from commodity pools outstanding no 
longer than thirty (30) days from the date they are due;
    (B) Receivables from foreign clearing organizations;
    (C) Receivables from registered futures commission merchants or 
brokers, resulting from commodity futures or option transactions, 
except those specifically excluded under paragraph (a)(2)(ii) of this 
Appendix B.
    (iv) Deduct all inventories (including work in process, finished 
goods, raw materials and inventories held for resale) except for 
readily marketable spot commodities; or spot commodities which 
adequately collateralize indebtedness under 17 CFR 1.17(c)(7);
    (v) Guarantee deposits with commodities clearing organizations are 
not required to be deducted from net worth;

[[Page 70344]]

    (vi) Stock in commodities clearing organizations to the extent of 
its margin value is not required to be deducted from net worth;
    (vii) Deduct from net worth the amount by which any advances paid 
by the security-based swap dealer on cash commodity contracts and used 
in computing net capital exceeds 95 percent of the market value of the 
commodities covered by such contracts.
    (viii) Do not include equity in the commodity accounts of partners 
in net worth.
    (ix) In the case of all inventory, fixed price commitments and 
forward contracts, except for inventory and forward contracts in the 
inter-bank market in those foreign currencies which are purchased or 
sold for further delivery on or subject to the rules of a contract 
market and covered by an open futures contract for which there will be 
no charge, deduct the applicable percentage of the net position 
specified below:
    (A) Inventory which is currently registered as deliverable on a 
contract market and covered by an open futures contract or by a 
commodity option on a physical--No charge.
    (B) Inventory which is covered by an open futures contract or 
commodity option--5% of the market value.
    (C) Inventory which is not covered--20% of the market value.
    (D) Fixed price commitments (open purchases and sales) and forward 
contracts which are covered by an open futures contract or commodity 
option--10% of the market value.
    (E) Fixed price commitments (open purchases and sales) and forward 
contracts which are not covered by an open futures contract or 
commodity option--20% of the market value.
    (x) Deduct for undermargined customer commodity futures accounts 
the amount of funds required in each such account to meet maintenance 
margin requirements of the applicable board of trade or, if there are 
no such maintenance margin requirements, clearing organization margin 
requirements applicable to such positions, after application of calls 
for margin, or other required deposits which are outstanding three 
business days or less. If there are no such maintenance margin 
requirements or clearing organization margin requirements on such 
accounts, then deduct the amount of funds required to provide margin 
equal to the amount necessary after application of calls for margin, or 
other required deposits outstanding three days or less to restore 
original margin when the original margin has been depleted by 50 
percent or more. Provided, To the extent a deficit is deducted from net 
worth in accordance with paragraph (a)(2)(ii) of this Appendix B, such 
amount shall not also be deducted under this paragraph (a)(2)(x). In 
the event that an owner of a customer account has deposited an asset 
other than cash to margin, guarantee or secure his account, the value 
attributable to such asset for purposes of this paragraph shall be the 
lesser of (A) the value attributable to such asset pursuant to the 
margin rules of the applicable board of trade, or (B) the market value 
of such asset after application of the percentage deductions specified 
in paragraph (a)(2)(ix) of this Appendix B or, where appropriate, 
specified in paragraph (c)(1)(iv), (vi), or (vii) of Sec.  240.18a-1 of 
this chapter;
    (xi) Deduct for undermargined non-customer and omnibus commodity 
futures accounts the amount of funds required in each such account to 
meet maintenance margin requirements of the applicable board of trade 
or, if there are no such maintenance margin requirements, clearing 
organization margin requirements applicable to such positions, after 
application of calls for margin, or other required deposits which are 
outstanding two business days or less. If there are no such maintenance 
margin requirements or clearing organization margin requirements, then 
deduct the amount of funds required to provide margin equal to the 
amount necessary after application of calls for margin, or other 
required deposits outstanding two days or less to restore original 
margin when the original margin has been depleted by 50 percent or 
more. Provided, To the extent a deficit is deducted from net worth in 
accordance with paragraph (a)(2)(ii) of this Appendix B such amount 
shall not also be deducted under this paragraph (a)(2)(xi). In the 
event that an owner of a non-customer or omnibus account has deposited 
an asset other than cash to margin, guarantee or secure his account, 
the value attributable to such asset for purposes of this paragraph 
shall be the lesser of (A) the value attributable to such asset 
pursuant to the margin rules of the applicable board of trade, or (B) 
the market value of such asset after application of the percentage 
deductions specified in paragraph (a)(2)(ix) of this Appendix B or, 
where appropriate, specified in paragraph (c)(1)(iv), (vi), or (vii) of 
Sec.  240.18a-1 of this chapter;
    (xii) In the case of open futures contracts and granted (sold) 
commodity options held in proprietary accounts carried by the security-
based swap dealer which are not covered by a position held by the 
security-based swap dealer or which are not the result of a ``changer 
trade'' made in accordance with the rules of a contract market, deduct:
    (A) For a security-based swap dealer which is a clearing member of 
a contract market for the positions on such contract market cleared by 
such member, the applicable margin requirement of the applicable 
clearing organization; (B) For a security-based swap dealer which is a 
member of a self-regulatory organization, 150% of the applicable 
maintenance margin requirement of the applicable board of trade or 
clearing organization, whichever is greater; or
    (C) For all other security-based swap dealers, 200% of the 
applicable maintenance margin requirement of the applicable board of 
trade or clearing organization, whichever is greater; or
    (D) For open contracts or granted (sold) commodity options for 
which there are no applicable maintenance margin requirements, 200% of 
the applicable initial margin requirement; Provided, the equity in any 
such proprietary account shall reduce the deduction required by this 
paragraph (a)(2)(xii) if such equity is not otherwise includable in net 
capital.
    (xiii) In the case of a security-based swap dealer which is a 
purchaser of a commodity option which is traded on a contract market, 
the deduction shall be the same safety factor as if the security-based 
swap dealer were the grantor of such option in accordance with 
paragraph (a)(2)(xii), but in no event shall the safety factor be 
greater than the market value attributed to such option.
    (xiv) In the case of a security-based swap dealer which is a 
purchaser of a commodity option not traded on a contract market which 
has value and such value is used to increase net capital, the deduction 
is ten percent of the market value of the physical or futures contract 
which is the subject of such option but in no event more than the value 
attributed to such option.
    (xv) A loan or advance or any other form of receivable shall not be 
considered ``secured'' for the purposes of paragraph (a)(2) of this 
Appendix B unless the following conditions exist:
    (A) The receivable is secured by readily marketable collateral 
which is otherwise unencumbered and which can be readily converted into 
cash: Provided, however, That the receivable will be considered secured 
only to the extent of the market value of such collateral after 
application of the percentage deductions specified in

[[Page 70345]]

paragraph (a)(2)(ix) of this Appendix B; and
    (B)(1) The readily marketable collateral is in the possession or 
control of the security-based swap dealer; or
    (2) The security-based swap dealer has a legally enforceable, 
written security agreement, signed by the debtor, and has a perfected 
security interest in the readily marketable collateral within the 
meaning of the laws of the State in which the readily marketable 
collateral is located.
    (xvi) The term cover for purposes of this Appendix B shall mean 
cover as defined in 17 CFR 1.17(j).
    (xvii) The term customer for purposes of this Appendix B shall mean 
customer as defined in 17 CFR 1.17(b)(2). The term non-customer for 
purposes of this Appendix B shall mean non-customer as defined in 17 
CFR 1.17(b)(4).
    (b) Every registered security-based swap dealer in computing net 
capital pursuant to Sec.  240.18a-1 shall comply with the following:
    (1) Swaps. Where a swap-related asset or liability is specifically 
treated or defined in 17 CFR 1.17 and is not generally or specifically 
treated or defined in Sec.  240.15c3-1 or this Appendix B, the 
inclusion or exclusion of all or part of such asset or liability for 
net capital shall be in accordance with 17 CFR 1.17.
    (i) Credit default swaps referencing broad-based securities 
indices. (A) Short positions (selling protection). In the case of a 
swap that is a short credit default swap referencing a broad-based 
securities index, deducting the percentage of the notional amount based 
upon the current basis point spread of the credit default swap and the 
maturity of the credit default swap in accordance with the following 
table:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                Basis point spread
                                                         -----------------------------------------------------------------------------------------------
       Length of time to maturity of  CDS contract          100 or less                                                                     700 or more
                                                                (%)        101-300  (%)    301-400  (%)    401-500  (%)    501-699  (%)         (%)
--------------------------------------------------------------------------------------------------------------------------------------------------------
12 months or less.......................................            0.67            1.33            3.33            5.00            6.67           10.00
13 months to 24 months..................................            1.00            2.33            5.00            6.67            8.33           11.67
25 months to 36 months..................................            1.33            3.33            6.67            8.33           10.00           13.33
37 months to 48 months..................................            2.00            4.00            8.33           10.00           11.67           15.00
49 months to 60 months..................................            2.67            4.67           10.00           11.67           13.33           16.67
61 months to 72 months..................................            3.67            5.67           11.67           13.33           15.00           18.33
73 months to 84 months..................................            4.67            6.67           13.33           15.00           16.67           20.00
85 months to 120 months.................................            5.67           10.00           15.00           16.67           18.33           26.67
121 months and longer...................................            6.67           13.33           16.67           18.33           20.00           33.33
--------------------------------------------------------------------------------------------------------------------------------------------------------

     (B) Long positions (purchasing protection). In the case of a swap 
that is a long credit default swap referencing a broad-based securities 
index, deducting 50% of the deduction that would be required by 
paragraph (b)(1)(i)(A) of this Appendix B if the swap was a short 
credit default swap.
    (C) Long and short positions. (1) Long and short credit default 
swaps. In the case of swaps that are long and short credit default 
swaps referencing the same obligor or obligation, that are in the same 
spread category, and that are in the same maturity category or are in 
the next maturity category and have a maturity date within three months 
of the other maturity category, deducting the percentage of the 
notional amount specified in the higher maturity category under 
paragraph (b)(1)(i)(A) of this Appendix B on the excess of the long or 
short position.
    (2) Long basket of obligors and long credit default swap. In the 
case of a swap that is a long credit default swap referencing a broad-
based securities index and the security-based swap dealer is long a 
basket on the same underlying obligors, deducting 50% of the amount 
specified in Sec.  240.15c3-1(c)(2)(vi) for the components of the 
basket, provided the security-based swap dealer can deliver the 
components of the basket to satisfy the obligation of the security-
based swap dealer on the credit default swap.
    (3) Short basket of obligors and short credit default swap. In the 
case of a swap that is a short credit default swap referencing a broad-
based securities index and the security-based swap dealer is short a 
basket on the same underlying obligors, deducting the amount specified 
in Sec.  240.15c3-1(c)(2)(vi) for the components of the basket.
    (2) All other swaps. (i) In the case of any swap that is not a 
credit default swap, deducting the amount calculated by multiplying the 
notional value of the swap by the percentage specified in:
    (A) Sec.  240.15c3-1 applicable to the reference asset if Sec.  
240.15c3-1 specifies a percentage deduction for the type of asset;
    (B) 17 CFR 1.17 applicable to the reference asset if 17 CFR 1.17 
specifies a percentage deduction for the type of asset and Sec.  
240.15c3-1 does not specify a percentage deduction for the type of 
asset; or
    (C) In the case of an interest rate swap, Sec.  240.15c3-
1(c)(2)(vi)(A) based on the maturity of the swap, provided that the 
percentage deduction must be no less than 1%.
    (ii) A security-based swap dealer may reduce the deduction under 
this paragraph (b)(2)(ii) by an amount equal to any reduction 
recognized for a comparable long or short position in the reference 
asset or interest rate under 17 CFR 1.17 or Sec.  240.15c3-1.
    11. Section 240.18a-1c is added to read as follows:


Sec.  240.18a-1c  Consolidated Computations of Net Capital for Certain 
Subsidiaries and Affiliates of Security-Based Swap Dealers (Appendix C 
to 17 CFR 240.18a-1).

    Every security-based swap dealer in computing its net capital 
pursuant to Sec.  240.18a-1 shall include in its computation all 
liabilities or obligations of a subsidiary or affiliate that the 
security-based swap dealer guarantees, endorses, or assumes either 
directly or indirectly.
    12. Section 240.18a-1d is added to read as follows:


Sec.  240.18a-1d  Satisfactory Subordinated Loan Agreements (Appendix D 
to 17 CFR 240.18a-1).

    (a) Introduction. (1) This Appendix sets forth minimum and non-
exclusive requirements for satisfactory subordinated loan agreements. 
The Commission may require or the security-based swap dealer may 
include such other provisions as deemed necessary or appropriate to the 
extent such provisions do not cause the subordinated loan agreement to 
fail to meet the minimum requirements of this Appendix D.
    (2) Certain definitions. For purposes of Sec.  240.18a-1 and this 
Appendix D:
    (i) The term ``subordinated loan agreement'' shall mean the 
agreement or

[[Page 70346]]

agreements evidencing or governing a subordinated borrowing of cash.
    (ii) The term ``Payment Obligation'' shall mean the obligation of a 
security-based swap dealer to repay cash loaned to the security-based 
swap dealer pursuant to a subordinated loan agreement and ``Payment'' 
shall mean the performance by a security-based swap dealer of a Payment 
Obligation.
    (iii) The term ``lender'' shall mean the person who lends cash to a 
security-based swap dealer pursuant to a subordinated loan agreement.
    (b) Minimum requirements for subordinated loan agreements. (1) 
Subject to paragraph (a) of this section, a subordinated loan agreement 
shall mean a written agreement between the security-based swap dealer 
and the lender, which has a minimum term of one year, and is a valid 
and binding obligation enforceable in accordance with its terms 
(subject as to enforcement to applicable bankruptcy, insolvency, 
reorganization, moratorium and other similar laws) against the 
security-based swap dealer and the lender and their respective heirs, 
executors, administrators, successors and assigns.
    (2) Specific amount. All subordinated loan agreements shall be for 
a specific dollar amount which shall not be reduced for the duration of 
the agreement except by installments as specifically provided for 
therein and except as otherwise provided in this Appendix D.
    (3) Effective subordination. The subordinated loan agreement shall 
effectively subordinate any right of the lender to receive any Payment 
with respect thereto, together with accrued interest or compensation, 
to the prior payment or provision for payment in full of all claims of 
all present and future creditors of the security-based swap dealer 
arising out of any matter occurring prior to the date on which the 
related Payment Obligation matures consistent with the provisions of 
Sec.  240.18a-1 and Sec.  240.18a-1d, except for claims which are the 
subject of subordinated loan agreements that rank on the same priority 
as or junior to the claim of the lender under such subordinated loan 
agreements.
    (4) Proceeds of subordinated loan agreements. The subordinated loan 
agreement shall provide that the cash proceeds thereof shall be used 
and dealt with by the security-based swap dealer as part of its capital 
and shall be subject to the risks of the business.
    (5) Certain rights of the security-based swap dealer. The 
subordinated loan agreement shall provide that the security-based swap 
dealer shall have the right to deposit any cash proceeds of a 
subordinated loan agreement in an account or accounts in its own name 
in any bank or trust company;
    (6) Permissive prepayments. A security-based swap dealer at its 
option but not at the option of the lender may, if the subordinated 
loan agreement so provides, make a Payment of all or any portion of the 
Payment Obligation thereunder prior to the scheduled maturity date of 
such Payment Obligation (hereinafter referred to as a ``Prepayment''), 
but in no event may any Prepayment be made before the expiration of one 
year from the date such subordinated loan agreement became effective. 
No Prepayment shall be made, if, after giving effect thereto (and to 
all Payments of Payment Obligations under any other subordinated loan 
agreements then outstanding the maturity or accelerated maturities of 
which are scheduled to fall due within six months after the date such 
Prepayment is to occur pursuant to this provision or on or prior to the 
date on which the Payment Obligation in respect of such Prepayment is 
scheduled to mature disregarding this provision, whichever date is 
earlier) without reference to any projected profit or loss of the 
security-based swap dealer, either its net capital would fall below $24 
million, its net capital would fall below 10% of the risk margin amount 
under Sec.  240.18a-1, or, if the security-based swap dealer is 
approved to calculate net capital under Sec.  240.18a-1(d), its 
tentative net capital would fall to an amount below $120 million. 
Notwithstanding the above, no Prepayment shall occur without the prior 
written approval of the Commission.
    (7) Suspended repayment. The Payment Obligation of the security-
based swap dealer in respect of any subordinated loan agreement shall 
be suspended and shall not mature if, after giving effect to Payment of 
such Payment Obligation (and to all Payments of Payment Obligations of 
such security-based swap dealer under any other subordinated loan 
agreement(s) then outstanding that are scheduled to mature on or before 
such Payment Obligation) either its net capital would fall below $24 
million, its net capital would fall below 10% of the risk margin amount 
under Sec.  240.18a-1, or, if the security-based swap dealer is 
approved to calculate net capital under Sec.  240.18a-1(d), its 
tentative net capital would fall to an amount below $120 million. The 
subordinated loan agreement may provide that if the Payment Obligation 
of the security-based swap dealer thereunder does not mature and is 
suspended as a result of the requirement of this paragraph (b)(7) for a 
period of not less than six months, the security-based swap dealer 
shall thereupon commence the rapid and orderly liquidation of its 
business, but the right of the lender to receive Payment, together with 
accrued interest or compensation, shall remain subordinate as required 
by the provisions of Sec.  240.18a-1 and Sec.  240.18a-1d.
    (8) Accelerated maturity--obligation to repay to remain 
subordinate. (i) Subject to the provisions of paragraph (b)(7) of this 
appendix, a subordinated loan agreement may provide that the lender 
may, upon prior written notice to the security-based swap dealer and 
the Commission given not earlier than six months after the effective 
date of such subordinated loan agreement, accelerate the date on which 
the Payment Obligation of the security-based swap dealer, together with 
accrued interest or compensation, is scheduled to mature to a date not 
earlier than six months after the giving of such notice, but the right 
of the lender to receive Payment, together with accrued interest or 
compensation, shall remain subordinate as required by the provisions of 
Sec. Sec.  240.18a-1 and 240.18a-1d.
    (ii) Notwithstanding the provisions of paragraph (b)(7) of this 
appendix, the Payment Obligation of the security-based swap dealer with 
respect to a subordinated loan agreement, together with accrued 
interest and compensation, shall mature in the event of any 
receivership, insolvency, liquidation, bankruptcy, assignment for the 
benefit of creditors, reorganization whether or not pursuant to the 
bankruptcy laws, or any other marshalling of the assets and liabilities 
of the security-based swap dealer but the right of the lender to 
receive Payment, together with accrued interest or compensation, shall 
remain subordinate as required by the provisions of Sec.  240.18a-1 and 
Sec.  240.18a-1d.
    (9) Accelerated maturity of subordinated loan agreements on event 
of default and event of acceleration--obligation to repay to remain 
subordinate. (i) A subordinated loan agreement may provide that the 
lender may, upon prior written notice to the security-based swap dealer 
and the Commission of the occurrence of any Event of Acceleration (as 
hereinafter defined) given no sooner than six months after the 
effective date of such subordinated loan agreement, accelerate the date 
on which the Payment Obligation of the security-based swap dealer, 
together with accrued interest or compensation, is scheduled to mature,

[[Page 70347]]

to the last business day of a calendar month which is not less than six 
months after notice of acceleration is received by the security-based 
swap dealer and the Commission. Any subordinated loan agreement 
containing such Events of Acceleration may also provide, that if upon 
such accelerated maturity date the Payment Obligation of the security-
based swap dealer is suspended as required by paragraph (b)(7) of this 
Appendix D and liquidation of the security-based swap dealer has not 
commenced on or prior to such accelerated maturity date, then 
notwithstanding paragraph (b)(7) of this appendix the Payment 
Obligation of the security-based swap dealer with respect to such 
subordinated loan agreement shall mature on the day immediately 
following such accelerated maturity date and in any such event the 
Payment Obligations of the security-based swap dealer with respect to 
all other subordinated loan agreements then outstanding shall also 
mature at the same time but the rights of the respective lenders to 
receive Payment, together with accrued interest or compensation, shall 
remain subordinate as required by the provisions of this Appendix D. 
Events of Acceleration which may be included in a subordinated loan 
agreement complying with this paragraph (b)(9) shall be limited to:
    (A) Failure to pay interest or any installment of principal on a 
subordinated loan agreement as scheduled;
    (B) Failure to pay when due other money obligations of a specified 
material amount;
    (C) Discovery that any material, specified representation or 
warranty of the security-based swap dealer which is included in the 
subordinated loan agreement and on which the subordinated loan 
agreement was based or continued was inaccurate in a material respect 
at the time made;
    (D) Any specified and clearly measurable event which is included in 
the subordinated loan agreement and which the lender and the security-
based swap dealer agree:
    (1) Is a significant indication that the financial position of the 
security-based swap dealer has changed materially and adversely from 
agreed upon specified norms; or
    (2) Could materially and adversely affect the ability of the 
security-based swap dealer to conduct its business as conducted on the 
date the subordinated loan agreement was made; or
    (3) Is a significant change in the senior management of the 
security-based swap dealer or in the general business conducted by the 
security-based swap dealer from that which obtained on the date the 
subordinated loan agreement became effective;
    (E) Any continued failure to perform agreed covenants included in 
the subordinated loan agreement relating to the conduct of the business 
of the security-based swap dealer or relating to the maintenance and 
reporting of its financial position; and
    (ii) Notwithstanding the provisions of paragraph (b)(7) of this 
appendix, a subordinated loan agreement may provide that, if 
liquidation of the business of the security-based swap dealer has not 
already commenced, the Payment Obligation of the security-based swap 
dealer shall mature, together with accrued interest or compensation, 
upon the occurrence of an Event of Default (as hereinafter defined). 
Such agreement may also provide that, if liquidation of the business of 
the security-based swap dealer has not already commenced, the rapid and 
orderly liquidation of the business of the security-based swap dealer 
shall then commence upon the happening of an Event of Default. Any 
subordinated loan agreement which so provides for maturity of the 
Payment Obligation upon the occurrence of an Event of Default shall 
also provide that the date on which such Event of Default occurs shall, 
if liquidation of the security-based swap dealer has not already 
commenced, be the date on which the Payment Obligations of the 
security-based swap dealer with respect to all other subordinated loan 
agreements then outstanding shall mature but the rights of the 
respective lenders to receive Payment, together with accrued interest 
or compensation, shall remain subordinate as required by the provisions 
of this Appendix (D). Events of Default which may be included in a 
subordinated loan agreement shall be limited to:
    (A) The net capital of the security-based swap dealer falling to an 
amount below either of $20 million or 8% of the risk margin amount 
under Sec.  240.18a-1, or, if the security-based swap dealer is 
approved to calculate net capital under Sec.  240.18a-1(d), its 
tentative net capital falling below $100 million, throughout a period 
of 15 consecutive business days, commencing on the day the security-
based swap dealer first determines and notifies the Commission, or the 
Commission first determines and notifies the security-based swap dealer 
of such fact;
    (B) The Commission revoking the registration of the security-based 
swap dealer;
    (C) The Commission suspending (and not reinstating within 10 days) 
the registration of the security-based swap dealer;
    (D) Any receivership, insolvency, liquidation, bankruptcy, 
assignment for the benefit of creditors, reorganization whether or not 
pursuant to bankruptcy laws, or any other marshalling of the assets and 
liabilities of the security-based swap dealer. A subordinated loan 
agreement that contains any of the provisions permitted by this 
paragraph (b)(9) shall not contain the provision otherwise permitted by 
paragraph (b)(8)(i) of this section.
    (c) Miscellaneous provisions. (1) Prohibited cancellation. The 
subordinated loan agreement shall not be subject to cancellation by 
either party; no Payment shall be made with respect thereto and the 
agreement shall not be terminated, rescinded or modified by mutual 
consent or otherwise if the effect thereof would be inconsistent with 
the requirements of Sec. Sec.  240.18a-1 and 240.18a-1d.
    (2) Every security-based swap dealer shall immediately notify the 
Commission if, after giving effect to all Payments of Payment 
Obligations under subordinated loan agreements then outstanding that 
are then due or mature within the following six months without 
reference to any projected profit or loss of the security-based swap 
dealer, either its net capital would fall below $24 million, its net 
capital would fall below 10% of the risk margin amount under Sec.  
240.18a-1, or, if the security-based swap dealer is approved to 
calculate net capital under Sec.  240.18a-1(d), its tentative net 
capital would fall to an amount below $120 million.
    (3) Certain legends. If all the provisions of a satisfactory 
subordinated loan agreement do not appear in a single instrument, then 
the debenture or other evidence of indebtedness shall bear on its face 
an appropriate legend stating that it is issued subject to the 
provisions of a satisfactory subordinated loan agreement which shall be 
adequately referred to and incorporated by reference.
    (4) Revolving subordinated loan agreements. A security-based swap 
dealer shall be permitted to enter into a revolving subordinated loan 
agreement that provides for prepayment within less than one year of all 
or any portion of the Payment Obligation thereunder at the option of 
the security-based swap dealer upon the prior written approval of the 
Commission. The Commission, however, shall not approve any prepayment 
if:
    (i) After giving effect thereto (and to all Payments of Payment 
Obligations

[[Page 70348]]

under any other subordinated loan agreements then outstanding, the 
maturity or accelerated maturities of which are scheduled to fall due 
within six months after the date such prepayment is to occur pursuant 
to this provision or on or prior to the date on which the Payment 
Obligation in respect of such prepayment is scheduled to mature 
disregarding this provision, whichever date is earlier) without 
reference to any projected profit or loss of the security-based swap 
dealer, either its net capital would fall below $24 million, its net 
capital would fall below 10% of the risk margin amount under Sec.  
240.18a-1, or, if the security-based swap dealer is approved to 
calculate net capital under Sec.  240.18a-1(d), its tentative net 
capital would fall to an amount below $120 million; or
    (ii) Pre-tax losses during the latest three-month period equaled 
more than 15% of current excess net capital.
    Any subordinated loan agreement entered into pursuant to this 
paragraph (c)(4) shall be subject to all the other provisions of this 
Appendix D. Any such subordinated loan agreement shall not be 
considered equity for purposes of paragraph (h) of Sec.  240.18a-1, 
despite the length of the initial term of the loan.
    (5) Filing. Two copies of any proposed subordinated loan agreement 
(including nonconforming subordinated loan agreements) shall be filed 
at least 30 days prior to the proposed execution date of the agreement 
with the Commission. The security-based swap dealer shall also file 
with the Commission a statement setting forth the name and address of 
the lender, the business relationship of the lender to the security-
based swap dealer, and whether the security-based swap dealer carried 
an account for the lender for effecting transactions in security-based 
swaps at or about the time the proposed agreement was so filed. All 
agreements shall be examined by the Commission prior to their becoming 
effective. No proposed agreement shall be a satisfactory subordinated 
loan agreement for the purposes of this section unless and until the 
Commission has found the agreement acceptable and such agreement has 
become effective in the form found acceptable.
    13. Section 240.18a-2 is added to read as follows:


Sec.  240.18a-2  Capital requirements for major security-based swap 
participants for which there is not a prudential regulator.

    (a) Every major security-based swap participant for which there is 
not a prudential regulator must at all times have and maintain positive 
tangible net worth.
    (b) The term tangible net worth means the net worth of the major 
security-based swap participant as determined in accordance with 
generally accepted accounting principles in the United States, 
excluding goodwill and other intangible assets. In determining net 
worth, all long and short positions in security-based swaps, swaps, and 
related positions must be marked to their market value. A major 
security-based swap participant must include in its computation of 
tangible net worth all liabilities or obligations of a subsidiary or 
affiliate that the participant guarantees, endorses, or assumes either 
directly or indirectly.
    (c) Every major security-based swap participant must comply with 
Sec.  240.15c3-4 as though it were an OTC derivatives dealer with 
respect to its security-based swap and swap activities, except that 
paragraphs (c)(5)(xiii) and (xiv) and (d)(8) and (9) of Sec.  240.15c3-
4 shall not apply.
    14. Section 240.18a-3 is added to read as follows:


Sec.  240.18a-3  Non-cleared security-based swap margin requirements 
for security-based swap dealers and major security-based swap 
participants for which there is not a prudential regulator.

    (a) Every security-based swap dealer and major security-based swap 
participant for which there is not a prudential regulator must comply 
with this section.
    (b) Definitions. For the purposes of this section:
    (1) The term account means an account carried by a security-based 
swap dealer or major security-based swap participant for a counterparty 
that holds non-cleared security-based swaps.
    (2) The term commercial end user means any person (other than a 
natural person) that:
    (i) Engages primarily in commercial activities that are not 
financial in nature and that is not a financial entity as that term is 
defined in 3C(g)(3) of the Act (15 U.S.C. 78o-3(g)(3)); and
    (ii) Is using non-cleared security-based swaps to hedge or mitigate 
risk relating to the commercial activities.
    (3) The term counterparty means a person with whom the security-
based swap dealer or major security-based swap participant has entered 
into a non-cleared security-based swap transaction.
    (4) The term equity means the total current fair market value of 
securities positions in an account of a counterparty (excluding the 
time value of an over-the-counter option), plus any credit balance and 
less any debit balance in the account after applying a qualifying 
netting agreement with respect to gross derivatives payables and 
receivables.
    (5) The term margin means the amount of positive equity in an 
account of a counterparty.
    (6) The term negative equity means equity of less than $0.
    (7) The term positive equity means equity of greater than $0.
    (8) The term non-cleared security-based swap means a security-based 
swap that is not, directly or indirectly, cleared by a clearing agency 
registered pursuant to section 17A of the Act.
    (9) The term security-based swap legacy account means an account 
that holds no security-based swaps entered into after the effective 
date of this section and that only is used to hold security-based swaps 
entered into prior to the effective date of this section and collateral 
for those security-based swaps.
    (c) Margin requirements. (1) Security-based swap dealers. (i) 
Calculation required. A security-based swap dealer must calculate with 
respect to each account of a counterparty as of the close of each 
business day:
    (A) The amount of equity in the account of the counterparty; and
    (B) The margin amount for the account of the counterparty 
calculated pursuant to paragraph (d) of this section.
    (ii) Account equity requirements. Except as provided in paragraph 
(c)(1)(iii) of this section, a security-based swap dealer must collect 
from a counterparty by noon of each business day cash, securities, and/
or money market instruments in an amount at least equal to, as 
applicable:
    (A) The negative equity in the account calculated as of the 
previous business day; and
    (B) The margin amount calculated under paragraph (c)(1)(i)(B) of 
this section as of the previous business day to the extent that amount 
is greater than the amount of positive equity in the account on the 
previous business day.
    (iii) Exceptions. (A) Commercial end users. The requirements of 
paragraph (c)(1)(ii) of this section do not apply to an account of a 
counterparty that is a commercial end user.

Alternative A to Sec.  240.18a-3(c)(1)(iii)(B)

    (B) Security-based swap dealers. The requirements of paragraph 
(c)(1)(ii)(B) of this section do not apply to an account of a 
counterparty that is a security-based swap dealer.

Alternative B to Sec.  240.18a-3(c)(1)(iii)(B)

    (B) Security-based swap dealers. Cash, securities and money market

[[Page 70349]]

instruments posted by a counterparty that is a security-based swap 
dealer to meet the requirements of paragraph (c)(1)(ii)(B) of this 
section must be carried by an independent third-party custodian 
pursuant to the requirements of section 3E(f) of the Act.
    (C) Counterparties that require third-party custodians. The 
requirements of paragraph (c)(1)(ii)(B) of this section do not apply to 
an account of a counterparty that is not a commercial end user and that 
requires the cash, securities, and money market instruments delivered 
to meet the margin amount to be carried by an independent third-party 
custodian pursuant to the requirements of section 3E(f) of the Act, 
provided cash, securities, and money market instruments necessary to 
meet the requirements of paragraph (c)(1)(ii)(B) of this section are 
delivered to the independent third-party custodian.
    (D) Security-based swap legacy accounts. The requirements of 
paragraph (c)(1)(ii)(B) of this section do not apply to a legacy 
security-based swap account of a counterparty that is not a commercial 
end user.
    (2) Major security-based swap participants. (i) Calculation 
required. A major security-based swap participant must calculate as of 
the close of each business day the amount of equity in the account of 
each counterparty.
    (ii) Account equity requirements. Except as provided in paragraph 
(c)(2)(iii) of this section, a major security-based swap participant 
must by noon of each business day:
    (A) Collect from a counterparty cash, securities and/or money 
market instruments in an amount equal to the negative equity in the 
account calculated on the previous business day pursuant to paragraph 
(c)(2)(i) of this section; and
    (B) Deliver to a counterparty cash, securities and/or money market 
instruments in an amount equal to the positive equity in the account 
calculated on the previous business day pursuant to paragraph (c)(2)(i) 
of this section.
    (iii) Exceptions. (A) Transactions with commercial end users. The 
requirements of paragraph (c)(2)(ii)(A) of this section do not apply to 
a counterparty that is a commercial end user.
    (B) Transactions with security-based swap dealers. The requirements 
of paragraph (c)(2)(ii)(A) of this section do not apply to a 
counterparty that is a security-based swap dealer.

    Note to paragraph (c)(2)(iii)(B):  A security-based swap dealer 
must collect from a counterparty that is a major security-based swap 
participant cash, securities, and/or money market instruments as 
required by paragraph (c)(1)(ii) of this section.

    (C) Security-based swap legacy accounts. The requirements of 
paragraph (c)(2)(ii) of this section do not apply to a legacy security-
based swap account of a counterparty that is not a commercial end user.
    (3) Deductions for securities held as collateral. The fair market 
value of securities and money market instruments held in the account of 
a counterparty must be reduced by the amount of the deductions the 
security-based swap dealer would apply to the securities and money 
market instruments pursuant to Sec.  240.15c3-1 or Sec.  240.18a-1, as 
applicable, for the purpose of determining whether the level of equity 
in the account meets the requirement of paragraph (c)(1)(ii) of this 
section.
    (4) Collateral requirements. A security-based swap dealer and a 
major security-based swap participant when calculating the amount of 
equity in the account of a counterparty may take into account cash and 
the fair market value of securities and money market instruments 
pledged and held as collateral in the account provided:
    (i) The collateral is subject to the physical possession or control 
of the security-based swap dealer or the major security-based swap 
participant;
    (ii) The collateral is liquid and transferable;
    (iii) The collateral may be liquidated promptly by the security-
based swap dealer or the major security-based swap participant without 
intervention by any other party;
    (iv) The collateral agreement between the security-based swap 
dealer or the major security-based swap participant and the 
counterparty is legally enforceable by the security-based swap dealer 
or the major security-based swap participant against the counterparty 
and any other parties to the agreement;
    (v) The collateral does not consist of securities issued by the 
counterparty or a party related to the security-based swap dealer, the 
major security-based swap participant, or to the counterparty; and
    (vi) If the Commission has approved the security-based swap 
dealer's use of a VaR model to compute net capital, the approval allows 
the security-based swap dealer to calculate deductions for market risk 
for the type of collateral.
    (5) Qualified netting agreements. A security-based swap dealer or 
major security-based swap participant may include the effect of a 
netting agreement that allows the security-based swap dealer or major 
security-based swap participant to net gross receivables from and gross 
payables to a counterparty upon the default of the counterparty, for 
the purposes of the calculations required pursuant to paragraphs 
(c)(1)(i)(A) and (c)(2)(i) of this section, if:
    (i) The netting agreement is legally enforceable in each relevant 
jurisdiction, including in insolvency proceedings;
    (ii) The gross receivables and gross payables that are subject to 
the netting agreement with a counterparty can be determined at any 
time; and
    (iii) For internal risk management purposes, the security-based 
swap dealer or major security-based swap participant monitors and 
controls its exposure to the counterparty on a net basis.
    (6) Minimum transfer amount. Notwithstanding any other provision of 
this rule, a security-based swap dealer or major security-based swap 
participant is not required to collect or deliver cash, securities or 
money market instruments pursuant to this section with respect to a 
particular counterparty unless and until the total amount of cash, 
securities or money market instruments that is required to be collected 
or delivered, and has not yet been collected or delivered, with respect 
to the counterparty is greater than $100,000.
    (7) Frequency of calculations increased. The calculations required 
pursuant to paragraphs (c)(1)(i) and (c)(2)(i) of this section must be 
made more frequently than the close of each business day during periods 
of extreme volatility and for accounts with concentrated positions.
    (8) Liquidation. A security-based swap dealer and major security-
based swap participant must take prompt steps to liquidate securities 
and money market instruments in an account that does not meet the 
account equity requirements of this section to the extent necessary to 
eliminate the account equity deficiency.
    (d) Calculating margin amount. A security-based swap dealer must 
calculate the margin amount required by paragraph (c)(1)(i)(B) of this 
section for non-cleared security-based swaps as follows:
    (1) Standardized approach. (i) Credit default swaps. For credit 
default swaps, the security-based swap dealer must use the method 
specified in Sec.  240.18a-1(c)(1)(vi)(A) or, if the security-based 
swap dealer is registered with the Commission as a broker or dealer, 
the method specified in Sec.  240.15c3-1(c)(2)(vi)(O)(1).

[[Page 70350]]

    (ii) All other security-based swaps. For security-based swaps other 
than credit default swaps, the security-based swap dealer must use the 
method specified in Sec.  240.18a-1(c)(1)(vi)(B) or, if the security-
based swap dealer is registered with the Commission as a broker or 
dealer, the method specified in Sec.  240.15c3-1(c)(2)(vi)(O)(2).
    (2) Model approach. For security-based swaps other than equity 
security-based swaps, a security-based swap dealer authorized by the 
Commission to compute net capital pursuant to Sec.  240.18a-1(d) or 
Sec.  240.15c3-1e may use its internal market risk model subject to the 
requirements in Sec.  240.18a-1(d) or Sec.  240.15c3-1e in lieu of 
using the methods required in paragraphs (d)(1)(i) and (ii) of this 
section.
    (e) Risk monitoring and procedures. A security-based swap dealer 
must monitor the risk of each account and establish, maintain, and 
document procedures and guidelines for monitoring the risk of accounts 
as part of the risk management control system required by Sec.  
240.15c3-4. The security-based swap dealer must review, in accordance 
with written procedures, at reasonable periodic intervals, its non-
cleared security-based swap activities for consistency with the risk 
monitoring procedures and guidelines required by this section. The 
security-based swap dealer also must determine whether information and 
data necessary to apply the risk monitoring procedures and guidelines 
required by this section are accessible on a timely basis and whether 
information systems are available to adequately capture, monitor, 
analyze, and report relevant data and information. The risk monitoring 
procedures and guidelines must include, at a minimum, procedures and 
guidelines for:
    (1) Obtaining and reviewing account documentation and financial 
information necessary for assessing the amount of current and potential 
future exposure to a given counterparty permitted by the security-based 
swap dealer;
    (2) Determining, approving, and periodically reviewing credit 
limits for each counterparty, and across all counterparties;
    (3) Monitoring credit risk exposure to the security-based swap 
dealer from non-cleared security-based swaps, including the type, 
scope, and frequency of reporting to senior management;
    (4) Using stress tests to monitor potential future exposure to a 
single counterparty and across all counterparties over a specified 
range of possible market movements over a specified time period;
    (5) Managing the impact of credit exposure related to non-cleared 
security-based swaps on the security-based swap dealer's overall risk 
exposure;
    (6) Determining the need to collect collateral from a particular 
counterparty, including whether that determination was based upon the 
creditworthiness of the counterparty and/or the risk of the specific 
non-cleared security-based swap contracts with the counterparty;
    (7) Monitoring the credit exposure resulting from concentrated 
positions with a single counterparty and across all counterparties, and 
during periods of extreme volatility; and
    (8) Maintaining sufficient equity in the account of each 
counterparty to protect against the largest individual potential future 
exposure of a non-cleared security-based swap carried in the account of 
the counterparty as measured by computing the largest maximum possible 
loss that could result from the exposure.
    15. Section 240.18a-4 is added to read as follows:


Sec.  240.18a-4  Segregation requirements for security-based swap 
dealers and major security-based swap participants.

    (a) Definitions. For the purposes of this section:
    (1) The term cleared security-based swap means any security-based 
swap that is, directly or indirectly, submitted to and cleared by a 
clearing agency registered with the Commission pursuant to section 17A 
of the Act (15 U.S.C. 78q-1);
    (2) The term excess securities collateral means securities and 
money market instruments carried for the account of a security-based 
swap customer that have a market value in excess of the current 
exposure of the security-based swap dealer to the customer, excluding:
    (i) Securities and money market instruments held in a qualified 
clearing agency account but only to the extent the securities and money 
market instruments are being used to meet a margin requirement of the 
clearing agency resulting from a security-based swap transaction of the 
customer; and
    (ii) Securities and money market instruments held in a qualified 
registered security-based swap dealer account but only to the extent 
the securities and money market instruments are being used to meet a 
margin requirement of the other security-based swap dealer resulting 
from the security-based swap dealer entering into a non-cleared 
security-based swap transaction with the other security-based swap 
dealer to offset the risk of a non-cleared security-based swap 
transaction between the security-based swap dealer and the customer.
    (3) The term qualified clearing agency account means an account of 
a security-based swap dealer at a clearing agency established to hold 
funds and other property in order to purchase, margin, guarantee, 
secure, adjust, or settle cleared security-based swap transactions for 
the security-based swap customers of the security-based swap dealer 
that meets the following conditions:
    (i) The account is designated ``Special Clearing Account for the 
Exclusive Benefit of the Cleared Security-Based Swap Customers of [name 
of security-based swap dealer]'';
    (ii) The clearing agency has acknowledged in a written notice 
provided to and retained by the security-based swap dealer that the 
funds and other property in the account are being held by the clearing 
agency for the exclusive benefit of the security-based swap customers 
of the security-based swap dealer in accordance with the regulations of 
the Commission and are being kept separate from any other accounts 
maintained by the security-based swap dealer with the clearing agency; 
and
    (iii) The account is subject to a written contract between the 
security-based swap dealer and the clearing agency which provides that 
the funds and other property in the account shall be subject to no 
right, charge, security interest, lien, or claim of any kind in favor 
of the clearing agency or any person claiming through the clearing 
agency, except a right, charge, security interest, lien, or claim 
resulting from a cleared security-based swap transaction effected in 
the account.
    (4) The term qualified registered security-based swap dealer 
account means an account at another security-based swap dealer 
registered with the Commission pursuant to section 15F of the Act that 
is not an affiliate of the security-based swap dealer and that meets 
the following conditions:
    (i) The account is designated ``Special Account for the Exclusive 
Benefit of the Security-Based Swap Customers of [name of security-based 
swap dealer]'';
    (ii) The account is subject to a written acknowledgement by the 
other security-based dealer provided to and retained by the security-
based swap dealer that the funds and other property held in the account 
are being held by the other security-based swap dealer for the 
exclusive benefit of the security-based

[[Page 70351]]

swap customers of the security-based swap dealer in accordance with the 
regulations of the Commission and are being kept separate from any 
other accounts maintained by the security-based swap dealer with the 
other security-based swap dealer;
    (iii) The account is subject to a written contract between the 
security-based swap dealer and the other security-based swap dealer 
which provides that the funds and other property in the account shall 
be subject to no right, charge, security interest, lien, or claim of 
any kind in favor of the other security-based swap dealer or any person 
claiming through the other security-based swap dealer, except a right, 
charge, security interest, lien, or claim resulting from a non-cleared 
security-based swap transaction effected in the account; and
    (iv) The account and the assets in the account are not subject to 
any type of subordination agreement between the security-based swap 
dealer and the other security-based swap dealer.
    (5) The term qualified security means:
    (i) Obligations of the United States;
    (ii) Obligations fully guaranteed as to principal and interest by 
the United States; and
    (iii) General obligations of any State or subdivision of a State 
that:
    (A) Are not traded flat and are not in default;
    (B) Were part of an initial offering of $500 million or greater; 
and
    (C) Were issued by an issuer that has published audited financial 
statements within 120 days of its most recent fiscal year-end.
    (6) The term security-based swap customer means any person from 
whom or on whose behalf the security-based swap dealer has received or 
acquired or holds funds or other property for the account of the person 
with respect to a cleared or non-cleared security-based swap 
transaction. The term does not include a person to the extent that 
person has a claim for funds or other property which by contract, 
agreement or understanding, or by operation of law, is part of the 
capital of the security-based swap dealer or is subordinated to all 
claims of security-based swap customers of the security-based swap 
dealer.
    (7) The term special account for the exclusive benefit of security-
based swap customers means an account at a bank that is not the 
security-based swap dealer or an affiliate of the security-based swap 
dealer and that meets the following conditions:
    (i) The account is designated ``Special Account for the Exclusive 
Benefit of the Security-Based Swap Customers of [name of security-based 
swap dealer]'';
    (ii) The account is subject to a written acknowledgement by the 
bank provided to and retained by the security-based swap dealer that 
the funds and other property held in the account are being held by the 
bank for the exclusive benefit of the security-based swap customers of 
the security-based swap dealer in accordance with the regulations of 
the Commission and are being kept separate from any other accounts 
maintained by the security-based swap dealer with the bank; and
    (iii) The account is subject to a written contract between the 
security-based swap dealer and the bank which provides that the funds 
and other property in the account shall at no time be used directly or 
indirectly as security for a loan or other extension of credit to the 
security-based swap dealer by the bank and, shall be subject to no 
right, charge, security interest, lien, or claim of any kind in favor 
of the bank or any person claiming through the bank.
    (b) Physical possession or control of excess securities collateral. 
(1) A security-based swap dealer must promptly obtain and thereafter 
maintain physical possession or control of all excess securities 
collateral carried for the accounts of security-based swap customers.
    (2) A security-based swap dealer has control of excess securities 
collateral only if the securities and money market instruments:
    (i) Are represented by one or more certificates in the custody or 
control of a clearing corporation or other subsidiary organization of 
either national securities exchanges, or of a custodian bank in 
accordance with a system for the central handling of securities 
complying with the provisions of Sec. Sec.  240.8c-1(g) and 240.15c2-
1(g) the delivery of which certificates to the security-based swap 
dealer does not require the payment of money or value, and if the books 
or records of the security-based swap dealer identify the security-
based swap customers entitled to receive specified quantities or units 
of the securities so held for such security-based swap customers 
collectively;
    (ii) Are the subject of bona fide items of transfer; provided that 
securities and money market instruments shall be deemed not to be the 
subject of bona fide items of transfer if, within 40 calendar days 
after they have been transmitted for transfer by the security-based 
swap dealer to the issuer or its transfer agent, new certificates 
conforming to the instructions of the security-based swap dealer have 
not been received by the security-based swap dealer, the security-based 
swap dealer has not received a written statement by the issuer or its 
transfer agent acknowledging the transfer instructions and the 
possession of the securities or money market instruments, or the 
security-based swap dealer has not obtained a revalidation of a window 
ticket from a transfer agent with respect to the certificate delivered 
for transfer;
    (iii) Are in the custody or control of a bank as defined in section 
3(a)(6) of the Act, the delivery of which securities or money market 
instruments to the security-based swap dealer does not require the 
payment of money or value and the bank having acknowledged in writing 
that the securities and money market instruments in its custody or 
control are not subject to any right, charge, security interest, lien 
or claim of any kind in favor of a bank or any person claiming through 
the bank;
    (iv)(A) Are held in or are in transit between offices of the 
security-based swap dealer; or
    (B) Are held by a corporate subsidiary if the security-based swap 
dealer owns and exercises a majority of the voting rights of all of the 
voting securities of such subsidiary, assumes or guarantees all of the 
subsidiary's obligations and liabilities, operates the subsidiary as a 
branch office of the security-based swap dealer, and assumes full 
responsibility for compliance by the subsidiary and all of its 
associated persons with the provisions of the Federal securities laws 
as well as for all of the other acts of the subsidiary and such 
associated persons; or
    (v) Are held in such other locations as the Commission shall upon 
application from a security-based swap dealer find and designate to be 
adequate for the protection of customer securities.
    (3) Each business day the security-based swap dealer must determine 
from its books and records the quantity of excess securities collateral 
in its possession and control as of the close of the previous business 
day and the quantity of excess securities collateral not in its 
possession and control as of the previous business day. If the 
security-based swap dealer did not obtain possession or control of all 
excess securities collateral on the previous business day as required 
by this section and there are securities or money market instruments of 
the same issue and class in any of the following non-control locations:
    (i) Securities or money market instruments subject to a lien 
securing an obligation of the security-based swap dealer, then the 
security-based swap dealer, not later than the next business

[[Page 70352]]

day on which the determination is made, must issue instructions for the 
release of the securities or money market instruments from the lien and 
must obtain physical possession or control of the securities or money 
market instruments within two business days following the date of the 
instructions;
    (ii) Securities or money market instruments held in a qualified 
clearing agency account, then the security-based swap dealer, not later 
than the next business day on which the determination is made, must 
issue instructions for the release of the securities or money market 
instruments by the clearing agency and must obtain physical possession 
or control of the securities or money market instruments within two 
business days following the date of the instructions;
    (iii) Securities or money market instruments held in a qualified 
registered security-based swap dealer account maintained by another 
security-based swap dealer, then the security-based swap dealer, not 
later than the next business day on which the determination is made, 
must issue instructions for the release of the securities or money 
market instruments by the other security-based swap dealer and must 
obtain physical possession or control of the securities or money market 
instruments within two business days following the date of the 
instructions;
    (iv) Securities or money market instruments loaned by the security-
based swap dealer, then the security-based swap dealer, not later than 
the next business day on which the determination is made, must issue 
instructions for the return of the loaned securities or money market 
instruments and must obtain physical possession or control of the 
securities or money market instruments within five business days 
following the date of the instructions;
    (v) Securities or money market instruments failed to receive more 
than 30 calendar days, then the security-based swap dealer, not later 
than the next business day on which the determination is made, must 
take prompt steps to obtain physical possession or control of the 
securities or money market instruments through a buy-in procedure or 
otherwise;
    (vi) Securities or money market instruments receivable by the 
security-based swap dealer as a security dividend, stock split or 
similar distribution for more than 45 calendar days, then the security-
based swap dealer, not later than the next business day on which the 
determination is made, must take prompt steps to obtain physical 
possession or control of the securities or money market instruments 
through a buy-in procedure or otherwise; or
    (vii) Securities or money market instruments included on the books 
or records of the security-based swap dealer as a proprietary short 
position or as a short position for another person more than 10 
business days (or more than 30 calendar days if the security-based swap 
dealer is a market maker in the securities), then the security-based 
swap dealer must, not later than the business day following the day on 
which the determination is made, take prompt steps to obtain physical 
possession or control of such securities or money market instruments.
    (c) Deposit requirement for special account for the exclusive 
benefit of security-based swap customers. (1) A security-based swap 
dealer must maintain a special account for the exclusive benefit of 
security-based swap customers that is separate from any other bank 
account of the security-based swap dealer. The security-based swap 
dealer must at all times maintain in the special account for the 
exclusive benefit of security-based swap customers, through deposits 
into the account, cash and/or qualified securities in amounts computed 
in accordance with the formula set forth in Sec.  240.18a-4a. In 
determining the amount maintained in a special account for the 
exclusive benefit of security-based swap customers, the security-based 
swap dealer must deduct:
    (i) The percentage of the value of a general obligation of a State 
or subdivision of a State specified in Sec.  240.15c3-1(c)(2)(vi);
    (ii) The aggregate value of general obligations of a State or 
subdivision of a State to the extent the amount of the obligations of a 
single issuer exceeds 2% of the amount required to be maintained in the 
special account for the exclusive benefit of security-based swap 
customers;
    (iii) The aggregate value of all general obligations of a State or 
subdivision of a State to the extent the amount of the obligations 
exceeds 10% of the amount required to be maintained in the special 
account for the exclusive benefit of security-based swap customers; and
    (iv) The amount of funds held at a single bank to the extent the 
amount exceeds 10% of the equity capital of the bank as reported by the 
bank in its most recent Consolidated Reports of Condition and Income.
    (2) It is unlawful for a security-based swap dealer to accept or 
use credits identified in the items of the formula set forth in Sec.  
240.18a-4a except to establish debits for the specified purposes in the 
items of the formula.
    (3) The computations necessary to determine the amount required to 
be maintained in the special account for the exclusive benefit of 
security-based swap customers must be made daily as of the close of the 
previous business day and any deposit required to be made into the 
account must be made on the next business day following the computation 
no later than 1 hour after the opening of the bank that maintains the 
account. The security-based swap dealer may make a withdrawal from the 
special account for the exclusive benefit of security-based swap 
customers only if the amount remaining in the account after the 
withdrawal is equal to or exceeds the amount required to be maintained 
in the account pursuant to paragraph (c)(1) of this section.
    (4) A security-based swap dealer must promptly deposit into a 
special account for the exclusive benefit of security-based swap 
customers funds or qualified securities of the security-based swap 
dealer if the amount of funds and/or qualified securities in one or 
more special accounts for the exclusive benefit of security-based swap 
customers falls below the amount required to be maintained pursuant to 
this section.
    (d) Requirements for non-cleared security-based swaps. (1) Notice. 
A security-based dealer and a major security-based swap participant 
must provide the notice required pursuant to section 3E(f)(1)(A) of the 
Act (15 U.S.C. 78c-5(f)) to a counterparty in writing prior to the 
execution of the first non-cleared security-based swap transaction with 
the counterparty occurring after the effective date of this section.
    (2) Subordination. (i) Counterparty that elects to have individual 
segregation at an independent third-party custodian. A security-based 
swap dealer must obtain an agreement from a counterparty that chooses 
to require segregation of funds or other property pursuant to section 
3E(f) of the Act (15 U.S.C. 78c-5(f)) in which the counterparty agrees 
to subordinate all of its claims against the security-based swap dealer 
to the claims of security-based swap customers of the security-based 
swap dealer but only to the extent that funds or other property 
provided by the counterparty to the independent third-party custodian 
are not treated as customer property as that term is defined in 11 
U.S.C. 741 in a liquidation of the security-based swap dealer.
    (ii) Counterparty that elects to have no segregation. A security-
based swap dealer must obtain an agreement from a

[[Page 70353]]

counterparty that does not choose to require segregation of funds or 
other property pursuant to section 3E(f) of the Act (15 U.S.C. 78c-
5(f)) or paragraph (c)(3) of this section in which the counterparty 
agrees to subordinate all of its claims against the security-based swap 
dealer to the claims of security-based swap customers of the security-
based swap dealer.
    16. Section 240.18a-4a is added to read as follows:

 Rule 18a-4a--Formula for Determining the Amount To Be Maintained in the
    Special Account for the Exclusive Benefit of Security-Based Swap
                                Customers
------------------------------------------------------------------------
                                         Credits             Debits
------------------------------------------------------------------------
1. Free credit balances and other  $--------.........  .................
 credit balances in the accounts
 carried for security-based swap
 customers.
2. Monies borrowed collateralized  $--------.........  .................
 by securities in accounts
 carried for security-based swap
 customers.
3. Monies payable against          $--------.........  .................
 security-based swap customers'
 securities loaned.
4. Security-based swap customers'  $--------.........  .................
 securities failed to receive.
5. Credit balances in firm         $--------.........  .................
 accounts which are attributable
 to principal sales to security-
 based swap customers.
6. Market value of stock           $--------.........  .................
 dividends, stock splits and
 similar distributions receivable
 outstanding over 30 calendar
 days.
7. Market value of short security  $--------.........  .................
 count differences over 30
 calendar days old.
8. Market value of short           $--------.........  .................
 securities and credits (not to
 be offset by longs or by debits)
 in all suspense accounts over 30
 calendar days.
9. Market value of securities      $--------.........  .................
 which are in transfer in excess
 of 40 calendar days and have not
 been confirmed to be in transfer
 by the transfer agent or the
 issuer during the 40 days.
10. Debit balances in accounts     ..................  $--------
 carried for security-based swap
 customers, excluding unsecured
 accounts and accounts doubtful
 of collection.
11. Securities borrowed to         ..................  $--------
 effectuate short sales by
 security-based swap customers
 and securities borrowed to make
 delivery on security-based swap
 customers' securities failed to
 deliver.
12. Failed to deliver of security- ..................  $--------
 based swap customers' securities
 not older than 30 calendar days.
13. Margin required and on         ..................  $--------
 deposit with the Options
 Clearing Corporation for all
 option contracts written or
 purchased in accounts carried
 for security-based swap
 customers.
14. Margin related to security     ..................  $--------
 future products written,
 purchased or sold in accounts
 carried for security-based swap
 customers required and on
 deposit in a qualified clearing
 agency account at a clearing
 agency registered with the
 Commission under section 17A of
 the Act (15 U.S.C. 78q-1) or a
 derivatives clearing
 organization registered with the
 Commodity Futures Trading
 Commission under section 5b of
 the Commodity Exchange Act (7
 U.S.C. 7a-1).
15. Margin related to cleared      ..................  $--------
 security-based swap transactions
 in accounts carried for security-
 based swap customers required
 and on deposit in a qualified
 clearing agency account at a
 clearing agency registered with
 the Commission pursuant to
 section 17A of the Act (15
 U.S.C. 78q-1).
16. Margin related to non-cleared  ..................  $--------
 security-based swap transactions
 in accounts carried for security-
 based swap customers required
 and held in a qualified
 registered security-based swap
 dealer account at another
 security-based swap dealer.
    Total Credits................  $--------.........  .................
    Total Debits.................  ..................  $--------
    Excess of Credits over Debits  $--------.........  .................
------------------------------------------------------------------------

    Note A. Item 1 shall include all outstanding drafts payable to 
security-based swap customers which have been applied against free 
credit balances or other credit balances and shall also include 
checks drawn in excess of bank balances per the records of the 
security-based swap dealer.
    Note B. Item 2 shall include the amount of options-related or 
security futures product-related Letters of Credit obtained by a 
member of a registered clearing agency or a derivatives clearing 
organization which are collateralized by security-based swap 
customers' securities, to the extent of the member's margin 
requirement at the registered clearing agency or derivatives 
clearing organization.
    Note C. Item 3 shall include in addition to monies payable 
against security-based swap customer's securities loaned the amount 
by which the market value of securities loaned exceeds the 
collateral value received from the lending of such securities.
    Note D. Item 4 shall include in addition to security-based swap 
customers' securities failed to receive the amount by which the 
market value of securities failed to receive and outstanding more 
than thirty (30) calendar days exceeds their contract value.
    Note E. (1) Debit balances in accounts shall be reduced by the 
amount by which a specific security (other than an exempted 
security) which is collateral for margin requirements exceeds in 
aggregate value 15 percent of the aggregate value of all securities 
which collateralize all accounts receivable; provided, however, the 
required reduction shall not be in excess of the amount of the debit 
balance required to be excluded because of this concentration rule. 
A specified security is deemed to be collateral for an account only 
to the extent it is not an excess margin security.
    (2) Debit balances in special omnibus accounts, maintained in 
compliance with the requirements of section 4(b) of Regulation T 
under the Act (12 CFR 220.4(b)) or similar accounts carried on 
behalf of another security-based swap dealer, shall be reduced by 
any deficits in such accounts (or if a credit, such credit shall be 
increased) less any calls for margin, marks to the market, or other 
required deposits which are outstanding 5 business days or less.
    (3) Debit balances in security-based swap customers' accounts 
included in the formula under item 10 shall be reduced by an amount 
equal to 1 percent of their aggregate value.
    (4) Debit balances in accounts of household members and other 
persons related to principals of a security-based swap dealer and 
debit balances in cash and margin accounts of affiliated persons of 
a security-based swap dealer shall be excluded from the Reserve 
Formula, unless the security-based swap dealer can demonstrate that 
such debit balances are directly related to credit items in the 
formula.
    (5) Debit balances in accounts (other than omnibus accounts) 
shall be reduced by the amount by which any single security-based 
swap customer's debit balance exceeds 25% (to the extent such amount 
is greater than $50,000) of the broker-dealer's tentative net 
capital (i.e., net capital prior to securities haircuts) unless the 
security-based swap dealer can demonstrate that the debit balance is 
directly related to credit items in the Reserve Formula. Related 
accounts (e.g., the separate accounts of an individual, accounts 
under common control or subject to cross guarantees) shall be deemed 
to be a single security-based swap customer's accounts for purposes 
of this provision.
    If the Commission is satisfied, after taking into account the 
circumstances of the concentrated account including the quality, 
diversity, and marketability of the collateral securing the debit 
balances in accounts subject to this provision, that the 
concentration of debit balances is appropriate, then the Commission 
may, by order, grant a partial or plenary exception from this 
provision.
    The debit balance may be included in the reserve formula 
computation for five

[[Page 70354]]

business days from the day the request is made.
    (6) Debit balances of joint accounts, custodian accounts, 
participations in hedge funds or limited partnerships or similar 
type accounts or arrangements of a person who would be excluded from 
the definition of security-based swap customer (``non-security-based 
swap customer'') which persons includible in the definition of 
security-based swap customer shall be included in the Reserve 
Formula in the following manner: if the percentage ownership of the 
non-security-based swap customer is less than 5 percent then the 
entire debit balance shall be included in the formula; if such 
percentage ownership is between 5 percent and 50 percent then the 
portion of the debit balance attributable to the non-security-based 
swap customer shall be excluded from the formula unless the 
security-based swap dealer can demonstrate that the debit balance is 
directly related to credit items in the formula; if such percentage 
ownership is greater than 50 percent, then the entire debit balance 
shall be excluded from the formula unless the security-based swap 
dealer can demonstrate that the debit balance is directly related to 
credit items in the formula.
    Note F. Item 13 shall include the amount of margin required and 
on deposit with Options Clearing Corporation to the extent such 
margin is represented by cash, proprietary qualified securities, and 
letters of credit collateralized by security-based swap customers' 
securities.
    Note G. (a) Item 14 shall include the amount of margin required 
and on deposit with a clearing agency registered with the Commission 
under section 17A of the Act (15 U.S.C. 78q-1) or a derivatives 
clearing organization registered with the Commodity Futures Trading 
Commission under section 5b of the Commodity Exchange Act (7 U.S.C. 
7a-1) for security-based swap customer accounts to the extent that 
the margin is represented by cash, proprietary qualified securities, 
and letters of credit collateralized by security-based swap 
customers' securities.
    (b) Item 14 shall apply only if the security-based swap dealer 
has the margin related to security futures products on deposit with:
    (1) A registered clearing agency or derivatives clearing 
organization that:
    (i) Maintains security deposits from clearing members in 
connection with regulated options or futures transactions and 
assessment power over member firms that equal a combined total of at 
least $2 billion, at least $500 million of which must be in the form 
of security deposits. For purposes of this Note G, the term 
``security deposits'' refers to a general fund, other than margin 
deposits or their equivalent, that consists of cash or securities 
held by a registered clearing agency or derivative clearing 
organization;
    (ii) Maintains at least $3 billion in margin deposits; or
    (iii) Does not meet the requirements of paragraphs (b)(1)(i) 
through (b)(1)(ii) of this Note G, if the Commission has determined, 
upon a written request for exemption by or for the benefit of the 
security-based swap dealer, that the security-based swap dealer may 
utilize such a registered clearing agency or derivatives clearing 
organization. The Commission may, in its sole discretion, grant such 
an exemption subject to such conditions as are appropriate under the 
circumstances, if the Commission determines that such conditional or 
unconditional exemption is necessary or appropriate in the public 
interest, and is consistent with the protection of investors; and
    (2) A registered clearing agency or derivatives clearing 
organization that, if it holds funds or securities deposited as 
margin for security futures products in a bank, as defined in 
section 3(a)(6) of the Act (15 U.S.C. 78c(a)(6)), obtains and 
preserves written notification from the bank at which it holds such 
funds and securities or at which such funds and securities are held 
on its behalf. The written notification shall state that all funds 
and/or securities deposited with the bank as margin (including 
security-based swap customer security futures products margin), or 
held by the bank and pledged to such registered clearing agency or 
derivatives clearing agency as margin, are being held by the bank 
for the exclusive benefit of clearing members of the registered 
clearing agency or derivatives clearing organization (subject to the 
interest of such registered clearing agency or derivatives clearing 
organization therein), and are being kept separate from any other 
accounts maintained by the registered clearing agency or derivatives 
clearing organization with the bank. The written notification also 
shall provide that such funds and/or securities shall at no time be 
used directly or indirectly as security for a loan to the registered 
clearing agency or derivatives clearing organization by the bank, 
and shall be subject to no right, charge, security interest, lien, 
or claim of any kind in favor of the bank or any person claiming 
through the bank. This provision, however, shall not prohibit a 
registered clearing agency or derivatives clearing organization from 
pledging security-based swap customer funds or securities as 
collateral to a bank for any purpose that the rules of the 
Commission or the registered clearing agency or derivatives clearing 
organization otherwise permit; and
    (3) A registered clearing agency or derivatives clearing 
organization that establishes, documents, and maintains:
    (i) Safeguards in the handling, transfer, and delivery of cash 
and securities;
    (ii) Fidelity bond coverage for its employees and agents who 
handle security-based swap customer funds or securities. In the case 
of agents of a registered clearing agency or derivatives clearing 
organization, the agent may provide the fidelity bond coverage; and
    (iii) Provisions for periodic examination by independent public 
accountants; and
    (4) A derivatives clearing organization that, if it is not 
otherwise registered with the Commission, has provided the 
Commission with a written undertaking, in a form acceptable to the 
Commission, executed by a duly authorized person at the derivatives 
clearing organization, to the effect that, with respect to the 
clearance and settlement of the security-based swap customer 
security futures products of the broker-dealer, the derivatives 
clearing organization will permit the Commission to examine the 
books and records of the derivatives clearing organization for 
compliance with the requirements set forth in Sec.  240.15c3-3a, 
Note G. (b)(1) through (3).
    (c) Item 14 shall apply only if a security-based swap dealer 
determines, at least annually, that the registered clearing agency 
or derivatives clearing organization with which the security-based 
swap dealer has on deposit margin related to security futures 
products meets the conditions of this Note G.

    By the Commission.

    Dated: October 18, 2012.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2012-26164 Filed 11-21-12; 8:45 am]
BILLING CODE 8011-01-P