[Federal Register Volume 77, Number 248 (Thursday, December 27, 2012)]
[Notices]
[Pages 76311-76314]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-31129]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-68498; File No. AN-FICC-2012-09]


Self-Regulatory Organizations; Fixed Income Clearing Corporation; 
Notice of Filing of Advance Notice and Notice of No Objection Relating 
to the Replacement of the Prepayment Component of the Value-at-Risk 
Charge

December 20, 2012.
    Pursuant to Section 806(e)(1) of the Payment, Clearing, and 
Settlement Supervision Act of 2012 (``Clearing Supervision Act'') \1\ 
and Rule 19b-4(n)(1)(i),\2\ notice is hereby given that on November 14, 
2012, the Fixed Income Clearing Corporation (``FICC'') filed

[[Page 76312]]

with the Securities and Exchange Commission (``Commission'') the 
advance notice described in Items I and II below, which Items have been 
prepared primarily by FICC. This publication serves as notice of no 
objection to the advance notice and solicits comments on the advance 
notice from interested persons.
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    \1\ 12 U.S.C. 5465(e)(1).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
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I. Clearing Agency's Statement of the Terms of Substance of the Advance 
Notice

    FICC is proposing to replace the prepayment model component 
(``Prepayment Model Change'') of the Mortgage-Backed Securities 
Division (``MBSD'') Value-at-Risk charge (``VaR Charge'').

II. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Advance Notice

    In its filing with the Commission, FICC included statements 
concerning the purpose of and basis for the advance notice and 
discussed any comments it received on the proposed rule change and 
advance notice. The text of these statements may be examined at the 
places specified in Item IV below. FICC has prepared summaries, set 
forth in sections A and B below, of the most significant aspects of 
such statements.\3\
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    \3\ The Commission has modified the text of the summaries 
prepared by FICC.
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(A) Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Advance Notice

Description of Change
(i) Overview
    A key component of each MBSD clearing member's Required Fund 
Deposit (e.g., margin) is the VaR Charge.\4\ The VaR Charge is based on 
simulating to-be-announced (``TBA'') price returns which are dependent 
on projecting interest rates and prepayment levels. FICC maps TBA 
eligible pools into TBA CUSIPS for cash flow calculations. The cash 
flow of a TBA CUSIP is the sum of all discounted future monthly cash 
flows. The future cash flows include the projected monthly principal 
payment (both scheduled payment and prepayment) and interest rate 
expense on the estimated outstanding balance.
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    \4\ See MBSD Rule 4.
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    The MBSD currently uses a prepayment model developed by the Office 
of Thrift Supervision (``OTS''); this particular model is no longer 
being supported with parameter updates. Therefore, the MBSD is 
proposing to replace the current model it is using with a new one which 
it has developed.
(ii) Structure of the New Model
    The proposed new prepayment model would rely on market-observed 
data that would allow calibration to occur on a regular basis to 
capture the prepayment risk of the mortgage pools underlying the TBAs. 
Model parameters will be updated daily using a rolling window of 252-
day historical two-year swap rates, ten-year swap rates, and mortgage 
current coupons for a given product category.
    The two-year benchmark would allow FICC to estimate the potential 
prepayment impact from refinance opportunities offered by the 
adjustable rate mortgage market. The ten-year swap rate is a standard 
benchmark for fixed rate mortgages. The current coupon rates are 
implied from the TBA market prices. Therefore, the FICC believes that 
the new model will be more responsive to changing market conditions 
than the current prepayment model.
    A key component of any prepayment model is a mortgage rate model 
which estimates the current coupon (the secondary mortgage rate) for 
the TBA mortgage pools under various interest rate scenarios. The 
monthly prepayment speed will be estimated based on intensity function 
based on the refinancing incentive, loan age, and burnout (percentage 
of loans that fail to prepay despite apparent refinance incentives). 
This monthly prepayment speed is used to simulate TBA price returns for 
the VaR Charge component of the MBSD margin calculation. In the OTS 
model, the concept of ``seasonality'' is directly incorporated into the 
prepayment model. The factor is less of a driver of mortgage prepayment 
activity and FICC does not believe that it is necessary to incorporate 
this as a distinct assumption in the new prepayment model. There is a 
minor effect of seasonality through the pool factor.
    During the analysis and design phase of the new prepayment model, 
FICC considered whether to utilize a ``security level'' model versus a 
``loan level'' model. Loan level models focus on loan-to-value ratio, 
credit score, and spread at origination, which are aspects of hedging 
and risk assessment--particularly in evaluating exposure to involuntary 
prepayments (foreclosure, work-outs, etc.) that typically arise beyond 
TBA settlement cycle (less than 90 days). Loan level models are 
generally used by firms that trade and initiate mortgage-backed 
securities. FICC, whose processing activity at the MBSD spans a short 
horizon, chose a security level prepayment model which measures 
security level attributes that can measure short-term prepayment speed, 
i.e., the spread between the current coupon and the TBA coupon, 
seasoning, and average maturity. These are key attributes of voluntary 
prepayments that can impact TBA prices during the settlement cycle. 
FICC's external model validation team concluded that the proposed 
prepayment model is appropriate in measuring short-term prepayment 
speeds.
Anticipated Effect on and Management of Risks
    FICC believes that the proposed Prepayment Model Change will 
enhance the risk management of the positions cleared at the MBSD. 
First, FICC believes that the proposed Prepayment Model Change will 
enhance risk management because the current prepayment model is no 
longer being supported with parameter updates, and thus relies on stale 
information and produces possibly inaccurate results. Second, as part 
of the migration to the new model, several steps were taken to reduce 
the potential risks to FICC and its members, including: validation of 
the proposed model by an external party, back-testing to validate model 
performance and analysis to determine the impact of the changes to the 
VaR requirements for the MBSD Members. Results of FICC's analysis 
indicate that the proposed Prepayment Model Change will be more 
responsive to changing market dynamics and FICC believes it will not 
negatively impact FICC and its members.

(B) Clearing Agency's Statement on Comments on the Advance Notice 
Received From Members, Participants, or Others

    No written comments were solicited or received with respect to the 
proposed change.

III. Date of Effectiveness of the Advance Notice and Timing for 
Commission Action

    The proposed changes contained in the advance notice may be 
implemented pursuant to Section 806(e)(1)(G) of Clearing Supervision 
Act \5\ if the Commission does not object to the proposed changes 
within 60 days of the later of (i) the date that the Commission 
receives the notice of the proposed changes or (ii) the date the 
Commission receives any further information it requests for 
consideration of the notice. The clearing agency shall not implement 
the proposed changes contained in the advance notice if the

[[Page 76313]]

Commission objects to the proposed changes.\6\
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    \5\ 12 U.S.C. 5465(e)(1)(G).
    \6\ 12 U.S.C. 5465(e)(1)(F).
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    The Commission may extend the period for review by an additional 60 
days if the proposed changes raise novel or complex issues, subject to 
the Commission providing the clearing agency with prompt written notice 
of the extension.\7\ Proposed changes may be implemented in fewer than 
60 days from the receipt of the advance notice, or the date the 
Commission receives any further information it requested, if the 
Commission notifies the clearing agency in writing that it does not 
object to the proposed changes and authorizes the clearing agency to 
implement the proposed changes on an earlier date, subject to any 
conditions imposed by the Commission.\8\
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    \7\ 12 U.S.C. 5465(e)(1)(H).
    \8\ 12 U.S.C. 5465(e)(1)(I).
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    The clearing agency shall post notice on its web site of proposed 
changes that are implemented.\9\
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    \9\ 17 CFR 240.19b-4(n)(1)(i).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to [email protected]. Please include 
File Number AN-FICC-2012-09 on the subject line.

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 AN-FICC-2012-09. 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/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the advance notice that are filed 
with the Commission, and all written communications relating to the 
advance notice between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for 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 10:00 a.m. and 
3:00 p.m. Copies of such filings also will be available for inspection 
and copying at the principal office of FICC and on FICC's Web site at 
http://www.dtcc.com/downloads/legal/rule_filings/2012/ficc/FICC-AN-2012-09.pdf.
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number AN-FICC-2012-09 
and should be submitted on or before January 17, 2013.

V. Commission Findings and Notice of No Objection

(A) Standard of Review

    Although Title VIII does not specify a standard that the Commission 
must apply to determine whether to object to an advance notice, the 
Commission believes that the purpose of Title VIII, as stated under 
Section 802(b),\10\ is relevant to the review of advance notices.
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    \10\ 12 U.S.C. 5461(b).
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    The stated purpose of Title VIII is to mitigate systemic risk in 
the financial system and promote financial stability, by (among other 
things) authorizing the Federal Reserve Board to promote uniform risk 
management standards for systemically important FMUs, and providing an 
enhanced role for the Federal Reserve Board in the supervising of risk 
management standards for systemically important FMUs.\11\ Therefore, 
the Commission believes that when reviewing advance notices for FMUs, 
the consistency of an advance notice with Title VIII may be judged 
principally by reference to the consistency of the advance notice with 
applicable rules of the Federal Reserve Board governing payment, 
clearing, and settlement activity of the designated FMU.\12\
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    \11\ 12 U.S.C. 5461(b).
    \12\ See Financial Market Utilities, 77 FR 45907 (Aug. 2, 2012).
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    Section 805(a) requires the Federal Reserve Board and authorizes 
the Commission to prescribe standards for the payment, clearing, and 
settlement activities of FMUs designated as systemically important, in 
consultation with the supervisory agencies. Section 805(b) of the 
Clearing Supervision Act \13\ requires that the objectives and 
principles for the risk management standards prescribed under Section 
805(a) shall be to:
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    \13\ 12 U.S.C. 5464(b).
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     Promote robust risk management;
     Promote safety and soundness;
     Reduce systemic risks; and
     Support the stability of the broader financial system.
    The relevant rules of the Federal Reserve Board prescribing risk 
management standards for designated FMUs by their terms do not apply to 
designated FMUs that are clearing agencies registered with the 
Commission.\14\ Therefore, the Commission believes that the objectives 
and principles by which the Federal Reserve Board is required and the 
Commission is authorized to promulgate such rules, as expressed in 
Section 805(b) of Title VIII,\15\ are the appropriate standards at this 
time by which to evaluate advance notices.\16\ Accordingly, the 
analysis set forth below is organized by reference to the stated 
objectives and principles in Section 805(b).
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    \14\ 12 CFR 234.1(b).
    \15\ 12 U.S.C. 5464(b).
    \16\ The risk management standards that have been adopted by the 
Commission in Rule 17Ad-22 are substantially similar to those of the 
Federal Reserve Board applicable to designated FMUs other than those 
designated clearing organizations registered with the CFTC or 
clearing agencies registered with the Commission. See Clearing 
Agency Standards, Exchange Act Release No. 34-68080 (Oct. 22, 2012). 
To the extent such Commission standards are in effect at the time 
advance notices are reviewed in the future, the standards would be 
relevant to the analysis. Moreover, the analysis of clearing agency 
rule filings under the Exchange Act would incorporate such standards 
directly.
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(B) Discussion of Advance Notice

    The modeling of Prepayment Risk could significantly affect the risk 
management functions of the clearing agency that are related to 
systemic risk. The output of a prepayment model becomes an input into 
the calculation of the VaR Charge, which in turn determines a member's 
required clearing fund deposit. Weaknesses in the model could lead to 
the clearing fund being inappropriately low, and thus exposing the 
clearing agency to greater risk should a member default.
    The OTS Model is no longer supported by parameter updates and has 
not been supported by such updates since December 31, 2011. The current 
model's reliance on stale parameters results in a potentially 
inaccurate determination of the speed of prepayments and thus a 
potentially inaccurate VaR Charge. This lack of calibration makes the 
OTS Model

[[Page 76314]]

unreliable and increases the risk that MBSD is not collecting 
sufficient margin given market conditions. Moving to the FICC Model 
that can be updated as the economic environment changes promotes robust 
risk management and reduces systemic risk because these changes can be 
more accurately reflected in margin calculations.
    The Commission is conditioning its notice of no objection on FICC 
implementing policies and procedures reasonably designed to ensure that 
FICC timely analyzes and monitors the performance and appropriateness 
of the FICC Model. As discussed above, the OTS model directly 
incorporates the concept of seasonality, while the FICC model does not. 
In addition, the FICC model relies on market-observed data to capture 
the prepayment risk of the mortgage pools underlying the TBAs. The 
Commission understands that the OTS and many industry models use 
historical data on actual prepayments to determine the level of 
prepayment risk. The Commission believes it is important for both FICC 
and the Commission to observe how the FICC model compares to actual 
seasonality and prepayment history, two parameters that had previously 
informed the OTS model. As a result, the Commission would expect such 
policies and procedures to assess the performance of the FICC Model as 
compared to other published or calculated prepayment rate forecasts and 
to analyze the VaR coverage resulting from the use of the FICC Model as 
compared to the coverage that would be obtained after applying 
alternate VaR methodologies, such as the index-based haircut 
methodology already utilized by FICC. The Commission expects that this 
analysis would be disseminated to the Commission on a monthly basis.
    The Commission believes that the replacement of the OTS Model with 
the FICC Model, subject to the conditions described above, meets the 
objectives and principles for the risk management standards prescribed 
under Section 805(a). The ability for FICC to update the FICC Model in 
response to changing economic conditions allows FICC to more 
appropriately calculate and collect margin, which better enables FICC 
to respond in the event that a member defaults. This in turn promotes 
robust risk management and safety and soundness, reduces systemic risk 
and supports the stability of the broader financial system.

Conclusion

    It is therefore noticed, pursuant to Section 806(e)(1)(I) of the 
Clearing Supervision Act,\17\ that, the Commission does not object to 
the Prepayment Model Change (File No. AN-FICC-2012-09) and that FICC be 
and hereby is authorized to implement the Prepayment Model Change (File 
No. AN-FICC-2012-09) subject to FICC implementing policies and 
procedures reasonably designed to ensure that FICC timely analyzes and 
monitors the performance and appropriateness of the FICC Model.
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    \17\ 12 U.S.C. 5465(e)(1)(I).

    By the Commission.
Kevin O'Neill,
Deputy Secretary.
[FR Doc. 2012-31129 Filed 12-26-12; 8:45 am]
BILLING CODE 8011-01-P