[Federal Register Volume 85, Number 73 (Wednesday, April 15, 2020)]
[Notices]
[Pages 21037-21047]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-07896]


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

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-88615; File No. SR-NSCC-2020-802]


Self-Regulatory Organizations; National Securities Clearing 
Corporation; Notice of Filing of Advance Notice To Enhance National 
Securities Clearing Corporation's Haircut-Based Volatility Charge 
Applicable to Illiquid Securities and UITs and Make Certain Other 
Changes to Procedure XV

April 9, 2020.
    Pursuant to Section 806(e)(1) of Title VIII of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act entitled the Payment, 
Clearing, and Settlement Supervision Act of 2010 (``Clearing 
Supervision Act'') \1\ and Rule 19b-4(n)(1)(i) under the Securities 
Exchange Act of 1934 (``Act''),\2\ notice is

[[Page 21038]]

hereby given that on March 16, 2020, National Securities Clearing 
Corporation (``NSCC'') filed with the Securities and Exchange 
Commission (``Commission'') the advance notice SR-NSCC-2020-802 
(``Advance Notice'') as described in Items I, II and III below, which 
Items have been prepared by the clearing agency.\3\ The Commission is 
publishing this notice to solicit comments on the Advance Notice from 
interested persons.
---------------------------------------------------------------------------

    \1\ 12 U.S.C. 5465(e)(1).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ On January 28, 2020, NSCC filed this Advance Notice as a 
proposed rule change (SR-NSCC-2020-003) with the Commission pursuant 
to Section 19(b)(1) of the Act, 15 U.S.C. 78s(b)(1), and Rule 19b-4 
thereunder, 17 CFR 240.19b-4. A copy of the proposed rule change is 
available at http://www.dtcc.com/legal/sec-rule-filings.aspx.
---------------------------------------------------------------------------

I. Clearing Agency's Statement of the Terms of Substance of the Advance 
Notice

    This Advance Notice consists of modifications to NSCC's Rules & 
Procedures (``Rules'') \4\ in order to enhance the calculation of 
certain components of the Clearing Fund formula. First, the proposed 
rule change would clarify and enhance the methodology for identifying 
securities as illiquid for purposes of determining the applicable 
calculation of the volatility component of the Clearing Fund formula, 
and would revise the definition of ``Illiquid Security'' in the Rules 
to reflect these changes.\5\ Second, the proposed rule change would 
enhance the calculation of the haircut-based volatility component of 
the Clearing Fund formula that is applied to positions in (1) Illiquid 
Securities (which include securities that are priced at less than a 
penny (``sub-penny securities'') and initial public offerings 
(``IPOs'')), and (2) unit investment trusts (``UITs''). Third, the 
proposed rule change would eliminate the existing Illiquid Charge, as 
the risk it was designed to address would be addressed by the other 
enhancements being proposed. Finally, NSCC would make certain changes 
to Section I.(A) of Procedure XV (Clearing Fund Formula and Other 
Matters) of the Rules (``Procedure XV'') \6\ for greater transparency. 
Each of these proposed changes are described in greater detail below.
---------------------------------------------------------------------------

    \4\ Capitalized terms not defined herein are defined in the 
Rules, available at http://dtcc.com/~/media/Files/Downloads/legal/
rules/nscc_rules.pdf.
    \5\ See Rule 1 (Definitions and Descriptions). Id.
    \6\ Procedure XV, supra note 4.
---------------------------------------------------------------------------

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

    In its filing with the Commission, the clearing agency included 
statements concerning the purpose of and basis for the Advance Notice 
and discussed any comments it received on the Advance Notice. The text 
of these statements may be examined at the places specified in Item IV 
below. The clearing agency has prepared summaries, set forth in 
sections A and B below, of the most significant aspects of such 
statements.

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

    NSCC has not received or solicited any written comments relating to 
this proposal. NSCC will notify the Commission of any written comments 
received by NSCC.

(B) Advance Notice Filed Pursuant to Section 806(e) of the Clearing 
Supervision Act

Description of Proposed Changes
    NSCC is proposing a number of enhancements to its methodology for 
calculations of certain components of the Clearing Fund. First, NSCC is 
proposing to (1) clarify and improve the transparency and use of the 
term ``Illiquid Security'' for purposes of determining the applicable 
calculation of the volatility component of the Clearing Fund formula to 
Net Unsettled Positions in those securities, and (2) enhance the 
methodology used in this term by including additional criteria.\7\ 
Specifically, certain criteria relating to listing national securities 
exchanges would continue to be utilized and would be enhanced and 
described with greater clarity and transparency under the proposed 
changes. In addition, NSCC would (i) add securities' market 
capitalization and a median illiquidity ratio, as described in greater 
detail below, as additional measurements of liquidity and (ii) remove 
the references to OTC Bulletin Board and OTC Link issue. NSCC would 
revise the definition of ``Illiquid Security'' in the Rules to reflect 
these enhancements.
---------------------------------------------------------------------------

    \7\ ``Net Unsettled Positions'' and ``Net Balance Order 
Unsettled Positions'' refer to net positions that have not yet 
passed their settlement date, or did not settle on their settlement 
date, and are referred to collectively in this filing as Net 
Unsettled Positions. NSCC does not take into account any offsets, 
such as inventory held at other clearing agencies, when determining 
Net Unsettled Positions for the purpose of calculating the 
volatility component. See Procedure XV, supra note 4.
---------------------------------------------------------------------------

    Second, NSCC would enhance the calculation of the haircut-based 
volatility component of the Clearing Fund methodology for Net Unsettled 
Positions in securities whose volatility is less amenable to 
statistical analysis and securities whose volatility is amenable to 
generally accepted statistical analysis only in a complex manner. 
Currently, NSCC uses a fixed percentage in the calculation of charges 
for Net Unsettled Positions in each of these securities.\8\ NSCC would 
modify these calculations by adding two specific categories for 
Illiquid Securities (as newly defined pursuant to the proposed changes) 
and UITs. For Illiquid Securities, NSCC would apply a percentage that 
is based on the applicable security's price level and for both Illiquid 
Securities and UITs, NSCC would recalculate the applicable percentages 
applied to such securities at least annually. NSCC would retain the 
existing general categories for securities whose volatility is less 
amenable to statistical analysis and securities whose volatility is 
amenable to generally accepted statistical analysis only in a complex 
manner for securities that fall within those descriptions but that are 
not Illiquid Securities or UITs, and would continue to apply a fixed 
percentage to such securities.
---------------------------------------------------------------------------

    \8\ See Section I.(A)(1)(a)(ii) and Section I.(A)(2)(a)(ii) of 
Procedure XV, supra note 4.
---------------------------------------------------------------------------

    Third, NSCC would eliminate the existing Illiquid Charge. The 
Illiquid Charge was designed to cover the risk that NSCC may be unable 
to easily liquidate Net Unsettled Positions in Illiquid Securities in 
the event of a Member default due to the securities' lack of 
marketability and other characteristics. This risk would be addressed 
by the enhanced criteria for identifying Illiquid Securities, and the 
enhanced calculation of the applicable haircut-based volatility charge 
proposed by this filing. Therefore, NSCC believes the Illiquid Charge 
would no longer be needed to address these risks. In connection with 
this proposed change, NSCC would also remove the definition of 
``Illiquid Position'' from the Rules, as this term is only used in 
connection with the calculation of the Illiquid Charge.
    Finally, NSCC would provide greater detail to describe the 
treatment of Net Unsettled Positions in corporate and municipal bonds 
and long Net Unsettled Positions in Family-Issued Securities in Section 
I.(A) of Procedure XV for greater transparency.
    Each of the proposed changes is described in more detail below.
(i) Overview of the Required Fund Deposit and NSCC's Clearing Fund
    As part of its market risk management strategy, NSCC manages its 
credit exposure to Members by determining the appropriate Required Fund 
Deposits

[[Page 21039]]

to the Clearing Fund and monitoring its sufficiency, as provided for in 
the Rules.\9\ The Required Fund Deposit serves as each Member's margin. 
The objective of a Member's Required Fund Deposit includes mitigation 
of potential losses to NSCC associated with liquidation of the Member's 
portfolio in the event NSCC ceases to act for that Member (hereinafter 
referred to as a ``default'').\10\ The aggregate of all Members' 
Required Fund Deposits, together with certain other deposits required 
under the Rules, constitutes the Clearing Fund of NSCC, which it would 
access, among other instances, should a defaulting Member's own 
Required Fund Deposit be insufficient to satisfy losses to NSCC caused 
by the liquidation of that Member's portfolio.
---------------------------------------------------------------------------

    \9\ See Rule 4 (Clearing Fund) and Procedure XV (Clearing Fund 
Formula and Other Matters), supra note 4. NSCC's market risk 
management strategy is designed to comply with Rules 17Ad-22(e)(4) 
and (e)(6) under the Securities Exchange Act of 1934, where these 
risks are referred to as ``credit risks.'' 17 CFR 240.17Ad-22(e)(4) 
(e)(6).
    \10\ The Rules identify when NSCC may cease to act for a Member 
and the types of actions NSCC may take. For example, NSCC may 
suspend a firm's membership with NSCC or prohibit or limit a 
Member's access to NSCC's services in the event that Member defaults 
on a financial or other obligation to NSCC. See Rule 46 
(Restrictions on Access to Services) of the Rules, supra note 4.
---------------------------------------------------------------------------

    Pursuant to the Rules, each Member's Required Fund Deposit amount 
consists of a number of applicable components, each of which is 
calculated to address specific risks faced by NSCC, as identified 
within Procedure XV.\11\ Generally, the largest component of Members' 
Required Fund Deposits is the volatility component. The volatility 
component is designed to calculate the amount of money that could be 
lost on a portfolio over a given period of time assumed necessary to 
liquidate the portfolio, within a 99% confidence level.
---------------------------------------------------------------------------

    \11\ See Procedure XV, supra note 4.
---------------------------------------------------------------------------

    NSCC has two methodologies for calculating the volatility 
component. For the majority of Net Unsettled Positions, NSCC calculates 
the volatility component as the greater of (1) the larger of two 
separate calculations that utilize a parametric Value at Risk (``VaR'') 
model, (2) a gap risk measure calculation based on the concentration 
threshold of the largest non-index position in a portfolio, and (3) a 
portfolio margin floor calculation based on the market values of the 
long and short positions in the portfolio (``VaR Charge'').\12\ 
Pursuant to Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure 
XV, certain Net Unsettled Positions are excluded from the calculation 
of the VaR Charge and are instead charged a haircut-based volatility 
component that is calculated by multiplying the absolute value of the 
position by a percent determined by NSCC that is (i) not less than 10% 
for securities whose volatility is less amenable to statistical 
analysis and (ii) not less than 2% for securities whose volatility is 
amenable to generally accepted statistical analysis only in a complex 
manner.\13\ Generally, certain equity securities, including Illiquid 
Securities, fall within the first category as securities whose 
volatility is less amenable to statistical analysis and fixed-income 
securities, including UITs, fall within the second category as 
securities whose volatility is amenable to generally accepted 
statistical analysis only in a complex manner.\14\ The securities that 
fall within either one of these categories tend to exhibit 
unpredictable illiquid characteristics, such as low trading volumes or 
infrequent trading. Because the VaR Charge is a model-based 
calculation, which generally relies on predictability, this charge may 
be less reliable for measuring market risk of securities that exhibit 
unpredictable illiquid characteristics.\15\ Therefore, NSCC believes 
that the haircut-based volatility charge is a more appropriate measure 
of volatility for Net Unsettled Positions in these securities.
---------------------------------------------------------------------------

    \12\ See Sections I.(A)(1)(a)(i) and I.(A)(2)(a)(i) of Procedure 
XV, supra note 4.
    \13\ Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure 
XV, supra note 4.
    \14\ UITs are redeemable securities, or units, issued by 
investment companies that offer fixed security portfolios for a 
defined period of time.
    \15\ More specifically, the model that is used to calculate the 
VaR Charge relies on assumptions that are based on historic 
observations of a security's price. Such assumptions are not 
reliable predictors of price for securities that exhibit illiquid 
characteristics, which generally have low trading volumes or are 
infrequently traded.
---------------------------------------------------------------------------

    In addition to charging a haircut-based volatility component rather 
than a VaR Charge for certain Illiquid Securities, Members' Required 
Fund Deposits may also include an Illiquid Charge, which is calculated 
as described in Sections I.(A)(1)(h) and I.(A)(2)(f) of Procedure 
XV.\16\ The Illiquid Charge is a component of the Clearing Fund that 
may be assessed with respect to ``Illiquid Positions,'' which are Net 
Unsettled Positions in ``Illiquid Securities'' that exceed applicable 
volume thresholds, as described in the definition of Illiquid Position 
in Rule 1 of the Rules.\17\ The Illiquid Charge is designed to mitigate 
the risk that NSCC may face when liquidating Net Unsettled Positions in 
these securities following a Member default.
---------------------------------------------------------------------------

    \16\ Sections I.(A)(1)(h) and I.(A)(2)(f) of Procedure XV, supra 
note 4.
    \17\ Rule 1, supra note 4.
---------------------------------------------------------------------------

    Currently, an Illiquid Security is defined in the Rules as ``a 
security, other than a family-issued security as defined in Procedure 
XV, that either (i) is not traded on or subject to the rules of a 
national securities exchange registered under [the Act]; or (ii) is an 
OTC Bulletin Board \18\ or OTC Link issue.'' \19\
---------------------------------------------------------------------------

    \18\ The OTC Bulletin Board is an interdealer quotation system 
that is used by subscribing members of the Financial Industry 
Regulatory Authority (``FINRA'') to reflect market making interest 
in eligible securities (as defined in FINRA's Rules). See http://www.finra.org/industry/otcbb/otc-bulletin-board-otcbb.
    \19\ OTC Link is an electronic inter-dealer quotation system 
that displays quotes from broker-dealers for many over-the-counter 
securities. See https://www.otcmarkets.com.
---------------------------------------------------------------------------

    NSCC regularly assesses its market and credit risks, as such risks 
are related to its margining methodologies, to evaluate whether margin 
levels are commensurate with the particular risk attributes of each 
relevant product, portfolio, and market.\20\ The proposed changes 
described below are a result of NSCC's regular review of the 
effectiveness of its margining methodology.
---------------------------------------------------------------------------

    \20\ See 17 CFR 240.17Ad-22(e)(6)(i), (e)(6)(vi).
---------------------------------------------------------------------------

(ii) Proposed Enhancements to the Definition of Illiquid Security
    NSCC is proposing to revise the Rules to (1) enhance certain 
existing criteria used in the definition of Illiquid Security for 
purposes of determining the applicable calculation of the volatility 
component; (2) remove certain criteria that would become unnecessary 
following the proposed enhancements; (3) enhance the definition by 
introducing additional criteria; and (4) repurpose the enhanced 
definition of Illiquid Security to use with respect to the calculation 
of the volatility component, as described below. NSCC believes that the 
proposed changes would provide Members with improved clarity and 
transparency into the methodology used to apply this definition. The 
proposed change would also provide NSCC with additional measures of a 
security's liquidity to improve its ability to apply margin that 
reflects the risk characteristics of that security.
    Following the implementation of the proposed enhancements to this 
definition, as described below, the definition of Illiquid Security in 
Rule 1 of the Rules would be a security that: (i) Is not listed on a 
specified securities exchange (defined below) as determined on a daily 
basis; (ii) is listed on a specified securities exchange and, as

[[Page 21040]]

determined on a monthly basis, (a)(I) its market capitalization is 
considered a micro-capitalization (as described below) as of the last 
business day of the prior month or (II) it is an American depositary 
receipt (``ADR''); and (b) the median of its calculated illiquidity 
ratio (defined below) of the prior six months exceeds a threshold that 
would be determined by NSCC on a monthly basis and is based on the 99th 
percentile of the illiquidity ratio of non-micro-capitalization common 
stocks \21\ over the prior six months; or (iii) is listed on a 
specified securities exchange, and, as determined on a monthly basis, 
has fewer than 31 business days of trading history over the past 153 
business days on such exchange. As discussed above, because the VaR 
Charge is a model-based calculation, which generally relies on 
predictability, the VaR Charge may be less reliable for measuring 
market risk of securities that exhibit unpredictable illiquid 
characteristics.\22\ Each of the types of securities that would be in 
the definition of Illiquid Security are securities that tend to exhibit 
unpredictable illiquid characteristics including limited trading 
volumes or infrequent trading.
---------------------------------------------------------------------------

    \21\ Securities that are exchange-traded products (``ETPs'') or 
ADRs would not be included when calculating the illiquidity ratio 
threshold. ETPs are not included when calculating the illiquidity 
ratio threshold because the underlying common stocks that comprise 
the indexes of equity ETPs are included in the calculation. ADRs are 
not included when calculating the illiquidity ratio threshold 
because the market capitalization of ADRs may be difficult to 
calculate because each ADR often converts to different number of 
shares of a local security. In addition, if NSCC is unable to 
retrieve data to calculate the illiquidity ratio for the median 
illiquidity ratio for a security on any day, NSCC would use a 
default value for that day for purposes of the calculation for the 
security (i.e., the security would essentially be treated as 
illiquid for that day).
    \22\ See supra note 15.
---------------------------------------------------------------------------

    For purposes of this definition a ``specified securities exchange'' 
would be a national securities exchange that has established listing 
services and is covered by industry pricing and data vendors.\23\ 
Initially, NSCC would define micro-capitalization as capitalization of 
less than $300 million. Consistent with generally prevailing views, 
NSCC believes that given the lack of public information and limited 
trading volumes, securities with capitalization below this threshold 
tend to involve higher risks and exhibit illiquid characteristics.\24\ 
NSCC may adjust this definition from time to time as appropriate in 
order to continue to reflect a threshold that captures securities with 
capitalization that would indicate that the securities exhibit illiquid 
characteristics. Changes to the micro-capitalization threshold would be 
subject to NSCC's model risk management governance procedures set forth 
in the Clearing Agency Model Risk Management Framework (``Model Risk 
Management Framework'').\25\ NSCC would notify Members of changes to 
the micro-capitalization threshold by important notice. For purposes of 
the definition of Illiquid Security, the ``illiquidity ratio'' of a 
security on any day would be equal to (i) the price return of such 
security on such day (based on the natural logarithm of the ratio 
between the closing price of the stock on such day to the closing price 
of the stock on the prior trading day) divided by (ii) the average 
daily trading amount \26\ of such security over the prior 20 business 
days.\27\
---------------------------------------------------------------------------

    \23\ The exchanges that would initially be specified securities 
exchanges are: New York Stock Exchange LLC, NYSE American LLC, NYSE 
Arca, Inc., The Nasdaq Stock Market and Cboe BZX Exchange, Inc.
    \24\ See, e.g., https://www.sec.gov/reportspubs/investor-publications/investorpubsmicrocapstockhtm.html.
    \25\ See Securities Exchange Act Release No. 81485 (August 25, 
2017), 82 FR 41433 (August 31, 2017) (File No. SR-NSCC-2017-008) 
(describes the adoption of the Model Risk Management Framework of 
NSCC which sets forth the model risk management practices of NSCC) 
and Securities Exchange Act Release No. 84458 (October 19, 2018), 83 
FR 53925 (October 25, 2018) (File No. SR-NSCC-2018-009) (amends the 
Model Risk Management Framework). The Model Risk Management 
Framework describes the model management practices adopted by NSCC, 
which have been designed to assist NSCC in identifying, measuring, 
monitoring, and managing the risks associated with the design, 
development, implementation, use, and validation of ``models'' which 
would include the methodology for determining the volatility 
component of the Clearing Fund. Id.
    \26\ The daily trading amount equals the daily trading volume 
multiplied by the end-of-day price.
    \27\ NSCC believes that the 20-business day period is sufficient 
to reflect recent market activity for the security.
---------------------------------------------------------------------------

(a) Enhancements to the Existing Criteria in the Definition of Illiquid 
Security
    NSCC is proposing to enhance existing criteria in the definition of 
Illiquid Security as set forth below.
    In the current definition, an Illiquid Security is a security that 
is ``either (i) not traded or subject to the rules of a national 
securities exchange registered under the Securities Exchange Act of 
1934, as amended; or (ii) is an OTC Bulletin Board or OTC Link issue.'' 
\28\ On a daily basis, NSCC receives from third party vendors data 
relating to securities processed through NSCC which indicates the 
exchanges, if any, on which each security is listed. If a security is 
not listed on of one of the national securities exchanges covered by 
the third party vendors, then, currently, NSCC would consider that 
security an Illiquid Security for the purpose of calculating the 
Illiquid Charge.\29\ Based on historic performances, NSCC believes the 
national securities exchanges that the vendors cover for this purpose 
are appropriate for determining if a security exhibits characteristics 
of liquidity because such exchanges have established listing services 
and are covered by industry pricing and data vendors. NSCC believes 
that such exchanges tend to list securities that exhibit liquid 
characteristics such as having more available public information, 
larger trading volumes and higher capitalization. NSCC continues to 
believe this analysis is appropriate for identifying securities that 
exhibit illiquid characteristics, and would retain and enhance this 
criterion in the definition in the Rules by specifying that it uses the 
specified securities exchanges that have established listing services 
and that are covered by industry pricing and data vendors and providing 
that it would determine on a daily basis whether securities are subject 
to the rules of a specified securities exchange.
---------------------------------------------------------------------------

    \28\ See Rule 1, supra, note 4.
    \29\ The exchanges that have established listing services that 
the vendors cover for this purpose are: New York Stock Exchange LLC, 
NYSE American LLC, NYSE Arca, Inc., The Nasdaq Stock Market and Cboe 
BZX Exchange, Inc. Members' Clearing Fund Summary reports, available 
through the DTCC Risk Portal, identify securities within their 
portfolio by the ticker symbol and whether those securities are 
considered Illiquid Securities for purposes of the calculation of 
the Illiquid Charge. This information provides Members with insight 
into the basis for their margin calculations.
---------------------------------------------------------------------------

    NSCC would use the same process for determining whether a security 
is an Illiquid Security based on if such security is listed on a 
national security exchange and would enhance the definition to reflect 
the process that will be used. NSCC would change ``national securities 
exchange registered under the Securities Exchange Act of 1934, as 
amended'' to ``specified securities exchange'' in the definition of 
Illiquid Security and add a defined term for ``specified securities 
exchange'', which would be a national securities exchange that has 
established listing services and is covered by industry pricing and 
data vendors.
    As a further enhancement, NSCC is proposing to replace the phrase 
``not traded on or subject to the rules of'' with ``not listed on'' to 
more accurately describe the process that NSCC and its vendors use to 
determine if a security is on a national securities exchange. In 
addition, determining whether a security is listed on an exchange is 
more definitive and more reliably verifiable

[[Page 21041]]

than determining whether a security is traded on or subject to the 
rules of a securities exchange. NSCC is also proposing to remove 
references to the OTC Bulletin Board and OTC Link issues in the 
definition of Illiquid Security. NSCC believes that the definition as 
revised pursuant to this rule change would capture securities listed on 
the OTC Bulletin Board and OTC Link and the reference to such platforms 
is unnecessary.
    NSCC is also proposing to remove the phrase ``other than a family 
issued security as defined in Procedure XV'' from the definition of 
Illiquid Security because family issued security is not defined in 
Procedure XV and, given the new proposed use of the definition of 
Illiquid Security together with other proposed changes, it is not 
necessary to exclude Family-Issued Securities from the definition. The 
current defined term ``Illiquid Security'' is only used in the defined 
term ``Illiquid Position'' and in sections relating to the Illiquid 
Charge which would be removed pursuant to the proposed changes as 
described herein. The phrase ``other than a family issued security as 
defined in Procedure XV'' was intended to ensure that long Net 
Unsettled Positions in Family-Issued Securities are excluded from the 
Illiquid Charge.\30\ Currently, short Net Unsettled Positions in 
Family-Issued Securities whose volatility is less amenable to 
statistical analysis are subject to the haircut set forth in Sections 
I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure XV. In addition, short 
Net Unsettled Positions in Family-Issued Securities that are Illiquid 
Positions are currently subject to the Illiquid Charge.\31\ Long Net 
Unsettled Positions in Family Issued Securities are not subject to the 
haircut set forth Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of 
Procedure XV nor to the Illiquid Charge.
---------------------------------------------------------------------------

    \30\ Long Net Unsettled Positions in Family-Issued Securities 
are not subject to the Illiquid Charge because the risk that long 
Net Unsettled Positions in Family-Issued Securities raise, wrong way 
risk, is separately provided for by a separate charge for such 
securities. See Section I.(A)(1)(a)(iv) and Section I.(A)(2)(a)(iv), 
supra note 4. Wrong way risk is a risk that an exposure to a 
counterparty is highly likely to increase when the creditworthiness 
of that counterparty deteriorates. See Principles for financial 
market infrastructures, issued by the Committee on Payment and 
Settlement Systems and the Technical Committee of the International 
Organization of Securities Commissions, pg. 47 n.65 (April 2012), 
available at http://www.bis.org/publ/cpss101a.pdf. Short Net 
Unsettled Positions in Family-Issued Securities do not present the 
same wrong way risk as long Net Unsettled Positions in Family-Issued 
Securities. See note 29 below.
    \31\ The defined term ``Illiquid Security'' currently excludes 
``a family issued security as defined in Procedure XV'', however, 
family issued security is not defined in Procedure XV. The defined 
term Illiquid Security was added to the Rules in 2017. See 
Securities Exchange Act Release No. 80260 (March 16, 2017), 82 FR 
14781 (March 22, 2017) (File No. SR-NSCC-2017-001). When the defined 
term was added, the section where family issued securities was 
defined in Procedure XV was referring to a separate charge that was 
applied to long Net Unsettled Positions in Family-Issued Securities 
and the exclusion of ``family issued security'' from the defined 
term Illiquid Security was intended to refer to long Net Unsettled 
Positions in Family-Issued Securities not short Net Unsettled 
Positions in Family-Issued Securities.
---------------------------------------------------------------------------

    As described below, following the proposed rule change, the defined 
term Illiquid Security would be repurposed to be used in Sections 
I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure XV which sections 
would apply to certain short Net Unsettled Positions in Family-Issued 
Securities.\32\ As is the case currently, only long Net Unsettled 
Positions in Family-Issued Securities would be excluded from the 
calculations in Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of 
Procedure XV which would be noted in I.(A)(1)(a)(ii) as proposed below. 
The proposed rule change would not change the treatment of long Net 
Unsettled Positions in Family-Issued Securities which would remain 
subject to the calculations set forth in Sections I.(A)(1)(a)(iv) and 
I.(A)(2)(a)(iv) of Procedure XV.
---------------------------------------------------------------------------

    \32\ NSCC has identified exposure to specific wrong-way risk 
when it acts as central counterparty to a Member with long positions 
in Family-Issued Securities. In the event a Member with long 
positions in Family-Issued Securities defaults, NSCC would close out 
those positions following a likely drop in the creditworthiness of 
the issuer, possibly resulting in a loss to NSCC from a resulting 
drop in price in the securities. As such, NSCC provides a specific 
charge for such securities. See id. Short positions present a 
different risk profile than long positions in this close out 
scenario based on, in part, the difference in the potential 
responsiveness of price change to quantity that may occur when NSCC 
is liquidating a long position in an Illiquid Security, compared to 
when it is liquidating a short position. As a result, the charge for 
Family-Issued Securities is only applied to long positions in such 
securities.
---------------------------------------------------------------------------

    NSCC believes that each of these proposed changes would improve the 
definition for its new proposed purpose and improve Members' 
transparency into the application of the existing criteria of the 
Illiquid Security definition.
(b) New Criteria in the Definition of Illiquid Security
    NSCC is also proposing to include additional criteria in order to 
identify securities that exhibit illiquid characteristics and may not 
be captured by the existing definition as described below.
    Although the criterion for this definition relating to whether a 
security is traded on or subject to the rules of a specified securities 
exchange would be determined on a daily basis, as noted above, under 
the proposal, NSCC would also apply new criteria, described below, on a 
monthly basis, to identify those securities that are subject to the 
rules of a specified securities exchange but may still exhibit illiquid 
characteristics and should be identified as Illiquid Securities. The 
new criteria would be based on (i) the security's market capitalization 
and (ii) the trading history of the security. In addition, ADRs would 
also be subject to additional review to determine if they should be 
deemed to be Illiquid Securities.
    First, NSCC is proposing to revise the definition of Illiquid 
Security to identify securities issued by an entity with a micro-
capitalization, which can be a characteristic of illiquidity. For 
purposes of this criterion, NSCC would calculate the product of the 
outstanding shares and market price on a daily basis for each issuance. 
Each month, NSCC would use the average of those calculations over the 
prior month to determine market capitalization. If the average for a 
particular security is below a threshold determined by NSCC from time 
to time, the security would be considered micro-capitalization. 
Initially, NSCC would define micro-capitalization as capitalization of 
less than $300 million. Securities with a capitalization below $300 
million and which are considered micro-capitalization tend to exhibit 
illiquid characteristics such as limited public information and lower 
trading volumes. NSCC may update the micro-capitalization threshold 
from time to time as announced by an important notice to the Members. 
Changes to the threshold would be subject to NSCC's model risk 
governance procedures set forth in the Model Risk Management 
Framework.\33\
---------------------------------------------------------------------------

    \33\ See supra note 25.
---------------------------------------------------------------------------

    If the average market capitalization of a security is considered 
micro-capitalization or if the security is an ADR, then the security 
would be subject to an additional illiquidity ratio test described 
below to determine if it is an Illiquid Security. NSCC believes it is 
appropriate to subject a security to the illiquidity ratio test if a 
security is considered within the range of micro-capitalization because 
the capitalization of a security could be an indicator of the lack of 
liquidity of a security. In addition, for ADRs, the market 
capitalization of the ADR may be difficult to calculate because each 
ADR often converts to different number of shares of a local security. 
As a result, NSCC has decided to subject all ADRs to the illiquidity 
ratio test to determine if it is an Illiquid Security. As noted

[[Page 21042]]

above,\34\ ETPs and ADRs would be excluded from the pool of securities 
that are used to calculate the illiquidity ratio threshold. However, 
ETPs that are considered micro-capitalization and ADRs would be subject 
to the illiquidity ratio test to determine if they are Illiquid 
Securities.
---------------------------------------------------------------------------

    \34\ See supra note 21.
---------------------------------------------------------------------------

    If a security is considered within the range of micro-
capitalization or if the security is an ADR, it would be subject to 
additional illiquidity ratio test that would include the application of 
an ``illiquidity ratio'' to determine if the security should be deemed 
an Illiquid Security. The illiquidity ratio of a security on any day 
would be equal to (i) the security's price return on such day (based on 
the natural logarithm of the ratio between the closing price of the 
stock on such day to the closing price of the stock on the prior 
trading day) divided by (ii) the average daily trading amount \35\ of 
such security over the prior 20 business days.\36\ The illiquidity 
ratio for each security that is subject to this illiquidity ratio test 
would be determined monthly.
---------------------------------------------------------------------------

    \35\ Supra note 26.
    \36\ For example, assuming Stock A has a closing price of $10 on 
day 1, and a closing price of $11 on day 2, then the ``price 
return'' as of day 2 would be abs(log(11/10)) = 0.09531018. Assuming 
the average daily trading amount of the stock over the prior 20 
business days is $1,100,000, the daily ``illiquidity ratio'' for 
Stock A on day 2 is 0.09531018 divided by 1,100,000 x 10[supcaret]6 
= 0.0866.
---------------------------------------------------------------------------

    A security that is subject to the illiquidity ratio test would only 
be deemed an Illiquid Security if the calculated median illiquidity 
ratio of the prior six months exceeds a threshold to be determined by 
NSCC on a monthly basis based on the 99th percentile of the illiquidity 
ratio of non-micro-capitalization common stocks over the prior six 
months.\37\ If the calculated median illiquidity ratio of a security 
did not exceed such threshold it would not be deemed an Illiquid 
Security and would be subject to the VaR Charge. NSCC believes the 
illiquidity ratio would provide it with a reliable measurement of a 
security's liquidity because NSCC would use the absolute value of the 
daily return-to-volume ratio to capture price impact. Given the same 
dollar amount of trading activity, higher price impact typically 
indicates less liquidity.
---------------------------------------------------------------------------

    \37\ See supra note 21.
---------------------------------------------------------------------------

    Second, NSCC would include in the Illiquid Security definition 
securities that are subject to the rules of a specified securities 
exchange, but, as determined on a monthly basis, have fewer than 31 
business days of trading history over the past 153 business days on 
such exchange. NSCC has historically used this time period to identify 
IPOs which tend to exhibit illiquid characteristics due to their 
limited trading history.\38\
---------------------------------------------------------------------------

    \38\ NSCC has observed that the use of the metric, 31 business 
days of trading over the past 153 business days, has been useful in 
identifying securities, such as IPOs, that exhibit illiquid 
characteristics based on their limited trading history. As such, 
NSCC would use this metric in the definition of Illiquid Security to 
ensure that these securities, including IPOs, are identified as 
Illiquid Securities.
---------------------------------------------------------------------------

    In order to implement these proposed changes, NSCC would include 
these additional criteria in the revised definition of ``Illiquid 
Security'' in Rule 1 of the Rules.
(iii) Proposed Enhancement to the Volatility Component Applicable to 
Illiquid Securities and UITs
    NSCC is also proposing to enhance the calculation of the haircut-
based volatility component for Illiquid Securities and UITs. As 
described above, Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of 
Procedure XV currently provide that NSCC has the discretion to exclude 
from the VaR Charge Net Unsettled Positions in classes of securities 
whose volatility is (1) less amenable to statistical analysis, or (2) 
amenable to generally accepted statistical analysis only in a complex 
manner, and permits NSCC to instead calculate the volatility charge for 
Net Unsettled Positions in these securities as a haircut-based 
charge.\39\
---------------------------------------------------------------------------

    \39\ See Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of 
Procedure XV, supra note 4.
---------------------------------------------------------------------------

    Pursuant to this authority, NSCC calculates the volatility charge 
for IPOs by multiplying the absolute value of the Net Unsettled 
Position by a fixed 15%, and calculates the volatility charge for all 
other Illiquid Securities (as currently defined) and sub-penny 
securities by multiplying the absolute value \40\ of the Net Unsettled 
Position by a fixed 20%. Net Unsettled Positions in UITs are subject to 
the same haircut-based volatility charge as other securities whose 
volatility is amenable to generally accepted statistical analysis only 
in a complex manner. Today, NSCC generally does not adjust the 
applicable haircut-based volatility charge, which is a percent that is 
no less than 2%, pursuant to Procedure XV.
---------------------------------------------------------------------------

    \40\ For purposes of the calculating the absolute value, the 
share price of each sub-penny security is rounded up to one cent. If 
a transaction in any security with a share price below one cent is 
entered into NSCC's Continuous Net Settlement system or Balance 
Order Accounting Operation, NSCC rounds up the price of the security 
to one cent.
---------------------------------------------------------------------------

    Based on backtesting results, NSCC has observed that market price 
movements are correlated to a security's market price. Therefore, NSCC 
believes it would be able to calculate a haircut-based volatility 
charge that more appropriately addresses the risks presented by a Net 
Unsettled Position if NSCC considers a security's price level or risk 
profile when determining the haircut percentage to be used in that 
calculation. As described below, NSCC is proposing to enhance the 
calculation of the haircut-based volatility component for Illiquid 
Securities and UITs. In order to implement the changes described below, 
NSCC would revise Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of 
Procedure XV by including new subsections (A)(I) and (II) and (B)(I) 
and (II) relating to such securities.
a. Enhancing the Volatility Charge for Illiquid Securities
    First, NSCC is proposing to enhance the haircut-based volatility 
charge for Illiquid Securities. The applicable percent would be 
determined at least annually \41\ as the highest of (1) 10%, (2) a 
percent benchmarked to be sufficient to cover 99.5th percentile of the 
historical 3-day return of each group of Illiquid Securities \42\ in 
each Member's portfolio and (3) a percent benchmarked to be sufficient 
to cover 99th percentile of the historical 3-day return of each group 
in each Member's portfolio after incorporating a fixed transaction 
cost.\43\ The applicable percent, and the determination of how often 
the applicable percent is determined if more often than annually, would 
be subject to NSCC's model risk management governance procedures set 
forth in the Model Risk Management Framework.\44\ The look-back period 
for this calibration would be no less than five years and would 
initially be five years to be consistent with the historical data set 
used in model development. The look-back period may be adjusted by NSCC 
as necessary consistent with the model risk management practices 
adopted by NSCC to respond to, for example, market events that impact 
liquidity in the market and Member backtesting

[[Page 21043]]

deficiencies. Adjustments to the look-back period would be subject to 
NSCC's model risk governance procedures set forth in the Model Risk 
Management Framework.\45\ Generally, lower priced securities that may 
present NSCC with a greater risk would be charged a haircut-based 
volatility charge based on a higher percent.
---------------------------------------------------------------------------

    \41\ A number of important considerations consistent with the 
model risk management practices adopted by NSCC could prompt more 
frequent haircut review, such as material deterioration of Members' 
backtesting performance, market events or structure changes, and 
model validation findings. See also Model Risk Management Framework 
supra note 25.
    \42\ NSCC would group Illiquid Securities by price level, and 
Illiquid Securities that are sub-penny securities would be 
separately grouped by long or short position, as discussed in more 
detail below.
    \43\ The fixed transaction cost would be equal to one-half of 
the estimated bid-ask spread and would be included in the simulated 
liquidation gain/loss of the positions in each Member's portfolio.
    \44\ See supra note 25.
    \45\ See supra note 25.
---------------------------------------------------------------------------

    NSCC would group Illiquid Securities by price level, and Illiquid 
Securities that are sub-penny securities would be separately grouped by 
long or short position, where each group is assigned a percent to be 
used in the calculation of the haircut-based volatility charge. The 
price level groupings would be subject to NSCC's model risk management 
governance procedures set forth in the Model Risk Management 
Framework.\46\ The proposal would allow NSCC to calculate this charge 
based on the market price of Illiquid Securities. With respect to an 
Illiquid Security that is not a sub-penny security, NSCC would 
calculate one haircut-based volatility charge for short and long 
positions. However, with respect to an Illiquid Security that is a sub-
penny security, NSCC would calculate the haircut-based volatility 
charge for short positions and long positions separately. NSCC believes 
the proposed change is appropriate for Illiquid Securities that are 
sub-penny securities, particularly as short positions in sub-penny 
securities could experience price movements of more than 100%. Further, 
these securities are typically issued by companies with low market 
capitalization, and may be susceptible to market manipulation, 
enforcement actions, or private litigation. The proposed change would 
allow NSCC to calculate a haircut-based volatility charge that accounts 
for this risk of price movements. Although sub-penny securities would 
be separately grouped by price level based on the sub-penny values, 
since the price of sub-penny securities is rounded up to one cent when 
it is entered into the Continuous Net Settlement System and Balance 
Order Accounting Operation, the current market price of each sub-penny 
security would be deemed to be one cent for purposes of applying the 
haircut-based volatility charge.
---------------------------------------------------------------------------

    \46\ See supra note 25.
---------------------------------------------------------------------------

    By setting a floor of 10%, the proposal would allow NSCC to charge 
an amount that has been adequate, based on historical observation, to 
address risks presented by Net Unsettled Positions in these securities 
and is consistent with the current methodology, which also sets a floor 
for the haircut-based volatility charge of no less than 10%. In this 
way, the haircut-based volatility charge would be calculated to allow 
NSCC to collect margin at levels that reflect the risk presented by 
these Net Unsettled Positions. Unlike the current methodology which 
provides NSCC the discretion to apply a haircut, NSCC would not have 
discretion as to whether to apply the haircut-based volatility charge 
to Illiquid Securities and all Illiquid Securities would be subject to 
the charge.
    In order to implement this proposed change, NSCC would describe the 
haircut-based volatility charge applicable to Illiquid Securities in 
the new Sections I.(A)(1)(a)(ii)(B)(I) and I.(A)(2)(a)(ii)(B)(I) of 
Procedure XV.
b. Enhancing the Volatility Charge for UITs
    NSCC is also proposing to revise the calculation of the haircut-
based volatility charge applied to UITs by reviewing the percent used 
in this calculation at least annually, in order to apply a haircut-
based volatility charge to Net Unsettled Positions in UITs that is more 
closely based on a measurement of the risk presented by Members' 
portfolio composition and market conditions.
    Currently, NSCC applies a haircut-based volatility charge that is a 
fixed 2% to Net Unsettled Positions in securities whose volatility is 
amenable to generally accepted statistical analysis (for example, the 
methodology used to calculate the VaR Charge) only in a complex manner, 
which include UITs. NSCC is proposing to continue to apply a haircut-
based volatility charge to Net Unsettled Positions in UITs that would 
be no less than 2%, as currently provided for in Procedure XV, but 
would re-calculate the applicable percent designated by NSCC at least 
annually. The re-calculation of the applicable percent would be subject 
to NSCC's model risk management governance procedures set forth in the 
Model Risk Management Framework.\47\ Subject to this existing floor, 
the applicable percent would be benchmarked to be sufficient to cover 
99.5th percentile of the historical 3-day return of UITs in each 
Member's portfolio, with a lookback period of no less than five years. 
Unlike the current methodology which provides NSCC the discretion to 
apply a haircut, NSCC would not have discretion as to whether to apply 
the haircut-based volatility charge to UITs and all UITs would be 
subject to the charge.
---------------------------------------------------------------------------

    \47\ See supra note 25.
---------------------------------------------------------------------------

    In order to implement this proposed change, NSCC would describe the 
haircut-based volatility charge applicable to UITs in the new Sections 
I.(A)(1)(a)(ii)(B)(II) and I.(A)(2)(a)(ii)(B)(II) of Procedure XV.
c. Enhancing Existing Language for Volatility Charge
    NSCC is also proposing to re-arrange the existing language relating 
to securities whose volatility is (1) less amenable to statistical 
analysis, or (2) amenable to generally accepted statistical analysis 
only in a complex manner, to clarify the language and make it more 
transparent. NSCC would move the description of securities whose 
volatility is less amenable to statistical analysis to new Sections 
I.(A)(1)(a)(ii)(A)(I) and I.(A)(2)(a)(ii)(A)(I) of Procedure XV and 
move the description of securities whose volatility is amenable to 
generally accepted statistical analysis only in a complex manner to new 
Sections I.(A)(1)(a)(ii)(A)(II) and I.(A)(2)(a)(ii)(A)(II). NSCC would 
indicate that securities that are Illiquid Securities or UITs would not 
be subject to these general categories. NSCC would also remove the 
phrase ``such as OTC Bulletin Board or Pink Sheet issues or issues 
trading below a designated dollar threshold (e.g., five dollars)'' 
which was intended as an example of securities whose volatility is less 
amenable to statistical analysis because NSCC does not believe that the 
example adequately describes all of the securities that are less 
amenable to statistical analysis and may be misleading. In addition, 
securities in the example would include securities that are Illiquid 
Securities and that would no longer be subject to this general 
category. In addition, NSCC is proposing to remove the phrase ``other 
than corporate and municipal bonds,'' which qualifies securities 
amenable to generally accepted statistical analysis only in a complex 
manner, because the treatment of corporate and municipal bonds would be 
clarified as set forth in subsection (v) below.
    NSCC believes that the new defined term Illiquid Security would 
identify all securities for which a haircut is currently applied 
because such securities are less amenable to statistical analysis 
pursuant to Sections I.(A)(1)(a)(ii)(x) and I.(A)(2)(a)(ii)(x) of 
Procedure XV.\48\ The haircut for Illiquid Securities upon 
implementation of the rule change would be calculated pursuant to the 
new category for Illiquid Securities under Sections

[[Page 21044]]

I.(A)(1)(a)(ii)(B)(I) and I.(A)(2)(a)(ii)(B)(I) of Procedure XV rather 
than Sections I.(A)(1)(a)(ii)(A)(I) and I.(A)(2)(a)(ii)(A)(I) of 
Procedure XV. NSCC believes that UITs are currently substantially all 
of the securities for which a haircut is currently applied because such 
securities are amenable to generally accepted statistical analysis only 
in a complex manner pursuant to Sections I.(A)(1)(a)(ii)(y) and 
I.(A)(2)(a)(ii)(y) of Procedure XV.\49\ The haircut for UITs upon 
implementation of the rule change would be calculated pursuant to the 
new category for UITs under Sections I.(A)(1)(a)(ii)(B)(II) and 
I.(A)(2)(a)(ii)(B)(II) of Procedure XV rather than Sections 
I.(A)(1)(a)(ii)(A)(II) and I.(A)(2)(a)(ii)(A)(II) of Procedure XV.
---------------------------------------------------------------------------

    \48\ See Sections I.(A)(1)(a)(ii)(x) and I.(A)(2)(a)(ii)(x) of 
Procedure XV, supra note 4.
    \49\ See Sections I.(A)(1)(a)(ii)(y) and I.(A)(2)(a)(ii)(y) of 
Procedure XV, supra note 4. Note that the haircuts for municipal and 
corporate bonds which are also fixed-income securities that are 
amenable to generally accepted statistical analysis only in a 
complex manner are separately calculated pursuant to Sections 
I.(A)(1)(a)(iii) and I.(A)(2)(a)(iii) of Procedure XV. See Sections 
I.(A)(1)(a)(iii) and I.(A)(2)(a)(iii) of Procedure XV, supra note 4. 
Examples of fixed income securities that may remain subject to 
calculations under Sections I.(A)(1)(a)(ii)(A)(I) and 
I.(A)(2)(a)(ii)(A)(I) of Procedure XV would include preferred stock 
or other fixed income securities that are amenable to generally 
accepted statistical analysis only in a complex manner other than 
UITs or corporate or municipal bonds.
---------------------------------------------------------------------------

    There are some types of securities that are amenable to generally 
accepted statistical analysis only in a complex manner that would not 
constitute UITs and for which a haircut would continue to be calculated 
using the category for securities that are amenable to generally 
accepted statistical analysis only in a complex manner upon 
implementation of the rule change. NSCC believes that there are no 
current types of securities for which the haircut would be calculated 
using the general category for securities that are less amenable to 
statistical analysis upon implementation of the rule change. NSCC, 
however, may deem it necessary to calculate a haircut for securities 
that fall within this existing category, if such securities do not fall 
within the categories for Illiquid Securities, after assessing margin 
suitability or future asset class reviews. Therefore, NSCC is proposing 
to keep these two more general categories in the Rules revised as 
contemplated above. As with these existing general categories 
currently, NSCC would have the discretion to determine whether a 
security fits within one of these categories. NSCC would follow its 
existing risk management practices and procedures when determining 
whether to apply a security that is not an Illiquid Security or a UIT 
to one of these categories. Applying a new security to one of these 
categories would be subject to NSCC's model risk management governance 
procedures set forth in the Model Risk Management Framework.\50\
---------------------------------------------------------------------------

    \50\ See supra note 25.
---------------------------------------------------------------------------

(iv) Proposal To Eliminate the Illiquid Charge
    NSCC is proposing to eliminate the existing Illiquid Charge in 
conjunction with the aforementioned enhancements. The Illiquid Charge 
is currently imposed on Net Unsettled Positions in Illiquid Securities, 
in addition to other applicable components of the Clearing Fund. 
Because the current haircut-based volatility charge is a flat charge, 
calculated as a percentage of the absolute value of these Net Unsettled 
Positions, it may not currently address the lack of liquidity and 
marketability that are characteristic of Illiquid Securities. The 
Illiquid Charge is calculated and applied to address these additional 
risks. Currently, due to the existing definition of Illiquid Security, 
the Illiquid Charge has limited applicability, and generally only 
applies to a small population of securities that exhibit illiquid 
characteristics (i.e., over-the-counter securities traded off-
exchange).\51\
---------------------------------------------------------------------------

    \51\ Between November 2017 and November 2018, the Illiquid 
Charge represented an average of approximately 1.5% of the total 
Clearing Fund requirement.
---------------------------------------------------------------------------

    However, NSCC believes the proposed enhancements would address the 
risks presented by Net Unsettled Positions in Illiquid Securities more 
adequately. As described above, the enhanced methodology for 
identifying Illiquid Securities would enable NSCC to identify 
additional securities that could pose credit exposure to NSCC. Further, 
NSCC believes that the proposed methodology for calculating the 
applicable haircut-based volatility charge would be more responsive to 
the risks presented by Net Unsettled Positions in those securities 
because it would be based on historical performance and would be 
recalibrated more frequently. Therefore, NSCC is proposing to eliminate 
the Illiquid Charge in connection with these proposed rule changes as 
it would be no longer needed to address the risks presented by Illiquid 
Securities.
    In connection with this change, NSCC would also remove the 
definition of ``Illiquid Position'' from Rule 1 of the Rules, as this 
term is only used in connection with the Illiquid Charge.
    In order to implement this proposed change, NSCC would amend Rule 1 
of the Rules by removing the definition of ``Illiquid Position,'' and 
NSCC would amend Procedure XV by removing references to the Illiquid 
Charge in subsection (g) of Section I.(A)(1) and subsection (e) of 
Section I.(A)(2) and removing subsection (h) of Section I.(A)(1) and 
subsection (f) of Section I.(A)(2) where the Illiquid Charge is 
currently described.
(v) Proposal To Enhance Language in Section I.(A) of Procedure XV
    In addition to the enhancements described above, NSCC is proposing 
to make the following changes to Section I.(A) of Procedure XV: (x) Add 
language in subsections (1)(a)(ii) and (iii), and (2)(a)(ii) and (iii), 
that indicates that Net Unsettled Positions in corporate and municipal 
bonds are excluded from calculations in subsections (1)(a)(i) and (ii), 
and (2)(a)(i) and (ii), respectively; and (y) add language in 
subsections (1)(a)(ii) and (iv), and 2(a)(ii) and (iv), that indicates 
that long Net Unsettled Positions in Family-Issued Securities are 
excluded from calculations in subsections (1)(a)(i) and (ii), and 
(2)(a)(i) and (ii), respectively. The current language indicates that 
corporate and municipal bonds and long Net Unsettled Positions in 
Family-Issued Securities are excluded from calculations in subsections 
(1)(a)(i) and (2)(a)(i) but does not explicitly indicate that corporate 
and municipal bonds and long Net Unsettled Positions in Family-Issued 
Securities are excluded from (1)(a)(ii) and (2)(a)(ii). NSCC currently 
applies a haircut for corporate and municipal bonds pursuant to 
(1)(a)(iii) and (2)(a)(iii) and long Net Unsettled Positions in Family-
Issued Securities pursuant to subsections (1)(a)(iii) and (2)(a)(iii) 
and does not apply a haircut for those securities pursuant to 
subsections (1)(a)(ii) or (2)(a)(ii).\52\ The proposed changes are 
intended to improve Members' transparency into the treatment of Net 
Unsettled Positions in corporate and municipal bonds and long Net 
Unsettled Positions in Family-Issued Securities in Section I.(A) of 
Procedure XV and would not change NSCC's methodology with respect to 
corporate and municipal bonds or long Net Unsettled Positions in 
Family-Issued Securities.
---------------------------------------------------------------------------

    \52\ As discussed above, currently, short Net Unsettled 
Positions in Family-Issued Securities whose volatility is less 
amenable to statistical analysis are subject to the haircut set 
forth in Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure 
XV. In addition, short Net Unsettled Positions in Family-Issued 
Securities that are Illiquid Positions are currently subject to the 
Illiquid Charge.
---------------------------------------------------------------------------

Expected Effect on and Management of Risk
    NSCC believes that the proposed changes to enhance the margining

[[Page 21045]]

methodology applied to Illiquid Securities and UITs and to eliminate 
the Illiquid Charge would enable NSCC to better limit its risk 
exposures to Members arising out of their Net Unsettled Positions.
    First, the proposal to enhance the methodology for identifying 
Illiquid Securities would improve NSCC's ability to limit its risk 
exposures posed by Net Unsettled Positions in these securities by 
allowing it to (1) better identify securities that exhibit illiquid 
characteristics, and (2) calculate a volatility margin component that 
is appropriate for those characteristics.
    Second, the proposal to enhance the calculation of the volatility 
component applied to Net Unsettled Positions in Illiquid Securities and 
in UITs would enable NSCC to limit its credit exposures posed by these 
securities. The proposal would more appropriately address the risks 
presented by a Net Unsettled Position in these securities by applying a 
calculation that considers a security's price level and risk profile 
when determining the haircut percentage to be used in that calculation. 
Therefore, by enabling NSCC to calculate and collect margin that more 
accurately reflects the risk characteristics of Illiquid Securities and 
UITs in its Members' Net Unsettled Positions, these proposals would 
enhance NSCC's risk management capabilities.
    Finally, NSCC's proposal to eliminate the Illiquid Charge would 
affect NSCC's management of risk by removing a component from the 
Clearing Fund calculations that is no longer needed to address the 
risks posed by Net Unsettled Positions in Illiquid Securities. Such 
risks would be better addressed by the proposed changes to the 
methodology for identifying Illiquid Securities and the enhancement to 
the calculation of the applicable volatility charge. This proposed 
change would remove a component from its Clearing Fund that would no 
longer be needed to effectively manage risks.
    By providing NSCC with a more effective measurement of its 
exposures, as described above, the proposed change would also mitigate 
risk for Members because lowering the risk profile for NSCC would in 
turn lower the risk exposure that Members may have with respect to NSCC 
in its role as a central counterparty.
Consistency With the Clearing Supervision Act
    Although the Title VIII of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act entitled the Payment, Clearing, and Settlement 
Supervision Act of 2010 (``Clearing Supervision Act'') does not specify 
a standard of review for an advance notice, its stated purpose is 
instructive: To mitigate systemic risk in the financial system and 
promote financial stability by, among other things, promoting uniform 
risk management standards for systemically important financial market 
utilities and strengthening the liquidity of systemically important 
financial market utilities.\53\
---------------------------------------------------------------------------

    \53\ See 12 U.S.C. 5461(b).
---------------------------------------------------------------------------

    NSCC believes that the proposal is consistent with the Clearing 
Supervision Act, specifically with the risk management objectives and 
principles of Section 805(b), and with certain of the risk management 
standards adopted by the Commission pursuant to Section 805(a)(2), for 
the reasons described below.\54\
---------------------------------------------------------------------------

    \54\ 12 U.S.C. 5464(a)(2) and (b).
---------------------------------------------------------------------------

(i) Consistency With Section 805(b) of the Clearing Supervision Act
    For the reasons described below, NSCC believes that the proposed 
changes in this advance notice are consistent with the objectives and 
principles of these risk management standards as described in Section 
805(b) of the Clearing Supervision Act and in the Covered Clearing 
Agency Standards.
    As discussed above, NSCC is proposing to (i) change to the way it 
identifies illiquid securities and the way it calculates the volatility 
component of the Clearing Fund as applied to Net Unsettled Positions in 
illiquid securities and UITs, (ii) enhance the calculation of the 
haircut-based volatility component of the Clearing Fund Formula that is 
applied to such illiquid securities and UITs and (iii) eliminate the 
Illiquid Charge as the risk it was designed to address would be 
addressed by the other enhancements. The volatility charge is one of 
the components of its Members' Required Fund Deposits--a key tool that 
NSCC uses to mitigate potential losses to NSCC associated with 
liquidating a Member's portfolio in the event of Member default. NSCC 
believes the proposed changes are consistent with promoting robust risk 
management because they are designed to enable NSCC to better limit its 
exposure to Members in the event of a Member default.
    First, NSCC's proposal to introduce additional criteria for 
identifying illiquid securities by enhancing the definition of 
``Illiquid Security'' and using the definition for purposes of 
determining the volatility component of the Clearing Fund formula would 
better enable NSCC to limit its exposures to Net Unsettled Positions in 
securities that exhibit illiquid characteristics. Second, the proposal 
to enhance the calculation of the haircut-based volatility charge as 
applied to Illiquid Securities and UITs would better enable NSCC to 
limit its exposures to Members by basing this calculation on the risk 
characteristics of these securities. Finally, NSCC's proposal to 
eliminate the Illiquid Charge would enable NSCC to remove a component 
of the Required Fund Deposit that is no longer needed to address risks 
that would be more adequately addressed through the proposed 
enhancements to existing risk management measures, as described above.
    Furthermore, NSCC believes that the changes proposed in this 
advance notice are consistent with promoting safety and soundness, 
which, in turn, is consistent with reducing systemic risks and 
supporting the stability of the broader financial system, consistent 
with Section 805(b) of the Clearing Supervision Act.\55\ The proposed 
changes are designed to better limit NSCC's exposures to Members in the 
event of Member default. As discussed above, the proposed enhancements 
to the definition of Illiquid Security are designed to capture 
additional securities that exhibit illiquid characteristics, and would 
allow NSCC to limit its exposure to Members by applying a volatility 
component that is a more appropriate measure of volatility for Net 
Unsettled Positions in these securities. The proposed enhancements to 
the haircut-based volatility charge for Illiquid Securities and UITs 
would allow NSCC to collect margin at levels that better reflect the 
risk presented by these Net Unsettled Positions and would help NSCC 
limit its exposures to Members.
---------------------------------------------------------------------------

    \55\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------

    Removing the Illiquid Charge would help ensure the Clearing Fund 
calculation would not include unnecessary components, particularly as 
NSCC would be better able to address the risks this charge was designed 
to address through the other proposed risk management enhancements.
    By better limiting NSCC's exposures to Members in the event of a 
Member default, the proposed changes are consistent with promoting 
safety and soundness, which, in turn, is consistent with reducing 
systemic risks and supporting the stability of the broader financial 
system.
    As a result, NSCC believes the proposal would be consistent with 
the objectives and principles of Section 805(b) of the Clearing 
Supervision Act, which specify the promotion of robust

[[Page 21046]]

risk management, promotion of safety and soundness, reduction of 
systemic risks and support of the stability of the broader financial 
system.\56\
---------------------------------------------------------------------------

    \56\ Id.
---------------------------------------------------------------------------

(ii) Consistency With Section 805(a)(2) of the Clearing Supervision Act
    Section 805(a)(2) of the Clearing Supervision Act authorizes the 
Commission to prescribe risk management standards for the payment, 
clearing and settlement activities of designated clearing entities, 
like NSCC, and financial institutions engaged in designated activities 
for which the Commission is the supervisory agency or the appropriate 
financial regulator.\57\ The Commission has accordingly adopted risk 
management standards under Section 805(a)(2) of the Clearing 
Supervision Act and Section 17A of the Exchange Act (``Covered Clearing 
Agency Standards'').\58\
---------------------------------------------------------------------------

    \57\ 12 U.S.C. 5464(a)(2).
    \58\ 17 CFR 240.17Ad-22(e).
---------------------------------------------------------------------------

    The Covered Clearing Agency Standards require registered clearing 
agencies to establish, implement, maintain, and enforce written 
policies and procedures that are reasonably designed to meet certain 
minimum requirements for their operations and risk management practices 
on an ongoing basis.\59\ NSCC believes that the proposed changes are 
consistent with Rules 17Ad-22(e)(4)(i) and (e)(6)(i) and (v), each 
promulgated under the Act.\60\
---------------------------------------------------------------------------

    \59\ Id.
    \60\ 17 CFR 240.17Ad-22(e)(4)(i) and (e)(6)(i) and (v).
---------------------------------------------------------------------------

    Rule 17Ad-22(e)(4)(i) under the Act \61\ requires, in part, that 
NSCC establish, implement, maintain and enforce written policies and 
procedures reasonably designed to effectively identify, measure, 
monitor, and manage its credit exposures to participants and those 
arising from its payment, clearing, and settlement processes, including 
by maintaining sufficient financial resources to cover its credit 
exposure to each participant fully with a high degree of confidence.
---------------------------------------------------------------------------

    \61\ 17 CFR 240.17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

    As described above, NSCC believes that the proposed changes would 
enable it to better identify, measure, monitor, and, through the 
collection of Members' Required Fund Deposits, manage its credit 
exposures to Members by maintaining sufficient resources to cover those 
credit exposures fully with a high degree of confidence. More 
specifically, the proposed changes to the methodology for identifying 
Illiquid Securities would allow NSCC to better identify securities that 
may present credit exposures, for purposes of applying an appropriate 
margin charge. The proposed enhancements to the volatility charge 
applicable to Illiquid Securities and UITs would provide NSCC with a 
more effective measure of the risks that may be presented to NSCC by 
positions in the securities. Specifically, the proposal to base the 
calculation of the haircut-based volatility charge applied to positions 
in Illiquid Securities and UITs on those securities' price level and 
risk profile would enable NSCC to manage its credit exposures by 
allowing NSCC to collect and maintain sufficient resources to cover 
those credit exposures fully with a high degree of confidence. As an 
example, a recent impact study indicated that under the current 
methodology short positions in sub-penny securities and securities 
priced between one cent and one dollar exhibited the lowest average 
backtesting coverage percentages with 96.2% during the study period, 
whereas using the proposed methodology average backtesting coverage 
percentage for such securities would have increased to 99.5% over the 
study period. NSCC also believes that with the proposed changes NSCC 
could remove the Illiquid Charge from the Clearing Fund formula because 
the proposed changes would provide NSCC with a more effective measure 
of risks related to Net Unsettled Positions in Illiquid Securities. As 
such, the proposed enhancements to the calculation of the volatility 
component would permit NSCC to more effectively identify, measure, 
monitor and manage its exposures to risk, and would enable it to better 
limit its exposure to potential losses from Member default.
    Therefore, NSCC believes that the proposal would enhance NSCC's 
ability to effectively identify, measure and monitor its credit 
exposures and would enhance its ability to maintain sufficient 
financial resources to cover its credit exposure to each participant 
fully with a high degree of confidence. As such, NSCC believes the 
proposed changes are consistent with Rule 17Ad-22(e)(4)(i) under the 
Act.\62\
---------------------------------------------------------------------------

    \62\ Id.
---------------------------------------------------------------------------

    Rule 17Ad-22(e)(6)(i) under the Act \63\ requires, in part, that 
NSCC establish, implement, maintain and enforce written policies and 
procedures reasonably designed to cover its credit exposures to its 
participants by establishing a risk-based margin system that, at a 
minimum, considers, and produces margin levels commensurate with, the 
risks and particular attributes of each relevant product, portfolio, 
and market.
---------------------------------------------------------------------------

    \63\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------

    The Required Fund Deposits are made up of risk-based components (as 
margin) that are calculated and assessed daily to limit NSCC's credit 
exposures to Members. NSCC is proposing changes that are designed to 
more effectively address risk characteristics of Net Unsettled 
Positions in Illiquid Securities. NSCC believes that these changes 
would enable NSCC to produce margin levels that are more commensurate 
with the particular risk attributes of these securities, including the 
risk of increased transaction and market costs to NSCC to liquidate or 
hedge due to lack of liquidity or marketability of such positions.
    For example, by enhancing the methodology for Illiquid Securities 
through an additional review of market capitalization of a security and 
the use of an illiquidity ratio, NSCC believes that the proposed change 
would allow NSCC to better identify those securities that may exhibit 
illiquid characteristics. The proposed changes to the haircut-based 
methodology to base the calculation on the price level and risk profile 
of the applicable security, rather than a static percent, would, NSCC 
believes, enable NSCC to more effectively measure the risks that are 
particular to Illiquid Securities and UITs. Backtesting results 
indicate that by calculating a haircut-based volatility charge that 
addresses the risks presented by a security's price level or risk 
profile, the proposed methodology would result in a volatility charge 
that more appropriately addresses the risk of these securities.
    These proposed changes are designed to assist NSCC in maintaining a 
risk-based margin system that considers, and produces margin levels 
commensurate with, the risks and particular attributes of portfolios 
that exhibit illiquid risk attributes. Therefore, NSCC believes the 
proposed change is consistent with Rule 17Ad-22(e)(6)(i) under the 
Act.\64\
---------------------------------------------------------------------------

    \64\ Id.
---------------------------------------------------------------------------

    Rule 17Ad-22(e)(6)(v) under the Act \65\ requires, in part, that 
NSCC establish, implement, maintain and enforce written policies and 
procedures reasonably designed to cover its credit exposures to its 
participants by establishing a risk-based margin system that, at a 
minimum, uses an appropriate method for measuring credit exposure that 
accounts for relevant product risk factors and portfolio effects across 
products. NSCC is proposing to eliminate the Illiquid Charge because, 
NSCC believes, the other proposed

[[Page 21047]]

changes would provide NSCC with a more effective measure of the risks 
presented by Illiquid Securities. Eliminating this charge would enable 
NSCC to remove what would become, with the implementation of the other 
proposed changes, an unnecessary component from the Clearing Fund 
calculation, and would help NSCC to rely on a more appropriate method 
of measuring its exposures to this risk. Therefore, NSCC believes the 
proposed change is consistent with Rule 17Ad-22(e)(6)(v) under the 
Act.\66\
---------------------------------------------------------------------------

    \65\ 17 CFR 240.17Ad-22(e)(6)(v).
    \66\ Id.
---------------------------------------------------------------------------

Accelerated Commission Action Requested
    Pursuant to Section 806(e)(1)(I) of the Clearing Supervision 
Act,\67\ NSCC requests that the Commission notify NSCC that it has no 
objection to the Advance Notice as soon as practicable. As discussed in 
this filing, the proposed changes would improve NSCC's ability to 
manage the risks presented to it by positions in illiquid securities 
and UITs. More specifically, the proposed changes would (1) allow NSCC 
to better identify securities that exhibit illiquid characteristics and 
may present credit exposures for purposes of applying an appropriate 
margin charge, and (2) enhance the volatility charge applicable to 
illiquid securities and UITs to provide NSCC with a more effective 
measure of the risks that may be presented to NSCC by positions in 
these securities.
---------------------------------------------------------------------------

    \67\ 12 U.S.C. 5465(e)(1)(I).
---------------------------------------------------------------------------

    NSCC believes that both the current and recent market volatility, 
as well as rapidly developing world events that could be reasonably 
expected to cause prolonged and potentially extreme market volatility, 
could have a sudden negative impact on liquidity in certain market 
segments.
    Therefore, NSCC believes that there is good cause for the 
Commission to notify NSCC that it has no objection to the Advance 
Notice as soon as practicable, to allow NSCC to implement these 
important and time-sensitive risk management enhancements and have the 
ability to more effectively mitigate the risks presented by positions 
in illiquid securities and UITs.

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

    The proposed change may be implemented if the Commission does not 
object to the proposed change within 60 days of the later of (i) the 
date that the proposed change was filed with the Commission or (ii) the 
date that any additional information requested by the Commission is 
received. The clearing agency shall not implement the proposed change 
if the Commission has any objection to the proposed change.
    The Commission may extend the period for review by an additional 60 
days if the proposed change raises novel or complex issues, subject to 
the Commission providing the clearing agency with prompt written notice 
of the extension. A proposed change may be implemented in less than 60 
days from the date the advance notice is filed, or the date further 
information requested by the Commission is received, if the Commission 
notifies the clearing agency in writing that it does not object to the 
proposed change and authorizes the clearing agency to implement the 
proposed change on an earlier date, subject to any conditions imposed 
by the Commission.
    The clearing agency shall post notice on its website of proposed 
changes that are implemented.
    The proposal shall not take effect until all regulatory actions 
required with respect to the proposal are completed.

IV. Solicitation of Comments

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

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to [email protected]. Please include 
File Number SR-NSCC-2020-802 on the subject line.

Paper Comments

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

All submissions should refer to File Number SR-NSCC-2020-802. 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 website (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 website 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 the filing also will be available for inspection 
and copying at the principal office of NSCC and on DTCC's website 
(http://dtcc.com/legal/sec-rule-filings.aspx). All comments received 
will be posted without change. Persons submitting comments are 
cautioned that we do not redact or edit personal identifying 
information from comment submissions. You should submit only 
information that you wish to make available publicly. All submissions 
should refer to File Number SR-NSCC-2020-802 and should be submitted on 
or before April 30, 2020.

    By the Commission.
J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2020-07896 Filed 4-14-20; 8:45 am]
BILLING CODE 8011-01-P