98-29007. OTC Derivatives Dealers  

  • [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]
    
    
          
    
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    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
    
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    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
    
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    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
    
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    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)).
    ---------------------------------------------------------------------------
    
    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).
    ---------------------------------------------------------------------------
    
        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\
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        \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.
    ---------------------------------------------------------------------------
    
    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\
    ---------------------------------------------------------------------------
    
        \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).
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        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.
    ---------------------------------------------------------------------------
    
        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.
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        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\
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        \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.
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        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. 
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        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\
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        \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
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    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)).
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    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\
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        \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)).
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    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\
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        \103\ See Rules 3b-12(c) (17 CFR 240.3b-12(c)) and 15a-1(a)(3) 
    (17 CFR 240.15a-1(a)(3)).
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        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\
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        \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)).
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        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\
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        \105\ SIA Letter I, p. 8.
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        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.
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        \106\ EUDA Letter, p. 3.
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        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.
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        \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.
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        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.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        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\
    ---------------------------------------------------------------------------
    
        \114\ See Rule 15a-1(b)(4) (17 CFR 240.15a-1(b)(4)). The 
    Commission is not delegating this authority to its staff.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        \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\
    ---------------------------------------------------------------------------
    
        \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.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
         \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)).
    ---------------------------------------------------------------------------
    
        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\
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        \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\
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        \127\ See Section IV.F.2. of the Comment Summary.
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        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.
    ---------------------------------------------------------------------------
    
        \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.
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        \140\ 17 CFR 240.0-12.
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    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.
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        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).
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        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\
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        \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\
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        \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.
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        \164\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)).
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    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.
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        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\
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        \168\ SIA Letter I, pp. 11-12.
        \169\ DESCO Letter, p. 5.
        \170\ SIA Letter I, p. 12; DESCO Letter, p. 5.
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        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\
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        \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\
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        \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.
    ---------------------------------------------------------------------------
    
        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.
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    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\
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        \178\ See supra Section II.C.
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    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.
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        \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.
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        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\
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        \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.
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        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.
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        \187\ See Rule 15a-1(c) (17 CFR 240.15a-1(c)).
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    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\
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        \188\ 12 CFR 220.1.
        \189\ 12 CFR 220.1.
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        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.
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        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\
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        \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\
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        \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).
    ---------------------------------------------------------------------------
    
        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\
    ---------------------------------------------------------------------------
    
        \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.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        \207\ Proposing Release, Section III, 62 FR at 67952.
        \208\ SIA Letter II, p. 4.
        \209\15 U.S.C. 78k(a)(1).
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        \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.
    ---------------------------------------------------------------------------
    
        \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).
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        \217\ An unsecured receivable from an affiliated entity must be 
    deducted to the extent the receivable is not collateralized with 
    readily marketable securities.
    ---------------------------------------------------------------------------
    
        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\
    ---------------------------------------------------------------------------
    
        \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.
    ---------------------------------------------------------------------------
    
        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).
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        \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.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        \241\ See letters cited in Section V.A.2.b.i. of the Comment 
    Summary.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
    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.
    ---------------------------------------------------------------------------
    
        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.
    ---------------------------------------------------------------------------
    
        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.
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        \279\ 15 U.S.C. 78w(a)(2).
        \280\ 15 U.S.C. 78c(f).
    ---------------------------------------------------------------------------
    
        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\
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        \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\
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        \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.
    
    BILLING CODE 8010-01-W
    
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    [FR Doc. 98-29007 Filed 11-2-98; 8:45 am]
    BILLING CODE 8010-01-C
    
    
    

Document Information

Effective Date:
1/4/1999
Published:
11/03/1998
Department:
Securities and Exchange Commission
Entry Type:
Rule
Action:
Final rule.
Document Number:
98-29007
Dates:
The rules and rule amendments shall become effective on January 4, 1999.
Pages:
59362-59434 (73 pages)
Docket Numbers:
Release No. 34-40594, File No. S7-30-97
RINs:
3235-AH16: OTC Derivatives Dealers
RIN Links:
https://www.federalregister.gov/regulations/3235-AH16/otc-derivatives-dealers
PDF File:
98-29007.pdf
CFR: (33)
17 CFR 240.17a-12''
17 CFR 240.17a-11''
17 CFR 240.15a-1(d)
17 CFR 240.17a-11(e)
17 CFR 240.17a-5(h)(2)''
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