[Federal Register Volume 63, Number 212 (Tuesday, November 3, 1998)]
[Rules and Regulations]
[Pages 59362-59434]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-29007]
[[Page 59361]]
_______________________________________________________________________
Part II
Securities and Exchange Commission
_______________________________________________________________________
17 CFR Parts 200, 240, and 249
OTC Derivatives Dealers; Final Rule
Federal Register / Vol. 63, No. 212 / Tuesday, November 3, 1998 /
Rules and Regulations
[[Page 59362]]
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 200, 240, 249
[Release No. 34-40594; File No. S7-30-97]
RIN 3235-AH16
OTC Derivatives Dealers
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission is adopting rules and
rule amendments under the Securities Exchange Act of 1934 that tailor
capital, margin, and other broker-dealer regulatory requirements to a
class of registered dealers, called OTC derivatives dealers, that are
active in over-the-counter derivatives markets. Registration as an OTC
derivatives dealer under these rules is optional and is an alternative
to registration as a broker-dealer under the traditional broker-dealer
regulatory structure. It is available only to entities that engage in
dealer activities in eligible over-the-counter derivative instruments
and that meet certain financial responsibility and other requirements.
EFFECTIVE DATE: The rules and rule amendments shall become effective on
January 4, 1999.
FOR FURTHER INFORMATION CONTACT:
General
Catherine McGuire, Chief Counsel, Patrice M. Gliniecki, Special
Counsel, or Laura S. Pruitt, Special Counsel, at (202) 942-0073,
Division of Market Regulation, Securities and Exchange Commission, 450
Fifth Street, NW, Mail Stop 10-1, Washington, DC 20549.
Financial Responsibility and Books and Records
Michael Macchiaroli, Associate Director, at (202) 942-0132, Thomas
K. McGowan, Assistant Director, at (202) 942-0177, Christopher Salter,
Attorney, at (202) 942-0148, Victoria Pawelski, Attorney, at (202) 942-
4169, Matt Hughey, Accountant, at (202) 942-0143, or Gary Gregson,
Statistician, at (202) 942-4156, Division of Market Regulation,
Securities and Exchange Commission, 450 Fifth Street, NW, Mail Stop 10-
1, Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Executive Summary
A. Introduction
B. The Proposing Release
C. Final Rules and Rule Amendments
1. General
2. Scope of Permissible Securities Activities
a. Eligible OTC Derivative Instruments
b. Cash Management Securities Activities
c. Ancillary Portfolio Management Securities Activities
3. Intermediation of Securities Transactions
4. Exemptions for OTC Derivatives Dealers
a. Exemption from SRO Membership
b. Exemption from Certain Margin Requirements
c. Exemption from SIPA
5. Section 11(a) of the Exchange Act
6. Net Capital Requirements
7. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
8. Recordkeeping and Reporting
II. Discussion: New Rules and Amended Rules
A. Definitions
1. Rule 3b-12; Definition of OTC Derivatives Dealer
2. Rule 3b-13; Definition of Eligible OTC Derivative Instrument
3. Proposed Rule 3b-14; Definition of Permissible Derivatives
Counterparty
4. Proposed Rule 3b-16; Definition of Hybrid Security
5. Rules 3b-14 and 3b-15; Definitions of Cash Management
Securities Activities and Ancillary Portfolio Management
Securities Activities
a. Rule 3b-14; Cash Management Securities Activities
i. Counterparty Collateral
ii. Cash Management
iii. Financing
b. Rule 3b-15; Ancillary Portfolio Management Securities
Activities
i. Hedging
ii. Arbitrage
iii. Trading
iv. Documentation of Activities
B. Amendment to Rule 15b1-1; Registration with the Commission
C. Rule 15a-1; Securities Activities of OTC Derivatives Dealers
1. Scope of Permissible Securities Activities
2. Commission Orders Regarding OTC Derivatives Dealers'
Activities
3. Intermediation of Securities Transactions
4. Communications Regarding Securities Transactions
5. Confirmation of Securities Transactions
6. Position Limits
D. Exemptions for OTC Derivatives Dealers
1. Rule 15b9-2; Exemption from SRO Membership
2. Rule 36a1-1; Exemption from Certain Margin Requirements
3. Rule 36a1-2; Exemption from SIPA
E. Rule 11a1-6; Transactions for Certain Accounts of OTC
Derivatives Dealers
F. Net Capital Requirements for OTC Derivatives Dealers
1. Overview of Amendments to Rule 15c3-1
2. Reasons for Allowing OTC Derivatives Dealers to Use Value-at-
Risk Models
3. Discussion of Net Capital Requirements
a. Rule 15c3-1(a)(5)
b. Appendix F
i. Application Requirement
ii. Market Risk
iii. Credit Risk
iv. Qualitative Requirements for Value-at-Risk Models
v. Quantitative Requirements for Value-at-Risk Models
G. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
H. Recordkeeping and Reporting
1. Amendments to Rules 17a-3 and 17a-4; Books and Records to be
Maintained by OTC Derivatives Dealers
2. Amendments to Rule 17a-11; Notification Requirements
3. Rule 15c3-4; Internal Risk Management Control Systems for OTC
Derivatives Dealers
4. Rule 17a-12; Reports to be Made by OTC Derivatives Dealers
5. Amendments to Form X-17A-5
III. Costs and Benefits of the Rules and Rule Amendments
A. Comments and Survey
B. Benefits
1. Regulatory Capital Effects
2. Operational Cost Savings
3. Decreased Margin Requirements
C. Costs
1. Costs of Combining Activities into One Operation
2. Registration as an OTC Derivatives Dealer
3. Risk Management Adjustments
4. Books and Records Requirements
5. Regulatory Reporting
6. Regulation U Margin Requirements
D. Conclusion
IV. Efficiency, Competition, and Capital Formation
V. Summary of Final Regulatory Flexibility Analysis
A. Need for the Rules and Rule Amendments
B. Small Entities Subject to the Rules
C. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
D. Alternatives to Minimize Effect on Small Entities
VI. Paperwork Reduction Act
VII. Statutory Authority
Text of Rules and Rule Amendments
I. Executive Summary
A. Introduction
Over-the-counter (``OTC'') derivative instruments are important
financial management tools employed by many corporations, financial
institutions, governmental entities, and other end-users. Participants
in the OTC derivatives markets engage in transactions involving a wide
range of instruments in order to effectively manage risks associated
with their business activities or their financial assets.
Whether OTC derivatives transactions are structured as interest
rate swaps, cross currency swaps, equity swaps, basis swaps, total
return swaps, asset swaps, credit swaps, or options, they share certain
characteristics.\1\ For
[[Page 59363]]
example, each has a value or return related to the value or return of
an underlying asset. Asset classes can consist of securities or
virtually any other financial instrument, financial measure, or
physical commodity, such as interest rates, securities indices, foreign
currencies, metals or energy products, or spreads between the values of
different assets. More importantly, each of these instruments can
provide users with a carefully tailored method for managing a variety
of risks.\2\
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\1\ Swaps are contracts that typically allow the parties to the
contract to exchange cash flows related to the value or performance
of certain assets, rates, or indices for a specified period of time.
See generally Peter A. Abken, Beyond Plain Vanilla: A Taxonomy of
Swaps, Financial Derivatives Reader (Robert W. Kolb, ed.) (1992).
Most swaps are based on currencies or interest rates. Swaps that
provide for an exchange of values based on the value or performance
of equity securities make up a small, but growing, share of the
swaps market. Options are instruments that generally provide the
holder, in exchange for the payment of a premium, with benefits of
favorable movements in the underlying asset or index with limited or
no exposure to losses from unfavorable price movements. Typically,
OTC options provide for cash settlement, rather than the delivery of
the underlying asset. Credit derivatives function like contingent
options to the extent payments under the contract are triggered by
the occurrence of a credit event, such as a decline in an issuer's
credit rating or default in performance under a debt obligation.
\2\ See, e.g., Clifford W. Smith, Jr., Charles W. Smithson, and
D. Sykes Wilford, Managing Financial Risk, Financial Derivatives
Reader (Robert W. Kolb, ed.) (1992); Group of Thirty, Derivatives:
Practices and Principles (July 1993), Financial Derivatives: Actions
Needed to Protect the Financial System, United States General
Accounting Office Report (May 1994).
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OTC derivative instruments, for example, can be used by
corporations and local governments to lower funding costs, or by
multinational corporations to manage risk associated with fluctuating
exchange rates. They can also be used by portfolio managers to manage
volatility in investment portfolios or to obtain exposure to different
assets without taking a position in the cash markets. Because of the
benefits these instruments offer, the derivatives markets have grown
significantly over the past two decades.\3\
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\3\ The International Swaps and Derivatives Association
(``ISDA'') estimates that, as of December 31, 1996, the combined
notional amount of globally outstanding interest rate swaps,
currency swaps, and interest rate options has grown to over $29
trillion. See ``ISDA Market Survey,'' ISDA Internet web site (http:/
/www.isda.org).
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The traditional broker-dealer regulatory structure under the
Securities Exchange Act of 1934 (``Exchange Act),\4\ however, has not
permitted a firm to operate a competitive OTC derivatives business in
the United States that involves the broad range of OTC derivative
instruments currently available to participants in these markets. While
some of these OTC derivative instruments are securities, others are
not. OTC options on equity securities or on U.S. government securities,
for example, are securities within the meaning of section 3(a)(10) of
the Exchange Act.\5\ Firms that effect transactions in these or other
OTC derivative instruments that are securities in the United States are
required to register as broker-dealers under section 15(b) of the
Exchange Act \6\ and fulfill all requirements applicable to other
securities broker-dealers, including Exchange Act rules governing
margin and capital.
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\4\ 15 U.S.C. 78a et seq.
\5\ 15 U.S.C. 78c(a)(10)
\6\ 15 U.S.C. 78o(b).
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Traditional U.S. broker-dealer regulation seems particularly
restrictive when contrasted with OTC derivatives activities that are
conducted outside of the broker-dealer regulatory regime. Firms located
off-shore can often structure their securities activities in a manner
that will avoid or lessen the regulatory burdens imposed on broker-
dealers under U.S. law. For example, off-shore firms can often avoid
registering as broker-dealers in the United States if they engage in
securities transactions only with non-U.S. persons, or if they comply
with the requirements of Rule 15a-6 under the Exchange Act.\7\
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\7\ 17 CFR 240.15a-6.
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Similarly, because U.S. banks are excluded from the Exchange Act
definitions of ``broker'' and ``dealer,'' \8\ they are not subject to
U.S. broker-dealer regulation. They, therefore, may engage in a broad
range of OTC derivatives activities in accordance with guidance issued
by their appropriate banking regulators.\9\ In addition, firms that
effect transactions only in OTC derivative instruments that are not
securities are not subject to U.S. broker-dealer regulation.
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\8\ See Section 3(a)(4) of the Exchange Act (15 U.S.C.
78c(a)(4)) (defining broker) and Section 3(a)(5) of the Exchange Act
(15 U.S.C. 78c(a)(5)) (defining dealer). The exclusion for banks
from the definitions of ``broker'' and ``dealer'' under the Exchange
Act is available only to those banking institutions that satisfy the
definition of ``bank'' set forth in Section 3(a)(6) of the Exchange
Act (15 U.S.C. 78c(a)(6)).
\9\ Banking regulators have issued guidance to banks engaging in
derivatives activities. See e.g., Federal Financial Institutions
Examination Council, Supervisory Policy Statement on Investment
Securities and End-User Derivatives Activities, 63 FR 20191 (Apr.
23, 1998); Federal Reserve Board, Trading and Capital-Markets
Activities Manual (1998) (including discussions of various
derivative instruments, such as credit derivatives); Federal Reserve
SR Letter 97-21, Risk Management and Capital Adequacy of Exposures
Arising from Secondary Market Credit Activities (July 11, 1997);
Federal Reserve SR Letter 97-18, Application of Market Risk Capital
Requirements to Credit Derivatives (June 13, 1997); FDIC FIL 62-96,
Supervisory Guidance for Credit Derivatives (Aug. 19, 1996); Federal
Reserve SR Letter 96-17, Supervisory Guidance for Credit Derivatives
(Aug. 12, 1996); OCC Bulletin 96-43, Credit Derivatives (Aug. 12
1996); OCC Bulletin 96-25, Fiduciary Risk Management of Derivatives
and Mortgage-Backed Securities (Apr. 30, 1996); OCC Bulletin 94-31,
Questions and Answers for BC-277 (May 10, 1994); and Risk Management
of Financial Derivatives, OCC Banking Circular No. 277 (Oct. 1993).
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The potential costs of broker-dealer regulation, as applied to
dealers in OTC derivative instruments, have affected the way U.S.
securities firms conduct business in the OTC derivatives markets. In
many instances, U.S. securities firms have decided to separate their
securities activities from their non-securities activities. These firms
often place their non-securities OTC derivatives activities in
separate, unregistered affiliates located in the United States, and
conduct some or all of their securities OTC derivatives activities from
abroad. However, fragmenting a firm's OTC derivatives business in this
manner may hinder its ability to manage risk and compete for business.
For example, U.S. securities firms have voiced concerns regarding
their ability to manage counterparty credit risk effectively under the
traditional broker-dealer regulatory regime. Typically, in order to
reduce credit exposure to a single counterparty, dealers in OTC
derivative instruments enter into master agreements with their
counterparties that provide for netting of the outstanding financial
obligations existing between the dealers and their counterparties. As
these firms have pointed out, it would be more efficient and effective
to conduct both securities and non-securities OTC derivatives
transactions with a counterparty through a single legal entity, subject
to appropriately tailored regulatory requirements, rather than through
multiple legal entities. The firms have also indicated that certain
counterparties prefer to deal with a firm through a single entity that
is capable of transacting business across a broad range of OTC
derivative instruments.
B. The Proposing Release
In response to the concerns raised by firms seeking to conduct an
OTC derivatives business in the United States, the Commission proposed
to establish a form of limited broker-dealer regulation that would give
the firms an opportunity to conduct business in a vehicle subject to
modified regulation appropriate to the OTC derivatives markets.\10\
This form of limited broker-dealer regulation was intended to allow
securities firms to establish dealer
[[Page 59364]]
affiliates, referred to as ``OTC derivatives dealers,'' that would be
able to compete more effectively with banks and foreign dealers in
global OTC derivatives markets, while also maintaining standards
necessary to ensure investor protection.
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\10\ Exchange Act Release No. 39454 (Dec. 17, 1997), 62 FR 67940
(Dec. 30, 1997) (``Proposing Release'').
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In the Proposing Release, the Commission specifically solicited
comment on the extent to which persons eligible to become registered as
OTC derivatives dealers believed that the proposal would address
competitive inequalities that discouraged securities firms from
conducting an OTC derivatives business in the United States. Commenters
were also asked to express their views on the application of the
Commission's broker-dealer rules to OTC derivatives dealers and whether
additional amendments or exemptions were needed for this class of
dealers.
The Commission received twenty-one comment letters in response to
the proposed rules and rule amendments, including comments from, among
others, industry representatives, self-regulatory organizations, and
other regulators.\11\ The majority of the commenters endorsed the
Commission's initiative to develop an alternative regulatory framework
for OTC derivatives dealers. These commenters supported the
Commission's intent to provide a regulatory framework for OTC
derivatives dealers that would enable these dealers to compete more
effectively with both banks and foreign dealers in OTC derivatives
markets. They often noted in particular their support of the
Commission's efforts to address the regulatory costs imposed by
existing capital requirements on securities firms seeking to operate an
OTC derivatives business in the United States.\12\
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\11\ The staff of the Division of Market Regulation has prepared
a summary of the comment letters received on the proposed rules and
rule amendments entitled ``Comment Summary for Proposing Release on
OTC Derivatives Dealers'' (hereinafter referred to as ``Comment
Summary''). Copies of the comment letters and the Comment Summary
have been placed in Public Reference File No. S7-30-97 and are
available for inspection in the Commission's Public Reference Room.
\12\ See Letters cited in Section II., n.1 of the Comment
Summary.
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The commenters, however, also suggested that the Commission modify
the proposed rules and rule amendments in various ways to more
accurately reflect the manner in which firms conduct an OTC derivatives
business. Many commenters stressed the need for the alternative
regulatory regime to establish a practical commercial framework for the
conduct of this business and to provide U.S. securities firms with
flexibility in structuring their derivatives activities.
C. Final Rules and Rule Amendments
1. General
After considering the comment letters, the Commission is adopting
rules and rule amendments that will allow U.S. securities firms to
establish separately capitalized entities that may engage in dealer
activities in eligible OTC derivative instruments, which include both
securities and non-securities OTC derivative instruments. OTC
derivatives dealers are also permitted to engage in certain additional
securities activities related to conducting an OTC derivatives
business. A firm engaging in the permitted activities has the option of
registering with the Commission under Section 15(b) of the Exchange
Act\13\ as an OTC derivatives dealer, subject to specially tailored
capital, margin, and various other requirements.
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\13\ 15 U.S.C. 78o(b).
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These tailored requirements are intended, in part, to improve the
efficiency and competitiveness of U.S. securities firms active in
global OTC derivatives markets. By permitting U.S. securities firms to
conduct both securities and non-securities OTC derivatives activities
through a single legal entity, the new structure will enable the firms
to enter into more comprehensive netting arrangements with
counterparties and thus more effectively manage credit risk. End-users
should also benefit as a result of a reduction in the legal risks that
arise when securities firms structure their derivatives activities in a
manner that avoids U.S. broker-dealer registration.\14\ As noted by one
commenter, all participants in the OTC derivatives markets have a vital
interest in ensuring that OTC derivatives transactions are available in
a framework where the legal rights and obligations of the parties to an
agreement are certain and enforceable.\15\ The new regulatory regime
for OTC derivatives dealers is intended to help provide that legal
certainty to these markets.
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\14\ See, e.g., Comment Letter from the End-Users of Derivatives
Association, Inc. (``EUDA Letter''). p. 1.
\15\ See Comment Letter from the International Swaps and
Derivatives Association, Inc. (``ISDA Letter''), pp. 1-2.
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As a ``dealer'' under the Exchange Act,\16\ an OTC derivatives
dealer remains subject to all other rules applicable to ``fully
regulated broker-dealers,'' \17\ unless otherwise provided by the new
rules and rule amendments. In addition, the Commission wishes to
emphasize that purchasers and sellers of OTC derivative instruments
that are securities will continue to be protected by the general anti-
manipulation and anti-fraud provisions, including Section 17(a) of the
Securities Act of 1933,\18\ and Section 9(a) \19\ and 10(b) \20\ of the
Exchange Act, and Rule 10b-5 thereunder.\21\
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\16\ See Section 3(a)(5) of the Exchange Act (15 U.S.C.
78c(a)(5)).
\17\ For purposes of this release, the term ``fully regulated
broker-dealer'' means a broker or dealer that is registered with the
Commission under section 15(b) of the Exchange Act (15 U.S.C.
78o(b)), but that is not an OTC derivatives dealer, and therefore is
subject to all statutes, rules, and regulations imposed on broker-
dealers under the transitional broker-dealer regulatory regime,
including membership in a securities self-regulatory organization.
\18\ 15 U.S.C. 78q(a).
\19\ 15 U.S.C. 78i(a).
\20\ 15 U.S.C. 78j(a).
\21\ 17 CFR 240.10b-5. See, e.g., In the Matter of BT Securities
Corporation, Exchange Act Release No. 35136 (Dec. 22, 1994).
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An OTC derivatives dealer also remains subject to all applicable
statutes, rules, and regulations of other U.S. financial regulators. In
particular, to the extent that the Commodity Exchange Act (``CEA'')
\22\ and the rules and regulations adopted under the CEA apply to the
activities of an OTC derivatives dealer, the new regulatory structure
in no way alters the application of these laws to the activities of an
OTC derivatives dealer.
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\22\ 7 U.S.C. 1 et seq.
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2. Scope of Permissible Securities Activities
In order to take advantage of the new regulatory regime for
conducting an OTC derivatives dealer business in the United States, an
OTC derivatives dealer must, among other things, limit its securities
activities to those specified in Rules 3b-12 and 15a-1. In general,
these rules provide that an OTC derivatives dealer's securities
activities must be limited to (1) engaging in dealer activities in
eligible OTC derivative instruments (as defined in Rule 3b-13) that are
securities; (2) issuing and reacquiring securities that are issued by
the dealer, including warrants on securities, hybrid securities, and
structured notes; (3) engaging in cash management securities activities
(as defined in Rule 3b-14); (4) engaging in ancillary portfolio
management securities activities (as defined in Rule 3b-15); and (5)
engaging in such other securities activities that the Commission
designates by order.\23\ An OTC
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derivatives dealer must also be affiliated with a fully regulated
broker-dealer.\24\
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\23\ The alternative regulatory framework generally does not
limit the non-securities activities of an OTC derivatives dealer,
provided that the dealer complies with financial responsibility and
internal risk management controls requirements. An OTC derivatives
dealer's non-securities activities are also restricted under this
framework by the practical limitations imposed by the definitions of
``cash management securities activities'' and ``ancillary portfolio
management securities activities.''
\24\ As proposed, the alternative regulatory framework defined
the term ``permissible derivatives counterparty,'' and required that
an OTC derivatives dealer's counterparties be limited to such
persons. In response to commenters' concerns, and in light of the
protections afforded through other provisions of the alternative
regulatory framework, the final rules do not restrict the persons
that may act as counterparties in OTC derivatives transactions. The
final rules, however, do not exempt OTC derivatives dealers or their
fully regulated broker-dealer affiliates from counterparty
limitations imposed under any other applicable regulatory or self-
regulatory requirements.
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The Commission has defined the terms ``cash management securities
activities'' and ``ancillary portfolio management securities
activities.'' \25\ These two terms replace the term ``permissible risk
management, arbitrage, and trading transactions,'' which was included
in the Proposing Release. The new terms serve substantially the same
purpose as the proposed term in that they describe the additional
securities activities in which an OTC derivatives dealer may engage in
connection with its OTC derivatives dealer business. As a practical
matter, a firm seeking to register as an OTC derivatives dealer will
need to be able to conduct these additional securities activities, such
as engaging in certain financing and hedging transactions, in order to
compete effectively with other market participants.
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\25\ See Rules 3b-14 (17 CFR 240.3b-14) and 3b-15 (17 CFR
240.3b-15).
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The final rules and rule amendments also contain restrictions to
prevent U.S. securities firms from moving their general securities
dealing activities into the new OTC derivatives dealer entity, or from
using these entities for substantial proprietary trading activities.
For example, the definitions of both ``cash management securities
activities'' and ``ancillary portfolio management securities
activities'' include limitations to prevent an OTC derivatives dealer
from engaging in dealing activities in cash market instruments or from
establishing a proprietary trading desk.
In addition, an OTC derivatives dealer's securities activities must
consist primarily of dealer activities in eligible OTC derivative
instruments that are securities, issuing and reacquiring its issued
securities, and cash management securities activities. Thus, if the
securities activities of an OTC derivatives dealer were to consist only
or primarily of ancillary portfolio management securities activities,
the dealer would be in violation of the rules.
a. Eligible OTC Derivative Instruments. As noted above, an OTC
derivatives dealer is permitted to engage in dealer activities in
``eligible OTC derivative instruments,'' as that term is defined in
Rule 3b-13. The term is defined broadly to encompass the wide range of
securities and non-securities OTC derivative instruments currently
existing in the derivatives markets, as well as to allow for the
inclusion of reasonably similar instruments that market participants
may develop in the future. The types of instruments that generally
satisfy the criteria set forth in Rule 3b-13 include interest rate
swaps, currency swaps, securities swaps, commodity swaps, OTC options
on similar asset classes, long-dated forwards on securities, and
forwards relating to assets other than securities. Other types of
instruments also satisfy the criteria in the rule.
Short-dated securities forwards, however, are excluded from the
definition of eligible OTC derivative instrument, as are securities
derivative instruments that are listed or traded on a national
securities exchange or on Nasdaq. Except as otherwise determined by the
Commission by order, a securities derivative instrument that is one of
a class of fungible instruments that are standardized as to their
material economic terms is also excluded from the definition.
The new regulatory framework also allows an OTC derivatives dealer
to issue and reacquire its issued securities, including hybrid
securities. For purposes of Rules 3b-12 and 15a-1, which describe the
permissible securities activities of an OTC derivatives dealer, the
term ``hybrid security'' is defined as a security that incorporates
payment features economically similar to the OTC derivative instruments
that are enumerated in the definition.\26\ The term ``hybrid security''
is used only in the context of an OTC derivatives dealer's permissible
securities activities under the rules, and is not intended to have a
broader application.
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\26\ See Rules 3b-12(d) (17 CFR 240.3b-12(d)) and 15a-1(e) (17
CFR 240.15a-1(e).
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b. Cash Management Securities Activities. An OTC derivatives dealer
may engage in ``cash management securities activities,'' as defined in
Rule 3b-14. Under the rule, an OTC derivatives dealer may engage in
cash management securities activities in connection with its
permissible securities activities or its non-securities activities
(that involve eligible OTC derivative instruments or other financial
instruments). Cash management securities activities include (1) any
acquisition or disposition of collateral provided by a counterparty, or
any acquisition or disposition of collateral to be provided to a
counterparty; (2) cash management; and (3) financing of certain
positions of the dealer. Any securities trading activities associated
with cash management by an OTC derivatives dealer must be at a level
commensurate with the dealer's bona fide operational needs, taking into
consideration the Commission's capital requirements for the dealer and
the amount of capital needed by the dealer to satisfy counterparties'
credit requirements.
c. Ancillary Portfolio Management Securities Activities. An OTC
derivatives dealer may also engage in ``ancillary portfolio management
securities activities,'' as defined in Rule 3b-15. These securities
activities must be limited to transactions in connection with the OTC
derivatives dealer's dealer activities in eligible OTC derivative
instruments, the issuance of securities by the dealer, or such other
securities activities that the Commission designates by order. They
must also (1) be conducted for the purpose of reducing the dealer's
market or credit risk or consist of incidental trading activities for
portfolio management purposes; and (2) be limited to risk exposures
within the market, credit, leverage, or liquidity risk parameters set
forth in the trading authorizations granted to the associated person
(or to the associated person's supervisor) who executes the transaction
for the dealer, and in the written guidelines approved by the dealer's
governing body and included in the dealer's internal risk management
control system (as required under new Rule 15c3-4). Rule 3b-15 also
requires that ancillary portfolio management securities activities be
conducted only by associated persons of the dealer who perform
substantial duties for the dealer in connection with its dealer
activities in eligible OTC derivative instruments.
Again, the limitations on an OTC derivatives dealer's ancillary
portfolio management securities activities under Rule 3b-15 are aimed
at preventing a fully regulated broker-dealer from moving its
securities book into its OTC derivatives dealer affiliate or otherwise
permitting the OTC derivatives dealer to engage in substantial
proprietary securities trading activities. An OTC derivatives dealer's
ability to engage in incidental securities trading activities for
portfolio management purposes under Rule 3b-15, however, recognizes
[[Page 59366]]
that the dealer may to a limited extent engage in securities trading
activity that may not be for the specific purpose of reducing its
market or credit risk.
The new regulatory structure for OTC derivatives dealers
incorporates the concept of managing risk on a portfolio-wide basis and
does not expressly limit the range of permissible ancillary portfolio
management securities activities. Instead, these activities are limited
by the requirement that they not give rise to risk exposures that, on
an aggregate portfolio basis, exceed the risk limits adopted for the
dealer's business under the rules. They are also limited by other
requirements that serve to ensure that the OTC derivatives dealer does
not engage in dealer activities in securities that are not eligible OTC
derivative instruments. The final rules are intended to be flexible and
to accommodate current business practices of OTC derivatives dealers.
Because the rules define a broad scope of permissible securities
activities, however, the restrictions on proprietary trading and
dealing in cash market instruments may prove inadequate. Rule 15a-1
therefore preserves the Commission's ability to clarify, by order,
whether certain securities activities are within the scope of ancillary
portfolio management securities activities.\27\
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\27\ See Rule 15a-1(b)(4) (17 CFR 240.15a-1(b)(4)).
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3. Intermediation of Securities Transactions
Rule 15a-1 generally requires that all securities transactions of
an OTC derivatives dealer, including securities OTC derivatives
transactions, be effected through its fully regulated broker-dealer
affiliate.\28\ The intermediation requirement is designed, in part, to
ensure that all securities transactions remain subject to existing
sales practice standards and to reduce the risk that counterparties
will mistakenly view an OTC derivatives dealer as a fully regulated
broker-dealer. Certain professional counterparties, however, are less
likely to need or expect the protections offered by the fully regulated
broker-dealer under this framework. Therefore, the rules provide two
limited exceptions to the broker-dealer intermediation requirement for
securities transactions.
---------------------------------------------------------------------------
\28\ See Rule 15a-1(c) (17 CFR 240.15a-1(c)). An OTC derivatives
dealer may issue and reacquire its issued securities through an
unaffiliated fully regulated broker-dealer. Id.
---------------------------------------------------------------------------
First, an OTC derivatives dealer is not required to use its fully
regulated broker-dealer affiliate to effect securities transactions
with a registered broker or dealer, a bank acting in a dealer capacity,
a foreign broker or dealer, or an affiliate of the OTC derivatives
dealer, provided that the counterparty is acting as principal. Second,
if an OTC derivatives dealer engages in an ancillary portfolio
management securities activity involving a foreign security, it is not
required to effect that securities transaction through its fully
regulated broker-dealer affiliate if a registered broker or dealer, a
bank, or a foreign broker or dealer is acting as agent for the OTC
derivatives dealer.
In addition, any person that solicits a potential counterparty to
engage in a securities transaction with an OTC derivatives dealer, or
otherwise has any contact with the counterparty regarding the
transaction, generally must be a registered representative of the fully
regulated broker-dealer affiliate.\29\ These persons may be dual
employees of both the OTC derivatives dealer and the fully regulated
broker-dealer. However, if the counterparty is a registered broker or
dealer, a bank acting in a dealer capacity, a foreign broker or dealer,
or an affiliate of the OTC derivatives dealer, employees of the OTC
derivatives dealer may solicit or have other forms of contact with the
counterparty, even if they are not also registered representatives of
the fully regulated broker-dealer. This is consistent with the
exception for these same counterparties from the general requirement
that an OTC derivatives dealer's securities transactions be effected
through its fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------
\29\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)). The rule provides
an exception for clerical and ministerial activities that are
conducted by associated persons of the OTC derivatives dealer.
---------------------------------------------------------------------------
In addition, the rule does not require registered representatives
of the fully regulated broker-dealer affiliate to be involved in
contacts with foreign counterparties, in certain situations. Contacts
with a foreign counterparty may generally be conducted by an associated
person of a foreign broker or dealer who is not resident in the United
States, if the foreign broker or dealer is affiliated with the OTC
derivatives dealer and is registered under applicable local law. This
approach recognizes the global nature of the OTC derivatives markets,
and the practical limitations imposed by requiring registered
representatives of the fully regulated broker-dealer affiliate to
participate in all such contacts. Any resulting securities transaction,
however, must generally be effected through the OTC derivatives
dealer's fully regulated broker-dealer affiliate.
4. Exemptions for OTC Derivatives Dealers
The final rules and rule amendments provide exemptions from certain
provisions of the Exchange Act to OTC derivatives dealers due to, among
other things, the unique nature of this business. Specifically, OTC
derivatives dealers are exempted from (a) membership in a securities
self-regulatory organization (``SRO''); (b) certain margin requirements
under the Exchange Act; and (c) the provisions of the Securities
Investor Protection Act of 1970\30\ (``SIPA''), including membership in
the Securities Investor Protection Corporation (``SIPC'').\31\
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\30\ 15 U.S.C. 78aaa et seq.
\31\ In 1996, Congress added section 36 to the Exchange Act (15
U.S.C. 78mm), which gives the Commission broad authority to exempt
any person from any of the provisions of the Exchange Act. The
exemptions from certain margin requirements under the Exchange Act
and from SIPA were adopted using this new exemptive authority.
---------------------------------------------------------------------------
a. Exemption from SRO Membership. Under Rule 15b9-2, OTC
derivatives dealers are exempt from membership in an SRO. SRO
membership for OTC derivatives dealers, and the additional regulation
it entails, is not warranted at this time. As a practical matter,
certain SRO rules are not consistent with the OTC derivatives dealer
regulatory structure, and accordingly, should not apply directly to the
OTC derivatives dealer. In addition, with limited exceptions, all
securities transactions of an OTC derivatives dealer must be effected
through its fully regulated broker-dealer affiliate, which will be an
SRO member. As a result, SRO rules, including sales practice
requirements, will generally apply to these securities transactions.
While the Commission had proposed that the designated examining
authority (``DEA'') of the OTC derivatives dealer's fully regulated
broker-dealer affiliate would review the OTC derivatives dealer's
activities for violations of Commission rules, the New York Stock
Exchange (``NYSE'') and the National Association of Securities Dealers,
Inc. (``NASD'') expressed serious concerns with overseeing OTC
derivatives dealers on a contractual basis (without the dealers being
SRO members). The Commission staff, therefore, will examine OTC
derivatives dealers to ensure compliance with Commission rules.
b. Exemption from Certain Margin Requirements. Federal regulations
that govern the collateral, or margin, that must be collected by
dealers in connection with securities transactions have created certain
competitive inequalities between registered broker-
[[Page 59367]]
dealers and other entities, including banks, that conduct an OTC
derivatives business. Registered broker-dealers that extend credit for
the purpose of purchasing or carrying securities are required to comply
with the provisions of Regulation T.\32\ The margin requirements for
banks are contained in Regulation U.\33\
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\32\ 12 CFR 220.1.
\33\ 12 CFR 221.1.
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After the Commission issued the Proposing Release, several
amendments to Regulation T were adopted that reduced the regulatory
distinctions between broker-dealers and other lenders.\34\ In general,
Regulation T and Regulation U permit lenders to extend good faith
credit against all non-equity securities and set specific limits on the
amount of credit lenders can extend on equity securities.\35\ However,
several differences between Regulation T and Regulation U still remain,
such as margin requirements for short OTC options. U.S. securities
firms have indicated that because of these differences, applying
Regulation T to their OTC derivatives business would continue to
unnecessarily inhibit their ability to compete in the derivatives
markets with banks and other lenders subject to Regulation U.
---------------------------------------------------------------------------
\34\ See Securities Credit Transactions, Borrowing by Brokers
and Dealers, Docket Nos. R-0905, R-0923, and R-0944, 63 FR 2806 (Jan
16, 1998).
\35\ See, e.g., 12 CFR 221.2(f).
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Given the nature of the bilateral financial instruments and the
relative sophistication of the counterparties in the OTC derivatives
markets, and the safeguards against excessive leverage contained in
Regulation U, the requirements of Regulation U are more appropriate for
the lending that occurs in these markets. Accordingly, under Rule 36a1-
1, transactions involving extensions of credit by an OTC derivatives
dealer are exempt from the provisions of Section 7(c) of the Exchange
Act \36\ and Regulation T, provided that the OTC derivatives dealer
complies with Section 7(d) of the Exchange Act \37\ and Regulation
U.\38\
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\36\ 15 U.S.C. 78g(c).
\37\ 15 U.S.C. 78g(d).
\38\ Because Regulation U is promulgated pursuant to Section
7(d) of the Exchange Act, an OTC derivatives dealer remains subject
to that provision. In addition, Rule 36a1-1 (17 CFR 240.36a1-1)
applies only to extensions of credit by an OTC derivatives dealer.
Section 7 of the Exchange Act continues to apply to persons
extending credit to an OTC derivatives dealer. Credit extended to an
OTC derivatives dealer, like credit extended to a fully regulated
broker-dealer, however, is excepted from section 7 of the Exchange
Act is it satisfies the conditions for such exceptions contained in
section 7.
---------------------------------------------------------------------------
c. Exemption from SIPA. Under Rule 36a1-2, OTC derivatives dealers
are exempt from the provisions of SIPA, including membership in SIPC.
The application of SIPA's liquidation provisions to an OTC derivatives
dealer in bankruptcy could undermine certain provisions of the
bankruptcy code applicable to the dealer's business. As a result, the
application of SIPA to OTC derivatives dealers would create legal
uncertainty about the rights of counterparties in transactions with OTC
derivatives dealers in the event of dealer insolvency. This uncertainty
could impair the ability of securities firms electing to register OTC
derivatives dealers to compete effectively with banks and foreign
dealers, which are not subject to similar legal uncertainty.
5. Section 11(a) of the Exchange Act
Rule 11a1-6 provides an exception under section 11(a) of the
Exchange Act \39\ for certain transactions effected by a fully
regulated broker-dealer for the account of its OTC derivatives dealer
affiliate. Section 11(a) makes it unlawful for a member of a national
securities exchange to effect transactions on that exchange for certain
accounts, including its own account or the account of an associated
person.
---------------------------------------------------------------------------
\39\ 15 U.S.C. 78k(a).
---------------------------------------------------------------------------
This general prohibition, however, is subject to numerous
exceptions. Among these is a general exception under section
11(a)(1)(G) for a member's proprietary transactions, where the member
is primarily engaged in a public securities business, as indicated by
certain calculations involving the member's gross revenues from the
preceding fiscal year (the ``business mix'' test), and the transactions
``yield,'' in accordance with Commission rules, priority, parity, and
precedence to transactions for accounts of persons who are not members,
or associated with members, of the exchange.\40\
---------------------------------------------------------------------------
\40\ See 15 U.S.C. 78k(a)(1)(G).
---------------------------------------------------------------------------
Rule 11a1-2 under the Exchange Act generally permits a member to
effect a transaction for the account of an associated person if the
member could have effected the transaction for its own account. The
rule, however, requires that the associated person independently meet
the ``business mix'' test in order for the member to rely on the
exception provided under Section 11(a)(1)(G) for transactions effected
for the account of that associated person.
Because an OTC derivatives dealer will be a newly created entity,
it will not be able to demonstrate that it meets this test.
Accordingly, new Rule 11a1-6, like existing Rule 11a1-2, allows a fully
regulated broker-dealer member to effect a transaction on the exchange
for the account of an affiliated OTC derivatives dealer if the member
would have been permitted to effect the transaction for its own
account. Rule 11a1-6 allows the fully regulated broker-dealer to rely
on the exception under section 11(a)(1)(G) for transactions it effects
for its OTC derivatives dealer affiliate even if that affiliate does
not meet the ``business mix'' test. The fully regulated broker-dealer
and the OTC derivatives dealer must comply with all other requirements
of section 11(a).
6. Net Capital Requirements
The net capital rule has been amended to include an alternative net
capital regime for OTC derivatives dealers. Under the amendments, an
OTC derivatives dealer will be subject to higher minimum capital
requirements than a fully regulated broker-dealer. The OTC derivatives
dealer, however, may also be authorized by the Commission to use value-
at-risk (``VAR'') models to calculate capital charges for market risk
and to take alternative charges for credit risk than those currently
prescribed. The minimum capital requirements for an OTC derivatives
dealer are tentative net capital of at least $100 million and net
capital of at least $20 million. Under the circumstances, these minimum
amounts will provide a sufficient liquid capital cushion for entities
that elect to register as an OTC derivatives dealer.
In order to use VAR models to calculate capital charges for market
risk and to take alternative charges for credit risk, under new
Appendix F to Rule 15c3-1, an OTC derivatives dealer must file an
application with, and obtain authorization from, the Commission. The
application, among other things, must describe the OTC derivatives
dealer's VAR model or models, including the manner in which the model
or models meet the requirements specified in Appendix F, and the
dealer's internal risk management controls system (as required under
Rule 15c3-4). The OTC derivatives dealer must also describe in the
application any non-marketable securities that it wants to include in
its VAR calculation.
An OTC derivatives dealer's VAR model must meet certain qualitative
and quantitative requirements under Appendix F that parallel rules
currently followed by U.S. banking agencies. To meet the qualitative
requirements, among other things, an OTC derivatives dealer must
integrate its VAR model into the firm's daily risk management process,
and subject its VAR model to stress tests, internal and external
audits, and backtesting. The quantitative requirements contain
statistical
[[Page 59368]]
parameters for VAR measures using a time horizon that is appropriate in
the regulatory capital context, as well as risk factors that must be
addressed in any model used. These parameters include the use of a ten-
day holding period and a 99% confidence level.
An OTC derivatives dealer applying Appendix F must also compute a
two-part credit risk capital charge, calculated on a counterparty-by-
counterparty basis. The first part of the charge is calculated based on
the net replacement value of all outstanding transactions with each
counterparty after taking into account netting arrangements and
possession of liquid collateral multiplied by a counterparty factor
derived from the creditworthiness of that counterparty. The second part
of the credit risk charge is a concentration charge that is also based
on the creditworthiness of a particular counterparty, but that only
applies when the net replacement value in the account of that
counterparty exceeds 25% of the OTC derivatives dealer's tentative net
capital.
Under Rule 15c3-4, an OTC derivatives dealer using Appendix F is
also required to establish a comprehensive system of internal controls
for monitoring and managing risks associated with its business
activities. The establishment of a system of controls is an important
element of the Commission's regulatory regime for OTC derivatives
dealers. The risks that an OTC derivatives dealer's system of internal
controls must specifically address include market, credit, leverage,
liquidity, legal, and operational risks associated with conducting an
OTC derivatives business.
The Commission will authorize an OTC derivatives dealer to use
Appendix F if it determines that the dealer has met the requirements
set forth in the rules relating to its VAR model and internal risk
management control systems. In addition, an OTC derivatives dealer must
file an application with the Commission before making any material
changes to its VAR model or internal risk management control systems
and receive authorization before implementing any such changes.
7. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
Under the new regulatory structure, a counterparty to an OTC
derivatives transaction generally will not be considered a ``customer''
for purposes of Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3, the
Commission's hypothecation and customer protection rules, and will not
be protected by SIPA. In particular, except as otherwise agreed to in
writing, if an OTC derivatives dealer notifies its counterparty that it
will not segregate the collateral and may use the counterparty's
collateral to further its own business operations, including
commingling and pledging the counterparty's assets, the counterparty
will not be considered a ``customer'' of the dealer for purposes of
Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3.
8. Recordkeeping and Reporting
The rules governing recordkeeping and reporting for an OTC
derivatives dealer have also been modified. The rules will remain
substantially the same as for fully regulated broker-dealers, but they
have been tailored to the business of OTC derivatives dealers.
Reporting will be required only on a quarterly basis. The reports will
include, among other things, information from the dealer regarding its
VAR computations, as well as various credit concentration information.
II. Discussion: New Rules and Amended Rules
After consideration of the issues raised in comment letters
concerning the alternative regulatory structure for OTC derivatives
dealers, the Commission is adopting new Rules 3b-12, 3b-13, 3b-14, 3b-
15, 11a1-6, 15a-1, 15b9-2, 15c3-4, 17a-12, 36a1-1, and 36a1-2 \41\
under the Exchange Act.\42\ The Commission is also amending Rule 30-3
of the Commission's rules of practice \43\ and Exchange Act Rules 8c-1,
15b1-1, 15c2-1, 15c2-5, 15c3-1, 15c3-2, 15c3-3, 17a-3, 17a-4, 17a-5,
and 17a-11.\44\ In addition, the Commission is revising Form X-17A-5
(FOCUS report).\45\
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\41\ 17 CFR 240.3b-12, 240.3b-13, 240.3b-14, 240.3b-15,
240.11a1-6, 240.15a-1, 240.15b9-2, 240.15c3-4, 240.17a-12, 240.36a1-
1, and 240.36a1-2.
\42\ 15 U.S.C. 78a et seq.
\43\17 CFR 200.30-3.
\44\ 17 CFR 240.8c-1, 240.15b1-1, 240.15c2-1, 240.15c2-5,
240.15c3-1, 240.15c3-2, 240.15c3-3, 240.17a-3, 240.17a-4, 240.17a-5,
and 240.17a-11.
\45\ 17 CFR 249.617.
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A. Definitions
The final rules set forth definitions of four new terms: (1) OTC
derivatives dealer; (2) eligible OTC derivative instrument; (3) cash
management securities activities; and (4) ancillary portfolio
management securities activities. Although the Commission had also
proposed to define the term ``permissible derivatives counterparty,''
the Commission has determined that it is unnecessary to use the term in
the final rules and rule amendments. In addition, the Commission is not
adopting a separate rule defining ``hybrid security,'' as proposed, but
rather is including a definition of ``hybrid security'' only for
purposes of the final rules that use the term. The definitions of the
new terms, and the reasons for adopting them in their revised forms,
are described below.
1. Rule 3b-12; Definition of OTC Derivatives Dealer
As proposed, Rule 3b-12 would have defined OTC derivatives dealer
to mean any dealer that limited its securities activities to (1)
engaging as a counterparty in transactions in eligible OTC derivative
instruments with permissible derivatives counterparties; (2) issuing
and reacquiring issued securities through a fully regulated broker or
dealer; or (3) engaging in other securities transactions that the
Commission designated by order. The OTC derivatives dealer would also
have been permitted to engage in ``permissible risk management,
arbitrage, and trading transactions,'' in connection with any of these
securities activities.
The proposed definition of OTC derivatives dealer was intended to
identify a category of dealers that would primarily be engaged as
counterparties in OTC derivatives transactions. The proposed definition
also recognized that these dealers would need to engage in certain
limited securities trading activities in connection with their OTC
derivatives dealing activities in order to operate a competitive
business. The Proposing Release, however, emphasized that an OTC
derivatives dealer should not be able to take advantage of the modified
regulatory requirements to engage in activities better suited to full
broker-dealer regulation.\46\
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\46\ Proposing Release, Section II.A.1., n.17, 62 FR at 67942,
n.17.
---------------------------------------------------------------------------
Several commenters requested that the Commission clarify that the
non-securities activities in which an OTC derivatives dealer would be
permitted to engage would not be limited in either scope or volume
(subject only to capital considerations).\47\ The commenters were
concerned that the language in the summary of the Proposing Release
stating that registration as an OTC derivatives dealer was available
only to entities acting primarily as counterparties in privately
negotiated OTC derivatives transactions was
[[Page 59369]]
potentially inconsistent with the ability of these entities to engage
in any non-securities activities.\48\ In response to these comments,
the Commission has revised the definition of OTC derivatives dealer to
emphasize that the definition limits only the securities activities
\49\ of a dealer seeking to operate an OTC derivatives business under
the new framework.\50\
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\47\ See Comment Summary, Section IV.A.1.; Comment Letter from
the Securities Industry Association's (``SIA'') OTC Derivative
Products Committee, dated April 6, 1998 (``SIA Letter I''), p. 5;
Comment Letter from Merrill Lynch & Co., Inc. (``Merrill Lynch
Letter''), p. 4.
\48\ See, e.g., SIA Letter I, p. 5.
\49\ As a practical matter, the non-securities activities of an
OTC derivatives dealer are limited by the capital requirements and
by the limits imposed on cash management and ancillary portfolio
management securities activities under this regulatory structure.
This parallels the system for fully regulated broker-dealers, which
does not prohibit non-securities activities by definition, but
rather imposes practical limitations on those activities under the
financial responsibility rules.
\50\ In its comment letter, the Commodity Futures Trading
Commission (``CFTC'') stated that the proposal for the alternative
regulatory framework for OTC derivatives dealers extended beyond the
Commission's authority to regulate securities. See Comment Letter
from the CFTC (``CFTC Letter''), p. 1. While the proposal was
appropriately restricted in scope to fall within the Commission's
statutory jurisdiction, the revisions made to Rule 3b-12 (17 CFR
240.3b-12), as well as to the other rules and rule amendments, that
strengthen the focus of the new regulatory framework on the
securities activities of an OTC derivatives dealer serve to clarify
the scope of the Commission's jurisdiction.
---------------------------------------------------------------------------
Several commenters also questioned the proposed definition's limits
on the scope of securities activities in which an OTC derivatives
dealer could engage.\51\ Merrill Lynch & Co., Inc. (``Merrill Lynch'')
suggested that an OTC derivatives dealer should be permitted to engage
in a full range of activities in securities derivative instruments
(including acting as a dealer in such instruments).\52\ Merrill Lynch
also noted that there were numerous types of securities principal
transactions in which an OTC derivatives dealer would need to engage to
support its derivatives business. It expressed concern that any
limitation on the nature or scope of such transactions could
unnecessarily restrict, and in certain cases could increase the risk
of, the dealer's derivatives business.\53\ Other commenters believed
that monitoring the limitations in the proposed rule could create
unnecessary burdens for both the dealers and the Commission, and that
the limitations were not always consistent with the manner in which an
OTC derivatives business is currently conducted.\54\
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\51\ See letters cited in Section IV.A.2. of the Comment
Summary.
\52\ Merrill Lynch Letter, p. 4.
\53\ Merrill Lynch Letter, p. 5. Similarly, the SIA commented
that, so long as an OTC derivatives dealer limited its securities
dealing activities to transactions in eligible OTC derivative
instruments with permissible derivatives counterparties, it was
neither necessary nor desirable to limit the non-dealing securities
activities of an OTC derivatives dealer. SIA Letter I, p. 6.
\54\ E.g., SIA Letter I, p. 6.
---------------------------------------------------------------------------
Commenters also addressed the issue that the alternative regulatory
structure for OTC derivatives dealers is not intended to permit U.S.
securities firms to move their general securities dealing activities
into an OTC derivatives dealer affiliate or to establish proprietary
securities trading desks in the new entity.\55\ In this regard, the
Government Finance Officers Association (``GFOA'') questioned whether
the proposal provided sufficient safeguards to ensure that a firm did
not move its dealer activity in cash market instruments, such as stocks
and bonds, to an OTC derivatives dealer.\56\ Other commenters, however,
believed that the proposal contained enough restrictions on securities
dealing activities to avoid such behavior by an OTC derivatives dealer
acting in good faith.\57\
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\55\ See, e.g, Proposing Release, Section II.A.1., n.17, 62 FR
67942, n.17.
\56\ Comment Letter from the Government Finance Officers
Association (``GFOA Letter''), p. 3.
\57\ E.g., Comment Letter from Morgan Stanley Dean Witter
(``MSDW Letter''), p. 10. In addition, one commenter suggested a
simple prohibition on that business instead of a series of detailed
and complex prophylactic limitations on the permissible activities
of an OTC derivatives dealer. Comment Letter from Salomon Smith
Barney (``Salomon Smith Barney Letter''), p. 2.
---------------------------------------------------------------------------
Taking these comments into account, the final rule provides that an
OTC derivatives dealer is a dealer that is affiliated with a registered
broker or dealer (other than an OTC derivatives dealer) and whose
securities activities are limited to (1) engaging in dealer \58\
activities in eligible OTC derivative instruments that are securities;
(2) issuing and reacquiring securities that are issued by the dealer,
including warrants on securities, hybrid securities,\59\ and structured
notes;\60\ (3) engaging in cash management securities activities (as
defined in Rule 3b-14); (4) engaging in ancillary portfolio management
securities activities (as defined in Rule 3b-15); and (5) engaging in
such other securities activities that the Commission designates by
order.
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\58\ When used in the context of eligible OTC derivative
instruments (as defined in Rule 3b-13 (17 CFR 240.3b-13) or in the
context of OTC derivative instruments in general, the term
``dealer'' activities includes buying, selling, and entering into
OTC derivative instruments. See Section 3(a)(5) of the Exchange Act
(15 U.S.C. 78c(a)(5)) (defining dealer).
\59\ See Section II.A.4. below, discussing the definition of the
term ``hybrid security.''
\60\ In the Proposing Release, the requirement that an OTC
derivatives dealer issue or reacquire its issued securities through
a fully regulated broker or dealer (other than an OTC derivatives
dealer) was set forth in proposed Rule 3b-12(a)(2), as well as in
proposed Rule 15a-1(a)(1)(ii), regarding the permissible securities
activities of an OTC derivatives dealer. This requirement, however,
has been omitted from final Rule 3b-12, and included only in final
Rule 15a-1(c). In this regard, while the securities transactions of
an OTC derivatives dealer generally must be effected through an
affiliated fully regulated broker-dealer, an OTC derivatives dealer
may issue and reacquire its issued securities through an
unaffiliated fully regulated broker-dealer. See Rule 15a-1(c) (17
CFR 240.15a-1(c)) (discussed in Section II.C.3. below).
---------------------------------------------------------------------------
As detailed in Section II.A.5. below, the Commission has defined
the terms ``cash management securities activities'' and ``ancillary
portfolio management securities activities.'' These two terms replace
the term ``permissible risk management, arbitrage, and trading
transactions,'' which was included in the Proposing Release. The new
terms serve substantially the same purpose as the proposed term in that
they describe the additional securities activities in which an OTC
derivatives dealer may engage in connection with its OTC derivatives
business. As a practical matter, a firm seeking to register as an OTC
derivatives dealer will need to be able to conduct these additional
securities activities, such as engaging in certain financing and
hedging transactions, in order to compete effectively with other market
participants.
The focus of the alternative regulatory structure for OTC
derivatives dealers, however, is on providing a regulatory vehicle that
will allow a U.S. securities firm to establish a separately capitalized
entity through which to book an OTC derivatives business. As a result,
the final rules, including the definitions of ``cash management
securities activities'' and ``ancillary portfolio management securities
activities'' contain appropriate limitations to prevent an OTC
derivatives dealer from engaging in dealing activities in cash market
instruments or in substantial proprietary trading activities.
Rule 3b-12, as adopted, also requires that the securities
activities of an OTC derivatives dealer consist primarily of engaging
in dealer activities in eligible OTC derivative instruments that are
securities, issuing and reacquiring its issued securities, and engaging
in cash management securities activities. Thus, if the securities
activities of an OTC derivatives dealer were to consist only or
primarily of ancillary portfolio management securities activities, the
OTC derivatives dealer would be in violation of the rule. For instance,
an OTC derivatives dealer that trades in exchange-traded futures
contracts may not engage in securities activities that consist only or
primarily of managing the risks of those futures transactions.
[[Page 59370]]
In addition, Rule 3b-12 expressly states that an OTC derivatives
dealer's securities activities may not consist of any securities
activities other than those included in the rule, including engaging in
any transaction in any security that is not an eligible OTC derivative
instrument, except for cash management securities activities, ancillary
portfolio management securities activities, and such other securities
activities that the Commission may designate by order. This position is
consistent with the general principle that a broker-dealer is not
permitted to move dealer activities in cash market instruments into the
OTC derivatives dealer.\61\
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\61\ As stated in the Proposing Release, except to the extent
expressly permitted under the rules and rule amendments, an OTC
derivatives dealer may not engage directly or indirectly in any
activity that may otherwise cause it to be a ``dealer'' as defined
in Section 3(a)(5) of the Exchange Act (15 U.S.C. 78c(a)(5)). This
includes, but is not limited to, without regard to the security, (1)
purchasing or selling securities as principal from or to customers;
(2) carrying a dealer inventory in securities (or any portion of an
affiliated broker-dealer's inventory); (3) quoting a market in or
publishing quotes for securities (other than quotes on one side of
the market on a quotations system generally available to non-broker-
dealers, such as a retail screen broker for government securities)
in connection with the purchase or sale of securities permitted
under Rule 15a-1; (4) holding itself out as a dealer or market-maker
or as being otherwise willing to buy or sell one or more securities
on a continuous basis; (5) engaging in trading in securities for the
benefit of others (including any affiliate), rather than solely for
the purpose of the OTC derivatives dealer's investment, liquidity,
or other permissible trading objective; (6) providing incidental
investment advice with respect to securities; (7) participating in a
selling group or underwriting with respect to securities; or (8)
engaging in purchases or sales of securities from or to an
affiliated broker-dealer except at prevailing market prices. See
Proposing Release, Section II.A.4., n.24, 62 FR at 67944, n.24.
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As some commenters noted, the ability of the Commission to issue
orders under Rule 15a-1(b)(1) identifying other permissible securities
activities in which an OTC derivatives dealer may engage should help to
mitigate concerns that the definition sets forth specific limitations
on the securities activities of these entities.\62\ As provided in the
Proposing Release, the Commission is amending Rule 30-3 of the Rules of
Practice to delegate its authority to issue these orders to the
Director of the Division of Market Regulation.\63\
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\62\ See, e.g., SIA Letter I, pp. 6-7. See also Rule 15a-1(b)(1)
(17 CFR 240.15a-1(b)(1)) and Section II.C.2. below, discussing the
ability of the Commission to issue orders under Rule 15a-1(b) (17
CFR 240.15a-1(b)) regarding the securities activities of OTC
derivatives dealers.
\63\ Proposing Release, Section II.C., n.27, 62 FR at 67944,
n.27. See Rule 30-3(a)(64) (17 CFR 200.30-3(a)(64)).
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2. Rule 3b-13; Definition of Eligible OTC Derivative Instrument
An OTC derivatives dealer is permitted to engage in dealer
activities in eligible OTC derivative instruments, as that term is
defined in Rule 3b-13. As proposed, Rule 3b-13 would have defined
``eligible OTC derivative instrument'' to mean any agreement, contract,
or transaction (1) that is not part of a fungible class of agreements,
contracts, or transactions that are standardized as to their material
economic terms; (2) that is based, in whole or in part, on the value
of, any interest in, any quantitative measure of, or the occurrence of
any event relating to, one or more securities, commodities, currencies,
interest or other rates, indices, or other assets, or involve certain
long-dated forward contracts, specifically contracts to purchase or
sell a security on a firm basis at least one year following the
transaction date; \64\ and (3) that is not entered into and traded on
or through an exchange, an electronic marketplace, or similar facility
supervised or regulated by the Commission, or any other multilateral
transaction execution facility.\65\
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\64\ The concern with forwards is that an OTC derivatives dealer
should not be able to engage in dealer activities in short-dated
securities forwards that may in effect replicate cash market
instruments or in certain government securities forwards, such as
Government National Mortgage Association (GNMA) forwards.
\65\ Proposing Release, Section II.A.2., 62 FR at 67942.
---------------------------------------------------------------------------
Several commenters criticized this proposed definition.\66\ For
example, the SIA argued that the proposed definition failed to include
certain important categories of transactions, such as transactions that
are based on the occurrence or nonoccurrence of specified events, but
that do not technically relate to one or more securities, commodities,
and the like, although they are associated with financial consequences,
such as credit derivatives.\67\ Morgan Stanley Dean Witter argued that
the requirement that eligible OTC derivative instruments be based on at
least one of an enumerated list of underlying assets could
unnecessarily limit these dealers' activities in rapidly evolving
products while Commission approval was being sought on a product-by-
product basis.\68\
---------------------------------------------------------------------------
\66\ See letters cited in Section IV.B. of the Comment Summary.
\67\ SIA Letter I, pp. 9-10; see also Merrill Lynch Letter, p.
7.
\68\ MSDW Letter, p. 6.
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The SIA also suggested alternative definitions of ``eligible OTC
derivative instrument'' and recommended that the Commission clarify
that it was not intending to construe or expand the definition of
``security'' under the Exchange Act.\69\ Several commenters asked that
the Commission clarify what instruments would be considered
``securities'' OTC derivative instruments and ``non-securities'' OTC
derivative instruments for purposes of the rules.\70\ Merrill Lynch
agreed in principle with the approach of proposed Rule 3b-13, but also
suggested that an OTC derivatives dealer be able to seek expedited
interpretative guidance for new derivative instruments.\71\
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\69\ SIA Letter I, p. 10. See also Comment Letter from SIA,
dated October 16, 1998 (``SIA Letter II''), pp. 2-3.
\70\ EUDA Letter, p. 2; GFOA Letter, p. 1; Comment Letter from
the New York Stock Exchange (``NYSE Letter''), p. 3.
\71\ Merrill Lynch Letter, p. 7.
---------------------------------------------------------------------------
Several commenters were also concerned that the proposed definition
required that forwards have a duration period of one year or more in
order to qualify as an eligible OTC derivative instrument, and
suggested shorter periods, such as one month or two weeks.\72\ The SIA
suggested that, in including a duration period for forwards, the
definition should distinguish between government securities forwards
and forwards involving non-government securities.\73\ In addition, the
SIA maintained that those securities forwards having material features
of a type described in the definition of eligible OTC derivative
instrument should qualify as eligible OTC derivative instruments.\74\
---------------------------------------------------------------------------
\72\ SIA Letter I, pp. 9-10; Merrill Lynch Letter, p. 7; Comment
Letter from D.E. Shaw & Co. L.P. (``DESCO Letter''), p. 7.
\73\ SIA Letter II, p. 2.
\74\ Id.
---------------------------------------------------------------------------
Several commenters raised concerns with the use of concepts from
the CEA in defining the term eligible OTC derivative instrument. In its
comment letter, the Commodity Futures Trading Commission (``CFTC'')
noted that the proposed definition relied on criteria that were similar
to, but not the same as, the criteria for qualifying transactions under
the CFTC's part 35 swaps exemption.\75\ The CFTC stated that a
registered OTC derivatives dealer could effect transactions that would
be permissible under the proposed rules, but that would not be exempted
under part 35 from the provisions of the CEA, and thus market
participants might face legal uncertainty concerns in entering into
certain derivatives transactions.
---------------------------------------------------------------------------
\75\ CFTC Letter, pp. 11-12. The CFTC's Part 35 regulations
exempt certain swap transactions from most provisions of the CEA,
provided that the transaction is conducted solely between ``eligible
swap participants,'' as defined in part 35 (17 CFR part 35).
---------------------------------------------------------------------------
On a similar note, two commenters were concerned that the proposed
[[Page 59371]]
definition adopted concepts from the CEA in excluding transactions that
were standardized or traded on ``an exchange, an electronic
marketplace, or similar facility supervised or regulated by the
Commission, or any other multilateral transaction execution facility.''
\76\ The SIA argued that the text potentially could exclude from the
definition a broad range of transactions involving exempt securities,
as well as transactions that did not involve securities at all, which
it believed should not be excluded from the proposed definition. The
SIA also opined that the proposed language would spawn significant
uncertainty over its scope.\77\ Morgan Stanley Dean Witter similarly
claimed that the use of terms contained in the CEA that were not
commonly understood in the securities law context caused the definition
of ``eligible OTC derivative instrument'' to be ambiguous.\78\
---------------------------------------------------------------------------
\76\ SIA Letter I, pp. 9-10; MSDW Letter, pp. 7-8.
\77\ SIA Letter I, p.9.
\78\ MSDW Letter, pp. 7-8.
---------------------------------------------------------------------------
In response to these comments, the Commission has revised the
definition of eligible OTC derivative instrument in several ways. As
adopted, Rule 3b-13 defines eligible OTC derivative instrument to mean,
subject to certain exceptions, any contract, agreement, or transaction
that provides, in whole or in part, on a firm or contingent basis, for
the purchase or sale of, or is based on the value of, or any interest
in, one or more commodities, securities, currencies, interest or other
rates, indices, quantitative measures, or other financial or economic
interests or property of any kind, or that involves any payment or
delivery that is dependent on the occurrence or nonoccurrence of any
event associated with a potential financial, economic, or commercial
consequence, or any combination or permutation of the foregoing.\79\
The term eligible OTC derivative instrument, however, does not include
certain forwards on securities, securities listed or traded on a
national securities exchange or on Nasdaq, or fungible securities
derivative instruments that are standardized as to their material
economic terms.\80\
---------------------------------------------------------------------------
\79\ Rule 3b-13(a) (17 CFR 240.3b-13(a).
\80\ See Rule 3b-13(b) (17 CFR 240.3b-13).
---------------------------------------------------------------------------
Rule 3b-13 defines eligible OTC derivative instrument broadly to
encompass the wide range of securities and non-securities OTC
derivative instruments currently existing in the derivatives markets,
as well as to allow for the inclusion of reasonably similar instruments
that market participants may develop in the future. The types of
instruments that generally satisfy the criteria set forth in Rule 3b-13
include interest rate swaps, currency swaps, equity swaps, swaps
involving physical commodities (such as metals or petroleum), OTC
options on equities (including equity indices), OTC options on U.S.
government securities, OTC debt options (including options on debt
indices), options on physical commodities, long-dated forwards on
securities, and forwards relating to other types of assets. Other types
of instruments also satisfy the criteria in the rule.
The definition of eligible OTC derivative instrument has also been
revised to omit terms commonly understood in the context of the CEA. As
a technical matter, exchange-traded futures will now fall within the
definition of eligible OTC derivative instrument. As discussed in
Section II.A.1. above, however, the rules limit only the securities
activities of an OTC derivatives dealer, and, subject to appropriate
capital treatment and compliance with internal risk management controls
requirements, an OTC derivatives dealer generally may engage in any
non-securities activities. Thus, the new regulatory structure does not
limit an OTC derivatives dealer's ability to engage in futures
activities, which is consistent with the current approach toward the
regulation of general securities broker-dealers. The activities of an
OTC derivatives dealer, however, must comply with any and all
applicable laws, including the CEA to the extent it applies to any
particular transaction.
In response to comments raised by the SIA,\81\ the final rule also
distinguishes between government securities forwards and other
securities forwards with respect to duration periods. Rule 3b-13
generally excludes from the definition of eligible OTC derivative
instrument forwards on a government security that settle within twelve
months, and certain other securities forwards that satisfy the
definition of ``eligible forward contract'' \82\ that settle within
four months.\83\ Although the duration period for an ``eligible forward
contract'' is shorter than the original proposal of one year for all
securities forwards, the periods better reflect the manner in which an
OTC derivatives business is conducted and will continue to constrain an
OTC derivatives dealer from improperly engaging in the types of forward
transactions that should occur in its fully regulated broker-dealer
affiliate.\84\ The final rule has also been revised to include as
eligible OTC derivative instruments those securities forwards that have
material economic features primarily of a type described in the
definition of eligible OTC derivative instrument (other than the
provision for the purchase and sale of a security on a firm basis).
---------------------------------------------------------------------------
\81\ See supra note 73.
\82\ For purpose of Rule 3b-13, the term ``eligible forward
contract'' means ``a forward contract that provides for the purchase
or sale of a security other than a government security, provided
that, if such contract provides for the purchase or sale of margin
stock (as defined in Regulation U of the Regulations of the Board of
Governors of the Federal Reserve System, 12 CFR part 221), such
contract either (1) provides for the purchase or sale of such stock
by the issuer thereof (or an affiliate that is not a bank or a
broker or dealer); or (2) provides for the transfer of transaction
collateral in an amount that would satisfy the requirements, if any,
that would be applicable assuming the OTC derivatives dealer party
to such transaction were not eligible for the exemption from
Regulation T of the Regulations of the Board of Governors of the
Federal Reserve System, 12 CFR part 220, set forth in (Rule 36a1-1).
\83\ In its comment letter, the SIA requested guidance regarding
the application of the duration requirement for securities forwards
in the context of certain transaction structures that require a
forward to be market-to-market and repriced. See SIA Letter II, p.
2, n.1. For example, a contract may provide that it is to be
periodically marked-to-market and repriced with a settlement payment
to be made on each repricing date in an amount equal to the change
in the value of the underlying security. Id. In response to the
SIA's request, under Rule 3b-13, where a securities forward
transaction provides for reset or repricing dates, such dates will
be viewed as settlement dates, and will cause the forward to be
separated into shorter duration periods, only if the parties can
close out the transaction on such dates. For example, if a one-year
securities forward resets monthly to mitigate the credit risk
associated with the transaction, and the parties can close out the
forward on the reset date, for purposes of Rule 3b-13, the
transaction will be regarded as separate one-month forward
transaction. If, however, the parties are not able to close out the
forward, or otherwise discharge their obligations under the contract
by accelerating all or part of the originally scheduled physical
settlement, on the reset dates, then the reset dates will not be
viewed as separate settlement dates.
\84\ A fully regulated broker-dealer is not permitted to move
its securities book to the OTC derivatives dealer by forwarding out
its positions and then reversing those transactions. See Rule 15a-
1(a) (17 CFR 240.15a-1(a).
---------------------------------------------------------------------------
The definition of eligible OTC derivative instrument excludes
securities derivative instruments that are listed or traded on an
exchange or on Nasdaq. Similarly, the definition excludes those
securities derivative instruments that are one of a class of fungible
instruments that are standardized as to their material economic terms.
With respect to the exclusion for certain fungible instruments, the
Commission has retained the authority under Rule 15a-1(b)(2) to
determine by order that a securities derivative instrument that is one
of a class of fungible instruments that are standardized as to their
material economic terms is within the scope of eligible OTC derivative
instrument. This
[[Page 59372]]
authority will permit the Commission, in limited circumstances, to
expand the types of securities derivative instruments in which an OTC
derivatives dealer may engage in dealer activities. The Commission is
amending Rule 30-3 of the Rules of Practice to delegate this authority
to the Director of the Division of Market Regulation.\85\
---------------------------------------------------------------------------
\85\ See Rule 30-3(a)(65) (17 CFR 200.30-3(a)(65). See also
Section II.C.2. below, discussing the ability of the Commission to
issue orders under rule 15a-1(b) (17 CFR 240.15a-1(b) regarding the
securities activities of OTC derivatives dealers.
---------------------------------------------------------------------------
As noted above, the Commission responded to commenters' concerns by
adopting an expansive definition of eligible OTC derivative instrument,
with few exclusions. The final rule thereby permits an OTC derivatives
dealer to deal in a broad array of financial instruments in order to
accommodate current business practices.\86\ Because of this
accommodation, however, the Commission has also reserved the authority
under Rule 15a-1(b) to issue orders clarifying whether certain
contracts, agreements, or transactions are within the scope of eligible
OTC derivative instrument.\87\
---------------------------------------------------------------------------
\86\ The Commission will consider the economic realities of a
securities transaction, and not the label assigned to the
transaction, for purposes of determining whether a particular
transaction is permitted under the alternative regulatory framework.
See, e.g., In the Matter of BT Securities Corporation, Exchange Act
Release No. 35136 (Dec. 22, 1994). For example, an OTC derivatives
dealer may not engage in a forward transaction that would otherwise
not be permitted under the framework in the guise of options or
other permitted transactions.
\87\ See Rule 15a-1(b)(3) (17 CFR 240.15a-1(b)(3). Unlike other
provisions contained in these rules that permit the expansion of OTC
derivatives dealers' activities, this authority has not been
delegated to the staff.
---------------------------------------------------------------------------
The final rules, however, do not define the term ``securities OTC
derivative instrument,'' which is intended to encompass OTC derivative
instruments that are securities. The term ``security'' is defined in
section 3(a)(10) of the Exchange Act,\88\ and the final rules do not
interpret or amend the definition of ``security'' under the Exchange
Act. Staff guidance will continue to remain available regarding the
applicability of the federal securities laws to any particular OTC
derivative instrument.\89\
---------------------------------------------------------------------------
\88\ 15 U.S.C. 78c(a)(10).
\89\ Questions on this subject should be addressed to the Office
of Chief Counsel, Division of Market Regulation, Securities and
Exchange Commission, 450 Fifth Street, NW, Mail Stop 10-1,
Washington, DC 20549, (202) 942-0073
---------------------------------------------------------------------------
3. Proposed Rule 3b-14; Definition of Permissible Derivatives
Counterparty
Proposed Rule 3b-14 defined those entities and natural persons that
would have been eligible to engage in an OTC derivatives transaction
with an OTC derivatives dealer. As the Proposing Release noted, these
persons included the same persons who currently are eligible to effect
transactions with swaps dealers under the CFTC's Part 35
regulations.\90\ The Proposing Release also sought specific comment on
whether the definition of permissible derivatives counterparty should
be expanded to include natural persons having at least $5 million in
total assets who entered into OTC derivatives transactions to hedge
existing or anticipated assets or liabilities.\91\
---------------------------------------------------------------------------
\90\ Proposing Release, Section II.A.3., 62 FR at 67942.
\91\ Id.
---------------------------------------------------------------------------
Most commenters suggested that a broad range of persons should be
able to act as permissible derivatives counterparties, and believed
that the definition should be expanded, at a minimum, to include
natural persons having at least $5 million in total assets as
proposed.\92\ The SIA opined that these natural persons were
appropriate counterparties and would benefit from having access to risk
mitigation products that could be tailored to their individual
circumstances and objectives.\93\
---------------------------------------------------------------------------
\92\ See letters cited in Section IV.C. of the Comment Summary.
\93\ SIA Letter I, p. 10.
---------------------------------------------------------------------------
A few commenters, however, raised concerns that the proposed group
of permissible derivatives counterparties could include unsophisticated
persons who would need the protections provided by the securities sales
practice requirements.\94\ D.E. Shaw & Co. noted that an OTC
derivatives dealer would have to rely upon information provided by the
counterparty as to its total assets or net worth, and suggested that an
OTC derivatives dealer should only be required to have a ``reasonable
belief'' that the counterparty was a ``permissible derivatives
counterparty.'' \95\
---------------------------------------------------------------------------
\94\ See, e.g., NYSE Letter, p. 3; EUDA Letter, p. 2.
\95\ DESCO Letter, pp. 7-8.
---------------------------------------------------------------------------
The CFTC, in turn, raised concerns that conflicts might arise
between the Commission's rules and the CFTC's rules in connection with
the proposed definition of permissible derivatives counterparty,
particularly if the definition were expanded to include parties who
would not be eligible swap participants under the CFTC's Part 35
regulations. The CFTC suggested that if an OTC derivatives dealer were
to enter into a transaction with a permissible derivatives counterparty
that was not an eligible swap participant, the transaction would be
outside the exemption of the Part 35 regulations, and could therefore
constitute an illegal futures or commodity option contract.\96\
---------------------------------------------------------------------------
\96\ CFTC Letter, p. 12.
---------------------------------------------------------------------------
In response to commenters' concerns, and in light of the
protections afforded through other provisions of the alternative
regulatory framework, the final rules do not restrict the persons that
may act as counterparties in OTC derivatives transactions with an OTC
derivatives dealer. Instead, the final rules contain certain safeguards
designed to protect an OTC derivatives dealer's counterparties, as well
as to prevent trading in standardized and fungible OTC derivative
instruments that are securities.
In particular, Rule 15a-1 requires, subject to limited exceptions,
an OTC derivatives dealer to effect any securities transaction through
its fully regulated broker-dealer affiliate, subject to all applicable
sales practice requirements.\97\ In addition, Rule 3b-13 excepts from
the definition of eligible OTC derivative instrument those securities
contracts that are one of a class of fungible instruments that are
standardized as to their material economic terms.\98\ The elimination
of counterparty restrictions also addresses concerns that confusion
about the applicability of the CEA could arise as a result of any
differences between the terms ``permissible derivatives counterparty''
and ``eligible swap participant.'' As noted above, this rulemaking does
not affect the applicability of the CEA to any particular transaction.
---------------------------------------------------------------------------
\97\ Rule 15a-1(c) (17 CFR 240.15a-1(c)).
\98\ Rule 3b-13(b)(2)(ii) (17 CFR 240.3b-13(b)(2)(ii)).
---------------------------------------------------------------------------
4. Proposed Rule 3b-16; Definition of Hybrid Security
As proposed, Rule 3b-16 would have defined hybrid security to mean
a security that incorporates payment features economically similar to
options, forwards, futures, swap agreements, or collars involving
currencies, interest rates, commodities, securities, or indices (or any
combination, permutation, or derivative of such contract or underlying
interest). The definition of hybrid security did not raise many
comments.
The CFTC, however, expressed concerns that, in proposing a
definition of hybrid security, no consideration was given to the scope
of the exemption for hybrid instruments contained in the CFTC's Part 34
regulations.\99\ The CFTC
[[Page 59373]]
noted that some of the instruments that would qualify as ``acceptable''
hybrid securities were actually futures or commodity option contracts
that were not exempted under the CFTC's Part 34 regulations and could
thus be illegal under the CEA.\100\
---------------------------------------------------------------------------
\99\ CFTC Letter, p. 13. Hybrid instruments are depository
instruments or securities instruments, such as debt or equity
securities, that have one or more commodity-dependent components
with payment features similar to commodity futures or commodity
option contracts. Under the CFTC's part 34 regulations, such
instruments may be exempt from regulation under the CEA if the sum
of the commodity-dependent values of the commodity-dependent
components of the instrument is less than the commodity-dependent
value of the commodity-independent component. 17 CFR part 34.
\100\ CFTC Letter, p. 13.
---------------------------------------------------------------------------
The term hybrid security, however, is limited to securities that
incorporate the enumerated payment features. In addition, the
alternative regulatory framework employs the term only in the context
of an OTC derivatives dealer's ability to issue and reacquire its
issued securities (including hybrid securities) under Rules 3b-12 and
15a-1. Moreover, as stated previously, an OTC derivatives dealer
remains subject to all other applicable statutes, rules, and
regulations. To the extent that the offer and sale of hybrid securities
by an OTC derivatives dealer are covered by the CEA, the transactions
would need to be structured to qualify for available exemptions.
Nevertheless, because of the limited use of the term under the
alternative regulatory framework, the Commission is not adopting a
separate rule defining ``hybrid security,'' but rather is including a
definition of the term only for purposes of Rules 3b-12 and 15a-1.
Certain revisions have been made to the definition of ``hybrid
security'' to achieve conformity with the revisions to the final
definition of eligible OTC derivative instrument as set forth in Rule
3b-13.\101\ Accordingly, for purposes of Rules 3b-12 and 15a-1, a
``hybrid security'' is defined to mean a security that incorporates
payment features economically similar to options, forwards, futures,
swap agreements, or collars involving currencies, interest or other
rates, commodities, securities, indices, quantitative measures, or
other financial or economic interests or property of any kind, or any
payment or delivery that is dependent on the occurrence or
nonoccurrence of any event associated with a potential financial,
economic, or commercial consequence (or any combination, permutation,
or derivative of such contract or underlying interest).\102\
---------------------------------------------------------------------------
\101\ See discussion at Section II.A.2. above See also SIA
Letter II, p. 3, n.2.
\102\ See Rules 3b-12(d) (17 CFR 240.3b-12(d)) and 15a-1(e) (17
CFR 240.15a-1(e)).
---------------------------------------------------------------------------
5. Rules 3b-14 and 3b-15; Definitions of Cash Management Securities
Activities and Ancillary Portfolio Management Securities Activities
Proposed Rule 3b-15 would have permitted an OTC derivatives dealer
to engage in a limited range of securities activities, described under
the rule as ``permissible risk management, arbitrage, and trading
transactions,'' in connection with the dealer's business as a
counterparty in eligible OTC derivative instruments and as an issuer of
securities. As discussed above, the focus of the alternate regulatory
system for OTC derivatives dealers is to permit U.S. securities firms
to establish a separately capitalized booking vehicle for an OTC
derivatives business. However, in order to operate a competitive
business, an OTC derivatives dealer must also be able to engage in
limited securities trading activities in connection with its OTC
derivatives dealing business. This includes the ability to take
possession of and sell counterparty collateral, to invest short-term
cash balances, to engage in certain financing transactions, and to
manage risks associated with its OTC derivatives positions or its
issuance of securities.
These related securities activities, however, must be subject to
appropriate limitations to prevent an OTC derivatives dealer from
engaging in dealing activity in cash market instruments. An OTC
derivatives dealer should not be provided with an unfair regulatory
advantage over a fully regulated broker-dealer due to the availability
of modified capital and margin requirements. In addition, an entity
that engages in comprehensive securities dealing activity should be
subject to full broker-dealer regulation, including existing capital
and margin requirements, and be subject to supervision by an SRO.
Moreover, appropriate limitations on the related securities
activities of an OTC derivatives dealer must be in place to prevent the
dealer from engaging in substantial proprietary securities trading
activities. The alternative regulatory framework is not intended to
allow an OTC derivatives dealer to operate in a manner similar to an
active securities trader, such as a hedge fund. Accordingly, under the
final rules, an OTC derivatives dealer may not engage in any
transaction in any security that is not an eligible OTC derivative
instrument, with the exception of activities permitted under final
Rules 3b-14 and 3b-15, as discussed below.\103\
---------------------------------------------------------------------------
\103\ See Rules 3b-12(c) (17 CFR 240.3b-12(c)) and 15a-1(a)(3)
(17 CFR 240.15a-1(a)(3)).
---------------------------------------------------------------------------
Under the regulatory framework, as proposed, the definition of
``permissible risk management, arbitrage, and trading transactions''
attempted to carefully define activities associated with managing the
risk of an OTC derivatives dealer's business, while excluding other
securities dealing and proprietary trading activities. Based on the
comments received on the scope of ``permissible risk management,
arbitrage, and trading transactions,'' however, the final rules have
been restructured to more accurately reflect the types of cash
management and portfolio management activities engaged in by dealers in
OTC derivative instruments. Therefore, as noted above, the Commission
is not adopting a definition of ``permissible risk management,
arbitrage, and trading transactions,'' but rather is defining two new
terms: ``cash management securities activities'' and ``ancillary
portfolio management securities activities.'' \104\
---------------------------------------------------------------------------
\104\ With certain exceptions (see Section II.C.3. below), all
cash management securities activities and ancillary portfolio
management securities activities must be effected through an OTC
derivatives dealer's fully regulated broker-dealer affiliate. See
Rule 15a-1(c) (17 CFR 240.15a-1(c)).
---------------------------------------------------------------------------
a. Rule 3b-14; Cash Management Securities Activities. An OTC
derivatives dealer may engage in ``cash management securities
activities,'' as defined in Rule 3b-14. Under the rule, an OTC
derivatives dealer may engage in cash management securities activities
in connection with its securities activities as permitted under Rule
15a-1 (discussed in Section II.C.1. below) or its non-securities
activities that involve eligible OTC derivative instruments or other
financial instruments. Cash management securities activities are
limited to (1) any taking possession of, and any subsequent sale or
disposition of, collateral provided by a counterparty, or any
acquisition of, and any subsequent sale or disposition of, collateral
to be provided to a counterparty; (2) cash management; and (3)
financing of certain positions of the dealer. Each of these three
categories of cash management securities activities is discussed in
more detail below.
i. Counterparty Collateral. Proposed Rule 3b-15(a) would have
allowed an OTC derivatives dealer to take possession of and sell
counterparty collateral, in connection with the dealer's business as a
counterparty in eligible OTC derivative instruments and as an issuer of
securities. The SIA
[[Page 59374]]
argued that this provision unduly restricted the scope of activities,
and requested that the rule be modified to allow an OTC derivatives
dealer to engage in (1) any disposition of collateral provided by a
counterparty; and (2) the acquisition of, and any subsequent sale or
disposition of, collateral to be provided to a counterparty.\105\
---------------------------------------------------------------------------
\105\ SIA Letter I, p. 8.
---------------------------------------------------------------------------
To allow an OTC derivatives dealer to take appropriate action with
respect to counterparty collateral, an OTC derivatives dealer's
activities should not be limited to taking possession of and selling
collateral, but should also extend to other dispositions of the
collateral. Therefore, Rule 3b-14(a), as adopted, has been revised to
expand the permissible activities of an OTC derivatives dealer with
respect to counterparty collateral.
Rule 3b-14(a), like proposed Rule 3b-15(a), does not limit any use
of the counterparty collateral consistent with the agreements entered
into between dealers and their counterparties. As the End-Users of
Derivatives Association, Inc. (``EUDA'') noted, many end-users deny
counterparties free use of posted collateral because it may expose the
pledging party to significant additional credit risk.\106\ In this
regard, Rule 3b-14 is not intended to have any effect on individually
negotiated collateral support agreements or any rehypothecation rights
contained in these agreements.
---------------------------------------------------------------------------
\106\ EUDA Letter, p. 3.
---------------------------------------------------------------------------
ii. Cash Management. Rule 3b-14(b), as adopted, permits an OTC
derivatives dealer to engage in cash management activities in
connection with the dealer's securities activities (as permitted under
Rule 15a-1) or its non-securities activities that involve eligible OTC
derivative instruments or other financial instruments.\107\ Rule 3b-
14(b) applies only to managing cash of the OTC derivatives dealer, and
not of its affiliates. Thus, any securities trading activities
associated with cash management by an OTC derivatives dealer must be at
a level commensurate with the OTC derivatives dealer's bona fide
operational needs, taking into consideration the Commission's capital
requirements for the OTC derivatives dealer and the amount of capital
needed to satisfy the credit requirements of counterparties.
---------------------------------------------------------------------------
\107\ As proposed, Rule 3b-15(b) would have permitted an OTC
derivatives dealer to engage in transactions involving cash
management, in connection with the dealer's business as a
counterparty in eligible OTC instruments and as an issuer of
securities. Proposing Release, Section II.A4., 62 FR at 67943. No
commenters specifically addressed permitted cash management
practices.
---------------------------------------------------------------------------
Cash management securities activities must also be limited to
trading in instruments that are sufficiently liquid and otherwise
recognized as appropriate cash management instruments. In addition,
these activities may not involve moving government securities
repurchase agreement or other trading books from a fully regulated
broker-dealer into its OTC derivatives dealer affiliate.
iii. Financing. Under proposed Rule 3b-15(d), an OTC derivatives
dealer generally would have been permitted to engage in financing
transactions in connection with its business as a counterparty in
eligible OTC derivative instruments and as an issuer of securities. The
proposed rule would also have required that these financing activities
be limited to transactions involving securities positions established
through the taking possession of or sale of counterparty collateral,
cash management, or hedging activity. The SIA regarded these
limitations as unduly restrictive, and believed that an OTC derivatives
dealer should be permitted to finance any aspect of its permitted
activities, subject to compliance with Section 7(c) or (d) of the
Exchange Act, as applicable.\108\
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\108\ SIA Letter I, p. 8.
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In response to these concerns, Rule 3b-14(c) provides that an OTC
derivatives dealer may finance through securities transactions any
position of the dealer acquired in connection with its permissible
securities activities or its non-securities activities that involve
eligible OTC derivative instruments or other financial instruments.
Proposed Rule 3b-15 would have permitted financing of certain
securities positions by means of repurchase and reverse repurchase
agreements, buy/sell transactions,\109\ and lending and borrowing
transactions. The final rule eliminates the list of restrictions on the
types of transactions in which an OTC derivatives dealer may engage to
finance its positions. However, a broker-dealer may not run such things
as a repurchase agreement, stock lending, or buy/sell book out of an
affiliated OTC derivatives dealer in order, for example, to have access
to financing for the OTC derivatives dealer's business.
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\109\ A buy/sell transaction is in many respects the economic
equivalent of a repurchase transaction. The principal respect in
which it differs is that title to the instrument that is the subject
of the transaction passes to another party. See Proposing Release,
Section II.A.4., n.22, 62 FR at 67943, n.22.
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b. Rule 3b-15; Ancillary Portfolio Management Securities
Activities. In addition to cash management securities activities, an
OTC derivatives dealer may engage in ``ancillary portfolio management
securities activities,'' as defined in Rule 3b-15. Under the rule,
these securities activities must be limited to transactions in
connection with the OTC derivatives dealer's dealer activities in
eligible OTC derivative instruments, the issuance of securities by the
dealer, or such other securities activities that the Commission may
designate by order. They must also (1) be conducted for the purpose of
reducing the market or credit risk of the dealer or consist of
incidental trading activities for portfolio management purposes; and
(2) be limited to risk exposures within the market, credit, leverage,
and liquidity risk parameters set forth in both the trading
authorizations granted to the associated person (or to the associated
person's supervisor) who executes the transaction for, or on behalf of,
the dealer, and the written guidelines approved by the dealer's
governing body and included in the dealer's internal risk management
control system.\110\ Rule 3b-15 also requires that ancillary portfolio
management securities activities be conducted only by associated
persons of the dealer who perform substantial duties for or on behalf
of the dealer in connection with its dealer activities in eligible OTC
derivative instruments.
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\110\ As discussed in Section II.H.3. below, Rule 15c3-4 (17 CFR
240.15c3-4) requires an OTC derivatives dealer to establish,
document, and maintain a system of internal controls for monitoring
and managing risk associated with its business activities.
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The limitations on an OTC derivatives dealer's portfolio management
activities under Rule 3b-15 are aimed at preventing the fully regulated
broker-dealer from moving its securities book into its OTC derivatives
dealer affiliate, establishing a proprietary trading desk in the OTC
derivatives dealer, or authorizing personnel or trading units
specifically to engage in proprietary trading activities.\111\ These
activities are not within the scope of an OTC derivatives dealer's
primary role as a booking vehicle for OTC derivatives transactions, and
a firm engaging in
[[Page 59375]]
these activities would be in violation of the rules.\112\
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\111\ See also Section II.A.1. above, discussing the limitations
on securities activities imposed under Rule 3b-12. In short, the
scope of permissible portfolio management securities activities is
further limited by the requirement under Rule 3b-12 that the
securities activities of an OTC derivatives dealer consist primarily
of engaging in dealer activities in eligible OTC derivative
instruments that are securities, issuing and requiring securities
that are issued by the dealer, and cash management securities
activities. See Rule 3b-12(b) (17 CFR 240.3b-12(b)).
\112\ See Rule 15a-1 (17 CFR 240.15a-1), and discussion in
Section II.C. below.
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Rule 3b-15, however, does permit an OTC derivatives dealer to
engage in incidental securities trading activities for portfolio
management purposes. In permitting this, the rule recognizes that an
OTC derivatives dealer may to a limited extent engage in a securities
trading activity for portfolio management purposes that may not
necessarily be for the specific purpose of reducing the dealer's market
or credit risk.\113\ This provision of the rule, however, is not
intended to permit an OTC derivatives dealer to engage in substantial
securities trading that is not for the purpose of reducing the dealer's
market or credit risk arising out of its dealer activities in eligible
OTC derivative instruments (or its issuance of securities).
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\113\ For example, a firm that has a long position in equity
volatility as a result of OTC derivatives transactions with
counterparties is not required to engage in ancillary portfolio
management securities activities that reduce that volatility
exposure. Instead, for example, a firm that believes that equity
volatility exposure. Instead, for example, a firm that believes that
equity volatility is underpriced in the market could enter into
exchange-listed derivatives transactions to create or increase
existing long volatility exposure. Similarly, a firm whose OTC
derivatives portfolio included risk exposure to a particular asset
category or credit could enter into non-OTC derivatives transactions
in securities that would effectively convert that exposure to a
different asset category or credit.
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As discussed more fully below, the Commission has responded to
commenters by easing the restrictions on the non-dealing securities
activities of OTC derivatives dealers and by broadly defining ancillary
portfolio management securities activities. The final rules are
intended to be flexible and to accommodate current business practices
of OTC derivatives dealers. Because, as drafted, the rule defines a
broad scope of permissible activities, the restrictions on proprietary
trading and dealing in cash markets may prove inadequate. Thus, Rule
15a-1(b)(4) preserves the Commission's ability to clarify, by order,
whether certain securities activities of an OTC derivatives dealer are
within the scope of ancillary portfolio management securities
activities.\114\
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\114\ See Rule 15a-1(b)(4) (17 CFR 240.15a-1(b)(4)). The
Commission is not delegating this authority to its staff.
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Because the commenters generally focused on the categories of
activities identified in the definition of ``permissible risk
management, arbitrage, and trading transactions'' under proposed Rule
3b-15, each of these categories is discussed separately below.
i. Hedging. Under proposed Rule 3b-15(c), an OTC derivatives dealer
would have been permitted to ``hedge an element of market or credit
risk associated with one or more existing or anticipated transactions
in eligible OTC derivative instruments or the issuance of securities,
including warrants on securities, hybrid securities, or structured
notes.'' This is the only section of the proposed rules that
specifically addressed the risk management practices of an OTC
derivatives dealer. For that reason, some commenters believed that the
Commission should more clearly define what activities would be
considered ``hedging activity.'' \115\ They essentially did not want an
OTC derivatives dealer to be limited to hedging only those risks
arising in connection with the dealer's business as a counterparty in
eligible OTC derivative instruments and as an issuer of securities, but
rather wanted the firm to be able to manage risks on a portfolio-wide
basis through hedging or other risk management techniques.
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\115\ See, e.g., Comment Letter from the Association of the Bar
of the City of New York, Committee on Futures Regulation (``ABCNY
Committee Letter''), p. 3; see also letters cited in Section
IV.F.1.b. of the Comment Summary.
---------------------------------------------------------------------------
For instance, the SIA regarded the limitation on the ``hedging''
activities listed in the proposed rule as unduly restrictive, and
believed that an OTC derivatives dealer should be permitted to ``engage
in any risk management transaction that is designed to implement
management's decision as to the market risk profile the firm wishes to
obtain.'' \116\ In this regard, the SIA commented that dealers do more
than just hedge their positions, and that many dealers take on levels
of risk consistent with certain risk parameters. The SIA also claimed
that an OTC derivatives dealer should be permitted to manage the risks
associated with cash management, financing, and other permissible
securities positions, in addition to the risks arising from permissible
derivative and hybrid positions.\117\ D.E. Shaw & Co., in turn, stated
that an OTC derivatives dealer should also be able to engage in risk
management activities that involve the hedging of ``liquidity, legal,
or operational risks, or any other risks for which derivative hedging
products are developed.'' \118\
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\116\ SIA Letter I, p. 8.
\117\ Id. See also Merrill Lynch Letter, p. 5. In a later
comment letter, the SIA also stated that, so long as an OTC
derivatives dealer's securities activities consisted primarily of
conducting an OTC derivatives dealing business, an OTC derivatives
dealer should be permitted to engage in cash market securities
trading activities for portfolio management purposes, provided that
these activities did not give rise to portfolio risk exposures that,
on an aggregate basis, exceeded the risk management parameters for
the dealer's business pursuant to proposed Rule 15c3-4. SIA Letter
II, p. 1. It maintained that this approach would permit the dealers
to engage in portfolio management activities consistent with the
manner in which such firms currently manage their OTC derivatives
businesses, but would still preclude firms from establishing OTC
derivatives dealers to conduct a proprietary trading business in
cash market securities. Id. While Rule 3b-15, as adopted, has been
revised in response to the SIA's comments, the rule includes
additional limitations as a means of permitting reasonable portfolio
management securities activities, while also prohibiting overly
broad securities trading activities.
\118\ DESCO Letter, p. 7.
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As discussed earlier, in response to comments received regarding
the manner in which dealers in OTC derivative instruments conduct their
business activities, the Commission has restructured the final rules to
better reflect current firm practices. As a result, Rule 3b-15, as
adopted, incorporates the concept of managing risk on a portfolio-wide
basis, and omits any reference to the term ``hedging.'' Thus, the rule
does not expressly limit the range of permissible portfolio management
securities activities. Instead, these activities are limited by the
requirement that they not give rise to risk exposures that, on an
aggregate portfolio basis, exceed the risk limits adopted for the
dealer's business under Rule 15c3-4,\119\ as well as other requirements
that serve to ensure that the OTC derivatives dealer does not engage in
dealer activities in cash market securities or substantial proprietary
trading activities.
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\119\ In addition to the risk parameters set forth in the
written guidelines included in the dealer's internal risk management
control system under Rule 15c3-4 (17 CFR 240.15c3-4), the
appropriate levels of risk assumed by an OTC derivatives dealer are
also to be determined by the dealer through trading authorizations
or limits placed on the associated person executing a transaction on
the dealer's behalf. See Rule 3b-15(a)(3)(i) (17 CFR 240.3b-
15(a)(3)(i)).
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ii. Arbitrage. Under proposed Rule 3b-15(e), an OTC derivatives
dealer would have been permitted to engage in a transaction involving
arbitrage, provided that any arbitrage involving securities was limited
to arbitrage of a securities position that was acquired in connection
with the taking possession of or selling of counterparty collateral,
cash management, or hedging activity.\120\ The SIA requested that
[[Page 59376]]
permissible arbitrage activities be expanded to include (1) arbitrage
of eligible OTC derivatives instruments; (2) arbitrage of short
securities positions; and (3) arbitrage of prospective securities
purchases or sales under permitted forward arrangements.\121\
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\120\ The Proposing Release further stated that permissible
arbitrage transactions would be limited to transactions involving
closely related cash market and derivative instruments that were
effected close to one another in time for purposes of taking
advantage of price disparities in different markets. An example
would include transactions involving the purchase or sale of an
equity security and the acquisition of an option on the same equity
security that were effected close together in time, taking into
consideration market liquidity and hours of market operations.
Proposing Release, Section II.A.4., n.23, 62 FR at 67943, n.23.
\121\ SIA Letter I, p. 8. See also Section IV.F.1.d. of the
Comment Summary.
---------------------------------------------------------------------------
The final rules do not use the term ``arbitrage'' in describing the
scope of risk management activities in which an OTC derivatives dealer
may engage. Instead, the rules are intended to permit any portfolio
management transaction, including arbitrage transactions, that meet the
conditions in the rules. As a practical matter, however, a firm
engaging in an OTC derivatives business typically does not engage in
``arbitrage'' transactions that would not otherwise qualify as an
ancillary portfolio management securities activity. Rule 3b-15 allows a
firm to manage its positions and make a profit, provided that the
activities occur in connection with its derivatives dealing business
(or the issuance of securities) and meet the other conditions set forth
in the rule.
iii. Trading. To avoid inadvertent violations of the proposed rules
through an inability to properly document the purpose of a transaction,
proposed Rule 3b-15(f) would have allowed the OTC derivatives dealer to
engage in a limited number of certain additional trading transactions.
In particular, an OTC derivatives dealer generally would have been
permitted to engage in no more than 150 additional securities
transactions per year relating to a securities position acquired in
connection with the taking possession of or selling of counterparty
collateral, cash management, or hedging activity. Proposed Rule 3b-
15(f) would have further required an OTC derivatives dealer engaging in
any such trading transaction to maintain and enforce written policies
and procedures reasonably designed to achieve compliance with the other
provisions of proposed Rule 3b-15.
Commenters generally criticized proposed Rule 3b-15(f).\122\ This
provision was essentially crafted to create a limited ``safe harbor''
to protect dealers from committing inadvertent violations of the
proposed rules because of their inability to properly document the
purpose of a transaction. The majority of commenters, however, had
difficulty understanding or applying the provision. For example, the
SIA expressed concern that the limitation on trading activities might
inadvertently exclude the purchase or disposition of securities
delivered or received, or to be delivered or received, by the OTC
derivatives dealer pursuant to the terms of an eligible OTC derivative
instrument.\123\ It also recommended that the proposed 150 transaction
basket be clarified to indicate that the basket was not intended to
place a limit on the number of securities transactions that could be
entered into by an OTC derivatives dealer if such transactions could be
demonstrated to relate to permitted activities.
---------------------------------------------------------------------------
\122\ See Section IV.F.1.e. of the Comment Summary.
\123\ SIA Letter I, pp. 8-9.
---------------------------------------------------------------------------
Several commenters thought the 150 transaction limit was too low.
For example, the SIA believed that the proposed basket was potentially
too small and would not adequately reflect the character and scope of a
particular firm's activities.\124\ As an alternative, several
commenters recommended that the size of any such basket be related to
the scope of the OTC derivatives dealer's activities rather than a
specified number of transactions.\125\ The Committee on Futures
Regulation of the Association of the Bar of the City of New York
suggested that, instead of an arbitrary number of ``allowable''
transactions per year, the Commission, through its examination process,
make determinations of whether a securities transaction was entered
into with a good faith belief that it satisfied one of the purposes set
forth in the rule.\126\
---------------------------------------------------------------------------
\124\ Id.
\125\ E.g., SIA Letter I, p. 9; Merrill Lynch Letter, p. 6.
\126\ ABCNY Committee Letter, p. 3.
---------------------------------------------------------------------------
In response to these comments, the Commission has not included a
safe harbor provision in either Rule 3b-14 or Rule 3b-15 allowing for
inadvertent violations of the rules. Rather, under the final rules, an
OTC derivatives dealer may engage in cash management securities
activities and ancillary portfolio management securities activities, as
those terms are defined in Rules 3b-14 and 3b-15.
iv. Documentation of Activities. Proposed Rule 3b-15(f), which
contained the 150 transaction ``safe harbor,'' also generated concern
regarding whether an OTC derivatives dealer would be required to
document the purpose of each individual transaction. Commenters argued
that, to the extent the rules required individual transaction
documentation, they were inconsistent with portfolio management
practices. Instead, commenters suggested that dealers be allowed to
demonstrate on a portfolio-wide basis that their cash market
transactions were consistent with the restrictions set forth in the
rules.\127\
---------------------------------------------------------------------------
\127\ See Section IV.F.2. of the Comment Summary.
---------------------------------------------------------------------------
As discussed in the Proposing Release, the nature of risk
management activities makes it difficult to determine whether a
particular transaction satisfies the requirements set forth in the
rules.\128\ The requirement that an OTC derivatives dealer develop
reasonable procedures for ensuring compliance with the restrictions in
the rules was intended, in fact, to accommodate current portfolio risk
management practices. The rules do not require that documentation of
the intended purposes of individual securities trades be maintained by
the OTC derivatives dealer. Rather, an OTC derivatives dealer must
develop reasonable procedures for ensuring compliance with the
restrictions set forth in the rules and for demonstrating the
relationship between its risk management activities and the positions
it maintains on a portfolio-wide basis.\129\
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\128\ Proposing Release, Section II.A.4., 62 FR at 67943.
\129\ See Section II.H.3. below, discussing Rule 15c3-4 (17 CFR
240.15c3-4), which addresses internal risk management control
systems for OTC derivatives dealers.
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B. Amendment to Rule 15b1-1; Registration With the Commission
Under the proposed amendments to Rule 15b1-1,\130\ a firm seeking
to register as an OTC derivatives dealer would have been required to
register with the Commission by filing Form BD, the Uniform Application
for Broker-Dealer Registration.\131\ No comments were received
regarding these proposed amendments. Accordingly, the amendments to
Rule 15b1-1 are being adopted as proposed.
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\130\ 17 CFR 240.15b1-1.
\131\ 17 CFR 249.501.
---------------------------------------------------------------------------
A firm that elects to register as an OTC derivatives dealer must
file an application for registration on Form BD, in accordance with the
instructions on the form. The form must be filed with the Central
Registration Depository, a computer system operated by the NASD. In
completing Item 10 of the form, which asks an applicant to disclose its
planned business activities, an OTC derivatives dealer must respond by
checking ``other'' and writing in that it proposes to engage in the
business of an OTC derivatives dealer.\132\ Some OTC
[[Page 59377]]
derivatives dealers may also be required to comply with Exchange Act
provisions applicable to government securities activities.\133\ For
instance, if an OTC derivatives dealer were to write an option on a
government security, it would be considered to be a government
securities dealer. Pursuant to Section 15C(a)(1)(B)(i),\134\ a broker
or dealer effecting, inducing, or attempting to induce the purchase or
sale of a government security must file with the appropriate regulatory
agency written notice that it is a government securities broker or
dealer.\135\ As a result, an OTC derivatives dealer that engages in
government securities transactions must also file notice of such
activities with the Commission, by checking ``yes'' in response to Item
13A on Form BD.
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\132\ See also Section II.F.3.b.i. below, discussing the
requirement that an OTC derivatives dealer send an application to
the Commission with respect to the dealer's use of VAR models to
calculate net capital.
\133\ In this regard, the SIA noted in its comment letter that
an OTC derivatives dealer registered with the Commission that
engages in transactions in eligible OTC derivative instruments that
government securities would exempt from registration as a government
securities dealer under Exchange Act Section 15C (15 U.S.C. 78o-5),
subject to the notice requirement under Exchange Act section
15c(a)(1)(B) (15 U.S.C. 78o-5(a)(1)(B). SIA Letter I, p. 13.
\134\ 15 U.S.C. 78o-5(a)(1)(B)(i).
\135\ It must similarly file a written notice when it ceases to
act as a government securities broker or dealer. 15 U.S.C. 78o-
5(a)(1)(B)(i). See also Section 3(a)(44) of the Exchange Act (15
U.S.C. 78c(a)(44)) (defining government securities dealer).
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C. Rule 15a-1; Securities Activities of OTC Derivatives Dealers
1. Scope of Permissible Securities Activities
Proposed Rule 15a-1 would have permitted an OTC derivatives dealer
to (1) engage as a counterparty in transactions in eligible OTC
derivative instruments with permissible derivatives counterparties; (2)
issue and reacquire issued securities, including warrants on
securities, hybrid securities, and structured notes; and (3) engage in
other securities transactions that the Commission designated by order.
In connection with these activities, an OTC derivatives dealer would
also have been permitted to engage in permissible risk management,
arbitrage, and trading transactions, as defined in proposed Rule 3b-15.
Because Rule 15a-1 describes the securities activities in which an
OTC derivatives dealer may engage, it parallels the requirements
contained in Rule 3b-12, which defines the term ``OTC derivatives
dealer.'' Thus, the comments addressing proposed Rule 15a-1 were
generally consistent with those concerning proposed Rule 3b-12.\136\
The SIA urged that the rule be simplified by (1) making the proposed
regulatory category available to ``dealers who are not engaged in the
business of buying and selling securities other than securities that
are eligible OTC derivative instruments''; and (2) deleting the
proposed restrictions on non-dealing activities in securities contained
in proposed Rule 15a-1.\137\
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\136\ See Section II.A.1. above. For example, several commenters
believed that the scope of permissible securities transactions under
proposed Rule 15a-1 should be expanded, and that the proposed rule
would unduly restrict the activities of an OTC derivatives dealer.
See, generally, letters cited in Sections IV.A. and IV.E. of the
Comment Summary.
\137\ SIA Letter I, pp. 6-7.
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As discussed earlier, however, the new regime is not intended to
permit an OTC derivatives dealer to engage in substantial proprietary
securities trading activities. Rather, the purpose of the alternative
regulatory framework is to allow U.S. securities firms to elect to
establish a separately capitalized vehicle in which to book a client-
oriented OTC derivatives business. As a result, the restrictions on
these activities in Rule 15a-1 are necessary.
For the reasons discussed above and in Section II.A.1. with respect
to the definition of OTC derivatives dealer, the Commission has revised
Rule 15a-1 to provide that the securities activities of OTC derivatives
dealer must be limited to (1) engaging in dealer activities in eligible
OTC derivative instruments that are securities; (2) issuing and
reacquiring securities that are issued by the dealer, including
warrants on securities, hybrid securities, and structured notes; \138\
(3) engaging in cash management securities activities; (4) engaging in
ancillary portfolio management securities activities; and (5) engaging
in such other securities activities that the Commission designates by
order. In addition, an OTC derivatives dealer's securities activities
must consist primarily of engaging in dealer activities in eligible OTC
derivative instruments that are securities, issuing and reacquiring its
issued securities, and engaging in cash management securities
activities.\139\
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\138\ D.E. Shaw & Co. requested clarification regarding the
ability of an OTC derivatives dealer to issue and reacquire its
issued securities through a fully regulated broker-dealer. It asked
whether the phrase meant that the fully regulated broker-dealer must
be the issuer of the security or whether the fully regulated broker-
dealer must act as principal or agent in the purchase of securities
from, or the sale of securities to, the customer. D.E. Shaw & Co.
also asked whether the OTC derivatives dealer could be the issuer of
the security, as long as the OTC derivatives dealer complied with
the registration, confirmation, and similar requirements set forth
in the proposed rule. DESCO Letter, p. 9. In short, under Rule 15a-
1, an OTC derivatives dealer may only issue its own securities, or
reacquire its own securities, through a fully regulated broker-
dealer; it may not act in a sales capacity or directly reacquire its
securities from holders of such securities, except in limited
circumstances with respect to certain counterparties. See Rule 15a-
1(c) (17 CFR 240.15a-1(c)).
\139\ As noted in Section II.A.1. above, although the rules
limit the securities activities of OTC derivatives dealers, the
Commission has retained the authority under Rule 15a-1 to identify
other permissible securities activities for these entities. See Rule
15a-1(b)(1) (17 CFR 240.15a-1(b)(1)). This authority has been
delegated to the Director of the Division of Market Regulation. See
Rule 30-3(a)(64) (17 CFR 200.30-3(a)(64).
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The alternative regulatory framework for OTC derivatives dealers,
as adopted, also includes a provision requiring that the dealer develop
procedures to help ensure that it does not engage in securities
activities beyond those permitted under Rule 15a-1. As discussed
further in Section II.H.3. below, new Rule 15c3-4 requires an OTC
derivatives dealer to establish, document, and maintain a system of
internal risk management controls to assist it in managing the risks
associated with its business activities. As part of its obligations
under Rule 15c3-4, an OTC derivatives dealer's written guidelines must
include and discuss the dealer's procedures to prevent it from engaging
in securities transactions that are not permitted under Rule 15a-1. In
addition, Rule 15c3-4 requires the OTC derivatives dealer's management
to periodically review the dealer's business activities for consistency
with risk management guidelines, including whether procedures are in
place to prevent the dealer from engaging in any impermissible
securities transaction.
2. Commission Orders Regarding OTC Derivatives Dealers' Activities
Under Rule 15a-1(b), the Commission by order, entered upon its own
initiative or after considering an application for exemptive relief,
may clarify or expand the scope of permissible securities activities in
which an OTC derivatives dealer may engage or the scope of eligible OTC
derivative instruments. As discussed in earlier sections of this
release, such orders may (1) identify other permissible securities
activities in which an OTC derivatives dealer may engage; (2) determine
that a class of fungible instruments that are standardized as to their
material economic terms is within the scope of eligible OTC derivative
instrument; (3) clarify whether certain contracts, agreements, or
transactions are within the scope of eligible OTC derivative
instrument; or (4) clarify whether certain securities activities are
within the scope of ancillary portfolio management securities
activities.
Applications for exemptive orders under Section 15a-1(b) should be
filed
[[Page 59378]]
in accordance with Commission procedures set forth in Rule 0-12 under
the Exchange Act.\140\ The Commission may issue such orders to the
extent they are necessary or appropriate in the public interest, and
consistent with the protection of investors. In considering such
orders, the Commission will consider whether the securities activities
are of the type and nature of activities in which an OTC derivatives
dealer may engage under Rule 15a-1, including whether such activities
are integrated into, or integral to, the OTC derivatives dealing
business of OTC derivatives dealers.
---------------------------------------------------------------------------
\140\ 17 CFR 240.0-12.
---------------------------------------------------------------------------
3. Intermediation of Securities Transactions
Proposed Rule 15a-1 would have required an OTC derivatives dealer
to effect all securities transactions through a fully regulated broker-
dealer. Accordingly, under proposed Rule 15a-1, all applicable SRO
sales practice requirements would have applied to the securities
transactions of an OTC derivatives dealer.
Several commenters argued that a fully regulated broker-dealer
should not be required to intermediate every securities
transaction.\141\ The SIA maintained that the interpositioning of a
broker-dealer was not necessary, particularly given the sophisticated
character of the permissible derivatives counterparties, the active
participation by such counterparties in structuring instruments to
fulfill their particular needs, and the consensual negotiation of the
terms of individual transactions.\142\ The SIA further stated that, at
a minimum, an OTC derivatives dealer should not be required to effect
securities transactions through a fully regulated broker-dealer (1)
where the counterparty to the transaction was a bank, broker-dealer,
government securities broker, government securities dealer, or
supranational organization; or (2) in connection with risk management,
financing, arbitrage, or other trading transactions in which the OTC
derivatives dealer was not acting in its capacity as a dealer, but
rather as an investor or end-user.\143\ The SIA also objected to the
intermediation requirement in the context of offshore transactions
involving foreign securities.\144\
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\141\ See letters cited in Section IV.E.1. of the Comment
Summary.
\142\ SIA Letter I, p. 11.
\143\ SIA Letter I, p. 11. Similarly, D.E. Shaw & Co. argued
that, in order to level the playing field with non-U.S. broker-
dealers, an OTC derivatives dealer should be permitted to transact
business directly (without a U.S. broker-dealer intermediary) with
all parties with whom a non-U.S. broker-dealer could effect business
under Rule 15a-6(a)(4) under the Exchange Act (17 CFR 240.15a-
6(a)(4)), including a registered broker or dealer or a bank acting
in a broker or dealer capacity. Likewise, it believed that where the
OTC derivatives dealer itself is the counterparty to a securities
derivatives transaction, the OTC derivatives dealer should not be
required to effect the securities transaction through a fully
regulated broker-dealer in connection with risk management,
financing, arbitrage, or other trading transactions. DESCO Letter,
p. 4.
\144\ SIA Letter II, pp. 3-4. The SIA argued that the proposed
broker-dealer intermediation requirement in the context of offshore
transactions involving foreign securities could create significant
burdens on registrants, without meaningful corresponding benefits.
According to the SIA, if offshore transactions involving foreign
securities are required to be intermediated by the fully regulated
broker-dealer affiliate, firms might be required to register their
non-U.S. offices as branch offices of their fully regulated U.S.
broker-dealer (with potentially adverse tax, licensing, or other
regulatory consequences) or to confront prohibitive logistical
obstacles to compliance with the proposed requirement. The SIA was
also concerned about the application of this provision to OTC
derivatives transactions arranged and effected by employees resident
in a foreign office of an OTC derivatives dealer with a counterparty
that is also resident in a foreign jurisdiction. In this regard, it
noted that local law may require that the transaction be effected
through a locally registered entity, so that a transaction would
have to be intermediated by two separate entities. For that reason,
it suggested an exception to Rule 15a-1 for permissible securities
transaction with foreign counterparties that are arranged and
effected by non-U.S. resident employees of an OTC derivatives
dealer.
---------------------------------------------------------------------------
D.E. Shaw & Co. also questioned whether an OTC derivatives dealer
needed to effect a securities transaction through an affiliated broker-
dealer. It claimed that an OTC derivatives dealer should also be able
to effect these transactions through a bank or broker-dealer with which
it had a working relationship.\145\ Other commenters questioned the
proposed rule's distinction between securities transactions and non-
securities transactions, and claimed that if sales practice protection
was warranted for securities transactions, then counterparties should
receive similar protection for non-securities transactions undertaken
with an OTC derivatives dealer.\146\ The Chicago Board Options Exchange
(``CBOE''), in turn, sought clarification as to which specific SRO
sales practice rules would apply to a fully regulated broker-dealer
effecting securities transactions for an OTC derivatives dealer's
counterparties.\147\
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\145\ DESCO Letter, p. 3. D.E. Shaw & Co. stated that the
restriction to use affiliates limited flexibility and placed an
unnecessary burden on U.S. firms conducting a domestic derivatives
business.
\146\ See, e.g., GFOA Letter, pp. 2-3; EUDA Letter, p. 2.
\147\ Comment Letter from the Chicago Board Options Exchange
(''CBOE Letter''), p. 5. The CBOE asserted that there is currently a
disparity between NASD and NYSE options sales practice rules as
applied to listed options, and argued that this disparity, as well
as any other disparity between sales practice rules' application to
qualified counterparties' OTC derivatives transactions and their
listed options transactions, should be remedied.
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Based on the comments received, Rule 15a-1, as adopted, provides
certain limited exceptions to the requirement that securities
transactions of an OTC derivatives dealer be effected through its fully
regulated broker-dealer affiliate.\148\ However, the rule has not been
revised, as requested by some commenters, to eliminate the
intermediation requirement in connection with cash management or
ancillary portfolio management securities transactions in which the OTC
derivatives dealer is not acting as a dealer, but rather as an investor
or end-user.\149\ Accordingly, all cash management securities
activities and ancillary portfolio management securities activities of
an OTC derivatives dealer must be effected by a fully regulated broker-
dealer, unless the transaction is subject to one of the limited
exceptions discussed below.\150\
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\148\ As noted earlier, an OTC derivative dealer may issue and
reacquire its issued securities through an unaffiliated fully
regulated broker-dealer. See Rule 15a-1(c) (17 CFR 240.15a-1(c)).
\149\ See supra note 143 and accompanying text.
\150\ In addition, the Commission has not revised Rule 15a-1 to
extend sales practice requirements to non-securities transactions.
As a general matter, sales practice requirements arising under the
federal securities laws and SRO rules apply only to the securities
transactions of broker-dealers.
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The requirement that securities transactions be effected through a
fully regulated broker-dealer is designed, in part, to ensure that all
securities transactions remain subject to existing sales practice
standards.\151\ The requirement is also intended to prevent any
regulatory disparity from arising between an OTC derivatives dealer,
which is subject to modified capital and margin requirements, and a
fully regulated broker-dealer in connection with conducting securities
transactions. In addition, it is designed to reduce the risk that
counterparties will mistakenly view an OTC derivatives dealer as a
fully regulated broker-dealer, rather than as a booking vehicle for
derivatives transactions.\152\
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\151\ Unless otherwise expressly provided in the rules and rule
amendments, the fully regulated broker-dealer must comply with all
applicable sales practice requirements when effecting any securities
transaction for, or on behalf of, an OTC derivatives dealer.
\152\ For these same reasons, an OTC derivatives dealer may not
effect a securities transaction through an unaffiliated broker-
dealer, except in limited circumstances, or through a bank.
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However, if the counterparty to a securities transaction is acting
as principal and is itself either a registered broker or dealer
(including another OTC
[[Page 59379]]
derivatives dealer), a bank acting in a dealer capacity, a foreign
broker or dealer,\153\ or an affiliate of the OTC derivatives
dealer,\154\ the counterparty is less likely to require the protections
afforded by sales practice requirements. In addition, these
counterparties are not likely to mistakenly believe that an OTC
derivatives dealer is a fully regulated broker-dealer engaging in
general securities transactions. Therefore, an OTC derivatives dealer
is not required to use its fully regulated broker-dealer affiliate to
effect securities transactions with these listed entities. This
exception, however, applies only when the counterparty is acting as a
principal (that is, for its own account), and not as agent for one of
its customers.\155\
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\153\ The term ``foreign broker or dealer'' as used in Rule 15a-
1 means ``any person not resident in the United States (including
any U.S. person engaged in business as a broker or dealer entirely
outside the United States, except as otherwise permitted by
Sec. 240.15a-6 (17 CFR 240.15a-6)) that is not an office or branch
of, or a natural person associated with, a registered broker or
dealer, whose securities activities, if conducted in the United
States, would be described by the definition of `broker' in section
3(a)(4) of the Act (15 U.S.C. 78c(a)(4)) or `dealer' in section
3(a)(5) of the Act (15 U.S.C. 78c(a)(5)).'' See See 15a-1(g) (17 CFR
240.15a-1(g)). In general, a foreign bank may be able to satisfy the
terms of this definition.
\154\ For purposes of Rule 15a-1, the term ``affiliate'' means
``any organization (whether incorporated or unincorporated) that
directly or indirectly controls, is controlled by, or is under
common control with, the OTC derivatives dealer.'' See Rule 15a-1(f)
(17 CFR 240.15a-1(f)).
\155\ With respect to offshore transactions involving foreign
securities, Rule 15a-1 has not been revised to the extent suggested
by some commenters (see supra note 144), in part because of concerns
regarding the application of sales practice protections to foreign
counterparties and the proper maintenance of books and records
regarding those transactions. However, the general requirement that
communications regarding securities transactions be conducted by
associated persons of the affiliated fully regulated broker-dealer
has been revised to reflect the fact that firms operate OTC
derivatives businesses on a global basis, See Rule 15a-1(d) (17 CFR
240.15a-1(d)) (further discussed in Section II.C.4. below).
---------------------------------------------------------------------------
There is a second limited exception to Rule 15a-1(c), as adopted.
If an OTC derivatives dealer engages in a transaction that is an
ancillary portfolio management securities activity involving a foreign
security,\156\ it is not required to effect that transaction through
its fully regulated broker-dealer affiliate if a registered broker or
dealer, a bank, or a foreign broker or dealer is acting as agent for
the OTC derivatives dealer.\157\ This exception will permit an OTC
derivatives dealer to select one of these professional intermediaries
to represent it in foreign markets when purchasing or selling foreign
securities for hedging or portfolio management purposes.
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\156\ For purposes of Rule 15a-1, the term foreign security
means ``any security (including a depositary share issued by a
United States bank, provided that the depositary share is initially
offered and sold outside the United States in accordance with
Regulation S (17 CFR 230.901 through 230.904)) issued by a person
not organized or incorporated under the laws of the United States,
provided the transaction that involves such security is not effected
on a national securities exchange or on a market operated by a
registered national securities association; or a debt security
(including a convertible debt security) issued by an issuer
organized or incorporated under the laws of the United States that
is initially offered and sold outside the United States in
accordance with Regulation S (17 CFR 230.901 through 230.904).'' See
Rule 15a-1(h) [17 CFR 240.15a-1(h)].
\157\ See Rule 15a-1(c)(2) (17 CFR 240.15a-1(c)(2)). Rule 15c3-4
(17 CFR 240.15c3-4) requires that an OTC derivatives dealer's
written guidelines include the dealer's procedures to prevent it
from improperly relying on the exceptions to Rule 15a-1(c) and (d)
(discussed in Section II.C.4. below).
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4. Communications Regarding Securities Transactions
The requirement that securities transactions be effected through a
fully regulated broker-dealer means that the OTC derivatives dealer's
counterparties in these transactions will be considered customers of
the fully regulated broker-dealer. Therefore, any person that solicits
a potential counterparty to engage in a securities transaction with an
OTC derivatives dealer, or otherwise has any contact with the
counterparty regarding the transaction, generally must be a registered
representative of the fully regulated broker-dealer affiliate.\158\ As
noted in the Proposing Release, these persons may be dual employees of
the fully regulated broker-dealer and the OTC derivatives dealer,
subject to appropriate supervision by both firms.\159\
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\158\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)).
\159\ Fully regulated broker-dealers are responsible for
supervising only the securities activities of these dual employees.
They are not responsible for supervising a dual employee's non-
securities OTC derivatives activities conducted on behalf of the OTC
derivatives dealer.
---------------------------------------------------------------------------
The SIA, however, argued that all employees of the OTC derivatives
dealer having contact with counterparties to OTC derivatives
transactions effected through a fully regulated broker-dealer should
not have to be employees of the fully regulated broker-dealer and be
licensed as registered representatives of that firm.\160\ D.E. Shaw &
Co. claimed that the requirement for any person discussing the terms of
a securities transaction with a counterparty to be a registered
representative of the fully regulated broker-dealer was broader than
current NASD requirements. It therefore requested clarification that
the proposed rule would not expand the types of activities that would
require registration of associated persons.\161\
---------------------------------------------------------------------------
\160\ SIA Letter I, p. 12.
\161\ DESCO Letter, p. 4.
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Under the final rule, whether a registered representative of an OTC
derivatives dealer's fully regulated broker-dealer affiliate must be
involved in all contacts with a counterparty relating to a securities
transaction depends on the nature of the counterparty. Under Rule 15a-
1(d), if the counterparty is a registered broker or dealer, a bank
acting in a dealer capacity, a foreign broker or dealer, or an
affiliate of the OTC derivatives dealer, a registered representative of
the fully regulated broker-dealer affiliate does not have to be
involved in the contact. Thus, employees of the OTC derivatives dealer
may solicit or otherwise contact these enumerated counterparties, even
if the employees are not also registered representatives of the fully
regulated broker-dealer.\162\
---------------------------------------------------------------------------
\162\ This is consistent with the exception set forth in Rule
15a-1(c)(1) (17 CFR 240.15a-1(c)(1)).
---------------------------------------------------------------------------
In addition, in some circumstances, registered representatives of
the fully regulated broker-dealer affiliate are not required to be
involved in contacts with foreign counterparties. Under Rule 15a-1(d),
contacts with a foreign counterparty may generally be conducted by an
associated person of a foreign broker or dealer who is not resident in
the United States, if the foreign broker or dealer is affiliated with
the OTC derivatives dealer and is registered by a foreign financial
regulatory authority in the jurisdiction in which the counterparty is
resident or the associated person is located.\163\ Any resulting
securities transaction, however, must generally be effected through the
OTC derivatives dealer's fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------
\163\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)) and Rule 15a-1(i)
(17 CFR 240.15a-1(i)). See also supra note 155 and accompanying
text. This approach responds to commenters' concerns that it would
be inefficient and impractical to require a registered
representative of the OTC derivatives dealer's fully regulated
broker-dealer affiliate to conduct all contacts with all foreign
counterparties concerning permissible securities activities with the
OTC derivatives dealer.
---------------------------------------------------------------------------
The new regulatory structure for OTC derivatives dealers does not
expand on the types of activities that require registration of
associated persons under existing SRO rules. For example, to the extent
contact with an OTC derivatives dealer's counterparty regarding a
securities transaction involves only clerical or ministerial activities
that currently may be conducted by an unregistered associated person of
a fully regulated broker-dealer, then the employee of the OTC
derivatives dealer performing such activities need not be a registered
representative.\164\ Persons performing clerical and ministerial
[[Page 59380]]
functions may also be dual employees of the OTC derivatives dealer and
the fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------
\164\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)).
---------------------------------------------------------------------------
5. Confirmation of Securities Transactions
Rule 10b-10 under the Exchange Act \165\ requires broker-dealers to
send a written confirmation of each securities transaction with a
customer at or before completion of the transaction, containing certain
material information about the transaction. The Proposing Release
stated that in a securities transaction between an OTC derivatives
dealer and a counterparty (or customer) effected through a fully
regulated broker-dealer, the OTC derivatives dealer and the fully
regulated broker-dealer would each be responsible for sending a
confirmation to the counterparty under the rule.\166\ It further stated
that certain customers could choose not to receive two confirmations
for each securities transaction, but rather could instruct the OTC
derivatives dealer and the fully regulated broker-dealer to send one
joint confirmation on behalf of both parties.\167\
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\165\ 17 CFR 240.10b-10.
\166\ Proposing Release, Section 11.C., n.28, 62 FR at 67944,
n.28.
\167\ Id.
---------------------------------------------------------------------------
The SIA agreed that the counterparty to any securities transaction
would be a customer of the fully regulated broker-dealer and that the
fully regulated broker-dealer would have an obligation to deliver a
confirmation to the counterparty; however, the SIA argued that the
counterparty would not be a customer of the OTC derivatives dealer and,
accordingly, the OTC derivatives dealer should not be required to
deliver a confirmation.\168\ D.E. Shaw & Co. also questioned whether
there were any benefits in requiring multiple confirmations that would
justify the additional costs and paperwork. Instead, it believed that
the fully regulated broker-dealer should take responsibility for
sending out a joint confirmation accurately disclosing the respective
roles of the fully regulated broker-dealer and the OTC derivatives
dealer.\169\ In addition, the SIA and D.E. Shaw & Co. noted that if
each dealer were jointly and severally liable for a joint confirmation,
then the requirement to obtain customer consent to the sending of a
joint confirmation was unnecessary and burdensome.\170\
---------------------------------------------------------------------------
\168\ SIA Letter I, pp. 11-12.
\169\ DESCO Letter, p. 5.
\170\ SIA Letter I, p. 12; DESCO Letter, p. 5.
---------------------------------------------------------------------------
In response to the comments, the proposed requirement that the
fully regulated broker-dealer and the OTC derivatives dealer each have
to send a separate confirmation, unless the customer instructs them to
send a single joint confirmation, has been revised. Although generally
both the fully regulated broker-dealer and the OTC derivatives dealer
will be responsible for sending a confirmation, disclosing their
respective roles in the transactions, the two firms may establish
procedures through which the fully regulated broker-dealer will send a
joint confirmation on behalf of both firms in satisfaction of Rule 10b-
10.\171\
---------------------------------------------------------------------------
\171\ A joint confirmation, sent on behalf of both the OTC
derivatives dealer and the fully regulated broker-dealer effecting
the transaction must disclose all of the information required of
either party under the rule, including, but not limited to, the
identity of the security, the trade price, and the date and time of
the trade, the identity of each party and its capacity in the
transaction, the fact that the OTC derivatives dealer is not a
member of SIPC, and any transaction-related compensation earned by
either the fully regulated broker-dealer or the OTC derivatives
dealer in connection with the transaction. Both the OTC derivatives
dealer and the fully regulated broker-dealer will be considered
fully responsible for the contents of the joint confirmation. The
decision by the two firms to send a joint confirmation will not
otherwise affect the obligations of either party to the customer
under the anti-fraud provisions of the federal securities laws. In
addition, in the event that an OTC derivatives dealer engages in a
securities transaction that is not required to be effected through a
fully regulated broker-dealer under rule 15a-1 (17 CFR 240.15a-1),
then the OTC derivatives dealer must comply with the provisions of
Rule 10b-10 (17 CFR 240.10b-10), to the extent such provisions apply
to the transaction.
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6. Position Limits
Several commenters questioned the application of SRO position
limits to an OTC derivatives dealer's activities.\172\ The SIA, for
example, argued that an OTC derivatives dealer should either be subject
to a more realistic SRO position limit regime than was currently
applicable under NASD rules or be exempted from the application of SRO
position limits with respect to OTC securities options booked through a
fully regulated broker-dealer affiliate.\173\ The CBOE argued that the
rules would result in a competitive disparity between OTC and listed
index derivatives, because, as stated by the CBOE, an OTC derivatives
dealer's transactions in OTC equity options would be exempt from NASD
and CBOE position limits, but transactions in listed index and equity
options would not be exempt.\174\ As a result, it recommended that the
Commission eliminate listed options position limits entirely.\175\
---------------------------------------------------------------------------
\172\ See Section IV.J.1. of the Comment Summary.
\173\ SIA Letter I, p. 16. D.E. Shaw & Co. also sought
clarification that the requirement for executing securities OTC
derivatives transactions through a fully regulated broker-dealer was
not intended to subject OTC derivatives dealers to the options
position limits set forth in NASD rules. In is view, these position
limits constituted a competitive disadvantage for U.S. securities
firms as against banks and foreign dealers. DESCO Letter, pp. 2-3.
\174\ CBOE Letter, p. 2.
\175\ CBOE Letter, p. 3.
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The final rules and rule amendments do not change the current
application of position limits to securities transactions effected by a
broker-dealer on behalf of an OTC derivatives dealer. Therefore,
securities OTC derivatives transactions that are effected through
fully-regulated broker-dealers, which are members of SROs, will
continue to be subject to applicable SRO position limits.\176\ However,
in order to permit an OTC derivatives dealer to carry out its business
using portfolio risk management techniques, the Commission encourages
the NASD to revise its rules to recognize as ``hedged'' those OTC
option positions of an OTC derivatives dealer that are hedged on a
delta neutral basis.\177\
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\176\ See Rule 2860 of the NASD's Conduct Rules.
\177\ The Commission's support for recognizing options positions
hedged on a delta neutral basis as properly exempted from SRO
position limits is equally applicable to all option market
participants for options traded over-the-counter or on exchanges.
Therefore, the NASD and options exchange SROs are encouraged to
submit rule changes that will recognize delta neutral hedges for
both listed and OTC options.
---------------------------------------------------------------------------
D. Exemptions for OTC Derivatives Dealers
Collectively, the rules and rule amendments adopted in this final
rulemaking establish a new class of broker-dealers that will enjoy
certain exemptions from full broker-dealer registration and regulation,
subject to special requirements and conditions on their operations.
Although an OTC derivatives dealer will be exempt from SRO membership,
regular broker-dealer margin requirements, and SIPA (as discussed
below), an OTC derivatives dealer's securities activities will be
limited by Rule 15a-1.\178\
---------------------------------------------------------------------------
\178\ See supra Section II.C.
---------------------------------------------------------------------------
1. Rule 15b9-2; Exemption From SRO Membership
Proposed Rule 15b9-2 would have exempted an OTC derivatives dealer
from membership in a SRO,\179\ provided that it entered into an
agreement with
[[Page 59381]]
the examining authority designated pursuant to section 17(d) of the
Exchange Act \180\ for its registered broker-dealer affiliate. Under
this agreement, the DEA would have been expected to conduct a review of
the activities of the OTC derivatives dealer, report to the Commission
any potential violation of the Commission's rules, and evaluate the
dealer's procedures and controls designed to prevent violations.\181\
The OTC derivatives dealer would also have been subject to direct
examination by Commission staff.
---------------------------------------------------------------------------
\179\ In general, registered broker-dealers must become members
of an SRO. See Section 15(b)(8) of the Exchange Act (15 U.S.C.
78o(b)(8)). This SRO membership requirement ensures that securities
transactions meet SRO sales practice requirements, that employees of
SRO member firms who sell securities satisfy certain uniform
licensing requirements, that SRO members satisfy maintenance margin
and financial responsibility requirements, and that member firms
adhere to certain principles of trade and business conduct. See
sections 15(b)(8) and 15A(g)(3) of the Exchange Act (15 U.S.C.
78o(b)(8); 15 U.S.C. 78o-3(g)(3)).
\180\ 15 U.S.C. 78q(d).
\181\ See Proposing Release, Section II.D.2., 62 FR at 67946.
---------------------------------------------------------------------------
The SRO commenters believed that an OTC derivatives dealer should
become a member of either the DEA of its registered broker-dealer
affiliate or another SRO.\182\ In supporting this position, these
commenters noted such things as (1) the DEA is in the best position to
examine the OTC derivatives dealer given its surveillance and
examination knowledge of the registered broker-dealer affiliate; (2)
SRO rules impose certain supervisory obligations directly on each
member; and (3) SRO membership is necessary to ensure an OTC
derivatives dealer's cooperation during an examination.\183\ In order
to avoid conflict between the new regime and SRO rules, however, both
the NYSE and the NASDR recognized that an OTC derivatives dealer member
should not be subject to all SRO rules (such as margin rules), but
should only be subject to rules that applied to the dealer's unique
business.\184\
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\182\ NYSE Letter, p. 2; Comment Letter from NASD Regulation
(''NASDR Letter''), pp. 1-2. The NYSE objected to any structure that
would cause the DEA to be considered merely an agent of the
Commission, in part because it believed that such an approach would
have broad procedural ramifications. It also stated that the
proposal to have the DEA review the activities of OTC derivatives
dealers on a contractual basis, absent membership, would be
prohibited by the Exchange's Constitution. NYSE Letter, p. 2. NASDR
also opposed the proposal that an OTC derivatives dealer would not
be required to be a member of an SRO if it entered into an agreement
with the DEA for its broker-dealer affiliate, because it believed it
would create a difficult precedent and might impede effective
oversight of this new type of entity. NASDR Letter, pp. 1-2.
\183\ See section IV.H. of the Comment Summary.
\184\ NYSE Letter, p. 2; NASDR Letter, p. 3.
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In contrast, securities firms generally opposed any plan that would
require OTC derivatives dealers to become members of an SRO.\185\ More
than one commenter suggested that the oversight function should be
performed only by Commission staff, and that it might be appropriate to
establish a new SRO designed to oversee the activities of OTC
derivatives dealers.\186\
---------------------------------------------------------------------------
\185\ SIA Letter I, p. 14; MSDW Letter, pp. 20-21; DESCO Letter,
p. 3, n.2.
\186\ See, e.g., SIA Letter I, p. 14.
---------------------------------------------------------------------------
The Commission has determined that it is not necessary to require
OTC derivatives dealers to become members of an SRO and be subject to
the full range of SRO regulation at this time. Moreover, because the
NYSE and the NASD expressed serious concerns with overseeing OTC
derivatives dealers on a contractual basis, the Commission staff will
examine OTC derivatives dealers to ensure compliance with Commission
rules. This approach will provide the Commission staff with valuable
experience regarding the activities of dealers in OTC derivative
instruments. In addition, the expected small number of initial
registrants also supports direct Commission examination of OTC
derivatives dealers at this time.
In granting the Commission authority under Section 15(b)(9) to
exempt a class of brokers or dealers from the requirement of SRO
membership, Congress recognized that certain types of broker-dealers
could be regulated effectively by the Commission without the direct
oversight of an SRO. Given that certain SRO rules, such as margin
rules, are not consistent with the OTC derivatives dealer regulatory
scheme and that securities transactions generally will be effected
through a broker-dealer that will be a member of an SRO,\187\ the
Commission believes that SRO membership and the additional regulation
it would entail is not currently warranted. Accordingly, the Commission
finds that exempting OTC derivatives dealers from the SRO membership
requirement is consistent with the public interest and the protection
of investors.
---------------------------------------------------------------------------
\187\ See Rule 15a-1(c) (17 CFR 240.15a-1(c)).
---------------------------------------------------------------------------
2. Rule 36a1-1; Exemption From Certain Margin Requirements
As part of any OTC derivatives transaction, a dealer may require
its counterparty to deposit collateral with the dealer to provide some
assurance of the counterparty's ability to perform. Both the ability of
the dealer to collect collateral to secure payment under an OTC
derivative instrument and the amount of collateral the dealer must
collect currently depend on the regulatory status of the dealer.
Federal regulations that govern the collateral, or margin, that must be
collected by dealers in connection with securities transactions have
created certain competitive inequalities between registered broker-
dealers and other entities, including bank dealers, that conduct an OTC
derivatives business. Registered broker-dealers that extend credit for
the purpose of purchasing or carrying securities are required to comply
with the provisions of Regulation T.\188\ The margin requirements for
banks are contained in Regulation U.\189\
---------------------------------------------------------------------------
\188\ 12 CFR 220.1.
\189\ 12 CFR 220.1.
---------------------------------------------------------------------------
As noted above, despite the recent amendments to Regulation T,\190\
there remain several differences between Regulation T and Regulation
U.\191\ For example, the two regulations differ with respect to the
margin requirements for short OTC options. Compliance with the more
restrictive requirements of Regulation T places broker-dealers at a
competitive disadvantage with banks and other derivatives dealers by
preventing them from offering credit in securities OTC derivatives
transactions on terms that are as favorable as those offered by the
other dealers.
---------------------------------------------------------------------------
\190\ See Securities Credit Transactions, Borrowing by Brokers
and Dealers, Docket Nos. R-0905, R-0923, and R-0944, 63 FR 2806
(Jan. 16, 1998).
\191\ See Section I.C.4.b. above.
---------------------------------------------------------------------------
Under proposed Rule 36a1-1, extensions of credit by an OTC
derivatives dealer in permissible securities transactions generally
would have been exempt from Section 7 of the Exchange Act (and
Regulation T), provided that the OTC derivatives dealer complied with
other federal margin requirements applicable to non-broker-dealer
lenders (i.e., Regulation U). While the SIA noted its full support for
the proposal, it raised certain technical issues that could result from
the codification of the proposed provisions.\192\ Morgan Stanley Dean
Witter also supported the proposed rule, and stated that application of
Regulation U would provide sufficient safeguards against excessive
leverage and would permit an OTC derivatives dealer to extend credit on
a broader range of OTC derivative products.\193\ It also stated that
the SIA's clarifications were appropriate, and encouraged the
Commission to reassess whether additional exemptive relief would be
warranted in the future.\194\
---------------------------------------------------------------------------
\192\ SIA Letter I, pp. 14-15.
\193\ MSDW Letter, pp. 19-20.
\194\ MSDW Letter, App. A, p. ii.
---------------------------------------------------------------------------
In response to the comments received, the Commission has revised
Rule 36a1-1 to clarify that transactions involving the extension of
credit by an OTC derivatives dealer are exempt from the provisions of
section 7(c) of the Exchange Act,\195\ provided that the OTC
derivatives dealer complies with section
[[Page 59382]]
7(d) of the Exchange Act.\196\ Because Regulation U is promulgated
pursuant to section 7(d), an OTC derivatives dealer remains subject to
that provision. The final rule continues to provide that the exemption
from section 7(c), and Regulation T thereunder, does not apply to
extensions of credit made directly by a registered broker-dealer (other
than an OTC derivatives dealer) in connection with transactions in
eligible OTC derivative instruments for which an OTC derivatives dealer
acts as counterparty.\197\
---------------------------------------------------------------------------
\195\ 15 U.S.C. 78g(c).
\196\ 15 U.S.C. 78g(d).
\197\ OTC derivatives dealers that extend credit in securities
transactions that are required to be effected through a fully
regulated broker-dealer, however, may rely on the exemption form
section 7(c) and Regulation T provided under Rule 36a1-1.
---------------------------------------------------------------------------
The Commission believes that application of Regulation U in lieu of
Regulation T is appropriate for the lending that occurs in the OTC
derivatives market, given the nature of the bilateral financial
instruments and the relative sophistication of the counterparties.
Applying Regulation U to extensions of credit by OTC derivatives
dealers will provide sufficient safeguards, while allowing OTC
derivatives dealers to extend credit in accordance with their normal
business practices.\198\
---------------------------------------------------------------------------
\198\ While the CBOE supported allowing the OTC derivatives
positions of counterparties carried on the books of OTC derivatives
dealers to be exempt from Regulation T conditioned on the
application of Regulation U, it believed that application of
Regulation U would result in competitive disparities between OTC and
listed options markets. Accordingly, it requested a similar margin
treatment for listed options transactions. CBOE Letter, p.3. The
Commission, however, is not extending a similar margin treatment to
listed options at this time. The new regulatory framework is
intended to allow U.S. securities firms to compete more effectively
in global OTC derivatives markets. Any revisions to the regulatory
standards for exchange markets would require, among other things,
careful consideration of the differences between exchange markets
and OTC derivatives markets.
---------------------------------------------------------------------------
Because application of Regulation U will promote competition and
efficiency in the OTC derivatives market and will result in suitable
margin regulation for OTC derivatives dealers and their counterparties,
the Commission finds that exempting OTC derivatives dealers from
Section 7(c) of the Exchange Act is necessary or appropriate in the
public interest and consistent with the protection of investors. This
exemption is conditioned on the OTC derivatives dealer's compliance
with Section 7(d) of the Exchange Act.\199\
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\199\ Rule 36a1-1 applies only to extensions of credit by an OTC
derivatives dealer. Section 7 of the Exchange Act, however,
continues to apply to persons extending credit to an OTC derivatives
dealer. Credit extended to an OTC derivatives dealer, like credit
extended to a fully regulated broker-dealer, however, is excepted
from section 7 of the Exchange Act if it satisfies the conditions
for such exceptions contained in section 7.
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3. Rule 36a1-2; Exemption From SIPA
Under Rule 36a1-2, OTC derivatives dealers are exempt from the
provisions of SIPA,\200\ including membership in SIPC. As stated in the
Proposing Release, the application of SIPA's liquidation provisions to
an OTC derivatives dealer in bankruptcy could undermine certain
provisions of the bankruptcy code applicable to the dealer's
business.\201\ As a result, the potential application of SIPA to OTC
derivatives dealers would create legal uncertainty about the rights of
counterparties in transactions with registered OTC derivatives dealers
in the event of dealer insolvency.\202\ This uncertainty could impair
the ability of securities firms electing to register as OTC derivatives
dealers to compete effectively with banks and foreign dealers, which
are not subject to similar legal uncertainty.
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\200\ 15 U.S.C. 78aaa et seq.
\201\ Proposing Release, Section II.G., 62 FR at 67949-50. The
bankruptcy code contains certain exceptions to its automatic stay
provisions that enable a counterparty in a derivatives transaction
to exercise its rights to liquidate a position (i.e., it preserves a
counterparty's contractual termination, setoff, and collateral
foreclosure rights) in the event of the other counterparty's
insolvency. See, e.g., 11 U.S.C. 362(b)(6), (7), (17); id. at
sections 555, 556, 559, and 560. Several of these provisions,
however, may be subject to a stay order under SIPA. See 11 U.S.C.
555 (contractual right to liquidate a securities contract); id. at
section 559 (contractual right to liquidate a repurchase agreement).
\202\ Under the typical relationship where a counterparty
delivers collateral to an OTC derivatives dealer in order to cover
its contractual obligations to the dealer, the counterparty and the
OTC derivatives dealer have a relationship more analogous to a
debtor-creditor relationship than a fiduciary one. Accordingly,
these counterparties are not the type of investor intended to be
protected under SIPA. See Securities Investor Protection Corporation
v. Executive Services Corp., 423 F. Supp. 94 (S.D.N.Y. 1976), aff'd,
556 F.2d 98 (2d Cir. 1977).
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The commenters addressing this issue generally believed that the
SIPA exemption was both necessary and appropriate.\203\ In particular,
Morgan Stanley Dean Witter agreed with the statement in the Proposing
Release that the exemption was necessary to avoid potential legal
uncertainty about the rights of counterparties in transactions with
registered OTC derivatives dealers in the event of dealer
insolvency.\204\ Two other commenters noted that the exemptive relief
from SIPA and SIPC membership was critical to the commercial viability
of an OTC derivatives dealer.\205\
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\203\ SIA Letter I, p. 14; DESCO Letter, p. 13; MSDW Letter, p.
iv.
\204\ MSDW Letter, p. iv.
\205\ SIA Letter I, p. 14; DESCO Letter, p. 13.
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In response to the comments received, the exemption for OTC
derivatives dealers from the provisions of SIPA, including from
membership in SIPC, is being adopted in its proposed form. The purposes
of SIPA would not be promoted by its application to OTC derivatives
dealers, and could in fact result in legal uncertainty for OTC
derivatives dealers' counterparties. As a result, the Commission finds
that Rule 36a1-2, exempting OTC derivatives dealers from SIPA, is
necessary or appropriate in the public interest and consistent with the
protection of investors.\206\
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\206\ Section 2 of SIPA states that the provisions of the
Exchange Act generally apply as if SIPA ``constituted an amendment
to, and was included as a section of'' the Exchange Act. 15 U.S.C.
78bbb.
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E. Rule 11a1-6; Transactions for Certain Accounts of OTC Derivatives
Dealers
In response to the Proposing Release's general request for comment
on whether additional amendments or exemptions would be needed for OTC
derivatives dealers,\207\ the SIA requested that the Commission clarify
that an exchange member may execute transactions on a national
securities exchange for the account of its affiliated OTC derivatives
dealer without violating Section 11(a)(1) of the Exchange Act.\208\
Section 11(a)(1) \209\ makes it unlawful for a member of a national
securities exchange to effect transactions on that exchange for certain
accounts, including its own account or the account of an associated
person of the member.
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\207\ Proposing Release, Section III, 62 FR at 67952.
\208\ SIA Letter II, p. 4.
\209\15 U.S.C. 78k(a)(1).
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This general prohibition, however, is subject to numerous
exceptions.\210\ Among these is a general exception provided in section
11(a)(1)(G) \211\ for a member's proprietary transactions where (1) the
member is primarily engaged in a public securities business (the
``business mix'' test);\212\ and (2) the transactions ``yield,'' in
accordance with Commission rules, priority, parity, and
[[Page 59383]]
precedence to transactions for accounts of persons who are not members,
or associated with members, of the exchange.
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\210\ The Commission is also authorized to determine, by rule,
that additional types of transactions are excepted from the general
prohibition of section 11(a)(1). See section 11(a)(1)(I) of the
Exchange Act (15 U.S.C. 78k(a)(1)(I)). In adopting such a rule, the
Commission must find that such transactions are consistent with the
purposes of section 11(a), the protection of investors, and the
maintenance of fair and orderly markets. Id.
\211\ 15 U.S.C. 78k(a)(1)(G).
\212\ In order to take advantage of this exception, the member
must be ``primarily engaged in the business of underwriting and
distributing securities issued by other persons, selling securities
to customers, and acting as broker, or any one or more of such
activities, and whose gross income normally is derived principally
from such business and related activities.'' 15 U.S.C.
78k(a)(1)(G)(i).
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Rule 11a1-2 under the Exchange Act \213\ generally provides that a
member may effect a transaction for the account of an associated person
if the member would have been permitted, under section 11(a) and the
rules thereunder, to effect the transaction for its own account. The
rule, however, specifically limits the circumstances in which a member
may use the rule to rely on section 11(a)(1)(G) for transactions for
the account of an associated person. In that situation, the associated
person must independently meet the ``business mix'' test.\214\ Because
an OTC derivatives dealer will be a newly created entity, it will not
be able to demonstrate that it meets this test. Thus, the exchange
member with which it is associated will not be able to rely on section
11(a)(1)(G) for transactions it effects for the account of the OTC
derivatives dealer.
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\213\ 17 CFR 240.11a1-2.
\214\ This means that the associated person for whom the member
is effecting the transaction must have derived, during its preceding
fiscal year, more than 50% of its gross revenues from one or more of
the sources specified in Section 11(a)(1)G)(i). See Rule 11a1-2 (17
CFR 240.11a1-2).
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In response to this concern, the Commission is adopting Rule 11a1-
6. This new rule, which is modeled after Rule 11a1-2, will allow a
fully regulated broker-dealer member to effect a transaction on a
national securities exchange for the account of an associated person
that is an OTC derivatives dealer if the member would have been
permitted to effect the transaction for its own account under section
11(a) and the rules thereunder, other than Rule 11a1-2. Rule 11a1-6
permits the fully regulated broker-dealer to rely on the exception
provided under section 11(a)(i)(G) for transactions it effects for its
OTC derivatives dealer affiliate even if that affiliate does not meet
the ``business mix'' test. The fully regulated broker-dealer and the
OTC derivatives dealer, however, must comply with all other
requirements of section 11(a). Thus, for example, transactions effected
by the fully regulated broker-dealer for the account of the OTC
derivatives dealer must continue to yield priority, parity, and
precedence to transactions for accounts of persons who are not members,
or associated with members, of the exchange.
Although Rule 11a1-6 will allow a fully regulated broker-dealer to
execute securities transactions on behalf of its OTC derivatives dealer
affiliate, public customers will continue to receive priority and
precedence in the execution of their securities orders. Moreover,
excepting these transactions from the general prohibition of section
11(a)(1) is consistent with Congressional intent in enacting this
section. The Commission, therefore, finds that Rule 11a1-6 is
consistent with the purposes of section 11(a)(1), the protection of
investors, and the maintenance of fair and orderly markets.
F. Net Capital Requirements for OTC Derivatives Dealers
1. Overview of Amendments to Rule 15c3-1
The Commission is amending the net capital rule, Rule 15c3-1 under
the Exchange Act,\215\ as it applies to OTC derivatives dealers. In
general, the net capital rule requires every registered broker-dealer
to maintain certain specified minimum levels of net liquid assets, or
net capital, to enable each firm that falls below the minimum net
capital requirements to liquidate in an orderly fashion without the
need for a formal legal proceeding. The rule is designed to protect the
customers of a broker-dealer from losses that can be incurred upon a
broker-dealer's failure. The rule prescribes different required minimum
levels of capital based upon the nature of the broker-dealer's business
and whether the firm handles customer funds or securities. When
calculating its net capital, a broker-dealer must reduce its capital by
certain percentage amounts, or haircuts, on its securities positions.
The haircuts were designed not only to cover market risk, but also
other risks faced by the firm, such as credit and liquidity risk.
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\215\ 17 CFR 240.15c3-1.
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As noted in the Proposing Release, U.S. securities firms generally
state that firms avoid to the extent feasible booking swaps and other
types of OTC derivative instruments in the registered broker-dealer
because of the charges for these transactions under the net capital
rule./216/ In general, the rule requires a firm to subtract most
unsecured credits from its net worth when calculating its net capital,
and limits the hedging allowance against positions if OTC derivatives
dealers have unsecured credit exposures. The net capital rule's
treatment of OTC derivatives transactions generally requires broker-
dealers to reserve more capital with respect to these transactions than
do capital rules governing banks or foreign securities firms.
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\216\ See Proposing Release, Section II.E.1., 62 FR at 67946.
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The Commission is amending Rule 15c3-1 to provide alternative
methods for OTC derivatives dealers to calculate capital charges on OTC
derivatives transactions in several respects. Under Appendix F of Rule
15c3-1, which is being adopted substantially as proposed, an OTC
derivatives dealer is permitted to add back to its net worth any
unsecured credits arising from transactions in eligible OTC derivative
instruments.\217\ These will include unsecured accrued receivables as
well as unsecured counterparty exposure in the OTC instruments.
Appendix F also allows an OTC derivatives dealer to use VAR models to
compute its market risk charges on proprietary positions instead of
using the haircut structure under paragraph (c)(2)(vi) of the current
rule. As mentioned above, the current haircut approach allows more
limited offsetting among positions than the normal VAR model would
permit when computing capital charges. Appendix F also allows an OTC
derivatives dealer to use a less severe regime for credit risk, as
described below.
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\217\ An unsecured receivable from an affiliated entity must be
deducted to the extent the receivable is not collateralized with
readily marketable securities.
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Currently, some dealers use VAR models as part of their risk
management systems. These firms use VAR modeling to analyze, control,
and report the level of market risk from their trading activities. A
VAR estimate is the loss that is not expected to be exceeded at the
chosen confidence level for some time period. In practice, VAR models
aggregate several components of price risk into a single quantitative
measure of the potential for loss. In addition, VAR is based on a
number of underlying mathematical assumptions and firm-specific inputs.
For example, VAR models typically assume normality and that future
return distributions and correlations can be predicted by past
returns.\218\
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\218\ There is a wide variety of secondary source information
discussing both the positive and negative aspects of VAR. See
Philippe Jorion, Value at Risk: The New Benchmark for Controlling
Market Risk (1996) (explaining how to use VAR to manage market
risk); JP Morgan, RiskMetrics-Technical Document (1994) (providing a
detailed description of RiskMetrics, which is JP Morgan's
proprietary statistical model for quantifying market risk in fixed
income and equity portfolios); Tanya Styblo Beder, VAR: Seductive
but Dangerous, Financial Analysts Journal, September-October 1995,
at 12 (giving an extensive analysis of the different results from
applying three common VAR methods to three model portfolios);
Darrell Duffie and Jun Pan, An Overview of Value at Risk, The
Journal of Derivatives, Spring 1997, at 7 (giving a broad overview
of VAR models); Darryll Hendricks, Evaluation of Value-at-Risk
Models Using Historical Data, Federal Reserve Bank of New York
Economic Policy Review, April 1996, at 39 (examining twelve
approaches to VAR modeling on portfolios that do not include options
or other securities with non-linear pricing); and Robert Litterman,
Hot Spots and Hedges, Goldman Sachs Risk Management Series (1996)
(giving a detailed analysis on portfolio risk management, including
how to identify the primary sources of risk and how to reduce these
risks).
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[[Page 59384]]
2. Reasons for Allowing OTC Derivatives Dealers To Use Value-at-Risk
Models
During the past few years, the Commission has actively participated
in several international undertakings to gain further experience with
the use of VAR models to measure market and credit risk. For example,
through its membership in the International Organization of Securities
Commissions (``IOSCO''), the Commission has been cooperating with the
Basle Committee on Banking Supervision (``Basle Committee'') \219\ with
respect to the use of proprietary VAR models to determine bank capital
requirements for market risk.\220\
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\219\ The Governors of the G-10 countries established the Basle
Committee in 1974 to provide a forum for ongoing cooperation among
member countries on banking supervisory matters.
\220\ In July 1995, IOSCO's Technical Committee issued a paper
stating that further information and analysis was required before
the Technical Committee could consider the use of internal models by
securities firms to set regulatory capital standards for market
risk. Due to the differences between banks and securities firms, the
Technical Committee believed that more work was necessary before
allowing securities firms to use VAR models to establish their
capital requirements. The Implications for Securities Regulators of
the Increased Use of Value At Risk Models by Securities Firms,
Technical Committee of IOSCO, July 1995.
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Further, the Board of Governors of the Federal Reserve System, the
Office of the Comptroller of the Currency, and the Federal Deposit
Insurance Corporation (collectively, the ``U.S. Banking Agencies'')
have adopted rules implementing the Capital Accord \221\ for U.S. banks
and bank holding companies.\222\ Appendix F is generally consistent
with the U.S. Banking Agencies' rules, and incorporates the qualitative
and quantitative conditions imposed on banking institutions.
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\221\ The Basle Accord, or Capital Accord, is a common
measurement system and a minimum standard for capital adequacy of
international banks in the G-10 countries.
\222\ Federal Reserve System, Docket No. R-0884; Department of
the Treasury, Office of the Comptroller of the Currency, Docket No.
96-18; Federal Deposit Insurance Corporation, RIN 3064-AB64 (Sept.
6, 1996), 61 FR 47358.
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By allowing OTC derivatives dealers to use VAR models in
calculating their net capital requirement, the Commission has an
opportunity to gain valuable experience with the use of these models by
entities within its jurisdiction. This experience will enable the
Commission to reassess its current rules for determining capital
charges for market risk and determine whether more intensive subjective
examinations are needed to ensure compliance with Commission
regulations concerning the use of models.
The adoption of a more flexible approach for determining capital
requirements for OTC derivatives dealers is appropriate because of the
special nature of their business and the additional financial
responsibility requirements applicable to these firms. The final rule
requires an OTC derivatives dealer to maintain a minimum of $100
million in tentative net capital \223\ and at least $20 million in net
capital. OTC derivatives dealers are prohibited from accepting or
holding customer funds or securities or generally from owing money or
securities to customers in connection with securities activities. OTC
derivatives dealers are, however, allowed to hold counterparty
collateral or owe money or securities to counterparties, but only as a
result of contractual commitments. Finally, OTC derivatives dealers are
required to establish risk management controls pursuant to Rule 15c3-4.
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\223\ For an OTC derivatives dealer that elects to compute its
market risk charges under Appendix F, the term ``tentative net
capital'' means the net capital of an OTC derivatives dealer before
deducting charges for market and credit risk as computed pursuant to
Appendix F and increased by the balance sheet value (including
counterparty net exposure) resulting from transactions in eligible
OTC derivative instruments which would otherwise be deducted by
virtue of paragraph (c)(2)(iv) of Rule 15c3-1.
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3. Discussion of Net Capital Requirements
a. Rule 15c3-1(a)(5). Under paragraph (a)(5) of Rule 15c3-1, OTC
derivatives dealers are required to maintain tentative net capital of
not less than $100 million and net capital of not less than $20
million. In the Proposing Release, the Commission requested comment on
whether the $100 million tentative net capital and $20 million net
capital requirements would be adequate to ensure against excessive
leverage and risks other than credit or market risk.\224\ Many
commenters declined to comment on the minimum required amount.\225\ One
commenter opposed any minimum tentative net capital requirement because
other U.S. broker-dealers are not required to maintain minimum
tentative net capital under the net capital rule, and because it
believed that U.S. firms, and particularly small-sized, medium-sized,
and newly established OTC derivatives dealers, would be at a
competitive disadvantage.\226\
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\224\ Proposing Release, Section II.E.3.a., 62 FR at 67947.
\225\ See Section V.A.1. of the Comment Summary.
\226\ DESCO Letter, pp. 9-10.
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The final rule contains the minimum requirements of $100 million in
tentative net capital and $20 million in net capital. The minimum
tentative net capital and net capital requirements are necessary to
ensure against excessive leverage and risks other than credit or market
risk, all of which are now factored into the current haircuts. Further,
while the mathematical assumptions underlying VAR may be useful in
projecting possible daily trading losses under ``normal'' market
conditions, VAR may not help firms measure losses that fall outside of
normal conditions, such as during steep market declines.\227\
Accordingly, the minimum capital requirements provide additional
safeguards to account for possible extraordinary losses or decreases in
liquidity during times of stress which are not incorporated into VAR
calculations.
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227 Models such as the one specified in Appendix F typically
measure exposure at the first percentile, and steep market declines
are, by definition, below the first percentile.
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b. Appendix F. Appendix F applies only to an OTC derivatives dealer
that elects to be subject to the Appendix and has its application to
use Appendix F approved by the Commission. An OTC derivatives dealer
that elects to be subject to Appendix F is required to calculate
specific capital charges for market and credit risk. It is also
required to maintain a VAR model that meets certain minimum qualitative
and quantitative requirements described in Appendix F, and it must
adopt risk management control procedures as provided in Rule 15c3-4.
i. Application Requirement. An OTC derivatives dealer must be
authorized by the Commission to compute capital charges for market and
credit risk pursuant to Appendix F. To request this authorization, an
OTC derivatives dealer must file an application with the Commission
describing its VAR model, including whether the firm has developed its
own model, whether the firm intends to use VAR or alternative methods
to calculate net capital, and how the qualitative and quantitative
aspects described in Appendix F are incorporated into the model, and a
description of its risk management and control procedures.\228\
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\228\ See Sections II.F.3.b.iv. and v. below for a description
of the qualitative and quantitative requirements.
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More specifically, the application must include (1) an executive
summary of information provided in the application; (2) a description
of the
[[Page 59385]]
statistical models used for pricing OTC derivative instruments and for
computing VAR, a description of the applicant's controls over those
models, and a statement regarding whether the firm has developed its
own internal VAR model; and (3) a description of the policies and
procedures which the dealer employs in association with its internal
risk management control systems.\229\ The application must also
describe any alternative methods that the OTC derivatives dealer
intends to use to compute its market risk charge for equity
instruments, and categories of securities having no ready market or
which are below investment grade. Further, an OTC derivatives dealer
that wants to use internal credit ratings for counterparties that are
not rated by a nationally recognized statistical rating organization
(``NRSRO'' or ``rating organization'') must also include in its
application a description of its credit rating categories and rating
procedures.
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\229\ See Section II.H.3. below for a description of the risk
management controls that are required by Rule 15c3-4 (17 CFR
240.15c3-4)
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The Commission is amending Rule 30-3 of the Rules of Practice to
delegate its authority to approve or deny, in full or in part,
applications of OTC derivatives dealers to use Appendix F of Rule 15c3-
1 to the Director of the Division of Market Regulation.\230\ A denial
of an application by the Division would be reviewable by the
Commission.\231\ The Commission will grant the application and
authorize the OTC derivatives dealer to compute its net capital under
Appendix F if the dealer has adopted (1) the internal risk management
control systems required under Rule 15c3-4; and (2) a VAR model that
meets the criteria in paragraphs (e)(1) and (e)(2) of Appendix F. All
application information submitted will be kept confidential, in
accordance with the rules.
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\230\ See Rule 30-3(a)(7)(v) (17 CFR 200.30-3(a)(7)(v)).
\231\ See Rules 430 and 431 (17 CFR 201.430 and 17 CFR 201.431).
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Commenters noted the importance of including provisions for the
review of risk management practices, policies, and procedures employed
by OTC derivatives dealers, to assure that they are being executed in
accordance with their intended purposes.\232\ Accordingly, pursuant to
the final rule, an OTC derivatives dealer is required to obtain
authorization from the Commission before it may adopt any material
changes to its VAR or other models, including changes in the
qualitative or quantitative aspects of VAR models, before it may
materially change the categories of non-marketable securities it wishes
to include in its VAR model, or before it may materially alter its
internal risk management control systems. If an OTC derivatives dealer
desires to materially change its VAR model or internal risk management
control systems, it must file an amended application with the
Commission describing the changes. The OTC derivatives dealer will be
authorized by the Commission to implement the proposed changes if the
Commission determines that the changes meet the compliance standards of
Rule 15c3-4 and Appendix F, and the amended application complements the
internal review requirements imposed by those provisions. The final
rule also clarifies that an OTC derivatives dealer will be in violation
of the net capital rule if it fails to comply in all material respects
with the internal risk management control systems under Rule 15c3-4.
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\232\ See Comment Letter from the Working Group of the Risk
Management, OTC Derivative Products, and Capital Committees of the
Securities Industry Association (``SIA Working Group Letter''), pp.
1-5.
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ii. Market Risk. OTC derivatives dealers electing to apply Appendix
F pursuant to the final rule must deduct from their net worth a capital
charge for market risk \233\ that is equal to the sum of its VAR
charge, alternative charges for equity instruments and non-marketable
securities, and the charge for residual positions. First, OTC
derivatives dealers may use the VAR method to calculate capital charges
for market risk exposure for transactions in eligible OTC derivative
instruments and other proprietary positions of the OTC derivatives
dealer. Under the VAR method, a market risk capital charge is equal to
the VAR of its positions multiplied by a factor specified in Appendix
F.\234\
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\233\ In general, market risk is the risk of adverse price
movements resulting from a change in market prices, interest rates,
volatilities, correlations, or other market factors.
\234\ See Section II.F.3.b.iv. below for a discussion of how an
OTC derivatives dealer determines the appropriate multiplication
factor.
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Second, an OTC derivatives dealer may use an alternative method of
computing the market risk capital charge for equity instruments,
including OTC options. This alternative method may also be used by a
firm that does not receive Commission authorization to use a VAR model
for equity instruments. Under the alternative method, an OTC
derivatives dealer must deduct from its net worth an amount equal to
the largest theoretical loss calculated in accordance with the
theoretical pricing model set forth in Appendix A of Rule 15c3-1.\235\
The OTC derivatives dealer is permitted to use its own theoretical
pricing model as long as it contains the minimum pricing factors set
forth in Appendix A.\236\
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\235\ 17 CFR 240.15c3-1a. The Commission recently amended
Appendix A to include theoretical pricing models. Exchange Act
Release No. 38248 (Feb. 6, 1997), 62 FR 6474 (Feb. 12, 1997).
\236\ 17 CFR 240.15c3-1a(b)(1)(B). The minimum pricing factors
under Appendix A include:
(1) The current spot price of the underlying asset;
(2) The exercise price of the option;
(3) The remaining time until the option's expiration;
(4) The volatility of the underlying asset;
(5) Any cash flows associated with ownership of the underlying
asset that can reasonably be expected to occur during the remaining
life of the option; and
(6) The current term structure of interest rates.
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Third, an OTC derivatives dealer may not use a VAR model to
determine a capital charge for any category of securities having no
ready market or any category of debt securities which are below
investment grade, or any derivative instrument based on the value of
these categories of securities, unless the Commission has granted,
pursuant to paragraph (a)(1) of Appendix F, its application to use its
VAR model for any such category of securities. However, the dealer may
apply, pursuant to paragraph (a)(1) of Appendix F, for an alternative
treatment for any such category of securities, rather than calculate
the market risk capital charge for such category of securities under
paragraph (c)(2) (vi) and (vii) of the new capital rule.
Fourth, to the extent that a position has not been included in the
calculation of the market risk charge for VAR, or the alternative
method for equity instruments or for non-marketable securities, the
market risk charge for the position shall be computed under paragraph
(c)(2)(vi) of Rule 15c3-1.
iii. Credit Risk. An OTC derivatives dealer electing to apply
Appendix F must deduct from its net worth a capital charge for credit
risk.\237\ This charge has two parts and is computed on a counterparty-
by-counterparty basis. First, for each counterparty with an investment
or speculative grade rating, an OTC derivatives dealer must take a
capital charge equal to the net replacement value in the account of the
counterparty (``net replacement value'') \238\ multiplied by 8%, and
[[Page 59386]]
further multiplied by a counterparty factor. The counterparty factor is
based on the counterparty's rating by an NRSRO. The counterparty
factors range from 20% for counterparties that are highly rated to 100%
for counterparties with ratings among the lowest rating categories. By
using the ratings of the rating organization as a basis, the
counterparty factors link the size of the credit risk capital charge to
the perceived risk that the counterparty may default. A charge of 100%
of the net replacement value is assessed for counterparties rated below
speculative grade or that are insolvent, or in bankruptcy, or that have
senior unsecured long-term debt in default.
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\237\ In general, credit risk is the risk that a counterparty
will fail to perform its obligations to an OTC derivatives dealer.
\238\ For purposes of calculating credit risk charges, net
replacement value in the account of a counterparty means the
aggregate value of all receivables due from that counterparty
(computed by marking the value of such receivables to market daily),
including the effect of legally enforceable netting agreements and
the application of liquid collateral.
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The second part of the credit risk charge consists of a
concentration charge that applies when the net replacement value in the
account of any one counterparty exceeds 25% of the OTC derivatives
dealer's tentative net capital. In these situations, the amount of the
concentration charge is also based on the counterparty's rating by an
NRSRO. For counterparties that are highly rated, the concentration
charge equals 5% of the amount of the net replacement value in excess
of 25% of the OTC derivatives dealer's tentative net capital. The
concentration charge increases in relation to the OTC derivatives
dealer's exposure to lower rated counterparties. For example, the
concentration charge for counterparties with ratings among the lowest
rating categories would equal 50% of the amount of the net replacement
value in excess of 25% of the OTC derivatives dealer's tentative net
capital.
In the rule as proposed, the credit risk concentration charge
included a further provision that if the aggregate net replacement
values of all counterparties exceeded 300% of the OTC derivatives
dealer's tentative net capital, the OTC derivatives dealer would deduct
100% of the excess from its net worth. In the Proposing Release, the
Commission requested comment on whether the 300% threshold for
determining an overall concentration charge would result in excessive
concentration risk charges.\239\ Commenters suggested that the charge
would have to be eliminated in order for the proposal to be
viable.\240\ The final rule does not contain this further provision.
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\239\ Proposing Release, Section II.E.3.b.ii., 62 FR at 67948.
\240\ See, e.g., SIA Letter I, p. 3; Goldman Sachs Letter, p. 4;
Salomon Smith Barney Letter, p. 2; MSDW Letter, pp.18-19, iii;
Merrill Lynch Letter, p. 3.
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If a counterparty is not rated by a rating organization, an OTC
derivatives dealer is permitted to use its own ratings of the
counterparty to calculate its credit risk charge. In these situations,
however, the OTC derivatives dealer must demonstrate that its ratings
categories and due diligence procedures, including procedures for the
initial analysis and ongoing review of the counterparty (including
review of the total leverage of the counterparty), are equivalent to
those used by NRSROs. Several commenters requested that the Commission
clarify whether the OTC derivatives dealer's demonstration must be on a
counterparty-by-counterparty basis, and whether an affiliate of the
dealer could rate non-NRSRO counterparties.\241\ It is anticipated that
authorization of an OTC derivatives dealer's credit rating methodology
will occur as a whole rather than as to each counterparty. Further, the
final rule provides that such ratings may be made by an affiliated bank
or an affiliated broker-dealer of the OTC derivatives dealer, provided
that the affiliate's methodology has been authorized by the Commission.
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\241\ See letters cited in Section V.A.2.b.i. of the Comment
Summary.
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In the Proposing Release, the Commission requested comment on
alternatives to relying on the ratings of NRSROs for approximating the
risk that a counterparty may default.\242\ Several commenters advocated
the use of internal credit ratings of counterparties instead of or in
addition to NRSRO ratings to calculate counterparty default risk.\243\
Where available, NRSRO ratings are a reliable indicator of the
perceived risk that a counterparty may default. Therefore, it is only
in cases where a counterparty is not rated by an NRSRO that an OTC
derivatives dealer is permitted to use its own ratings of a
counterparty to calculate the credit risk charge.
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\242\ Proposing Release, Section II.E.3.b.ii., 62 FR at 67948.
\243\ See, e.g., ISDA Letter, p. 4; SIA Letter I, pp. 3-4;
Salomon Smith Barney Letter, p. 2; MSDW Letter, pp. 15-17; Merrill
Lynch Letter, p. 4.
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Commenters also requested that the Commission allow the use of
internal VAR models to assess credit risk regulatory capital, instead
of or in addition to the proposed percentage-based credit risk capital
charges. While the adoption of the current rule will provide valuable
experience with the use of VAR models to assess market risk for
regulatory capital purposes, the Commission has less confidence in the
use of VAR for credit risk. Therefore, the Commission has determined at
this time not to allow OTC derivatives dealers to employ credit risk
VAR modeling in calculating net capital requirements. The Commission,
however, expects to consider this issue in the future.
iv. Qualitative Requirements for Value-at-Risk Models. OTC
derivatives dealers that elect to apply Appendix F are required to have
VAR models that meet certain minimum qualitative requirements. The
qualitative requirements address four aspects of an OTC derivatives
dealer's risk management system. First, an OTC derivatives dealer's VAR
model must be integrated into, and thus relied upon, in the OTC
derivatives dealer's daily risk management process. Second, an OTC
derivatives dealer's policies and procedures must identify and provide
for appropriate stress tests.\244\ The OTC derivatives dealer's
policies and procedures must identify the procedures to follow in
response to the results of the stress tests as well as backtests, and
the OTC derivatives dealer is required to follow these procedures.
Third, an OTC derivatives dealer's VAR model and risk management
systems are required to undergo both periodic reviews that are
performed by internal audit staff and annual reviews that are conducted
by an independent public accountant.\245\ Fourth, an OTC derivatives
dealer is required to conduct backtesting of its VAR model.
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\244\ Stress tests are used to evaluate changes in the value of
a firm's portfolio under extreme market conditions. Stress tests
must include the core risk factors of: (1) Parallel yield curve
shifts; (2) changes in the steepness of yield curves; (3) parallel
yield curve shifts combined with changes in the steepness of yield
curves; (4) changes in yield volatilities; (5) changes in the value
of equity indices; (6) changes in equity index volatilities; (7)
changes in the value of key currencies (relative to the U.S.
dollar); (8) changes in foreign exchange rate volatilities; and (9)
changes in swap spreads in at least the G-7 countries plus
Switzerland. Stress tests should also be designed to reflect the
composition of the firm's portfolio.
\245\ The OTC derivatives dealer must discuss the timing and
nature of the periodic review by internal audit staff as part of the
application process. See Section II.F.3.b.i. above.
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As to the fourth element, the OTC derivatives dealer is required to
conduct backtesting by comparing each of its most recent 250 business
days' actual net trading profits or losses with the corresponding daily
VAR measures. In addition, once each quarter, the OTC derivatives
dealer must identify the number of exceptions, that is, the number of
business days for which the actual daily net trading loss, if any,
exceeds the corresponding daily VAR measure. The number of exceptions
determines the multiplication factor the
[[Page 59387]]
OTC derivatives dealer will be required to use for the following
quarter, and which will continue to apply until the next quarter's
backtesting results are obtained, unless the Commission determines that
a different adjustment or other action is appropriate. Depending on the
number of exceptions, the multiplication factors range from three to
four. Increasing the multiplication factor in response to the number of
backtesting exceptions increases an OTC derivatives dealer's market
risk charge, thus requiring an OTC derivatives dealer that uses an
inappropriate model to increase its net capital reserves. Although the
multiplication factor increases an OTC derivatives dealer's market risk
charge and corresponding capital requirement, firms are expected to
work to improve the reliability of their models rather than set aside
additional capital for an unreliable model.
v. Quantitative Requirements for Value-at-Risk Models. Appendix F
also contains minimum quantitative requirements to address regulatory
concerns. Because broker-dealers generally use VAR models to measure
portfolio volatility on a day-to-day basis, the rule imposes certain
requirements on VAR models to address regulatory capital-related
concerns where a longer time horizon is appropriate. For example, OTC
derivatives dealers are required to calculate VAR measures using a
confidence level with a price change equivalent to a ten-business day
movement in rates and prices, rather than a one-day price movement that
is used in many VAR models currently used by firms for internal risk
management purposes. The final rule also requires a one-year historical
observation period, and addresses risks to be accounted for in VAR
measures.
G. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
The proposed rules would have excluded from the definition of
customer, pursuant to Rules 8c-1,\246\ 15c2-1,\247\ and 15c3-3 under
the Exchange Act,\248\ a counterparty to an OTC derivatives transaction
that has consented, after receiving appropriate disclosures, to the
unrestricted use of its collateral by an OTC derivatives dealer. Rules
8c-1, 15c2-1, 15c3-2,\249\ and 15c3-3 generally restrict a broker-
dealer's use of customer funds and securities to finance its business
activities.
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\246\ 17 CFR 240.8c-1.
\247\ 17 CFR 240.15c2-1.
\248\ 17 CFR 240.15c3-3.
\249\ 17 CFR 240.15c3-2. The Commission did not propose to amend
Rule 15c3-2 in the Proposing Release. Rule 15c3-2 restricts the use
by a broker or dealer of funds arising out of any free credit
balance carried for the account of any customer unless the broker or
dealer complies with certain notice requirements.
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The SIA commented that the proposed exclusions should be expanded
to include counterparties to permissible cash management, risk
management, and financing transactions.\250\ In addition, the SIA
suggested that the Commission clarify that the disclosure requirement
could be met in any instance in which a counterparty has entered into
an agreement explicitly authorizing the repledging, rehypothecation,
substitution, or other disposition of collateral provided by the
counterparty.\251\ Further, the SIA sought to verify that
counterparties to transactions effected through a fully regulated
broker-dealer would not be considered a customer of the OTC derivatives
dealer for purposes of Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3.\252\
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\250\ SIA Letter I, pp. 12-13.
\251\ SIA Letter I, p. 13.
\252\ Id.; SIA Letter II, p. 5.
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The amendments to Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3 as adopted
clarify the original intent of the proposal. Further, an OTC
derivatives dealer that has received collateral from a counterparty
will not be carrying a free credit balance for the account of a
customer for the purposes of Rule 15c3-2 if the counterparty is not a
customer of the dealer pursuant to Rules 8c-1, 15c2-1, and 15c3-3. A
counterparty that has delivered collateral to an OTC derivatives dealer
pursuant to a transaction in an eligible OTC derivative instrument or
pursuant to the OTC derivatives dealer's cash management securities
activities or ancillary portfolio management securities activities is
not a customer for purposes of Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3,
but only if the counterparty has received a prominent written notice
from the OTC derivatives dealer that, at a minimum, discloses that (1)
except as otherwise agreed in writing by the OTC derivatives dealer and
the counterparty, the OTC derivatives dealer may repledge or otherwise
use the collateral in its business; (2) in the event of the dealer's
failure, the counterparty will likely be considered an unsecured
creditor of the dealer as to that collateral; (3) SIPA does not protect
the counterparty; and (4) the collateral will not be subject to the
requirements of Rules 8c-1, 15c2-1, 15c3-2, or 15c3-3.
H. Recordkeeping and Reporting
1. Amendments to Rules 17a-3 and 17a-4; Books and Records to be
Maintained by OTC Derivatives Dealers
The Proposing Release \253\ stated that OTC derivatives dealers,
like other registered broker-dealers, are required to comply with the
books and records requirements of Rules 17a-3 \254\ and 17a-4 \255\
under the Exchange Act. Rule 17a-3 would also have been amended to
require an OTC derivatives dealer to compile a register of all
derivatives transactions. In addition, Rule 17a-4 would have been
amended to require OTC derivatives dealers to retain records required
to be made pursuant to proposed Rules 15c3-4 and 17a-12.\256\
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\253\ Proposing Release, Section II.H.1., 62 FR at 67950.
\254\ 17 CFR 240.17a-3. In general, Rule 17a-3 under the
Exchange Act requires broker-dealers to make records concerning the
purchases and sales of securities, receipts and deliveries of
securities, and receipts and disbursements of cash. In addition, the
rule requires broker-dealers to make and keep ledgers reflecting
securities borrowed and securities received, repurchase and reverse
repurchase agreements, and a record of net capital computations.
\255\ 17 CFR 240.17a-4. Rule 17a-4 under the Exchange Act
specifies how long broker-dealers must keep the records required to
be made under Rule 17a-3 and how long they must keep other records
made in the normal course of business.
\256\ See Proposing Release, Section II.H.1., 62 FR at 67950.
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The Commission is adopting the amendments to Rules 17a-3 and 17a-4
as proposed. As several commenters have requested, the rules have been
clarified to allow the OTC derivatives dealer's books and records to be
maintained by an affiliated fully regulated broker-dealer. However, the
OTC derivatives dealer remains responsible for ensuring that its books
and records are properly maintained in accordance with Rules 17a-3 and
17a-4.
2. Amendments to Rule 17a-11; Notification Requirements
In the Proposing Release, the Commission stated that an OTC
derivatives dealer would be subject to the provisions of Rule 17a-11
under the Exchange Act,\257\ which requires a
[[Page 59388]]
broker-dealer to report capital and other operational problems to the
Commission and the broker-dealer's examining authority within specified
time periods.\258\ In addition, Rule 17a-11 would have been amended to
take into consideration the new tentative net capital requirements that
would apply to an OTC derivatives dealer. An OTC derivatives dealer
would have been required to provide notice to the Commission and to its
examining authority when its tentative net capital dropped below 120
percent of its required minimum and when its tentative net capital
dropped below its required minimum.\259\
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\257\ 17 CFR 240.17a-11. Under Rule 17a-11, if a broker-dealer's
net capital falls below the required minimum level, the broker-
dealer must provide both the Commission and the broker-dealer's DEA
with notice of such deficiency. A broker-dealer is also required to
give same-day notice if it fails to make and keep current its books
and records pursuant to Rules 17a-3 and 17a-4, and to submit a
report within 48 hours detailing the steps it is taking to correct
the problem. In addition, Rule 17a-11 requires a broker-dealer to
give notice when it discovers any material inadequacy in its system
of internal controls, or is notified of this inadequacy by its
independent public accountant. In these instances, the broker-dealer
is required to submit a report detailing steps being taken to
correct the inadequacy.
\258\ Proposing Release, Section II.H.2., 62 FR at 67950.
\259\ Under proposed Rule 15b9-2, an OTC derivatives dealer
would have been required to enter into an agreement with the
examining authority for one or more of its registered broker-dealer
affiliates. Under this agreement, the examining authority would have
agreed to conduct a review of the activities of the OTC derivatives
dealer. See supra note 181 and accompanying text.
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The Commission did not receive any comments that addressed the
proposed amendments to Rule 17a-11. However, as discussed in Section
II.D.1. above, the Commission is not requiring an OTC derivatives
dealer to enter into an agreement with the examining authority for one
of its registered broker-dealer affiliates that would require the
examining authority to conduct a review of the activities of the OTC
derivatives dealer. Therefore, the adopted amendments to Rule 17a-11
require an OTC derivatives dealer to provide the required notices only
to the Commission. With respect to tentative net capital, an OTC
derivatives dealer is required to provide notice to the Commission when
its tentative net capital drops below 120 percent of its required
minimum and when its tentative net capital drops below its required
minimum. The Commission is also amending Rule 17a-11 to require an OTC
derivatives dealer to notify the Commission of backtesting exceptions
identified pursuant to Appendix F of Rule 15c3-1.
3. Rule 15c3-4; Internal Risk Management Control Systems for OTC
Derivatives Dealers
Pursuant to proposed Rule 15c3-4, an OTC derivatives dealer would
have been required to establish a system of internal controls for
monitoring and managing risks associated with its business activities.
More specifically, proposed Rule 15c3-4 would have established the
basic elements for the design, implementation, and review of an OTC
derivatives dealer's risk management control system. The proposed rule
would have required an OTC derivatives dealer to assess a number of
aspects about its business environment when creating its risk
management control system. For example, an OTC derivatives dealer would
have been required to consider the sophistication and experience of
relevant trading, risk management, and internal audit personnel, as
well as the management philosophy and culture of the firm. In addition,
proposed Rule 15c3-4 would have required certain elements be included
in an OTC derivatives dealer's internal control systems. For example,
the proposed rule would have required the unit at the firm responsible
for monitoring risks to be separate from and senior to the trading
units whose activity created the risks.
The SIA Working Group commented \260\ that an OTC derivatives
dealer's internal risk management control system should specifically
address operational risk,\261\ market risk,\262\ credit risk,\263\
liquidity risk,\264\ and legal risk.\265\ In response to the comment,
the Commission has revised Rule 15c3-4 to clarify the specific risks to
be addressed by the OTC derivatives dealer's system of internal risk
management controls. In particular, Rule 15c3-4 requires that an OTC
derivatives dealer's system of internal risk management controls
specifically address market risk, credit risk, leverage risk, liquidity
risk, legal risk, and operational risk.
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\260\ SIA Working Group Letter, p. 1.
\261\ Operational risk encompasses the risk of loss due to the
breakdown of controls within the firm including, but not limited to,
unidentified limit excesses, unauthorized trading, fraud in trading
or in back office functions, inexperienced personnel, and unstable
and easily accessed computer systems.
\262\ Market risk involes the risk that prices or rates will
adversely change due to economic forces. Such risks include adverse
effects of movements in equity and interest rate markets, currency
exchange rates, and commodity prices. Market risk can also include
the risks associated with the cost of borrowing securities, dividend
risk, and correlation risk.
\263\ Credit risk comprises risk of loss resulting from
counterparty default on loans, swaps, options, and other similar
financial instruments during settlement.
\264\ Liquidity risk includes the risk that a firm will not be
able to unwind or hedge a position.
\265\ Legal risk arises from possible risk of loss due to an
uneforceable contract or an ultra vires act of a counterparty.
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Rule 15c3-4 has also been revised to require that an OTC
derivatives dealer's written guidelines include the dealer's procedures
to prevent it from engaging in any securities transaction that is not
permitted under Rule 15a-1 or from improperly relying on certain
exceptions set forth in Rule 15a-1 (including procedures to determine
whether a counterparty is acting in the capacity of principal or
agent).\266\ Under Rule 15c3-4, the dealer's management must also
periodically review the dealer's business activities for consistency
with risk management guidelines. The rule has been revised to require
management, as part of this process, to review whether procedures are
in place to prevent the dealer from engaging in impermissible
securities transactions and from improperly relying on the exceptions
contained in Rule 15a-1.\267\
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\266\ See Rule 15c3-4(c)(5)(xiii) and (xiv) (17 CFR 240.15c3-
4(c)(5)(xiii) and (xiv)). See also Rule 15a-1 (17 CFR 240.15a-1) and
Section II.C.1. above, discussing revisions to proposed Rule 15a-1.
\267\ See rule 15c3-4(d)(8) and (9) (17 CFR 240.15c3-4(d)(8) and
(9)).
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4. Rule 17a-12; Reports to be Made by OTC Derivatives Dealers
Proposed Rule 17a-12 would have required an OTC derivatives dealer
to file quarterly Financial Operational Combined Uniform Single Reports
(``FOCUS'' reports),\268\ and to include with its filing the enhanced
reporting information and evaluation of risks in relation to capital
provisions of the Framework for Voluntary Oversight of the Derivatives
Policy Group (``DPG'').\269\ Proposed Rule 17a-12 would also have
required an OTC derivatives dealer to file annually its audited
financial statements, a corresponding audit report, and three
supplemental audit reports regarding (1) material inadequacies and
reportable conditions; (2) derivatives pricing and modeling procedures;
and (3) compliance with internal risk management controls. The proposed
rule would have established guidelines for the content and form of the
annual report, accountant qualifications, the process for designating
an accountant, and audit objectives. For example, among other things,
the annual audit report would have been required to include a statement
of financial condition, a statement of income, a statement of cash
flows, a statement of
[[Page 59389]]
changes in owners' equity, and a statement of changes in subordinated
liabilities.
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\268\ Form X-17A-5 (17 CFR 249.617).
\269\ See Framework for Voluntary Oversight, Derivatives Policy
Group (Mar. 1995). The firms comprising the DPG consist of the six
U.S. broker-dealers with the largest OTC derivatives affiliates.
This group was organized to respond to the public policy interests
of Congress, federal agencies, and others in the OTC derivatives
activities of unregulated affiliates of SEC-registered broker-
dealers and CFTC-registered futures commission merchants. The
Framework for Voluntary Oversight specifies certain information that
the members of the DPG have voluntarily agreed to submit regarding
their OTC derivatives activities and establishes certain internal
control principles that group members should follow.
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The SIA requested clarification as to the scope of the auditor's
report regarding inventory pricing and modeling procedures.\270\ More
specifically, the SIA sought clarification that the objective of the
review of the inventory pricing and modeling procedures was to confirm
that (1) the pricing and modeling procedures relied upon by the OTC
derivatives dealer conform to the procedures submitted to the
Commission as part of its OTC derivatives dealer application; and (2)
the procedures comply with the qualitative and quantitative standards
set forth in proposed Rule 15c3-1f.\271\ Further clarification was
sought by the SIA and other commenters as to whether an OTC derivatives
dealer would be required to file its FOCUS report monthly or quarterly
and whether an OTC derivatives dealer would be required to comply with
Rule 17a-5 under the Exchange Act.\272\
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\270\ SIA Letter I, p. 4.
\271\ Id.
\272\ 17 CFR 240.17a-5. See Section V.D.4.a. of the Comment
Summary.
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Rule 17a-12 has been amended to clarify the scope of the auditor's
report on inventory pricing and modeling procedures. The rule requires
that, at a minimum, the accountant's report on inventory pricing and
modeling procedures confirm that (1) the pricing and modeling
procedures relied upon by the OTC derivatives dealer conform to the
procedures submitted to the Commission as part of its OTC derivatives
dealer application; and (2) the procedures comply with the qualitative
and quantitative standards set forth in Rule 15c3-1f. This does not
imply any lessening of the auditor's normal role in the audit of the
financial statements of the OTC derivatives dealer. Finally, the rule
provides that an OTC derivatives dealer must file its FOCUS report
quarterly, unless otherwise directed by the Commission, and amends Rule
17a-5 to clarify that an OTC derivatives dealer may comply with Rule
17a-5 by complying with the provisions of Rule 17a-12.
5. Amendments to Form X-17A-5
Proposed Rule 17a-12 would have required that certain conforming
changes be made to Rule 249.617 to require OTC derivatives dealers to
file the appropriate parts of Form X-17A-5, commonly known as the FOCUS
report. These changes would have provided for the appropriate
disclosure of the business activities of OTC derivatives dealers and
the risks associated with those activities.
Under the proposed amendments to Form X-17A-5, the net capital
computation worksheet would have been revised to reflect the proposed
net capital requirements for OTC derivatives dealers. Other changes
would have included revising the statement of financial condition and
the statement of income, and eliminating the customer reserve
computation and commission income line items. OTC derivatives dealers
would also have been required to include certain new information in the
quarterly FOCUS filing. This information would include credit
concentration information, together with a geographic breakdown and a
counterparty breakdown as described in the DPG Framework for Voluntary
Oversight. OTC derivatives dealers would also have been required to
provide, where applicable, a detailed summary of all long and short
securities and commodities positions, including all OTC derivatives
contracts. The SIA suggested several minor changes to the proposed
amendments to Form X-17A-5.\273\ For example, these suggestions
included expanding the scope of covered OTC instruments to include all
relevant sources of, or offsets to, market risk in an OTC derivatives
dealer's portfolio. The SIA's suggestions have been incorporated into
the amendments to Form X-17A-5, as adopted.
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\273\ SIA Letter I, pp. 16-17.
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III. Costs and Benefits of the Rules and Rule Amendments
The rules and rule amendments adopted by the Commission today
create a limited regulatory scheme for dealers active in the OTC
derivatives market and allow U.S. securities firms to establish
separately capitalized OTC derivatives dealer affiliates. OTC
derivatives dealers may act as dealers in eligible OTC derivative
instruments, which include both securities and non-securities OTC
derivative instruments. Registration as an OTC derivatives dealer is
optional and is an alternative to registration as a fully regulated
broker-dealer or to conducting a more limited OTC derivatives business
through an unregistered affiliate.
Under the limited regulatory scheme, an OTC derivatives dealer is
able to conduct its business more efficiently and at lower cost than if
it were a fully regulated broker-dealer. This is, in fact, because an
OTC derivatives dealer is subject to specifically tailored capital,
margin, and other broker-dealer regulatory requirements. With respect
to margin in particular, OTC derivatives dealers are exempted from the
margin requirements of Section 7(c) of the Exchange Act and Regulation
T thereunder, provided that they comply with Section 7(d) of the
Exchange Act and the requirements of Regulation U. Regulation U
generally allows OTC derivatives dealers to extend credit on OTC
derivative instruments on more flexible terms than Regulation T.
While registered OTC derivatives dealers will benefit from the new
regulatory scheme, regulators and financial markets will also benefit
if an unregistered derivatives dealer elects to register as an OTC
derivatives dealer. Net capital requirements and other financial
responsibility requirements imposed on registered OTC derivatives
dealers help to protect against excessive leverage and business risk,
and provide a cushion of capital against market declines and other
risks. In addition, Commission oversight authority, including reporting
and notice requirements, enable the Commission to monitor the financial
and operational condition and securities activities of OTC derivatives
dealers. Moreover, because an OTC derivatives dealer must adopt certain
internal risk management controls that promote financial
responsibility, the risk that significant losses by a single firm could
undermine the securities markets as a whole is reduced.
A. Comments and Survey
In the Proposing Release, the Commission requested comment on the
costs and benefits associated with the proposed rules and rule
amendments.\274\ More specifically, the Commission requested comment on
the one-time costs of any modifications to accounting, information
management, and recordkeeping systems required to implement the
proposed rules and rule amendments, as well as on the continuing costs
arising from compliance with the proposed rules and rule amendments.
The Commission also requested comment on the benefits from the modified
capital, margin, and other regulatory requirements. Commenters
indicated that the new regulatory structure would result in lower
capital requirements and would allow them to compete more effectively
with banks and foreign dealers.\275\ However, the Commission did not
receive any specific cost or benefit data in response to the Proposing
Release.
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\274\ Proposing Release, Section IV., 62 FR at 67952.
\275\ See Section VI. of the Comment Summary.
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In an effort to obtain more specific information on the potential
costs and
[[Page 59390]]
benefits of operating as an OTC derivatives dealer, Commission staff
asked broker-dealers to provide more specific estimates of the costs
and benefits of moving OTC derivatives business to, and conducting
business in the form of, an OTC derivatives dealer. Five firms that
believed OTC derivative dealer registration would be cost effective
provided cost information, and requested confidential treatment of the
data provided to the Commission.\276\ Most firms responding expected
significant benefits from registering as an OTC derivatives dealer
because of regulatory capital savings, increased capital efficiency,
and efficiencies resulting from business consolidation. These benefits
generally outweighed increased one-time and continuing operating costs
associated with combining activities currently conducted in a
registered broker-dealer with activities conducted in other
unregistered entities. The firms that responded to the survey also
stated that the margin requirements applicable to OTC derivatives
dealers are beneficial in instances where the less stringent Regulation
U applies to transactions instead of Regulation T, but costly to the
extent Regulation U applies to offshore business not previously subject
to either U.S. margin requirement.
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\276\ Two additional firms submitted responses to the survey,
but these responses are not reflected in this analysis. One firm
provided limited cost information that was excluded because the firm
indicated that, due to the small size of its OTC derivatives
business, it is not likely to register as an OTC derivatives dealer.
A second firm's response was excluded because it gave qualitative,
rather than quantitative, information. A summary of the responses to
the survey has been placed in Public Reference File No. S7-30-97 and
is available for inspection in the Commission's Public Reference
Room.
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Responses to the survey varied in terms of length and detail. Some
were more qualitative than quantitative. At times respondents combined
categories, making comparability and averaging more difficult. Where
possible, estimated costs and benefits are provided below.
B. Benefits
1. Regulatory Capital Effects
Most firms responding to the survey identified regulatory capital
effects as the most significant benefit resulting from operation as an
OTC derivatives dealer. By applying Appendix F instead of taking
traditional haircuts under paragraph (c)(2)(vi) of Rule 15c3-1, OTC
derivatives dealers will be required to reserve less regulatory capital
than they would if this business was conducted on the books of their
fully regulated broker-dealer affiliates.\277\ The five firms that
provided estimated regulatory capital savings figures estimated an
aggregate difference in net capital requirements of $1.25 billion if
they registered as OTC derivatives dealers. Additionally, assuming that
these firms would otherwise conduct their derivatives business through
a fully regulated broker-dealer, the staff estimated that their reduced
capital requirements would yield an aggregate annual benefit for the
use of this capital of approximately $138 million.\278\
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\277\ Many of these firms may currently conduct their OTC
derivatives business in unregistered or offshore affiliates not
subject to regulatory net capital requirements.
\278\ The total annual benefit was computed by multiplying the
regulatory capital savings of $1.25 billion by 11%, which is the
average of three estimated incremental rates of return provided by
three responding firms.
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2. Operational Cost Savings
The firms surveyed generally predicted that they would not
experience significant operational savings from operating as an OTC
derivatives dealer. They predicted, but did not quantify, potential
operational benefits from the consolidation of businesses into one
entity. These benefits include:
Streamlined transaction processing if all OTC derivatives
activity were consolidated into one entity;
Consolidated netting of counterparty credit exposures, and
margining of counterparty net balances; and
Consolidated transaction documentation by counterparty.
3. Decreased Margin Requirements
Most firms stated that the modified margin requirements would not
be a significant benefit of registering as an OTC derivatives dealer,
and did not quantify this benefit. The firms noted that margin
requirements under Regulation U would be more flexible when extending
credit than Regulation T, which applies to broker-dealers. They also
noted, however, that with respect to business previously conducted
offshore, which was not subject to Federal Reserve Board margin
requirements, complying with Regulation U would increase the cost of
doing business.
C. Costs
1. Costs of Combining Activities Into One Operation
A firm electing to register as an OTC derivatives dealer would
incur costs to combine activities currently conducted in a registered
broker-dealer with activities conducted in other unregistered entities.
It also would incur continuing costs to comply with the applicable
rules and rule amendments. Respondents to the survey identified, but
did not uniformly quantify, the costs associated with operating as an
OTC derivatives dealer. These costs include:
Forming and registering as an OTC derivatives dealer;
Adjusting risk management practices to conform with
Rules 15c3-1 and 15c3-4;
Enhancing and developing VAR and credit risk systems;
Complying with minimum capital requirements;
Making and retaining required books and records;
Preparing and submitting FOCUS reports and annual
audited financial statements;
Responding to examination requests;
Developing systems for compliance with the margin
requirements of Regulation U;
Subjecting offshore activities to Regulation U; and
Hiring compliance personnel.
Five firms responding to the survey estimated that their annual
operating costs would increase by at least $36 million in the aggregate
to conduct business as an OTC derivatives dealer. Respondents'
individual estimates of increased costs ranged from $900,000 to $26
million per year. However, they stated that the increases in operating
costs were far outweighed by estimated positive regulatory capital
effects. Although survey results were not uniformly comparable,
estimates of some specific operational costs follow.
2. Registration as an OTC Derivatives Dealer
One firm estimated that the cost of registering an entity as an OTC
derivatives dealer would be as high as $50,000. This firm noted that
set-up and registration costs would likely decrease for later
registrants, after the process becomes standardized.
3. Risk Management Adjustments
One firm did not consider the costs of further developing its VAR
and other statistical risk models to be attributable to the OTC
derivatives dealer specifically, because such development would be
required in any event. This firm and another firm each estimated the
cost of conforming their VAR model to the regulatory requirements to be
approximately $200,000. A third firm estimated the cost of obtaining
risk management systems and procedures that meet the regulatory
requirements to be at least $250,000. One firm stated that the
additional cost of compensating model-related personnel would be
approximately $650,000 per year.
[[Page 59391]]
4. Books and Records Requirements
Apart from a likely increase in outside auditor fees, firms
generally stated that the cost of compliance with books and records and
reporting requirements were not significant. One firm estimated that
the cost of systems changes necessary to create and maintain OTC
derivatives dealer books and records, as well as the cost of necessary
compliance personnel would be $500,000 in the first year. A second firm
estimated that the cost of compensating additional regulatory
compliance staff would be approximately $75,000 per year. A third firm
expected increased costs of $400,000 per year for audit and related
services, and for hiring additional personnel in the areas of
compliance, operations, and reporting.
5. Regulatory Reporting
One firm estimated that the cost for an OTC derivatives dealer to
prepare the required regulatory reports would be approximately $38,000
per year. This firm also estimated that internal and external auditor
fees would be $100,000 per year. Another firm estimated the cost of
preparation for regulatory examinations as $75,000 per year.
6. Regulation U Margin Requirements
One firm estimated the cost of maintaining OTC derivative dealer
margin to be approximately $75,000. The Commission has also considered
whether systemic risk would be created by permitting OTC derivatives
dealers to comply with the reduced margin requirements of Regulation U
as opposed to Regulation T. Although the collection of less margin in
some transactions may increase risk for OTC derivatives dealers, the
systemic risk is no greater for OTC derivatives dealers than for their
banking competitors. Further, this risk is offset in part by financial
responsibility safeguards applicable to OTC derivatives dealers, such
as the minimum capital requirements in Rule 15c3-1 and the internal
risk management control systems required by Rule 15c3-4.
D. Conclusion
Based on the survey results and its own analysis, the Commission
believes that the rules and rule amendments adopted today provide firms
that are active in the OTC derivatives market with a cost effective
alternative to conducting this business through a fully regulated
broker-dealer. In addition, it is important to note that registration
as an OTC derivatives dealer is optional. Thus, a firm can perform its
own cost and benefit analysis to determine whether registration as an
OTC derivatives dealer is an appropriate alternative for that firm.
IV. Efficiency, Competition, and Capital Formation
Section 23(a)(2) of the Exchange Act\279\ requires the Commission,
in adopting Exchange Act rules, to consider the impact any such rule
would have on competition and to not adopt a rule that would impose a
burden on competition not necessary or appropriate in furthering the
purposes of the Exchange Act. Furthermore, section 3(f) of the Exchange
Act\280\ provides that whenever the Commission is engaged in rulemaking
and is required to consider or determine whether an action is necessary
or appropriate in the public interest, the Commission shall consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation. The Commission
has considered the rules and rule amendments in light of the standards
cited in sections 23(a)(2) and 3(f) of the Exchange Act.
---------------------------------------------------------------------------
\279\ 15 U.S.C. 78w(a)(2).
\280\ 15 U.S.C. 78c(f).
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In the Proposing Release, the Commission requested comment on the
effect of the proposed rules and rule amendments on competition,
efficiency, and capital formation.\281\ Commenters generally indicated
that the reduced capital, margin, and other regulatory requirements
would allow an OTC derivatives dealer to compete more effectively with
banks and foreign dealers. However, commenters did not provide detailed
information or analysis on the limited regulatory scheme's effect on
competition, efficiency, or capital formation.\282\
---------------------------------------------------------------------------
\281\ Proposing Release, Sections IV. and V., 62 FR at 67952-53.
\282\ See Section VI. of the Comment Summary.
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The rules and rule amendments adopted by the Commission today
increase the ability of certain highly capitalized broker-dealers to
compete effectively in global securities markets by removing
substantial regulatory and economic barriers. Because registration as
an OTC derivatives dealers is optional and is an alternative to
registration as a fully regulated broker-dealer or to conducting a more
limited OTC derivatives business in an unregistered entity, a firm can
make its own analysis of the competitive advantages of being registered
as an OTC derivatives dealer.
Major dealers in the OTC derivatives market are generally large,
highly capitalized banks and securities firms. One commenter opposed
any minimum tentative net capital requirement, arguing that other U.S.
broker-dealers are not required to maintain minimum tentative net
capital under the net capital rule, and that U.S. firms, and
particularly small-sized, medium-sized, and newly established OTC
derivatives dealers, would be at a competitive disadvantage.\283\ It is
likely that smaller firms in the OTC derivatives business will not be
able to register as OTC derivatives dealers because they cannot satisfy
the minimum capital requirements. This will not prevent competition,
however, because these smaller firms may continue to conduct their OTC
derivatives business outside of the OTC derivatives dealer regulatory
structure, although they will not receive the benefits of the new
rules. Further, reducing minimum capital requirements would not be
consistent with investor protection.
---------------------------------------------------------------------------
\283\ DESCO Leter, pp. 9-10.
---------------------------------------------------------------------------
The minimum capital requirements imposed on OTC derivatives dealers
are necessary to help protect against excessive leverage and the risks
associated with conducting an OTC derivatives business, and to provide
a cushion of capital against severe market disturbances. It would not
be appropriate, for example, to require less capital from less active
OTC derivatives dealers. Firms of all sizes face risks, such as legal
risk, liquidity risk, and operational risk, which are not typically
incorporated into VAR calculations. Further, VAR may not measure losses
that fall outside of normal conditions, such as during steep market
declines. The minimum capital requirements provide additional
safeguards to account for possible extraordinary losses or decreases in
liquidity during times of market stress.
Two commenters suggested that the Commission address certain
competitive disparities that they argued exist between exchange-traded
products and seemingly similar products available in the OTC
derivatives market.\284\ The rules adopted today are only designed to
address competitive disparities between market participants within the
OTC derivatives market. They are not intended to address actual or
perceived competitive disparities between OTC products and any other
product or service.
---------------------------------------------------------------------------
\284\ CBOE Letter, pp. 1-2; Comment Letter from the Chicago
Mercantile Exchange, p. 2.
---------------------------------------------------------------------------
The rules and rule amendments promote market efficiency and capital
formation. The limited regulatory scheme provides U.S. broker-dealers
with an optional alternative to conducting OTC derivatives
[[Page 59392]]
transactions through fully regulated broker-dealers, but does not
create significant impediments to competition. As a result of the new
regulatory structure, the Commission will be better able to monitor the
financial and operational activities of OTC derivatives dealers.
Finally, minimum capital requirements will provide a cushion against
severe market disturbances, thus reducing the risk that a single firm
will experience significant losses and trigger such losses by other
market participants.
V. Summary of Final Regulatory Flexibility Analysis
A Final Regulatory Flexibility Analysis (``FRFA'') regarding the
rules and rule amendments under the Exchange Act that tailor capital,
margin, and other broker-dealer regulatory requirements to the
activities of OTC derivatives dealers has been prepared in accordance
with 5 U.S.C. 604. The FRFA notes that registration as an OTC
derivatives dealer is optional, and therefore will not impose any
reporting requirements for those entities choosing not to become
registered as OTC derivatives dealers. Those entities choosing to
register as OTC derivatives dealers under the new regulatory system
will be subject to the reporting requirements applicable to broker-
dealers under the Exchange Act.
A. Need for the Rules and Rule Amendments
As discussed more fully in the FRFA, the rules and rule amendments
are intended to give U.S. securities firms an opportunity to conduct
business in a vehicle subject to modified regulation appropriate to OTC
derivatives markets, and thereby to improve the efficiency and
competitiveness of U.S. securities firms participating in global OTC
derivatives markets. These improvements will be realized through a
limited regulatory structure that is expected to impose fewer costs on
firms conducting an OTC derivatives business than would be imposed
under the Commission's current rules. In particular, the application of
revised capital requirements and an exemption from the margin
requirements of Regulation T should make it feasible for firms to
conduct a business involving both securities and non-securities OTC
derivative instruments within the United States. Commenters generally
commended the Commission for its efforts to improve competition and
efficiency.
B. Small Entities Subject to the Rules
These rules and rule amendments will not significantly affect a
substantial number of small entities, as defined in the Commission's
rules.\285\ At the time of the Proposing Release, a broker-dealer
(including any person that would be an OTC derivatives dealer)
generally would be considered a small entity if (1) it had total
capital (net worth plus subordinated liabilities) of less than $500,000
on the date in the prior fiscal year as of which its audited financial
statements were prepared pursuant to Rule 17a-5(d) or, if not required
to file such statements, a broker-dealer that had total capital (net
worth plus subordinated liabilities) of less than $500,000 on the last
day of the preceding fiscal year (or in the time that it has been in
business, if shorter); and (2) it is not affiliated with any person
(other than a natural person) that is not a small business or small
organization.\286\
---------------------------------------------------------------------------
\285\ On June 24, 1998, several months after the Proposing
Release was published, the Commission amended its definitions of
small entities. See Exchange Act Release No. 40122 (June 24, 1998),
63 FR 35508 (June 30, 1998). The Commission's revised definition
applicable to broker-dealers, effective as of July 30, 1998,
maintains the capital standard set forth in the prior version, but
also expands the affiliation standard applicable to broker-dealers.
See Rule 0-10 under the Exchange Act (17 CFR 240.0-10). Although the
FRFA analyzes the rules and rule amendments under the previous
definition, the analysis applies equally under the Commission's new
definition.
\286\ Rule 0-10 (17 CFR 240.0-10).
---------------------------------------------------------------------------
The Commission requested comment with respect to the Initial
Regulatory Flexibility Analysis (``IRFA'') that was prepared when the
new regulatory regime was proposed. The Commission did not receive any
comments specifically concerning the IRFA. However, some of the
commenters addressed aspects of the rules that could potentially affect
small businesses. These comments are discussed below.
Under the amendments to Rule 15c3-1, OTC derivatives dealers are
required to maintain at least $100 million in tentative net capital and
at least $20 million in net capital. Based on these minimum capital
requirements, the FRFA notes that no OTC derivatives dealer would be
considered a small entity. Major dealers in OTC derivatives markets
tend to be the largest, highest-capitalized banks and securities firms.
The capital requirements for OTC derivatives dealers have been tailored
to this market and are necessary to ensure against excessive leverage
and the risks associated with conducting an OTC derivatives business,
as well as to provide for a cushion of capital against severe market
disturbances.
Registration as an OTC derivatives dealer is optional. The rules
and rule amendments do not require any broker-dealer to use this
alternative. Instead, all broker-dealers may consider whether, given
the nature of their business or any other relevant considerations, they
want to register as an OTC derivatives dealer. Accordingly, the rules
and rule amendments do not impose any additional costs on any entity,
including any small business, currently engaging in the business of
effecting transactions in OTC derivative instruments.
The rules and rule amendments guard against excessive leverage and
the risk associated with conducting an OTC derivatives business, and
provide a cushion of capital against severe market disturbances. In
order to do so, the final rules require that an OTC derivatives dealer
maintain $100 million in tentative net capital and $20 million in net
capital. Lesser net capital requirements for small entities seeking to
register as OTC derivatives dealers likely would not afford sufficient
protection against these risks.
Given the level of these net capital requirements, the Commission
is not aware of any small business or small organizations, as defined
in Rule 0-10, that could operate as OTC derivatives dealers under the
rule. In any event, the Commission is not aware of any small business
or small organizations, as defined in Rule 0-10, that currently are
active as dealers in OTC derivatives markets. In the Proposing Release,
the Commission specifically requested comment on whether there were
small entities that act as dealers in OTC derivatives, and what effect,
if any, the proposed rules and rule amendments would have on their
activities. No small entities, as defined in Rule 0-10 under the
Exchange Act, submitted comments addressing this issue. Only one
commenter, which is not a small entity under the Commission's rules,
addressed the impact of the rules on small entities that might wish to
take advantage of the new regulatory regime, noting that the $100
million tentative net capital requirement could have anti-competitive
consequences for small-and medium-sized firms and newer entrants to the
OTC derivatives business.
The final rules and rule amendments contain no limitations on the
ability of small entities to participate as counterparties in OTC
derivatives transactions with registered OTC derivatives dealers. Under
proposed Rule 3b-14, the term ``permissible derivatives counterparty''
would have included a range of financial institutions, corporations,
and other institutional entities with whom OTC
[[Page 59393]]
derivatives dealers would have been permitted to enter into OTC
derivatives transactions. Like OTC derivatives dealers, these
institutional counterparties are frequently large, well-capitalized
entities. Nevertheless, the proposed definition may have also included
potential counterparties that would be considered small entities for
purposes of the Regulatory Flexibility Act (``RFA'').\287\
---------------------------------------------------------------------------
\287\ 5 U.S.C. 601 et seq.
---------------------------------------------------------------------------
The Commission specifically requested comment regarding the
participation of these classes of persons in OTC derivatives markets,
whether any of them would be considered small entities, and what
effect, if any, the proposed rules and rule amendments would have on
their activities. The Commission also specifically requested comment
from small entities that would not be able to satisfy the definition of
permissible derivatives counterparty and, therefore, would not be
eligible to engage in transactions with OTC derivatives dealers. No
comments from small entities addressing this issue were received.
Numerous comments, however, were received regarding the proposed
definition of ``eligible derivatives counterparty.''
The majority of commenters on this issue suggested that a broad
range of persons should be able to act as permissible derivatives
counterparties, and believed that the definition should be expanded, at
a minimum, to include natural persons having at least $5 million in
total assets as proposed. Other commenters raised concerns that the
proposed group of permissible derivatives counterparties could include
unsophisticated persons who would need the protections provided by the
securities sales practice requirements.
In response to commenters' concerns, and in light of the
protections afforded through requiring intermediation of securities
transactions, the final rules do not limit the persons with whom an OTC
derivatives dealer may engage in transactions. Thus, to the extent that
a small entity could act as a counterparty to an OTC derivatives
transaction prior to the adoption of this new regulatory regime, it may
still act as a counterparty to an OTC derivatives dealer under the new
rules and rule amendments. Nothing in these rules, therefore, affects
the ability of a small entity to participate in an OTC derivatives
transaction. Other provisions of the rules that require broker-dealer
intermediation will help assure protection of small entities.
C. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
Because no small entity would be eligible to meet the requirements
of an OTC derivatives dealer, there is no compliance requirement for
small entities. The adopting release details the cost, benefits, and
compliance requirements for non-small entities that elect to register
as OTC derivatives dealers.
As explained in the FRFA, none of the recordkeeping, reporting, or
other compliance requirements under the rules and rule amendments are
expected to apply directly to counterparties that enter into
transactions with OTC derivatives dealers. No small entities commented
on this aspect of the proposal, and no commenters addressed the costs,
if any, on small entities that acted as counterparties to OTC
derivatives transactions with OTC derivatives dealers. Nevertheless,
the ability of an OTC derivatives dealer to consolidate its OTC
derivatives activities into a single entity under the new regulatory
regime with lower capital and margin requirements could result in lower
transactional costs to counterparties, including small entities.
D. Alternatives To Minimize Effect on Small Entities
As discussed further in the FRFA, the Commission has considered
alternatives to the rules and rule amendments that would minimize the
effects of the rules on small entities, but would still accomplish the
stated objectives of improving the efficiency and competitiveness of
U.S. securities firms participating in global OTC derivatives markets,
and make it feasible for these firms to conduct a business involving
securities and non-securities OTC derivative instruments within the
United States. Several of these alternatives were considered but
rejected, while other alternatives were taken into account in the final
rules. The final rules and rule amendments meet the Commission's stated
goals by tailoring capital, margin, and other regulatory requirements
to the activities of OTC derivatives dealers, while still providing
sufficient protections.
Registration as an OTC derivatives dealer is an alternative to
registration as a fully regulated broker-dealer, and is optional. The
Commission is not imposing any additional costs on any entity,
including any small businesses, currently engaging in the business of
effecting transactions in OTC derivative instruments, which could
remain subject to full regulation. The proposed capital requirements,
in particular, provide OTC derivatives dealers with significant
alternatives for computing risk charges. Thus, firms choosing to
register as OTC derivatives dealers may individually tailor the
methodology they will employ to calculate their net capital on an on-
going basis, subject to Commission staff authorization. This
flexibility should enable firms to keep costs of compliance as low as
possible.
The final rules and rule amendments guard against excessive
leverage and the risks associated with conducting an OTC derivatives
business, and provide a cushion of capital against severe market
disturbances. In order to do so, the final rules require that an OTC
derivatives dealer maintain $100 million in tentative net capital and
$20 million in net capital. Lesser net capital requirements for small
entities seeking to register as OTC derivatives dealers would not
afford sufficient protection against these risks, and this alternative
was therefore rejected. Similarly, additional exemptions from specific
broker-dealer regulations under the Exchange Act for small businesses
engaging in an OTC derivatives business, if there are any, would not be
warranted. Moreover, the Commission is not aware of any small
businesses that are currently engaged as dealers in OTC derivative
instruments.
Counterparties are expected to benefit from the final rules and
rule amendments by being able to engage in transactions in both
securities and non-securities OTC derivative instruments with a class
of registered dealers subject to Commission oversight. To the extent
that a small entity could act as a counterparty to an OTC derivatives
transaction prior to adoption of the new regulatory regime, it would
still be able to act in that capacity after adoption of the new rules
and rule amendments. Nothing in the Commission's optional regulatory
regime for OTC derivatives dealers affects a counterparty's ability to
enter into an OTC derivatives transaction with an OTC derivatives
dealer. A copy of the FRFA may be obtained by contacting Laura S.
Pruitt, Special Counsel, Division of Market Regulation, Securities and
Exchange Commission, 450 Fifth Street, NW., Mail Stop 10-1, Washington,
DC 20549, (202) 942-0073.
VI. Paperwork Reduction Act
As set forth in the Proposing Release, Rules 15c3-4, 17a-12,
Appendix F to Rule 15c3-1, and the amendments to Rule 17a-3 contain
collections of information within the meaning of the Paperwork
Reduction Act of 1995
[[Page 59394]]
(``PRA'').\288\ Accordingly, the collection of information requirements
contained in the rules and rule amendments were submitted to the Office
of Management and Budget (``OMB'') for review and were approved by OMB
which assigned the following control numbers: Rule 15c3-4, control
number 3235-0497; Rule 17a-12, control number 3235-0498; Appendix F to
Rule 15c3-1, control number 3235-0496; and amendments to Rule 17a-3,
control number 3235-0033. The collections of information are in
accordance with Section 3507 of the PRA.\289\
---------------------------------------------------------------------------
\288\ 44 U.S.C. 3501 et seq.
\289\ 44 U.S.C. 3507.
---------------------------------------------------------------------------
The collection of information obligations imposed by the rules and
rule amendments are mandatory. However, it is important to note that
registration as an OTC derivatives dealer is optional. The information
collected, retained, and/or filed pursuant to the rules and rule
amendments will be kept confidential to the extent permitted by the
Freedom of Information Act (5 U.S.C. 552 et seq.). An agency may not
conduct or sponsor, and a person is not required to comply with, a
collection of information unless it displays a currently valid OMB
control number.
The collections of information are necessary for persons to obtain
certain benefits or to comply with certain requirements. As described
in the Proposing Release, the rules and rule amendments to which the
collections of information are related implement a limited regulatory
system under the Exchange Act for OTC derivatives dealers. Under this
limited regulatory system, OTC derivatives dealers are permitted to
engage in dealing activities with respect to certain types of
securities and non-securities OTC derivatives instruments, and to issue
and reacquire their issued securities, without being required to comply
with the full range of capital, margin, and other regulatory
requirements applicable to other regulated broker-dealers.
The Proposing Release solicited comments on the proposed
collections of information. No comments were received that addressed
the PRA submission. However, the Commission did receive comments on
other aspects of the proposal. After carefully considering the comments
received, the Commission is retaining its collection of information
burden estimate. Thus the descriptions and estimated burdens of the
collection of information requirements have not changed, and are set
forth in the Proposing Release.
VII. Statutory Authority
The Commission is amending Title 17, Chapter II of the Code of
Federal Regulations pursuant to the Securities Exchange Act of 1934 (15
U.S.C. 78a et seq.) (particularly sections 3(b), 11(a), 15(a), 15(b),
15(c), 17(a), 23, and 36 thereof (15 U.S.C. 78c(b), 78k(a), 78o(a),
78o(b), 78o(c), 78q(a), 78w, and 78mm)).
Text of Rules and Rule Amendments
List of Subjects
17 CFR Part 200
Administrative practice and procedure, Authority delegations
(Government agencies).
17 CFR Parts 240 and 249
Broker-dealers, Reporting and recordkeeping requirements,
Securities.
For the reasons set forth in the preamble, Title 17, Chapter II of
the Code of Federal Regulations is amended as set forth below.
PART 200--ORGANIZATION; CONDUCT AND ETHICS; AND INFORMATION AND
REQUESTS
1. The authority citation for Part 200 continues to read in part as
follows:
Authority: 15 U.S.C. 77s, 78d-1, 78d-2, 78w, 78ll(d), 78mm, 79t,
77sss, 80a-37, 80b-11, unless otherwise noted.
* * * * *
2. Section 200.30-3 is amended by removing the period after
paragraph (a)(7)(iv) and in its place adding ``; and'' and by adding
paragraphs (a)(7)(v), (a)(64), (a)(65) and (a)(66) to read as follows:
Sec. 200.30-3 Delegation of authority to Director of Division of
Market Regulation.
* * * * *
(a) * * *
(7) * * *
(v) To review applications of OTC derivatives dealers filed
pursuant to Appendix F of Sec. 240.15c3-1f of this chapter, and to
grant or deny such applications in full or in part.
* * * * *
(64) Pursuant to Sec. 240.15a-1(b)(1) of this chapter, to issue
orders identifying other permissible securities activities in which an
OTC derivatives dealer may engage.
(65) Pursuant to Sec. 240.15a-1(b)(2) of this chapter, to issue
orders determining that a class of fungible instruments that are
standardized as to their material economic terms is within the scope of
eligible OTC derivative instrument.
(66) Pursuant to Sec. 240.17a-12 of this chapter:
(i) To authorize the issuance of orders requiring OTC derivatives
dealers to file, pursuant to Sec. 240.17a-12(a)(ii) of this chapter,
monthly, or at such times as shall be specified, Part IIB of Form X-
17A-5 (Sec. 249.617 of this chapter) and such other financial and
operational information as shall be specified.
(ii) Pursuant to Sec. 240.17a-12(n) of this chapter, to consider
applications by OTC derivatives dealers for exemptions from, and
extensions of time within which to file, reports required by
Sec. 240.17a-12 of this chapter, and to grant or deny such
applications.
* * * * *
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
3. The authority citation for part 240 continues to read in part as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee,
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k,
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d),
78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and
80b-11, unless otherwise noted.
* * * * *
4. By adding Secs. 240.3b-12 through 240.3b-15 to read as follows:
Sec. 240.3b-12 Definition of OTC derivatives dealer.
The term OTC derivatives dealer means any dealer that is affiliated
with a registered broker or dealer (other than an OTC derivatives
dealer), and whose securities activities:
(a) Are limited to:
(1) Engaging in dealer activities in eligible OTC derivative
instruments that are securities;
(2) Issuing and reacquiring securities that are issued by the
dealer, including warrants on securities, hybrid securities, and
structured notes;
(3) Engaging in cash management securities activities;
(4) Engaging in ancillary portfolio management securities
activities; and
(5) Engaging in such other securities activities that the
Commission designates by order pursuant to Sec. 240.15a-1(b)(1); and
(b) Consist primarily of the activities described in paragraphs
(a)(1), (a)(2), and (a)(3) of this section; and
(c) Do not consist of any other securities activities, including
engaging in any transaction in any security that is not an eligible OTC
derivative instrument, except as permitted under paragraphs (a)(3),
(a)(4), and (a)(5) of this section.
(d) For purposes of this section, the term hybrid security means a
security that incorporates payment features economically similar to
options,
[[Page 59395]]
forwards, futures, swap agreements, or collars involving currencies,
interest or other rates, commodities, securities, indices, quantitative
measures, or other financial or economic interests or property of any
kind, or any payment or delivery that is dependent on the occurrence or
nonoccurrence of any event associated with a potential financial,
economic, or commercial consequence (or any combination, permutation,
or derivative of such contract or underlying interest).
Sec. 240.3b-13 Definition of eligible OTC derivative instrument.
(a) Except as otherwise provided in paragraph (b) of this section,
the term eligible OTC derivative instrument means any contract,
agreement, or transaction that:
(1) Provides, in whole or in part, on a firm or contingent basis,
for the purchase or sale of, or is based on the value of, or any
interest in, one or more commodities, securities, currencies, interest
or other rates, indices, quantitative measures, or other financial or
economic interests or property of any kind; or
(2) Involves any payment or delivery that is dependent on the
occurrence or nonoccurrence of any event associated with a potential
financial, economic, or commercial consequence; or
(3) Involves any combination or permutation of any contract,
agreement, or transaction or underlying interest, property, or event
described in paragraphs (a)(1) or (a)(2) of this section.
(b) The term eligible OTC derivative instrument does not include
any contract, agreement, or transaction that:
(1) Provides for the purchase or sale of a security, on a firm
basis, unless:
(i) The settlement date for such purchase or sale occurs at least
one year following the trade date or, in the case of an eligible
forward contract, at least four months following the trade date; or
(ii) The material economic features of the contract, agreement, or
transaction consist primarily of features of a type described in
paragraph (a) of this section other than the provision for the purchase
or sale of a security on a firm basis; or
(2) Provides, in whole or in part, on a firm or contingent basis,
for the purchase or sale of, or is based on the value of, or any
interest in, any security (or group or index of securities), and is:
(i) Listed on, or traded on or through, a national securities
exchange or registered national securities association, or facility or
market thereof; or
(ii) Except as otherwise determined by the Commission by order
pursuant to Sec. 240.15a-1(b)(2), one of a class of fungible
instruments that are standardized as to their material economic terms.
(c) The Commission may issue an order pursuant to Sec. 240.15a-
1(b)(3) clarifying whether certain contracts, agreements, or
transactions are within the scope of eligible OTC derivative
instrument.
(d) For purposes of this section, the term eligible forward
contract means a forward contract that provides for the purchase or
sale of a security other than a government security, provided that, if
such contract provides for the purchase or sale of margin stock (as
defined in Regulation U of the Regulations of the Board of Governors of
the Federal Reserve System, 12 CFR Part 221), such contract either:
(1) Provides for the purchase or sale of such stock by the issuer
thereof (or an affiliate that is not a bank or a broker or dealer); or
(2) Provides for the transfer of transaction collateral in an
amount that would satisfy the requirements, if any, that would be
applicable assuming the OTC derivatives dealer party to such
transaction were not eligible for the exemption from Regulation T of
the Regulations of the Board of Governors of the Federal Reserve
System, 12 CFR part 220, set forth in Sec. 240.36a1-1.
Sec. 240.3b-14 Definition of cash management securities activities.
The term cash management securities activities means securities
activities that are limited to transactions involving:
(a) Any taking possession of, and any subsequent sale or
disposition of, collateral provided by a counterparty, or any
acquisition of, and any subsequent sale or disposition of, collateral
to be provided to a counterparty, in connection with any securities
activities of the dealer permitted under Sec. 240.15a-1 or any non-
securities activities of the dealer that involve eligible OTC
derivative instruments or other financial instruments;
(b) Cash management, in connection with any securities activities
of the dealer permitted under Sec. 240.15a-1 or any non-securities
activities of the dealer that involve eligible OTC derivative
instruments or other financial instruments; or
(c) Financing of positions of the dealer acquired in connection
with any securities activities of the dealer permitted under
Sec. 240.15a-1 or any non-securities activities that involve eligible
OTC derivative instruments or other financial instruments.
Sec. 240.3b-15 Definition of ancillary portfolio management securities
activities.
(a) The term ancillary portfolio management securities activities
means securities activities that:
(1) Are limited to transactions in connection with:
(i) Dealer activities in eligible OTC derivative instruments;
(ii) The issuance of securities by the dealer; or
(iii) Such other securities activities that the Commission
designates by order pursuant to Sec. 240.15a-1(b)(1); and
(2) Are conducted for the purpose of reducing the market or credit
risk of the dealer or consist of incidental trading activities for
portfolio management purposes; and
(3) Are limited to risk exposures within the market, credit,
leverage, and liquidity risk parameters set forth in:
(i) The trading authorizations granted to the associated person (or
to the supervisor of such associated person) who executes a particular
transaction for, or on behalf of, the dealer; and
(ii) The written guidelines approved by the governing body of the
dealer and included in the internal risk management control system for
the dealer pursuant to Sec. 240.15c3-4; and
(4) Are conducted solely by one or more associated persons of the
dealer who perform substantial duties for, or on behalf of, the dealer
in connection with its dealer activities in eligible OTC derivative
instruments.
(b) The Commission may issue an order pursuant to Sec. 240.15a-
1(b)(4) clarifying whether certain securities activities are within the
scope of ancillary portfolio management securities activities.
5. Section 240.8c-1 is amended by revising paragraph (b)(1) to read
as follows:
Sec. 240.8c-1 Hypothecation of customers' securities.
* * * * *
(b) * * *
(1) The term customer shall not include any general or special
partner or any director or officer of such member, broker or dealer, or
any participant, as such, in any joint, group or syndicate account with
such member, broker or dealer or with any partner, officer or director
thereof. The term also shall not include any counterparty who has
delivered collateral to an OTC derivatives dealer pursuant to a
transaction in an eligible OTC derivative instrument, or pursuant to
the OTC derivatives dealer's cash management securities activities or
ancillary portfolio management securities activities, and who has
received a prominent written
[[Page 59396]]
notice from the OTC derivatives dealer that:
(i) Except as otherwise agreed in writing by the OTC derivatives
dealer and the counterparty, the dealer may repledge or otherwise use
the collateral in its business;
(ii) In the event of the OTC derivatives dealer's failure, the
counterparty will likely be considered an unsecured creditor of the
dealer as to that collateral;
(iii) The Securities Investor Protection Act of 1970 (15 U.S.C.
78aaa through 78lll) does not protect the counterparty; and
(iv) The collateral will not be subject to the requirements of
Sec. 240.8c-1, Sec. 240.15c2-1, Sec. 240.15c3-2, or Sec. 240.15c3-3;
* * * * *
6. By adding Sec. 240.11a1-6 to read as follows:
Sec. 240.11a1-6 Transactions for certain accounts of OTC derivatives
dealers.
A transaction effected by a member of a national securities
exchange for the account of an OTC derivatives dealer that is an
associated person of that member shall be deemed to be of a kind that
is consistent with the purposes of section 11(a)(1) of the Act (15
U.S.C. 78k(a)(1)), the protection of investors, and the maintenance of
fair and orderly markets if, assuming such transaction were for the
account of a member, the member would have been permitted, under
section 11(a) of the Act and the other rules thereunder (with the
exception of Sec. 240.11a1-2), to effect the transaction.
7. By adding Sec. 240.15a-1 under the undesignated section heading
``Exemption of Certain OTC Derivatives Dealers'' to read as follows:
Sec. 240.15a-1 Securities activities of OTC derivatives dealers.
Preliminary Note: OTC derivatives dealers are a special class of
broker-dealers that are exempt from certain broker-dealer
requirements, including membership in a self-regulatory organization
(Sec. 240.15b9-2), regular broker-dealer margin rules
(Sec. 240.36a1-1), and application of the Securities Investor
Protection Act of 1970 (Sec. 240.36a1-2). OTC derivative dealers are
subject to special requirements, including limitations on the scope
of their securities activities (Sec. 240.15a-1), specified internal
risk management control systems (Sec. 240.15c3-4), recordkeeping
obligations (Sec. 240.17a-3(a)(10)), and reporting responsibilities
(Sec. 240.17a-12). They are also subject to alternative net capital
treatment (Sec. 240.15c3-1(a)(5)). This rule 15a-1 uses a number of
defined terms in setting forth the securities activities in which an
OTC derivatives dealer may engage: ``OTC derivatives dealer,''
``eligible OTC derivative instrument,'' ``cash management securities
activities,'' and ``ancillary portfolio management securities
activities.'' These terms are defined under Rules 3b-12 through 3b-
15 (Sec. 240.3b-12 through Sec. 240.3b-15).
(a) The securities activities of an OTC derivatives dealer shall:
(1) Be limited to:
(i) Engaging in dealer activities in eligible OTC derivative
instruments that are securities;
(ii) Issuing and reacquiring securities that are issued by the
dealer, including warrants on securities, hybrid securities, and
structured notes;
(iii) Engaging in cash management securities activities;
(iv) Engaging in ancillary portfolio management securities
activities; and
(v) Engaging in such other securities activities that the
Commission designates by order pursuant to paragraph (b)(1) of this
section; and
(2) Consist primarily of the activities described in paragraphs
(a)(1)(i), (a)(1)(ii), and (a)(1)(iii) of this section; and
(3) Not consist of any other securities activities, including
engaging in any transaction in any security that is not an eligible OTC
derivative instrument, except as permitted under paragraphs
(a)(1)(iii), (a)(1)(iv), and (a)(1)(v) of this section.
(b) The Commission, by order, entered upon its own initiative or
after considering an application for exemptive relief, may clarify or
expand the scope of eligible OTC derivative instruments and the scope
of permissible securities activities of an OTC derivatives dealer. Such
orders may:
(1) Identify other permissible securities activities;
(2) Determine that a class of fungible instruments that are
standardized as to their material economic terms is within the scope of
eligible OTC derivative instrument;
(3) Clarify whether certain contracts, agreements, or transactions
are within the scope of eligible OTC derivative instrument; or
(4) Clarify whether certain securities activities are within the
scope of ancillary portfolio management securities activities.
(c) To the extent an OTC derivatives dealer engages in any
securities transaction pursuant to paragraphs (a)(1)(i) through
(a)(1)(v) of this section, such transaction shall be effected through a
registered broker or dealer (other than an OTC derivatives dealer)
that, in the case of any securities transaction pursuant to paragraphs
(a)(1)(i), or (a)(1)(iii) through (a)(1)(v) of this section, is an
affiliate of the OTC derivatives dealer, except that this paragraph (c)
shall not apply if:
(1) The counterparty to the transaction with the OTC derivatives
dealer is acting as principal and is:
(i) A registered broker or dealer;
(ii) A bank acting in a dealer capacity, as permitted by U.S. law;
(iii) A foreign broker or dealer; or
(iv) An affiliate of the OTC derivatives dealer; or
(2) The OTC derivatives dealer is engaging in an ancillary
portfolio management securities activity, and the transaction is in a
foreign security, and a registered broker or dealer, a bank, or a
foreign broker or dealer is acting as agent for the OTC derivatives
dealer.
(d) To the extent an OTC derivatives dealer induces or attempts to
induce any counterparty to enter into any securities transaction
pursuant to paragraphs (a)(1)(i) through (a)(1)(v) of this section, any
communication or contact with the counterparty concerning the
transaction (other than clerical and ministerial activities conducted
by an associated person of the OTC derivatives dealer) shall be
conducted by one or more registered persons that, in the case of any
securities transaction pursuant to paragraphs (a)(1)(i), or (a)(1)(iii)
through (a)(1)(v) of this section, is associated with an affiliate of
the OTC derivatives dealer, except that this paragraph (d) shall not
apply if the counterparty to the transaction with the OTC derivatives
dealer is:
(1) A registered broker or dealer;
(2) A bank acting in a dealer capacity, as permitted by U.S. law;
(3) A foreign broker or dealer; or
(4) An affiliate of the OTC derivatives dealer.
(e) For purposes of this section, the term hybrid security means a
security that incorporates payment features economically similar to
options, forwards, futures, swap agreements, or collars involving
currencies, interest or other rates, commodities, securities, indices,
quantitative measures, or other financial or economic interests or
property of any kind, or any payment or delivery that is dependent on
the occurrence or nonoccurrence of any event associated with a
potential financial, economic, or commercial consequence (or any
combination, permutation, or derivative of such contract or underlying
interest).
(f) For purposes of this section, the term affiliate means any
organization (whether incorporated or unincorporated) that directly or
indirectly controls, is controlled by, or is under common control with,
the OTC derivatives dealer.
[[Page 59397]]
(g) For purposes of this section, the term foreign broker or dealer
means any person not resident in the United States (including any U.S.
person engaged in business as a broker or dealer entirely outside the
United States, except as otherwise permitted by Sec. 240.15a-6) that is
not an office or branch of, or a natural person associated with, a
registered broker or dealer, whose securities activities, if conducted
in the United States, would be described by the definition of
``broker'' in section 3(a)(4) of the Act (15 U.S.C. 78c(a)(4)) or
``dealer'' in section 3(a)(5) of the Act (15 U.S.C. 78c(a)(5)).
(h) For purposes of this section, the term foreign security means
any security (including a depositary share issued by a United States
bank, provided that the depositary share is initially offered and sold
outside the United States in accordance with Regulation S (17 CFR
230.901 through 230.904)) issued by a person not organized or
incorporated under the laws of the United States, provided the
transaction that involves such security is not effected on a national
securities exchange or on a market operated by a registered national
securities association; or a debt security (including a convertible
debt security) issued by an issuer organized or incorporated under the
laws of the United States that is initially offered and sold outside
the United States in accordance with Regulation S (17 CFR 230.901
through 230.904).
(i) For purposes of this section, the term registered person is:
(A) A natural person who is associated with a registered broker or
dealer and is registered or approved under the rules of a self-
regulatory organization of which such broker or dealer is a member; or
(B) If the counterparty to the transaction with the OTC derivatives
dealer is a resident of a jurisdiction other than the United States, a
natural person who is not resident in the United States and is
associated with a broker or dealer that is registered or licensed by a
foreign financial regulatory authority in the jurisdiction in which
such counterparty is resident or in which such natural person is
located, in accordance with applicable legal requirements, if any.
8. Section 240.15b1-1 is amended to revise paragraph (a) to read as
follows:
Sec. 240.15b1-1 Application for registration of brokers or dealers.
(a) An application for registration of a broker or dealer that is
filed pursuant to section 15(b) of the Act (15 U.S.C. 78o(b)) shall be
filed on Form BD (Sec. 249.501 of this chapter) in accordance with the
instructions to the form. A broker or dealer that is an OTC derivatives
dealer shall indicate where appropriate on Form BD that the type of
business in which it is engaged is that of acting as an OTC derivatives
dealer.
* * * * *
9. By adding Sec. 240.15b9-2 to read as follows:
Sec. 240.15b9-2 Exemption from SRO membership for OTC derivatives
dealers.
An OTC derivatives dealer, as defined in Sec. 240.3b-12, shall be
exempt from any requirement under section 15(b)(8) of the Act (15
U.S.C. 78o(b)(8)) to become a member of a registered national
securities association.
10. Section 240.15c2-1 is amended to revise paragraph (b)(1) to
read as follows:
Sec. 240.15c2-1 Hypothecation of customers' securities.
* * * * *
(b) * * *
(1) The term customer shall not include any general or special
partner or any director or officer of such broker or dealer, or any
participant, as such, in any joint, group or syndicate account with
such broker or dealer or with any partner, officer or director thereof.
The term also shall not include a counterparty who has delivered
collateral to an OTC derivatives dealer pursuant to a transaction in an
eligible OTC derivative instrument, or pursuant to the OTC derivatives
dealer's cash management securities activities or ancillary portfolio
management securities activities, and who has received a prominent
written notice from the OTC derivatives dealer that:
(i) Except as otherwise agreed in writing by the OTC derivatives
dealer and the counterparty, the dealer may repledge or otherwise use
the collateral in its business;
(ii) In the event of the OTC derivatives dealer's failure, the
counterparty will likely be considered an unsecured creditor of the
dealer as to that collateral;
(iii) The Securities Investor Protection Act of 1970 (15 U.S.C
78aaa through 78lll) does not protect the counterparty; and
(iv) The collateral will not be subject to the requirements of
Sec. 240.8c-1, Sec. 240.15c2-1, Sec. 240.15c3-2, or Sec. 240.15c3-3;
* * * * *
11. Section 240.15c2-5 is amended by adding paragraph (d) to read
as follows:
Sec. 240.15c2-5 Disclosure and other requirements when extending or
arranging credit in certain transactions.
* * * * *
(d) This section shall not apply to a transaction involving the
extension of credit by an OTC derivatives dealer, as defined in
Sec. 240.3b-12, if the transaction is exempt from the provisions of
Section 7(c) of the Act (15 U.S.C. 78g(c)) pursuant to Sec. 240.36a1-
1.
12. Section 240.15c3-1 is amended to add a sentence following the
first sentence in the introductory text of paragraph (a); adding
paragraphs (a)(5) and (c)(15) to read as follows:
Sec. 240.15c3-1 Net capital requirements for brokers or dealers.
(a) * * * In lieu of applying paragraphs (a)(1) and (a)(2) of this
section, an OTC derivatives dealer shall maintain net capital pursuant
to paragraph (a)(5) of this section. * * *
(5) In accordance with Appendix F to this section (Sec. 240.15c3-
1f), the Commission may grant an application by an OTC derivatives
dealer when calculating net capital to use the market risk standards of
Appendix F as to some or all of its positions in lieu of the provisions
of paragraph (c)(2)(vi) of this section and the credit risk standards
of Appendix F to its receivables (including counterparty net exposure)
arising from transactions in eligible OTC derivative instruments in
lieu of the requirements of paragraph (c)(2)(iv) of this section. An
OTC derivatives dealer shall at all times maintain tentative net
capital of not less than $100 million and net capital of not less than
$20 million.
* * * * *
(c) * * *
(15) The term tentative net capital shall mean the net capital of a
broker or dealer before deducting the securities haircuts computed
pursuant to paragraph (c)(2)(vi) of this section and the charges on
inventory computed pursuant to Appendix B to this section
(Sec. 240.15c3-1b). However, for purposes of paragraph (a)(5) of this
section, the term tentative net capital means the net capital of an OTC
derivatives dealer before deducting the charges for market and credit
risk as computed pursuant to Appendix F to this section (Sec. 240.15c3-
1f) or paragraph (c)(2)(vi) of this section, if applicable, and
increased by the balance sheet value (including counterparty net
exposure) resulting from transactions in eligible OTC derivative
instruments which would otherwise be deducted by virtue of paragraph
(c)(2)(iv) of this section.
* * * * *
13. By adding Sec. 240.15c3-1f to read as follows:
[[Page 59398]]
Sec. 240.15c3-1f Optional Market and Credit Risk Requirements for OTC
Derivatives Dealers (Appendix F to 17 CFR 240.15c3-1)
Application Requirements
(a) An OTC derivatives dealer may apply to the Commission for
authorization to compute capital charges for market and credit risk
pursuant to this Appendix F in lieu of computing securities haircuts
pursuant to Sec. 240.15c3-1(c)(2)(vi).
(1) An OTC derivatives dealer's application shall contain the
following information:
(i) Executive summary. An OTC derivatives dealer shall include in
its application an Executive Summary of information provided to the
Commission.
(ii) Description of methods for computing market risk charges. An
OTC derivatives dealer shall provide a description of all statistical
models used for pricing OTC derivative instruments and for computing
value-at-risk (``VAR''), a description of the applicant's controls over
those models, and a statement regarding whether the firm has developed
its own internal VAR models. If the OTC derivatives dealer's VAR model
incorporates empirical correlations across risk categories, the dealer
shall describe its process for measuring correlations and describe the
qualitative and quantitative aspects of the model which at a minimum
must adhere to the criteria set forth in paragraph (e) of this Appendix
F. The application shall further state whether the OTC derivatives
dealer intends to use an alternative method for computing its market
risk charge for equity instruments and, if applicable, a description of
how its own theoretical pricing model contains the minimum pricing
factors set forth in Appendix A (Sec. 240.15c3-1a). The application
shall also describe any category of securities having no ready market
or any category of debt securities which are below investment grade for
which the OTC derivatives dealer wishes to use its VAR model to
calculate its market risk charge or for which it wishes to use an
alternative method for computing this charge and a description of how
those charges would be determined.
(iii) Internal risk management control systems. An OTC derivatives
dealer shall provide a comprehensive description of its internal risk
management control systems and how those systems adhere to the
requirements set forth in Sec. 240.15c3-4(a) through (d).
(2) The Commission may approve the application after reviewing the
application to determine whether the OTC derivatives dealer:
(i) Has adopted internal risk management control systems that meet
the requirements set forth in Sec. 240.15c3-4; and
(ii) Has adopted a VAR model that meets the requirements set forth
in paragraphs (e)(1) and (e)(2) of this Appendix F.
(3) If the OTC derivatives dealer materially amends its VAR model
or internal risk management control systems as described in its
application, including any material change in the categories of non-
marketable securities that it wishes to include in its VAR model, the
dealer shall file an application describing the changes which must be
approved by the Commission before the changes may be implemented. After
reviewing the application for changes to the dealer's VAR model or
internal risk management control systems to determine whether, with the
changes, the OTC derivatives dealer's VAR model and internal risk
management control systems would meet the requirements set forth in
this Appendix F and Sec. 240.15c3-4, the Commission may approve the
application.
(4) The applications provided for in this paragraph (a) shall be
considered filed when received at the Commission's principal office in
Washington, DC. All applications filed pursuant to this paragraph (a)
shall be deemed to be confidential.
Compliance With Sec. 240.15c3-4
(b) An OTC derivatives dealer must be in compliance in all material
respects with Sec. 240.15c3-4 regarding its internal risk management
control systems in order to be in compliance with Sec. 240.15c3-1.
Market Risk
(c) An OTC derivatives dealer electing to apply this Appendix F
shall compute a capital charge for market risk which shall be the
aggregate of the charges computed below:
(1) Value-at-Risk. An OTC derivatives dealer shall deduct from net
worth an amount for market risk for eligible OTC derivative instruments
and other positions in its proprietary or other accounts equal to the
VAR of these positions obtained from its proprietary VAR model,
multiplied by the appropriate multiplication factor in paragraph
(e)(1)(iv)(C) of this Appendix F. The OTC derivatives dealer may not
elect to calculate its capital charges under this paragraph (c)(1)
until its application to use the VAR model has been approved by the
Commission.
(2) Alternative method for equities. An OTC derivatives dealer may
elect to use this alternative method to calculate its market risk for
equity instruments, including OTC options, upon approval by the
Commission on application by the dealer. Under this alternative method,
the deduction for market risk must be the amount computed pursuant to
Appendix A to Rule 15c3-1
(Sec. 240.15c3-1a). In this computation, the OTC derivatives dealer may
use its own theoretical pricing model provided that it contains the
minimum pricing factors set forth in Appendix A.
(3) Non-marketable securities. An OTC derivatives dealer may not
use a VAR model to determine a capital charge for any category of
securities having no ready market or any category of debt securities
which are below investment grade or any derivative instrument based on
the value of these categories of securities, unless the Commission has
granted, pursuant to paragraph (a)(1) of this Appendix F, its
application to use its VAR model for any such category of securities.
The dealer in any event may apply, pursuant to paragraph (a)(1) of this
Appendix F, for an alternative treatment for any such category of
securities, rather than calculate the market risk capital charge for
such category of securities under Sec. 240.15c3-1(c)(2)(vi) and (vii).
(4) Residual positions. To the extent that a position has not been
included in the calculation of the market risk charge in paragraphs
(c)(1) through (c)(3) of this section, the market risk charge for the
position shall be computed under Sec. 240.15c3-1(c)(2)(vi).
Credit Risk
(d) The capital charge for credit risk arising from an OTC
derivatives dealer's transactions in eligible OTC derivative
instruments shall be:
(1) The net replacement value in the account of a counterparty
(including the effect of legally enforceable netting agreements and the
application of liquid collateral) that is insolvent, or in bankruptcy,
or that has senior unsecured long-term debt in default;
(2) As to a counterparty not otherwise described in paragraph
(d)(1) of this section, the net replacement value in the account of the
counterparty (including the effect of legally enforceable netting
agreements and the application of liquid collateral) multiplied by 8%,
and further multiplied by the counterparty factor. The counterparty
factors are:
(i) 20% for counterparties with ratings for senior unsecured long-
term debt or commercial paper in the two highest rating categories by a
nationally
[[Page 59399]]
recognized statistical rating organization (``NRSRO'');
(ii) 50% for counterparties with ratings for senior unsecured long-
term debt in the third and fourth highest ratings categories by an
NRSRO; and
(iii) 100% for counterparties with ratings for senior unsecured
long-term debt below the four highest rating categories; and
(3) A concentration charge where the net replacement value in the
account of any one counterparty (other than a counterparty described in
paragraph (d)(1) of this section) exceeds 25% of the OTC derivatives
dealer's tentative net capital, calculated as follows:
(i) For counterparties with ratings for senior unsecured long-term
debt or commercial paper in the two highest rating categories by an
NRSRO, 5% of the amount of the net replacement value in excess of 25%
of the OTC derivatives dealer's tentative net capital;
(ii) For counterparties with ratings for senior unsecured long-term
debt in the third and fourth highest rating categories by an NRSRO, 20%
of the amount of the net replacement value in excess of 25% of the OTC
derivatives dealer's tentative net capital; and
(iii) For counterparties with ratings for senior unsecured long-
term debt below the four highest rating categories, 50% of the amount
of the net replacement value in excess of 25% of the OTC derivatives
dealer's tentative net capital.
(4) Counterparties that are not rated by an NRSRO may be rated by
the OTC derivatives dealer, or by an affiliated bank or affiliated
broker-dealer of the OTC derivatives dealer, upon approval by the
Commission on application by the OTC derivatives dealer. After
reviewing the application to determine whether the credit rating
procedures and rating categories are equivalent to those used by NRSROs
and that such ratings are current, the Commission may approve the
application. The OTC derivatives dealer must make and keep current a
record of the basis for the credit rating for each counterparty. The
record must be preserved for a period of not less than three years, the
first two years in an easily accessible place.
VAR Models
(e) An OTC derivatives dealer's VAR model must meet the following
qualitative and quantitative requirements:
(1) Qualitative requirements. An OTC derivatives dealerapplying
this Appendix F must have a VAR model that meets the following minimum
qualitative requirements:
(i) The OTC derivatives dealer's VAR model must be integrated into
the firm's daily risk management process;
(ii) The OTC derivatives dealer must conduct appropriate stress
tests of the VAR model, and develop appropriate procedures to follow in
response to the results of such tests;
(iii) The OTC derivatives dealer must conduct periodic reviews
(which may be performed by internal audit staff) of its VAR model. The
OTC derivatives dealer's VAR model also must be subject to annual
reviews conducted by independent public accountants; and
(iv) The OTC derivatives dealer must conduct backtesting of the VAR
model pursuant to the following procedures:
(A) Beginning one year after the OTC derivatives dealer begins
using its VAR model to calculate its net capital, the OTC derivatives
dealer must conduct backtesting by comparing each of its most recent
250 business days' actual net trading profit or loss with the
corresponding daily VAR measures generated for determining market risk
capital charges and calibrated to a one-day holding period and a 99
percent, one-tailed confidence level;
(B) Once each quarter, the OTC derivatives dealer must identify the
number of exceptions, that is, the number of business days for which
the actual daily net trading loss, if any, exceeded the corresponding
daily VAR measure; and
(C) An OTC derivatives dealer must use the multiplication factor
indicated in Table 1 of this Appendix F in determining its capital
charge for market risk until it obtains the next quarter's backtesting
results, unless the Commission determines that a different adjustment
or other action is appropriate.
Table 5.--Multiplication Factor Based on Results of Backtesting
------------------------------------------------------------------------
Multiplication
Number of exceptions factor
------------------------------------------------------------------------
4 or fewer............................................. 3.00
5...................................................... 3.40
6...................................................... 3.50
7...................................................... 3.65
8...................................................... 3.75
9...................................................... 3.85
10 or more.............................................. 4.00
------------------------------------------------------------------------
(2) Quantitative requirements. An OTC derivatives dealer applying
this Appendix F must have a VAR model that meets the following minimum
quantitative requirements:
(i) The VAR measures must be calculated on a daily basis using a 99
percent, one-tailed confidence level with a price change equivalent to
a ten-business day movement in rates and prices;
(ii) The effective historical observation period for VAR measures
must be at least one year, and the weighted average time lag of the
individual observations cannot be less than six months. Historical data
sets must be updated at least every three months and reassessed
whenever market prices or volatilities are subject to large changes;
(iii) The VAR measures must include the risks arising from the non-
linear price characteristics of options positions and the sensitivity
of the market value of the positions to changes in the volatility of
the underlying rates or prices. An OTC derivatives dealer must measure
the volatility of options positions by different maturities;
(iv) The VAR measures may incorporate empirical correlations within
and across risk categories, provided that the OTC derivatives dealer
has described its process for measuring correlations in its application
to apply this Appendix F and the Commission has approved its
application. In the event that the VAR measures do not incorporate
empirical correlations across risk categories, the OTC derivatives
dealer must add the separate VAR measures for the four major risk
categories in paragraph (e)(2)(v) of this Appendix F to determine its
aggregate VAR measure; and
(v) The OTC derivatives dealer's VAR model must use risk factors
sufficient to measure the market risk inherent in all covered
positions. The risk factors must address, at a minimum, the following
major risk categories: interest rate risk, equity price risk, foreign
exchange rate risk, and commodity price risk. For material exposures in
the major currencies and markets, modeling techniques must capture, at
a minimum, spread risk and must incorporate enough segments of the
yield curve to capture differences in volatility and less-than-perfect
correlation of rates along the yield curve. An OTC derivatives dealer
must provide the Commission with evidence that the OTC derivatives
dealer's VAR model takes account of specific risk in positions,
including specific equity risk, if the OTC derivatives dealer intends
to utilize its VAR model to compute capital charges for equity price
risk.
14. Section 240.15c3-3 is amended to revise paragraph (a)(1) to
read as follows, and in paragraph (h) to revise the phrase
``Sec. 240.17a-5,'' to read ``Secs. 240.17a-5 or 240.17a-12,''.
[[Page 59400]]
Sec. 240.15c3-3 Customer protection--reserves and custody of
securities.
(a) * * *
(1) The term customer shall mean any person from whom or on whose
behalf a broker or dealer has received or acquired or holds funds or
securities for the account of that person. The term shall not include a
broker or dealer, a municipal securities dealer, or a government
securities broker or government securities dealer. The term shall,
however, include another broker or dealer to the extent that broker or
dealer maintains an omnibus account for the account of customers with
the broker or dealer in compliance with Regulation T (12 CFR 220.1
through 220.19). The term shall not include a general partner or
director or principal officer of the broker or dealer or any other
person to the extent that person has a claim for property or funds
which by contract, agreement or understanding, or by operation of law,
is part of the capital of the broker or dealer or is subordinated to
the claims of creditors of the broker or dealer. The term also shall
not include a counterparty who has delivered collateral to an OTC
derivatives dealer pursuant to a transaction in an eligible OTC
derivative instrument, or pursuant to the OTC derivatives dealer's cash
management securities activities or ancillary portfolio management
securities activities, and who has received a prominent written notice
from the OTC derivatives dealer that:
(i) Except as otherwise agreed in writing by the OTC derivatives
dealer and the counterparty, the dealer may repledge or otherwise use
the collateral in its business;
(ii) In the event of the OTC derivatives dealer's failure, the
counterparty will likely be considered an unsecured creditor of the
dealer as to that collateral;
(iii) The Securities Investor Protection Act of 1970 (15 U.S.C.
78aaa et seq.) does not protect the counterparty; and
(iv) The collateral will not be subject to the requirements of
Sec. 240.8c-1, Sec. 240.15c2-1, Sec. 240.15c3-2, or Sec. 240.15c3-3;
* * * * *
15. By adding Sec. 240.15c3-4 to read as follows:
Sec. 240.15c3-4 Internal risk management control systems for OTC
derivatives dealers.
(a) An OTC derivatives dealer shall establish, document, and
maintain a system of internal risk management controls to assist it in
managing the risks associated with its business activities, including
market, credit, leverage, liquidity, legal, and operational risks.
(b) An OTC derivatives dealer shall consider the following when
adopting its internal control system guidelines, policies, and
procedures:
(1) The ownership and governance structure of the OTC derivatives
dealer;
(2) The composition of the governing body of the OTC derivatives
dealer;
(3) The management philosophy of the OTC derivatives dealer;
(4) The scope and nature of established risk management guidelines;
(5) The scope and nature of the permissible OTC derivatives
activities;
(6) The sophistication and experience of relevant trading, risk
management, and internal audit personnel;
(7) The sophistication and functionality of information and
reporting systems; and
(8) The scope and frequency of monitoring, reporting, and auditing
activities.
(c) An OTC derivatives dealer's internal risk management control
system shall include the following elements:
(1) A risk control unit that reports directly to senior management
and is independent from business trading units;
(2) Separation of duties between personnel responsible for entering
into a transaction and those responsible for recording the transaction
in the books and records of the OTC derivatives dealer;
(3) Periodic reviews (which may be performed by internal audit
staff) and annual reviews (which must be conducted by independent
certified public accountants) of the OTC derivatives dealer's risk
management systems;
(4) Definitions of risk, risk monitoring, and risk management; and
(5) Written guidelines, approved by the OTC derivatives dealer's
governing body, that include and discuss the following:
(i) The OTC derivatives dealer's consideration of the elements in
paragraph (b) of this section;
(ii) The scope, and the procedures for determining the scope, of
authorized activities or any nonquantitative limitation on the scope of
authorized activities;
(iii) Quantitative guidelines for managing the OTC derivatives
dealer's overall risk exposure;
(iv) The type, scope, and frequency of reporting by management on
risk exposures;
(v) The procedures for and the timing of the governing body's
periodic review of the risk monitoring and risk management written
guidelines, systems, and processes;
(vi) The process for monitoring risk independent of the business or
trading units whose activities create the risks being monitored;
(vii) The performance of the risk management function by persons
independent from or senior to the business or trading units whose
activities create the risks;
(viii) The authority and resources of the groups or persons
performing the risk monitoring and risk management functions;
(ix) The appropriate response by management when internal risk
management guidelines have been exceeded;
(x) The procedures to monitor and address the risk that an OTC
derivatives transaction contract will be unenforceable;
(xi) The procedures requiring the documentation of the principal
terms of OTC derivatives transactions and other relevant information
regarding such transactions;
(xii) The procedures authorizing specified employees to commit the
OTC derivatives dealer to particular types of transactions;
(xiii) The procedures to prevent the OTC derivatives dealer from
engaging in any securities transaction that is not permitted under
Sec. 240.15a-1; and
(xiv) The procedures to prevent the OTC derivatives dealer from
improperly relying on the exceptions to Sec. 240.15a-1(c) and
Sec. 240.15a-1(d), including the procedures to determine whether a
counterparty is acting in the capacity of principal or agent.
(d) Management must periodically review, in accordance with written
procedures, the OTC derivatives dealer's business activities for
consistency with risk management guidelines including that:
(1) Risks arising from the OTC derivatives dealer's OTC derivatives
activities are consistent with prescribed guidelines;
(2) Risk exposure guidelines for each business unit are appropriate
for the business unit;
(3) The data necessary to conduct the risk monitoring and risk
management function as well as the valuation process over the OTC
derivatives dealer's portfolio of products is accessible on a timely
basis and information systems are available to capture, monitor,
analyze, and report relevant data;
(4) Procedures are in place to enable management to take action
when internal risk management guidelines have been exceeded;
[[Page 59401]]
(5) Procedures are in place to monitor and address the risk that an
OTC derivatives transaction contract will be unenforceable;
(6) Procedures are in place to identify and address any
deficiencies in the operating systems and to contain the extent of
losses arising from unidentified deficiencies;
(7) Procedures are in place to authorize specified employees to
commit the OTC derivatives dealer to particular types of transactions,
to specify any quantitative limits on such authority, and to provide
for the oversight of their exercise of such authority;
(8) Procedures are in place to prevent the OTC derivatives dealer
from engaging in any securities transaction that is not permitted under
Sec. 240.15a-1;
(9) Procedures are in place to prevent the OTC derivatives dealer
from improperly relying on the exceptions to Sec. 240.15a-1(c) and
Sec. 240.15a-1(d), including procedures to determine whether a
counterparty is acting in the capacity of principal or agent;
(10) Procedures are in place to provide for adequate documentation
of the principal terms of OTC derivatives transactions and other
relevant information regarding such transactions;
(11) Personnel resources with appropriate expertise are committed
to implementing the risk monitoring and risk management systems and
processes; and
(12) Procedures are in place for the periodic internal and external
review of the risk monitoring and risk management functions.
16. Amend Sec. 240.17a-3, in paragraph (a)(4)(vi) by revising the
phrase ``Rule 17a-13 and Rule 17a-5 hereunder'' to read ``Sec. 240.17a-
5, Sec. 240.17a-12, and Sec. 240.17a-13'' and by adding a sentence to
the end of paragraph (a)(10) to read as follows:
Sec. 240.17a-3 Records to be made by certain exchange members,
brokers, and dealers.
(a) * * *
(10) * * * An OTC derivatives dealer shall also keep a record of
all eligible OTC derivative instruments as defined in Sec. 240.3b-13
in which the OTC derivatives dealer has any direct or indirect interest
or which it has written or guaranteed, containing, at a minimum, an
identification of the security or other instrument, the number of units
involved, and the identity of the counterparty.
* * * * *
17. Amend Sec. 240.17a-4 in paragraph (b)(8) introductory text by
revising the phrase ``Part IIA'' to read ``Part IIA or Part IIB'' and
by revising the phrase ``Sec. 240.17a-5(i)(xv)'' to read
``Sec. 240.17a-5(d) and Sec. 240.17a-12(b)''; in paragraph (b)(8)(xv)
by revising the phrase ``Sec. 240.17a-5'' to read ``Sec. 240.17a-5 and
Sec. 240.17a-12''; by adding paragraph (b)(10) to read as follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(10) The records required to be made pursuant to Sec. 240.15c3-4
and the results of the periodic reviews conducted pursuant to
Sec. 240.15c3-4(d).
* * * * *
18. Amend Sec. 240.17a-5 by adding paragraph (o) to read as
follows:
Sec. 240.17a-5 Reports to be made by certain brokers and dealers.
* * * * *
(o) Compliance with Sec. 240.17a-12. An OTC derivatives dealer may
comply with Sec. 240.17a-5 by complying with the provisions of
Sec. 240.17a-12.
19. Amend Sec. 240.17a-11 by redesignating paragraph (b) as
paragraph (b)(1) and by adding paragraph (b)(2) to read as follows; in
paragraph (c) introductory text by revising the phrase ``(c)(1), (c)(2)
or (c)(3)'' to read ``(c)(1), (c)(2), (c)(3) or (c)(4)''; by revising
paragraph (c)(3) and by adding paragraph (c)(4) to read as follows; in
paragraph (e) introductory text by adding the phrase ``or Sec. 240.17a-
12(f)(2)'' after the phrase ``240.17a-5(h)(2)'' and by adding the
phrase ``or Sec. 240.17a-12(e)(2)'' after the phrase ``240.17a-5(g)'';
and in paragraph (h) by revising the phrase ``Sec. 240.15c3-3(i) and
Sec. 240.17a-5(h)(2)'' to read ``Sec. 240.15c3-3(i), Sec. 240.17a-
5(h)(2), and Sec. 240.17a-12(f)(2)''.
Sec. 240.17a-11 Notification provisions for brokers and dealers.
* * * * *
(b) * * *
(2) In addition to the requirements of paragraph (b)(1) of this
section, an OTC derivatives dealer shall also provide notice if its
tentative net capital falls below the minimum amount required pursuant
to Sec. 240.15c3-1. The notice shall specify the OTC derivatives
dealer's net capital and tentative net capital requirements, and its
current amount of net capital and tentative net capital.
(c) * * *
(3) If a computation made by a broker or dealer pursuant to
Sec. 240.15c3-1 shows that its total net capital is less than 120
percent of the broker's or dealer's required minimum net capital, or if
a computation made by an OTC derivatives dealer pursuant to
Sec. 240.15c3-1 shows that its total tentative net capital is less than
120 percent of the dealer's required minimum tentative net capital.
(4) The occurrence of the fourth and each subsequent backtesting
exception under Sec. 240.15c3-1f(e)(1)(iv) during any 250 business day
measurement period.
* * * * *
20. By adding Sec. 240.17a-12 to read as follows:
Sec. 240.17a-12 Reports to be made by certain OTC derivatives dealers.
(a) Filing of quarterly reports. (1) This paragraph (a) shall apply
to every OTC derivatives dealer registered pursuant to Section 15 of
the Act (15 U.S.C. 78o).
(i) Every OTC derivatives dealer shall file Part IIB of Form X-17A-
5 (Sec. 249.617 of this chapter) within 17 business days after the end
of each calendar quarter and within 17 business days after the date
selected for the annual audit of financial statements where said date
is other than the end of the calendar quarter.
(ii) Upon receiving from the Commission written notice that
additional reporting is required, an OTC derivatives dealer shall file
monthly, or at such times as shall be specified, Part IIB of Form X-
17A-5 (Sec. 249.617 of this chapter) and such other financial or
operational information as shall be required by the Commission.
(2) The reports provided for in this paragraph (a) shall be
considered filed when received at the Commission's principal office in
Washington, DC. All reports filed pursuant to this paragraph (a) shall
be deemed to be confidential.
(3) Upon written application by an OTC derivatives dealer to the
Commission, the Commission may extend the time for filing the
information required by this paragraph (a). The written application
shall be filed with the Commission at its principal office in
Washington DC.
(b) Annual filing of audited financial statements. (1)(i) Every OTC
derivatives dealer registered pursuant to Section 15 of the Act (15
U.S.C. 78o) shall file annually, on a calendar or fiscal year basis, a
report which shall be audited by a certified public accountant. Reports
filed pursuant to this paragraph (b) shall be as of the same fixed or
determinable date each year, unless a change is approved in writing by
the Commission.
(ii) An OTC derivatives dealer succeeding to and continuing the
business of another OTC derivatives dealer need not file a report under
this paragraph (b) as of a date in the fiscal or calendar year in which
the succession occurs if the predecessor
[[Page 59402]]
OTC derivatives dealer has filed a report in compliance with this
paragraph (b) as of a date in such fiscal or calendar year.
(2) The annual audit report shall contain a Statement of Financial
Condition (in a format and on a basis which is consistent with the
total reported on the Statement of Financial Condition contained in
Form X-17A-5 (Sec. 249.617 of this chapter), Part IIB, a Statement of
Income, a Statement of Cash Flows, a Statement of Changes in
Stockholders' or Partners' or Sole Proprietor's Equity, and a Statement
of Changes in Liabilities Subordinated to Claims of General Creditors.
Such statements shall be in a format which is consistent with such
statements as contained in Form X-17A-5 (Sec. 249.617 of this chapter),
Part IIB. If the Statement of Financial Condition filed in accordance
with instructions to Form X-17A-5 (Sec. 249.617 of this chapter), Part
IIB, is not consolidated, a summary of financial data for subsidiaries
not consolidated in the Part IIB Statement of Financial Condition as
filed by the OTC derivatives dealer shall be included in the notes to
the consolidated statement of financial condition reported on by the
certified public accountant. The summary financial data shall include
the assets, liabilities, and net worth or stockholders' equity of the
unconsolidated subsidiaries.
(3) Supporting schedules shall include, from Part IIB of Form X-
17A-5 (Sec. 249.617 of this chapter), a Computation of Net Capital
under Sec. 240.15c3-1.
(4) A reconciliation, including appropriate explanations, of the
Computation of Net Capital under Sec. 240.15c3-1 contained in the audit
report with the broker's or dealer's corresponding unaudited most
recent Part IIB filing shall be filed with the report when material
differences exist. If no material differences exist, a statement so
indicating shall be filed.
(5) The annual audit report shall be filed not more than sixty days
after the date of the financial statements.
(6) Two copies of the annual audit report shall be filed at the
Commission's principal office in Washington, DC.
(c) Nature and form of reports. The financial statements filed
pursuant to paragraph (b) of this section shall be prepared and filed
in accordance with the following requirements:
(1) An audit shall be conducted by a certified public accountant
who shall be in fact independent as defined in paragraph (f) of this
section, and it shall give an opinion covering the statements filed
pursuant to paragraph (b) of this section.
(2) Attached to the report shall be an oath or affirmation that, to
the best knowledge and belief of the person making such oath or
affirmation, the financial statements and schedules are true and
correct and neither the OTC derivatives dealer, nor any partner,
officer, or director, as the case may be, has any significant interest
in any counterparty or in any account classified solely as that of a
counterparty. The oath or affirmation shall be made before a person
duly authorized to administer such oaths or affirmations. If the OTC
derivatives dealer is a sole proprietorship, the oath or affirmation
shall be made by the proprietor; if a partnership, by a general
partner; or if a corporation, by a duly authorized officer.
(3) All of the statements filed pursuant to paragraph (b) of this
section shall be confidential except that they shall be available for
use by any official or employee of the United States or by any other
person to whom the Commission authorizes disclosure of such information
as being in the public interest.
(d) Qualification of accountants. The Commission will not recognize
any person as a certified public accountant who is not duly registered
and in good standing as such under the laws of the State of his
principal office.
(e) Designation of accountant. (1) Every OTC derivatives dealer
shall file no later than December 10 of each year with the Commission's
principal office in Washington, DC a statement indicating the existence
of an agreement, dated no later than December 1 of that year, with a
certified public accountant covering a contractual commitment to
conduct the OTC derivatives dealer's annual audit during the following
calendar year.
(2) If the agreement is of a continuing nature, providing for
successive yearly audits, no further filing is required. If the
agreement is for a single audit, or if the continuing agreement
previously filed has been terminated or amended, a new statement must
be filed by the required date.
(3) The statement shall be headed ``Notice pursuant to Sec.
240.17a-12(e)'' and shall contain the following information:
(i) Name, address, telephone number, and registration number of the
OTC derivatives dealer;
(ii) Name, address, and telephone number of the certified public
accounting firm; and
(iii) The audit date of the OTC derivatives dealer for the year
covered by the agreement.
(4) Notwithstanding the date of filing specified in paragraph
(e)(1) of this section, every OTC derivatives dealer shall file the
notice provided for in paragraph (e) of this section within 30 days
following the effective date of registration as an OTC derivatives
dealer.
(f) Independence of accountant. A certified public accountant shall
be independent in accordance with the provisions of Sec. 210.2-01(b)
and (c) of this chapter.
(g) Replacement of accountant. (1) An OTC derivatives dealer shall
file a notice that must be received by the Commission's principal
office in Washington, DC not more than 15 business days after:
(i) The OTC derivatives dealer has notified the certified public
accountant whose opinion covered the most recent financial statements
filed under paragraph (b) of this section that the certified public
accountant's services will not be utilized in future engagements; or
(ii) The OTC derivatives dealer has notified a certified public
accountant who was engaged to give an opinion covering the financial
statements to be filed under paragraph (b) of this section that the
engagement has been terminated; or
(iii) A certified public accountant has notified the OTC
derivatives dealer that it will not continue under an engagement or
give an opinion covering the financial statements to be filed under
paragraph (b) of this section; or
(iv) A new certified public accountant has been engaged to give an
opinion covering the financial statements to be filed under paragraph
(b) of this section without any notice of termination having been given
to or by the previously engaged certified public accountant.
(2) Such notice shall state the date of notification of the
termination of the engagement of the former certified public accountant
or the engagement of the new certified public accountant, as
applicable, and the details of any disagreements existing during the 24
months (or the period of the engagement, if less) preceding such
termination or new engagement relating to any matter of accounting
principles or practices, financial statement disclosure, auditing scope
or procedure, or compliance with applicable rules of the Commission,
which disagreements, if not resolved to the satisfaction of the former
certified public accountant, would have caused the former certified
public accountant to make reference to them in connection with the
report on the subject matter of the disagreements.
[[Page 59403]]
The disagreements required to be reported in response to the preceding
sentence include both those resolved to the former certified public
accountant's satisfaction and those not resolved to the former
certified public accountant's satisfaction. Disagreements contemplated
by this section are those that occur at the decision-making level
(i.e., between principal financial officers of the OTC derivatives
dealer and personnel of the certified public accounting firm
responsible for rendering its report). The notice shall also state
whether the certified public accountant's report on the financial
statements for any of the past two years contained an adverse opinion
or a disclaimer of opinion or was qualified as to uncertainties, audit
scope, or accounting principles, and describe the nature of each such
adverse opinion, disclaimer of opinion, or qualification. The OTC
derivatives dealer shall also request the former certified public
accountant to furnish the OTC derivatives dealer with a letter
addressed to the Commission stating whether the former certified public
accountant agrees with the statements contained in the notice of the
OTC derivatives dealer and, if not, stating the respects in which the
former certified public accountant does not agree. The OTC derivatives
dealer shall file three copies of the notice and the certified public
accountant's letter, one copy of which shall be manually signed by the
sole proprietor, or a general partner or a duly authorized corporate
officer, as appropriate, and by the certified public accountant.
(h) Audit objectives. (1) The audit shall be made in accordance
with U.S. Generally Accepted Auditing Standards and shall include a
review of the accounting system, the internal accounting controls, and
procedures for safeguarding securities including appropriate tests
thereof for the period since the date of the prior audited financial
statements. The audit shall include all procedures necessary under the
circumstances to enable the certified public accountant to express an
opinion on the statement of financial condition, results of operations,
cash flows, and the Computation of Net Capital under Sec. 240.15c3-1.
The scope of the audit and review of the accounting system, the
internal accounting controls, and procedures for safeguarding
securities shall be sufficient to provide reasonable assurance that any
material inadequacies existing at the date of the examination in the
following are disclosed:
(i) The accounting system;
(ii) The internal accounting controls; and
(iii) The procedures for safeguarding securities.
(2) A material inadequacy in the accounting system, internal
accounting controls, procedures for safeguarding securities, and
practices and procedures referred to in paragraph (h) (1) of this
section that must be reported under these audit objectives includes any
condition which has contributed substantially to or, if appropriate
corrective action is not taken, could reasonably be expected to:
(i) Inhibit an OTC derivatives dealer from promptly completing
securities transactions or promptly discharging its responsibilities to
counterparties, other brokers and dealers, or creditors;
(ii) Result in material financial loss;
(iii) Result in material misstatements of the OTC derivatives
dealer's financial statements; or
(iv) Result in violations of the Commission's recordkeeping or
financial responsibility rules to an extent that could reasonably be
expected to result in the conditions described in paragraphs (h)(2)(i),
(ii), or (iii) of this section.
(i) Extent and timing of audit procedures. (1) The extent and
timing of audit procedures are matters for the certified public
accountant to determine on the basis of its review and evaluation of
existing internal controls and other audit procedures performed in
accordance with U.S. Generally Accepted Auditing Standards and the
audit objectives set forth in paragraph (h) of this section.
(2) If, during the course of the audit or interim work, the
certified public accountant determines that any material inadequacies
exist in the accounting system, internal accounting controls,
procedures for safeguarding securities, or as otherwise defined in
paragraph (h)(2) of this section, then the certified public accountant
shall call it to the attention of the chief financial officer of the
OTC derivatives dealer, who shall inform the Commission by telegraphic
or facsimile notice within 24 hours thereafter as set forth in
Sec. 240.17a-11(e) and (g). The OTC derivatives dealer shall also
furnish the certified public accountant with a copy of said notice to
the Commission by telegram or facsimile within the same 24 hour period.
If the certified public accountant fails to receive such notice from
the OTC derivatives dealer within that 24 hour period, or if the
certified public accountant disagrees with the statements contained in
the notice of the OTC derivatives dealer, the certified public
accountant shall inform the Commission by report of material inadequacy
within 24 hours thereafter as set forth in Sec. 240.17a-11(g). Such
report from the certified public accountant shall, if the OTC
derivatives dealer failed to file a notice, describe any material
inadequacies found to exist. If the OTC derivatives dealer filed a
notice, the certified public accountant shall file a report detailing
the aspects, if any, of the OTC derivatives dealer's notice with which
the certified public accountant does not agree.
(j) Accountant's report, general provisions.--(1) Technical
requirements. The certified public accountant's report shall be dated;
be signed manually; indicate the city and state where issued; and
identify without detailed enumeration the financial statements and
schedules covered by the report.
(2) Representations as to the audit. The certified public
accountant's report shall state that the audit was made in accordance
with U.S. Generally Accepted Auditing Standards; state whether the
certified public accountant reviewed the procedures followed for
safeguarding securities; and designate any auditing procedures deemed
necessary by the certified public accountant under the circumstances of
the particular case that have been omitted, and the reason for their
omission. Nothing in this section shall be construed to imply authority
for the omission of any procedure which certified public accountants
would ordinarily employ in the course of an audit made for the purpose
of expressing the opinions required under this section.
(3) Opinion to be expressed. The certified public accountant's
report shall state clearly the opinion of the certified public
accountant:
(i) In respect of the financial statements and schedules covered by
the report and the accounting principles and practices reflected
therein; and
(ii) As to the consistency of the application of the accounting
principles, or as to any changes in such principles which have a
material effect on the financial statements.
(4) Exceptions. Any matters to which the certified public
accountant takes exception shall be clearly identified, explained, and,
to the extent practicable, the effect of each such exception on the
related financial statements shall be provided.
(5) Definitions. For the purpose of this section, the terms audit
(or examination), accountant's report, and certified shall have the
meanings given in Sec. 210.1-02 of this chapter.
[[Page 59404]]
(k) Accountant's report on material inadequacies and reportable
conditions. The OTC derivatives dealer shall file concurrently with the
annual audit report a supplemental report by the certified public
accountant describing any material inadequacies or any matter that
would be deemed to be a reportable condition under U.S. Generally
Accepted Auditing Standards that are unresolved as of the date of the
certified public accountant's report. The report shall also describe
any material inadequacies found to have existed since the date of the
previous audit. The supplemental report shall indicate any corrective
action taken or proposed by the OTC derivatives dealer with regard to
any identified material inadequacies or reportable conditions. If the
audit did not disclose any material inadequacies or reportable
conditions, the supplemental report shall so state.
(l) Accountant's report on management controls. The OTC derivatives
dealer shall file concurrently with the annual audit report a
supplemental report by the certified public accountant indicating the
certified public accountant's opinion on the OTC derivatives dealer's
compliance with its internal risk management controls. The procedures
are to be performed and the report is to be prepared in accordance with
U.S. Generally Accepted Auditing Standards.
(m) Accountant's report on inventory pricing and modeling. (1) The
OTC derivatives dealer shall file concurrently with the annual audit
report a supplemental report by the certified public accountant
indicating the results of the certified public accountant's review of
the broker's or dealer's inventory pricing and modeling procedures.
This review shall be conducted in accordance with procedures agreed to
by the OTC derivatives dealer and by the certified public accountant
conducting the review. The purpose of the review is to confirm that the
pricing and modeling procedures relied upon by the OTC derivatives
dealer conform to the procedures submitted to the Commission as part of
its OTC derivatives dealer application, and that the procedures comply
with the qualitative and quantitative standards set forth in
Sec. 240.15c3-1f.
(2) The agreed-upon procedures are to be performed and the report
is to be prepared in accordance with U.S. Generally Accepted
Attestation Standards.
(3) Every OTC derivatives dealer shall file prior to the
commencement of the initial review, the procedures to be performed
pursuant to paragraph (m)(1) of this section with the Commission's
principal office in Washington, DC. Prior to the commencement of each
subsequent review, every OTC derivatives dealer shall file with the
Commission's principal office in Washington, DC notice of changes in
the agreed-upon procedures.
(n) Extensions and exemptions. Upon the written request of the OTC
derivatives dealer, or on its own motion, the Commission may grant an
extension of time or an exemption from any of the requirements of this
section either unconditionally or on specified terms and conditions.
(o) Notification of change of fiscal year. (1) In the event any OTC
derivatives dealer finds it necessary to change its fiscal year, it
must file a notice of such change with the Commission's principal
office in Washington, DC.
(2) Such notice shall contain a detailed explanation of the reasons
for the change. Any change in the filing period for the audit report
must be approved by the Commission.
(p) Filing requirements. For purposes of filing requirements as
described in Sec. 240.17a-12, these filings shall be deemed to have
been accomplished upon receipt at the Commission's principal office in
Washington, DC.
21. By adding Secs. 240.36a1-1 and 240.36a1-2 to read as follows:
Sec. 240.36a1-1 Exemptionfrom Section 7 for OTC derivatives dealers.
Preliminary Note: OTC derivatives dealers are a special class of
broker-dealers that are exempt from certain broker-dealer
requirements, including membership in a self-regulatory organization
(Sec. 240.15b9-2), regular broker-dealer margin rules
(Sec. 240.36a1-1), and application of the Securities Investor
Protection Act of 1970 (Sec. 240.36a1-2). OTC derivative dealers are
subject to special requirements, including limitations on the scope
of their securities activities (Sec. 240.15a-1), specified internal
risk management control systems (Sec. 240.15c3-4), recordkeeping
obligations (Sec. 240.17a-3(a)(10)), and reporting responsibilities
(Sec. 240.17a-12). They are also subject to alternative net capital
treatment (Sec. 240.15c3-1(a)(5)).
(a) Except as otherwise provided in paragraph (b) of this section,
transactions involving the extension of credit by an OTC derivatives
dealer shall be exempt from the provisions of section 7(c) of the Act
(15 U.S.C. 78g(c)), provided that the OTC derivatives dealer complies
with Section 7(d) of the Act (15 U.S.C. 78g(d)).
(b) The exemption provided under paragraph (a) of this section
shall not apply to extensions of credit made directly by a registered
broker or dealer (other than an OTC derivatives dealer) in connection
with transactions in eligible OTC derivative instruments for which an
OTC derivatives dealer acts as counterparty.
Sec. 240.36a1-2 Exemption from SIPA for OTC derivatives dealers.
Preliminary Note: OTC derivatives dealers are a special class of
broker-dealers that are exempt from certain broker-dealer
requirements, including membership in a self-regulatory organization
(Sec. 240.15b9-2), regular broker-dealer margin rules
(Sec. 240.36a1-1), and application of the Securities Investor
Protection Act of 1970 (Sec. 240.36a1-2). OTC derivative dealers are
subject to special requirements, including limitations on the scope
of their securities activities (Sec. 240.15a-1), specified internal
risk management control systems (Sec. 240.15c3-4), recordkeeping
obligations (Sec. 240.17a-3(a)(10)), and reporting responsibilities
(Sec. 240.17a-12). They are also subject to alternative net capital
treatment (Sec. 240.15c3-1(a)(5)).
OTC derivatives dealers, as defined in Sec. 240.3b-12, shall be
exempt from the provisions of the Securities Investor Protection Act of
1970 (15 U.S.C. 78aaa through 78lll).
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
22. The authority citation for part 249 continues to read in part
as follows:
Authority: 15 U.S.C. 78a, et seq., unless otherwise noted;
* * * * *
Sec. 249.617 [Amended]
23. Section 249.617 is amended by revising the phrase ``and
Sec. 240.17a-11'' in the section heading to read ``, Sec. 240.17a-11,
and Sec. 240.17a-12''; and by revising the phrase ``and Sec. 240.17a-
11'' to read ``, Sec. 240.17a-11, and Sec. 240.17a-12''.
24. Form X-17A-5 (referenced in Sec. 249.617) is amended by adding
section IIB to read as follows:
Note: Form X-17A-5 does not, and the amendments will not, appear
in the Code of Federal Regulations. Part IIB of Form X-17A-5 is
attached as Appendix A to this document.
Dated: October 23, 1998.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
Appendix A
Note: the text of Appendix A does not appear in the Code of
Federal Regulations.
General Instructions
The FOCUS Report (Form X-17A-511B) constitutes the basic financial
and operational report required of OTC derivatives dealers. Much of the
[[Page 59405]]
information required by the FOCUS report is the same or similar to the
information required to be reported by broker-dealers required to file
Form X-17A-5 Part II. Consequently, for those items that appear on both
forms, the instructions for X-17A-5 Part II are to be followed when
completing Form X-17A-5 Part IIB. The following instructions apply to
new information requests and to items appearing on both forms that have
been altered to better reflect an OTC derivatives dealers's unique
business.
Computation of Net Capital and Required Net Capital
(Under 15c3-1 Appendix F)
Tentative Net Capital
For purposes of paragraph (a)(5) of Rule 15c3-1 of this chapter
(Sec. 240.15c3-1), the term ``tentative net capital'' mean the net
capital of an OTC derivatives dealer before deducting the charges for
market and credit risk as computed pursuant to Appendix F and increased
by the balance sheet value (including counterparty net exposure)
resulting from transactions in eligible OTC derivative instruments
which would otherwise be deducted by virtue of paragraph (c)(2)(iv) of
Rule 15c3-1.
Market Risk Exposure
The capital requirement for an OTC derivatives dealer electing to
apply Appendix F of Rule 240.15c3-1 is computed as follows:
(1) Value-at-Risk. An OTC derivatives dealer shall deduct from net
worth an amount for market risk exposure for eligible OTC derivatives
transactions and other positions in its proprietary or other accounts
equal to the value at risk (``VAR'') of these positions obtained from
its proprietary VAR model, multiplied by the appropriate multiplication
factor. See paragraph (e)(1)(v)(C) of Appendix F for more information
on the multiplication factor. The proprietary model used to calculate
the capital requirement for market risk must be approved by the
Commission prior to its use.
(2) Alternative Method for Equities. An OTC derivatives dealer may
choose to use the Alternative Method to calculate market risk for
equity instruments, including OTC options. An OTC derivatives dealer
also may use this alternative method if the Commission does not approve
the OTC derivatives dealer's use of VAR models for equity instruments.
Under the alternative method, the deduction for market risk will be an
amount equal to the largest theoretical loss calculated in accordance
with the theoretical pricing model set forth in Appendix A of
Sec. 240.15c3-1. The OTC derivatives dealer may use its own theoretical
pricing model as long as it contains the minimum pricing factors set
forth in Appendix A.
(3) Non-Marketable Securities. An OTC derivatives dealer may not
use a VAR model a determine a capital charge for any category of
securities having no ready market or any category of debt securities
which are below investment grade, or any derivative instrument based on
the value of these categories of securities, unless the Commission has
granted, pursuant to paragraph (a)(1) of Appendix F, its application to
use its VAR model for any such category of securities. The dealer in
any event may apply, pursuant to paragraph (a)(1) of Appendix F, for an
alternative treatment for any such category of securities, rather than
calculate the market risk capital charge for such category of
securities under paragraphs (c)(2)(vi) and (vii) of Sec. 240.15c3-1.
(4) Residual Positions. To the extent that a position has not been
included in the calculation of the market risk charge in subparagraph
(1) through (3) of this paragraph, the market risk charge for the
position shall be computed under paragraph (c)(2)(vi) of Sec. 240.15c3-
1.
Credit Risk Exposure
The capital requirement for credit risk arising from an OTC
derivatives dealer's eligible OTC derivatives transactions consists of
a counterparty charge and a concentration charge. The counterparty
charge is computed as follows:
(1) The net replacement value for each counterparty (including the
effect of legally enforceable netting agreements and the application of
liquid collateral) multiplied by 8% multiplied by the counterparty
factor. The counterparty factors are 20% for entities with ratings for
senior unsecured long term debt or commercial paper in the two highest
rating categories by a nationally recognized statistical rating
organization (``NRSRO''); 50% for entities with ratings of senior
unsecured long term debt in the third and fourth highest ratings
categories by and NRSRO; and 100% for entities with ratings for senior
unsecured long term debt below the highest rating categories.
(2) The net replacement value for each counterparty (including the
effect of legally enforceable netting agreements and the application of
liquid collateral) that is insolvent, or in bankruptcy, or that has
senior unsecured long-term debt in default.
The concentration charge is computed as follows: where the net
replacement value in the account of any one counterparty exceeds 25% of
the OTC derivatives dealer's tentative net capital, deduct the
following amounts: for couterparties with ratings for senior unsecured
long-term debt or commercial paper in the two highest rating categories
by an NRSRO, 5% of the amount of the net replacement value in excess of
25% of the OTC derivatives dealer's tentative net capital; for
counterparties with ranting for senior unsecured long-term debt in the
third and fourth highest rating categories by an NRSRO, 20% of the
amount of the net replacement value in excess of 25% of the OTC
derivates dealer's tentative net capital; and for counterparties with
ratings for senior unsecured long-term debt below the four highest
rating categories, 50% of the amount of the net replacement value in
excess of 25% of the OTC derivatives dealer's tentative net capital.
Aggregate Securities and OTC Derivatives Positions
Provide information for each affiliated broker-dealer in a separate
column, or complete a separate schedule for each affiliated broker-
dealer. In the event a separate listing of a position, financial
instrument or otherwise is required pursuant to any of the provisions
Sec. 240.17h-1T, the dealer should indicate as such in the appropriate
section of this schedule. Where appropriate, indicate long and short
positions separately.
Paperwork Reduction Act Disclosure
Part IIB of Form X-17A-5 requires an OTC derivatives dealer to file
with the Commission certain financial and operational information. The
form is designed to enable the Commission to ascertain the nature and
scope of a dealer's over-the-counter derivatives activity and to
monitor the dealer's financial condition and risk exposure.
It is estimated that an OTC derivatives dealer will spend
approximately 20 hours completing Part IIB of Form X-17A-5. Any member
of the public may direct to the Commission any comments concerning the
accuracy of this burden estimate and any suggestions for reducing this
burden.
The information collected pursuant to Part IIB of Form X-17A-5 will
be kept confidential.
This collection of information has been reviewed by the Office of
Management and Budget (OMB) in accordance with the clearance
requirements of 44 U.S.C. 3507. This collection of information has been
assigned Control Number 3235-0498 by OMB.
[[Page 59406]]
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a
currently valid number. Section 17(a) of the Securities Exchange Act of
1934 authorizes the Commission to collect the information on this Form
from registrants. See U.S.C. 78q.
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[FR Doc. 98-29007 Filed 11-2-98; 8:45 am]
BILLING CODE 8010-01-C
