[Federal Register Volume 60, Number 242 (Monday, December 18, 1995)]
[Notices]
[Pages 65076-65087]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30660]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36573; File No. 600-27]
Self-Regulatory Organizations; Clearing Corporation for Options
and Securities; Order Approving Application for Exemption From
Registration as a Clearing Agency
December 12, 1995.
On December 14, 1992, the Clearing Corporation for Options and
Securities (``CCOS'')1 filed with the Securities and Exchange
Commission (``Commission'') an application for exemption from
registration as a clearing agency pursuant to Section 17A of the
Securities Exchange Act of 1934 (``Act'')2 and rule 17Ab2-1
thereunder.3 Notice of CCOS's application was published in the
Federal Register on June 23, 1993.4 Fourteen comment letters were
received in response to the notice of filing of the CCOS
application.5 On October 7, 1993, CCOS filed an amendment to its
application6 setting forth its intention to register Chicago Board
Brokerage, Inc. (``CBB'') as a U.S. government securities broker
pursuant to Section 15C of the Act7 and to proceed with CBB's
membership with the National Association of Securities Dealers
(``NASD'') as required by that section.8 Notice of the amendment
was published in the Federal Register on April 22, 1994, to solicit
comments.9 One hundred eleven comment letters were received in
response to the notice of filing of the amendment.10 This Order
grants CCOS's application for
[[Page 65077]]
exemption from registration as a clearing agency subject to certain
limitations and conditions as set forth below.
\1\CCOS is a wholly-owned subsidiary of the Board of Trade
Clearing Corporation (``BOTCC'') which provides clearing services
for futures and commodities transactions executed on the Board of
Trade of the City of Chicago (``CBOT'').
\2\15 U.S.C. Sec. 78q-1 (1988).
\3\17 CFR 240.17Ab2-1 (1994).
\4\Securities Exchange Act Release No. 32481 (June 16, 1993), 58
FR 34105 [File No. 600-27] (notice of filing of application for
exemption from registration as a clearing agency) (``CCOS
Release'').
\5\A complete list of comment letters for File No. 600-27 is
available for review in the Commission's Public Reference Room.
\6\Letter from Dennis Dutterer, Executive Vice President and
General Counsel, BOTCC, to Jonathan Katz, Secretary, Commission
(October 6, 1993). Letter from Fred Grede, Vice President, Board of
Trade of the City of Chicago (``CBOT''), to Brandon Becker,
Director, Division of Market Regulation (``Division''), Commission
(October 6, 1993).
\7\15 U.S.C. Sec. 78o-5 (1988).
\8\15 U.S.C. Sec. 78o-5(e)(1) (1988).
\9\Securities Exchange Act Release No. 33911 (April 15, 1994) 59
FR 19263 [File No. 600-27] (notice of filing of amendment to
application for exemption from registration as a clearing agency).
\10\Supra note 5.
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I. Description
A. Trade Clearance and Settlement
1. Overview
CCOS will provide clearance and settlement facilities for trades
executed by CBB and its customers in the CBB trading system.11 As
described in the amendment,12 CBB's business will be limited to
acting as an intermediary for U.S. government securities transactions
paired through its computer system.13
\11\CBB is a wholly-owned subsidiary of the CBOT and has
requested no-action relief from the Commission staff with respect to
the operation of the automated trading system for government
securities. Letter from Mark D. Young, Kirkland and Ellis, Counsel
for CBB, to Richard R. Lindsey, Division Director, Commission
(December 11, 1995). The staff issued a no-action letter to CBB
granting the relief requested and the Commission is issuing this
order based on its belief that CBB is in compliance with the terms
and conditions of the no-action letter. Letter from Richard R.
Lindsey, Division Director, Commission, to Mark D. Young, Kirkland
and Ellis, Counsel for CBB (December 12, 1995).
\12\Supra note 6.
\13\The government securities listed for purchase or sale
through the CBB system will consist of U.S. Treasury bills, notes,
and bonds in their various maturities which are deliverable under
financial futures contracts traded on the CBOT.
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The CBB trading system is designed to offer CBOT members an
opportunity to execute a customized package of transactions related to
Treasury futures contracts traded on the CBOT.14 The system will
permit the trading of government securities, independently and in
conjunction with CBOT futures on government securities (``basis
trades''),15 and repurchase and reverse repurchase agreement
contracts in government securities (``dollar rolls'').16 Using the
CBB trading system, therefore, CBOT traders in government securities
will be able to buy and sell the government securities underlying CBOT
futures contracts and using dollar rolls will be able to execute trades
that help inventory management. CBB will execute transactions for
system participants as broker. All trades will be effected through the
CBB's electronic network. The settlement date for outright purchase and
sale transactions will be the next business day except for when-issued
(``WI'') securities which will settle on the day of issuance by the
U.S. Treasury.
\14\Only CBOT individual members, employees of individual
members, and employees of CBOT member firms will be permitted to
operate terminals. Each terminal will be uniquely identified in its
communication with the central site, and each terminal operator will
be assigned an identification number. CBB will maintain complete,
time-sequenced electronic audit trails on all orders entered on, and
all transactions executed through, the CBB trading system. The
recorded activity will indicate, for a given order or transaction,
the identity of the terminal operator entering, changing, or
cancelling orders, the time such entry or change was effected, and
the date, time, volume, security, and price of each transaction
executed through the trading system.
\15\A basis trade is a trade in which the participants agree to
simultaneously buy or sell government securities against the
offsetting equivalent CBOT treasury futures contract. The basis
represents the price differential between a government security and
the futures delivery price.
\16\In a dollar roll transaction, the seller of the contract
delivers notes or bonds to the buyer in exchange for cash.
Settlement occurs the same day. At the time of execution, the seller
and buyer also agree to reverse the transaction at a price that
includes a financing interest amount with settlement occurring the
next day.
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Under the terms of the proposal, any CCOS participant or any
customer of a CCOS participant that is also a CBOT member or member
firm (hereinafter collectively referred to as a CBOT member) will be
able to obtain a CBB trading terminal.17 Each CCOS participant
will be required to enter into an agreement with CBB setting forth the
terms and conditions of access to and use of CBB's terminals. Using a
CBB terminal, a terminal operator will be able to view the terminal
displays to see the prices and quantities of current bids and offers,
which are displayed on an anonymous basis, and to review its trading
activity.
\17\The Board of Directors of CCOS may permit other clearing
agencies registered with the Commission or that are exempted from
registration by the Commission access to some or all of the services
offered by CCOS according to terms and conditions prescribed by the
Board of Directors. Clearing agencies that are granted access to
CCOS's services pursuant to CCOS Rule 309 will not be considered
participants of CCOS under the rules except as determined by the
Board of Directors. Letter from John C. Hiatt, President and Chief
Executive Officer, BOTCC, to Jonathan Kallman, Associate Director,
Commission (September 13, 1994).
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CBB is developing several methods for market participants to access
the CBB trading system. CBB will: (1) provide CBOT work station
terminals which will access the CBB trading system and include other
market information and trading systems available through the
CBOT;18 (2) provide an interface between CBB's central computer
and a CBOT member's internal computer network; and (3) provide access
through an interface with quotation vendors.19
\18\The CBB trading system is based on a modification of the
CBOT's Project A trading system. Project A, available to CBOT
members, is an electronic order entry facility developed to allow
trading over a local area network (for example, within the CBOT
building) of CBOT's futures contracts, options on futures contracts,
and other financial products. The Project A system is designed to
facilitate trading by active order matching or through the posting
of bids/offers on an electronic bulletin board.
\19\Quotation vendors will offer CBB trading screens and order
entry capability through their terminals which are served by
national telecommunications networks. CBB will contract on a
nonexclusive basis with one or more quotation vendors, each having
interactive capabilities, to carry the CBB system for use by CBOT
members.
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The system will permit users to execute basis trades as a single
transaction where the price will reflect the spread in basis points
between the futures contract and the underlying government securities.
The government securities will be priced at a certain number of basis
points above or below the futures contract.20
\20\The futures leg of the basis trade will take the last
reported trade price from the CBOT trading floor as the futures
transaction price. The transaction ticket for the government
securities leg of basis trades will include the commission charges
and accrued interest. Settlement for the government securities leg
will occur on the next business day in the same manner as outright
government securities trades.
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The system also will provide users with the ability to execute
dollar roll transactions. Dollar roll transactions are designed to
facilitate the financing of government securities through the lending
of government securities in exchange for cash and to facilitate the
lending of funds in exchange for government securities.21 Dollar
rolls will result in the creation of two simultaneous government
trades.
\21\The CBB terminals will list the dollar roll spreads through
bid and offer financing rates reflecting the annualized interest
rates paid or received on the transactions. The transaction amount
or value price on the trade date will reflect the settlement value
of the first leg of the dollar roll. The settlement value is the
amount of funds required to make or take delivery of the security.
The transaction amount for the second leg of the dollar roll will
reflect the fact that the holder of the overnight bond will not earn
the coupon interest during the term of the transaction.
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CBB will have a morning trading session for dollar rolls from the
opening of trading at 8:00 a.m. to 11:00 a.m. and an afternoon session
for dollar rolls from 3:15 p.m. to 5:00 p.m.22 For dollar rolls
executed during the morning session, the first leg will be for same day
(``T'') settlement, and the second leg will be for next day (``T+1'')
settlement. For dollar rolls executed during the afternoon session, the
first leg will settle on T+1, and the second leg will settle on the
following business day (``T+2'').
\22\Unless otherwise noted, all times stated are Eastern
Standard Time.
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CBB will match member trades and will submit the matched trades to
CCOS on a real time basis so that trade data executed through CBB
immediately flows to CCOS.23 CCOS will perform the
[[Page 65078]]
clearance and settlement functions for transactions executed through
CBB, including: delivery versus payment processing, position
consolidation, and original and variation margin calculation and
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processing as discussed below.
\23\CBB will create, operate, and maintain the computer system
that enables orders to be entered and executed. CBB has developed
trade matching software for U.S. Treasury bills, notes, and bonds,
including when-issued securities, basis trades, and dollar rolls.
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2. CCOS & BOTCC Cross-Margining Agreement
CCOS and BOTCC will establish a cross-margining arrangement whereby
all CCOS members, all of which are BOTCC members or CBOT members
affiliated with a BOTCC member, will hold certain futures and
government securities cleared by the respective clearing organizations
in special cross-margin accounts.24 All futures positions will be
held at BOTCC, and all government securities will be held at CCOS.
Government securities and futures held in the cross-margin accounts at
the respective clearing organization will be margined as if held in a
single account based upon the net risk of the positions. To facilitate
the cross-margining arrangement, CCOS and BOTCC will establish
procedures whereby CCOS and BOTCC each will have a security interest in
the positions held in the cross-margin accounts to secure all
obligations of the clearing members arising in connection with those
positions.
\24\Because all CCOS members are also BOTCC members or CBOT
members affiliated with a BOTCC member, all accounts at CCOS are
cross-margin accounts.
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B. System Safeguards
1. Margin Payment/Collection
CCOS will adopt, as one of its principal safeguards, a practice of
collecting original margin and variation margin on participant
obligations.25 In essence, CCOS will use the margin calculation
and payment time frames currently used by BOTCC in connection with its
clearance of CBOT futures contracts.26 CCOS will modify BOTCC's
margining system to address risks specific to the U.S. government
securities market.
\25\Original margin represents a performance bond that both
buyers and sellers must post when executing trades to assure that
their respective contractual obligations will be satisfied.
Variation margin is a mark to the market payment collected on a
twice daily basis to account for changes in the value of the
positions before the delivery process.
\26\BOTCC collects clearing member margin on a portfolio, or net
basis, reflecting the overall risk to the clearing corporation
associated with the totality of contracts in that clearing member's
portfolio. BOTCC uses a portfolio-based simulation model, the
Standard Portfolio Analysis (``SPAN'') system, which establishes
parameters to collect original margins based on the simulated losses
of clearing member portfolios under various scenarios.
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CCOS will calculate margin requirements at least twice daily, with
one calculation reflecting trading activity occurring from the 8:00
a.m. opening to 1:30 p.m. and with another calculation reflecting
trading activity from 1:30 p.m. to 5:00 p.m. CCOS will collect margin
deficiencies arising from participants' morning trading activity at
4:00 p.m. on that trade date (``T'') and will collect margin
deficiencies arising from participants' afternoon trading activities at
7:40 a.m. on T+1. In the event a clearing member fails to perform its
obligations to CCOS, the original margin will be used to cover any
financial liabilities which may result from the failed obligation. CCOS
will retain the authority to collect additional margin at any
time.27
\27\BOTCC, as facilities manager, will perform all margin
collection/payment functions on behalf of CCOS. CCOS will collect
commissions and settlement payments through its agent, the Bank of
New York.
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In order to margin government securities and futures positions in a
parallel fashion, CCOS will convert government securities to futures
contract equivalents prior to original margin determination.28
CCOS will convert government securities positions to futures-
equivalents based upon conversion factors established and published by
the CBOT for the most similar futures delivery month and the most
similar futures contract par amounts (i.e., face values).29 CCOS
will net the futures-equivalent positions of all government securities
deliverable with the corresponding futures contracts to produce a net
futures-equivalent position.30 The performance bond for all trades
generally will be collected at 7:40 a.m. on T+1.
\28\In establishing the original margin for government
securities it clears, CCOS began with the premise that cross-
margined government securities and futures products have essentially
the same market and credit risks. Therefore, CCOS will use the
original margin rates for futures contracts established by the Board
of Governors of BOTCC following recommendations of the BOTCC Risk
Management Committee.
The BOTCC Risk Management Committee is comprised of five of the
nine Governors of the BOTCC Board of Governors. All nine Governors
are owners or officers of BOTCC clearing member firms. The BOTCC
Risk Management Committee meets once a month or at the call of the
BOTCC Board Chairman or the Risk Management Committee Chairman. The
Committee bases its recommendation upon review by BOTCC and CBOT
staff of the conditions of the market place, including: statistical
analysis of central tendencies, dispersion, and correlations between
price changes of different commodities. Additionally, the Committee
draws upon the experiences of its members and uses their judgement
to predict market conditions in the near future. From this
information, the Risk Management Committee will typically set margin
rates that cover approximately the 99th percentile of absolute daily
price changes over the previous one, three, and six month periods.
\29\The formula for the conversion of government securities is:
Futures-Equivalents=Government Securities Par
Amounts x Conversion FactorFutures Par Amount
Since bonds being delivered into futures contract obligations
will have greater or lesser value than the futures, the conversion
factor is a means of equating bonds with various coupons and
maturity dates with the standard bond set by BOTCC. The standard
bond, which is equal to the corresponding future, has an 8% coupon
and a conversion factor of 1.
For example, assume there are two bonds, Bond X and Bond Y. Bond
X is the standard bond having an 8% yield to maturity and conversion
factor of 1 (Bond X is equal to the corresponding future). Bond Y is
worth 1.5 times Bond X (Bond Y could have greater coupon rates or a
longer period to maturity). If the future is trading at 85, then
Bond X is worth 85, and Bond Y is worth 1.5 times 85. Therefore, 1.5
is the conversion factor for Bond Y. In order to determine the
number of futures that equate with Bond Y, the face amount of Bond Y
is multiplied by the conversion factor, producing the futures value
amount. The futures value amount is then divided by 100,000 (each
futures contract equals $100,000) to give the number of futures
contracts equal to the bond.
\30\Futures on government securities act as an index of the many
bonds deliverable into them. Treasury bonds (``T-bonds'') having at
least fifteen years remaining to maturity are deliverable into the
T-bond future. Ten-year Treasury notes (``T-notes'') must have
maturities between six and one-half and ten years to be deliverable
into the ten-year T-note future. Five-year T-note futures accept
Treasury notes with time to maturity between four years, three
months and five years, three months. Two-year notes having
maturities between one year, nine months and two years are
deliverable into the two-year T-note future.
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CCOS will calculate each participant's variation margin pay/collect
amount and transmit the data to BOTCC for margin payment or collection.
Payment or collection amounts for each participant will include the
combined variation effects of the government securities and futures
positions in the participant's cross-margined account. Participants
will pay or collect midday variation margin in same-day funds by 4:00
p.m. each day, through their settlement banks. BOTCC will pay out 80%
of variation gains in excess of original margin deficits31 and
will collect 100% of variation losses.
\31\CCOS will withhold distribution of any variation margin
gains from participants with original margin requirement deficits.
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2. Settlement Values
At 3:00 p.m., CCOS will establish a settlement value for government
securities trades executed between 8:00 a.m. and 1:30 p.m. That value
will be based on the prices collected at 2:30 p.m. from GovPx, a
government securities pricing vendor. CCOS will mark new positions from
their transaction value,32 which will be
[[Page 65079]]
established at the execution of the trade, to their settlement
value,33 which will reflect gains or losses in the interim period,
and CCOS will mark open positions that were previously marked to the
prior day's settlement value to the new settlement value.
\32\The transaction value provided by CBB to CCOS will include
the accrued interest paid or received on each transaction. For
normal deliveries the accrued interest at the time of the
transaction and at marking to market are the same amount, but for
failed deliveries, the seller will have to pay the incremental
accrued interest for each day the fail continues. The daily
variation margin payments will include this incremental accrued
interest.
\33\Settlement values will reflect the settlement price
established twice a day and will include accrued interest but will
not include commissions and finance charges from dollar rolls.
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Trades executed from 1:30 p.m. through the 5:00 p.m. end of the
day's trading session will be marked to the 3:00 p.m. settlement value,
and the variation margin on the entire position will be calculated at
the end of the day. Participants will pay or collect the second
variation margin obligation the following morning at 7:40 a.m. CCOS
will send delivery instructions for normal settlement of government
securities transactions executed on T to the participants' settlement
banks at 11:30 a.m. on T+1.34
\34\Participants may transact dollar rolls (with same-day
settlement for the first leg) between 8:00 a.m. and 11:00 a.m. on
T+1 to offset delivery obligations due to settle on T+1.
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3. Loss Allocation and Liquidity Sources
CCOS will begin operations with an initial capitalization of $2
million. Together with CCOS's earnings, BOTCC will commit to provide
CCOS with additional capital as necessary to cover CCOS's continuing
costs of operations. Because CCOS will rely on BOTCC for certain
liquidity resources and because BOTCC's capital and credit lines are
committed to its futures business, BOTCC has agreed to dedicate
specific credit and financial resources to CCOS, and CCOS and BOTCC
have established a framework for allocating losses arising from cross-
margined accounts between the two entities.
With respect to liquidity, CCOS will establish a committed credit
facility which will be guaranteed by BOTCC. The credit facility
initially will be $5 million and will be increased in increments of $5
million for each $1 billion increase in CCOS's daily average net
settlements of government securities transactions over a ninety day
period. When the credit facility reaches $30 million as a result of
daily average net settlements of government securities reaching $6
billion, CCOS will review the size of the credit facility in
consultation with the Division staff.35
\35\As discussed below, $6 billion is the maximum average daily
net settlements of transactions in government securities agreed to
by CCOS and the Division during the exemptive period. Also as agreed
to by CCOS and the Division, CCOS's operations will be limited to a
maximum of $24 billion average daily net settlements of dollar
rolls.
These limits represent approximately five percent or less of
government securities and average daily volumes in dollar rolls. The
Commission believes these limits are appropriate at this time in
that they are large enough to allow CCOS to commence effective
operations yet of a limited nature that allows the Commission to
observe the effects of the CCOS clearing and settlement activities
on the government securities market.
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With respect to loss allocation, under the cross-margining
arrangement between CCOS and BOTCC, all government securities positions
cleared by CCOS will be maintained in a cross-margin account for which
BOTCC and CCOS have agreed to assume joint responsibility in the event
that a default or failure to settle occurs and there is a shortfall in
that account. BOTCC and CCOS each are guaranteeing up to 50% of the
obligations owed to each other with respect to a defaulting
participant's cross-margin account after use of the original margin
deposits of the participant and proceeds from the liquidation of the
participant's positions. Therefore, CCOS will have adequate resources
to protect itself and to fulfill its settlement obligations for a loss
up to at least $60 million.36
\36\I.e., $30 million from CCOS's guaranteed credit facilities
(repayment of which is guaranteed by BOTCC) plus $30 million from
BOTCC under its guarantee of cross-margining losses.
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II. Comment Letters
Public comment both supported and opposed CCOS's
application.37 More than sixty commenters, including several
common members of the Government Securities Clearing Corporation
(``GSCC'') and CCOS, supported the proposal. More than forty commenters
opposed the proposal, raising three basic arguments as to why the
Commission should deny the exemption request.38 These arguments
include the potential fragmentation of clearance and settlement
facilities for the U.S. Treasury market the concern that exempting CCOS
will mean ineffective and unequal regulation of clearing facilities for
those securities, and the concern that approval of CCOS will not
promote fair competition among clearing agencies. CCOS filed several
responses to the comments.39
\37\Supra note 5.
\38\Commenters raised additional issues in opposition to CCOS's
application. These issues included the concern that the introduction
of CCOS as another government securities clearing agency would
result in an increase in costs for U.S. Treasury brokers and the
concern that in the future decisions at GSCC will be made based on
the fear of losing potential customers to CCOS rather than based on
the best interest of the participants. With regard to the first
point, the Commission believes that if in fact any increase in costs
results from granting CCOS's exemption application, the benefits to
the government securities market, such as innovation arising from
competition, will outweigh any such costs. With regard to the second
point, while the Commission believes that GSCC will continue in the
future to base its decisions on what is in the best interest of its
participants and the government securities market and not on any
fear of losing current or potential participants, commenters should
be comforted by the fact that GSCC is subject to Section 19(b) of
the Act which requires SROs to file with the Commission any proposed
changes to their procedures, operations, or rules.
\39\The comment letters and CCOS's responses are discussed in
detail in the Discussion section of this order.
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The Commission received two letters from the Commodity Futures
Trading Commission (``CFTC'') regarding CCOS's application.40
BOTCC, as a futures clearing organization, is subject to regulation by
the CFTC under the Commodity Exchange Act (``CEA''); therefore, the
Commission carefully considered the comments of the CFTC regarding
CCOS's application. In its first letter to the Commission,41 the
CFTC noted that because of its position as the regulator of BOTCC, it
would have to consider and address the potential impact of CCOS's
activity on the financial integrity of BOTCC and on the futures market
for which it clears. Specifically, the CFTC was concerned with BOTCC's
role as a guarantor of CCOS's obligations and the impact on BOTCC's
financial integrity of any minimum capitalization or other requirements
imposed on CCOS by the Commission.42 The CFTC also stated that any
arrangements presenting cross-jurisdictional issues between the CFTC
and the Commission would require approval by both agencies. This would
include cross-margining programs, the imposition of clearing limits
and/or minimum margin requirements, and futures/cash basis trades
traded on the CBB and cleared through BOTCC and CCOS. The CFTC urged a
cooperative effort between itself and the Commission to avoid
duplicative or inconsistent regulation being imposed on the affected
entities.
\40\Letters from Jean A. Webb, Secretary, CFTC, to Jonathan G.
Katz, Secretary, Commission (July 23, 1993 and May 31, 1994).
\41\Letter from Jean A. Webb (July 23, 1993), supra note 40.
\42\Ultimately, this concern was alleviated by changing the
general BOTCC guarantee to a guarantee of a limited committed credit
facility. Refer to ``BOTCC Guarantee'' above.
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The CFTC's second letter43 responded to CCOS's amended
application in which CBOT set forth its intention to register CBB as a
government securities broker and its willingness to enter into certain
linkage arrangements with GSCC. The CFTC noted that the proposal to
enter into a linkage
[[Page 65080]]
arrangement with GSCC could have positive effects on the government
securities market, that the CBB/CCOS amended proposal could increase
competition among market participants, that the CBB electronic trading
system would provide government securities market participants with
easier access to market information, and that the registration of CCOS
as a clearing agency might lower the level of risk present in the
government securities market. While the CFTC's comments were generally
positive, it also reiterated its regulatory interests and the need to
review the potential impact of the various arrangements on BOTCC's
financial integrity and to assure compliance with the CEA.
\43\Letter from Jean A. Webb (May 31, 1994), supra note 40.
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The Commission recognizes the validity of the CFTC's concerns and
understands the importance of coordinating efforts among all regulators
concerned with the government securities market. The Commission will
continue to coordinate with these regulatory agencies to safeguard one
of the world's largest securities markets.
III. Discussion
A. Overview
The Commission is granting CCOS's application for exemption subject
to the conditions described below. The Commission believes such action
is consistent with the Act including the goals of fostering cooperation
and coordination with persons engaged in the clearance and settlement
of securities transactions, removing impediments to and perfecting the
mechanism of a national system for the prompt and accurate clearance
and settlement of securities transactions, and protecting investors and
the public interest.
As noted above, CCOS proposes to provide clearing facilities in
support of CBB's and CBOT's proposals. CBB's proposed automated trading
system for government securities represents an effort to make
government securities more readily available to CBOT members that trade
futures on government securities and thereby improves the efficiency of
arbitrage between the futures and cash markets and potentially
increases liquidity in both of those markets. Traders in these markets
often are called upon to accept position or market risks from
participants in the market for government securities. The market for
U.S. Treasury bonds, bills, and notes is the deepest, most liquid
market in the world. While these securities are traded all over the
world, the primary U.S. marketplace involves a core group of dealers,
brokers' brokers, banks, and institutional investors that trade
extensively among themselves over-the-counter. These market
participants often rely on futures markets, such as the CBOT, for their
derivative products as a way to transfer to traders on these markets
position and market risks related to U.S. government securities.
Traders on the futures exchanges, in turn, must be able to buy and sell
government securities to help manage their own risk and position
exposures efficiently.
Approval of the CCOS application will allow CCOS and its parent,
BOTCC, to provide the clearance and settlement services that are
necessary to support the CBB and CBOT proposals. This in turn should
help foster greater integration of clearing facilities that serve the
futures market and the underlying cash markets and should facilitate
the development of cross-margin facilities between those markets. BOTCC
already has extensive arrangements with its clearing bank network to
receive and deliver government securities among its clearing members,
and its clearing members maintain government securities at those banks
for their proprietary and customer accounts. As described above, CCOS
plans to build on those arrangements in providing its services in
support of CBB. Exempting CCOS from clearing agency registration should
allow CBB to move forward with its proposal and should allow CCOS and
BOTCC to obtain greater experience in managing risk exposures before
taking on self-regulatory responsibilities that would otherwise
accompany clearing agency registration.
Because many of CCOS's likely users are GSCC members and use GSCC's
services to clear and settle trades among themselves, a linkage among
CCOS, BOTCC, and GSCC to facilitate efficient clearance of trades is
essential.44 To this end, the Boards of Directors of GSCC, BOTCC,
and CCOS have been requested to establish a joint user committee to
settle the outstanding linkage and cross-margining issues and to report
to the GSCC, BOTCC, and CCOS Boards the committee's proposal for
linkage and cross-margining within three months of formation of the
committee.45
\44\Market Reform Act of 1990, S. Rep. 101-300 at 58-62.
President's Working Group on Financial Markets, Interim Report,
Appendix D (May 1988).
\45\Letter from Richard R. Lindsey, Division Director,
Commission, to John G. Macfarlane III, Chairman of the Board, GSCC,
and David Johnson, Chairman of the Board, BOTCC (December 12, 1995).
The Commission believes it is appropriate for CCOS to begin limited
operations prior to the implementation of such arrangements because
these arrangements, while important to coordinating GSCC's and
CCOS's systems, are not necessary for CCOS to commence operations.
The Commission will monitor closely efforts in this regard and
expects prompt action to implement linkages and cross-margin systems
that are acceptable to the common membership so that appropriate
linkages are in place when warranted. If it does not appear after six
months that the parties are able to agree to establish appropriate
linkage and cross-margining facilities, the Commission will consider
whether to mandate the development of linkage and cross-margining
facilities. If necessary, the Commission will use its authority under
the Act to direct that the responsible parties act in their best
interests to establish ``linked or coordinated facilities for clearance
and settlement of transactions in securities * * * [and] contracts of
sale for future delivery * * *.''46
\46\15 U.S.C. Secs. 78q-1 (a)(2)(A)(ii) and (d)(1) (1988).
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Approval of the application also should help foster innovation in
clearance and settlement of government securities. The CCOS proposal
will provide central clearing facilities for dollar rolls, which
represent a type of repurchase agreement transaction. CCOS's proposal
was one of the first formal responses to the recommendations of the
1992 Joint Report on the Government Securities Market,47 and the
Commission believes that the CCOS proposal may well have encouraged
others, including GSCC, to develop similar or wider services.
\47\Joint Report on the Government Securities Market, issued by
the Department of Treasury, the Securities and Exchange Commission
and the Board of Governors of the Federal Reserve System (January
1992) at 31 (recommending that an efficient processing system for
government securities repo activity be developed).
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B. Section 17A of the Act
1. Grant of Exemption
Section 17A(b)(1) of the Act authorizes the Commission to exempt
applicants from some or all of the clearing agency requirements of
Section 17A if the Commission finds such exemptions are consistent with
the public interest, the protection of investors, and the purposes of
Section 17A including the prompt and accurate clearance and settlement
of securities transactions and the safeguarding of securities and
funds.48 While the
[[Page 65081]]
Commission has never exercised its authority to exempt an applicant
entirely from the requirements of Section 17A, it has granted newly
registered clearing agencies narrowly drawn, temporary exemptions from
specific statutory requirements imposed by Section 17A in a manner that
achieves those statutory goals.49
\48\For legislative history concerning Section 17A of the Act,
see, e.g., Report of Senate Comm. on Housing and Urban Affairs,
Securities Acts Amendments of 1975: Report to Accompany S. 249, S.
Rep. No. 75, 94th Cong., 1st Sess., 4 (1975); Conference Comm.
Report to Accompany S. 249, Joint Explanatory Statement of Comm. of
Conference, H.R. Rep. No. 229, 94th Cong., 1st Sess., 102 (1975).
\49\E.g., in the Commission's order approving GSCC's temporary
registration as a clearing agency, the Commission temporarily
exempted GSCC from compliance with the statutory standards of
Sections 17A(b)(3)(B) and 17A(b)(4)(B) of the Act regarding a
clearing agency's rules designating classes of participants and the
standards used by the clearing agency to determine participation.
The Commission also exempted GSCC from Section 17A(b)(3)(C)
regarding fair representation of clearing agency participants in the
selection of its directors. Securities Exchange Act Release No.
25740 (May 24, 1988), 53 FR 19839.
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The market break in October 1987 and the markets' decline in
October 1989 demonstrated the central role of clearing agencies in U.S.
securities markets in reducing risk, improving efficiency, and
fostering investor confidence in the markets.50 In light of the
foregoing, the Commission believes it is appropriate for applicants
requesting exemption from clearing agency registration to meet
standards substantially similar to those required of registrants in
order to assure that the fundamental goals of Section 17A (i.e., safe
and sound clearance and settlement) will be achieved.
\50\Gerald Corrigan, President of the Federal Reserve Bank of
New York (``FRBNY''), noted: ``[T]he greatest threat to the
stability of the financial system as a whole [during the 1987 market
break] was the danger of a major default in one of these clearing
and settlement systems.'' Luncheon Address: Perspectives on Payment
System Risk Reduction by E. Gerald Corrigan, President, FRBNY,
reprinted in The U.S. Payment System: Efficiency, Risk and the Role
of the Federal Reserve 129-30 (1990).
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Because the Commission believes that CBB and CCOS will promote
innovation in the trading and clearing of government securities and
will further the integration of the futures and government securities
markets, it is approving CCOS's application for exemption in order that
CCOS may begin limited operations without meeting the entire panoply of
clearing agency registration requirements.51 Although, as
described below, CCOS is being held to substantially the same standards
as other registered clearing agencies, certain areas of CCOS's
operation require further development before CCOS can be considered for
registration under Section 17A of the Act. The Commission believes that
granting CCOS an exemption from registration subject to the regulatory
requirements and Commission oversight on CCOS during the exemptive
period should allow CCOS to further develop its system for clearing and
settling government securities in a safe and sound manner before its
seeks full registration as a clearing agency. In granting CCOS an
exemption from clearing agency registration, the Commission believes
that such an exemption is consistent with the requirements of Section
17A and that the framework of the exemption is such that the Commission
retains adequate regulatory power and oversight to ensure that CCOS's
services do not pose a threat to the stability of the government
securities markets.
\51\Section 17A, as amended by the Market Reform Act, directs
the Commission to use its authority to facilitate the establishment
of linked or coordinated facilities for clearance and settlement of
transactions in securities, securities options, contracts of sale
for future delivery and options thereon, and commodity options.
[Market Reform Act of 1990, Sec. 5, amending Sec. 17A(a)(2) of the
Securities Exchange Act of 1934, 15 U.S.C. 78q-1 (1990)].
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The Commission is imposing significant limits on CCOS as set forth
below.52 Should CCOS determine that a change in its operations or
procedures is necessary, CCOS will be required pursuant to this
exemptive order to amend its CA-1 and request that the Commission
modify the exemptive order. The Commission's oversight of CCOS, in
conjunction with the CFTC's oversight responsibilities of BOTCC, should
help nurture the establishment of safety mechanisms, such as cross-
margining, that further the goals of competition and integration in the
government securities and futures markets. Furthermore, as competition
leads to innovation and progress, the Commission believes CCOS's entry
into the clearance and settlement of government securities should be a
positive step towards the continued development of the world's largest
government securities market.
\52\The limits are described in Section III., Part D.,
Conditions.
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2. Registration Standards
Before granting registration to a clearing agency, Section 17A of
the Act requires that the Commission make a number of determinations
with respect to the clearing agency's organization, capacity, and
rules. Paragraphs (A) through (F) of Section 17A(b)(3) set forth
general criteria which a clearing agency must satisfy in order to be
registered. Congress reserved to the Commission the task of making
specific determinations as to whether an applicant's organization,
capacity, and rules satisfy the general criteria. In Securities
Exchange Act Release No. 16900, the Division set forth its views and
positions concerning satisfaction of the general criteria (``Standards
Release'').53
\53\Securities Exchange Act Release Nos. 16900 (June 17, 1980),
45 FR 41920 (announcement of standards for the registration of
clearing agencies) and 20221 (September 23, 1983), 48 FR 45167
(omnibus order granting full registration as clearing agencies to
The Depository Trust Company, Stock Clearing Corporation of
Philadelphia, Midwest Securities Trust Company, The Options Clearing
Corporation, Midwest Clearing Corporation, Pacific Securities
Depository, National Securities Clearing Corporation, and
Philadelphia Depository Trust Company).
Refer also to Section 19 of the Act, 15 U.S.C. 78s (1988), and
Rule 19b-4, 17 CFR 240.19b-4 (1992), setting forth certain
procedural requirements for registration and continuing Commission
oversight of clearing agencies and other self-regulatory
organizations.
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These statutory standards are designed to assure the safety and
soundness of the clearance and settlement system. As previously stated,
the Commission, in granting CCOS's exemption is requiring CCOS to meet
in substantial form these same statutory standards and is satisfied
that CCOS's operation will not be a threat to the safety or soundness
of the national market system. Furthermore, the Commission will
continue to monitor CCOS's operations to assure its soundness in the
clearance and settlement of government securities.
a. Safeguarding of Securities and Funds
Sections 17A(b)(3) (A) and (F) of the Act require a clearing agency
be organized and its rules designed to facilitate the prompt and
accurate clearance and settlement of securities transactions for which
it is responsible and to safeguard securities and funds in its custody
or control or for which it is responsible.54 The Commission
believes that CCOS meets these standards. Among other things, CCOS will
maintain appropriate audit and internal controls55 and will make
available
[[Page 65082]]
reports to participants concerning its internal accounting
controls.56 In addition, CCOS has developed several procedures to
safeguard securities and funds; prevent loss or destruction of
securities, funds, or data; and to recover from losses that do
occur.57
\54\15 U.S.C. 78q-1(b)(3) (A) and (F) (1988).
In addition to BOTCC's responsibilities as facilities manager,
CCOS must assure itself that BOTCC complies with all of the
safeguards, as appropriate, set forth in the section of the
Standards Release regarding the safeguarding of securities and funds
and prompt and accurate clearance and settlement of securities
transactions; and that these operations will be subject to
examination by CCOS's independent public accountant, the Commission
and the appropriate regulatory agency to the same extent as in the
case of a clearing agency which carries out its own processing.
Standards Release, supra note 53.
\55\Clearing agencies should have an audit committee which
selects or makes recommendations to the Board of Directors of the
clearing agency regarding the selection of the clearing agency's
public accountant. CCOS Rule 213 requires the establishment of an
audit committee consisting of at least three nonmanagement directors
of CCOS. The committee will, among other things, make
recommendations to the Board of Directors regarding the selection of
CCOS's independent public accountants.
CCOS proposes to employ outside independent auditors rather than
establish an internal audit department for CCOS. The outside
independent auditors will perform those duties typically performed
by an internal audit department and will report to the audit
committee, and conduct audit reviews as requested by the audit
committee, but not less than once per fiscal year. The Commission
believes that CCOS's method of establishing an audit committee and
its use of outside independent auditors meets the requirements of
the Act. Although the Standards Release recommends the use of an
internal audit department, the Commission has on previous occasions
found the use of outside auditors acceptable and falling within the
requirements of the Act. See Securities Exchange Act Release No.
27611 (January 12, 1990), 55 FR 1890 (order granting Delta
Government Options Corp. temporary registration as a clearing
agency).
\56\The Standards Release noted that the objectives of internal
accounting control are presumed to be a fundamental aspect of
management's responsibilities. CCOS proposes to direct its
independent public accountants to prepare an annual report on CCOS's
system of internal accounting controls, and present the report to
the CCOS Board of Directors. CCOS's proposal to use independent
public accountants to produce an annual report on its system of
internal accounting controls meets the requirements of the Act with
regard to the security and accuracy requirements under Section
17A(b)(3) (A) and (F) because it aids in assessing the safety and
integrity of the clearing agency operations and promotes confidence
and increased participation in the national clearance and settlement
system.
\57\CCOS proposes three levels of safeguards to prevent or
minimize interruption of service as a result of hardware, systems
software, or applications software failures. The first level
addresses procedural practices within CCOS to control migration of
changes in application systems to the production environment and the
implementation of new systems. The second and third levels address
interruptions in service due to equipment and systems software
failures at different levels of severity, i.e. short and long term
interruptions.
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i. Organization and Processing Capacity
A clearing agency should be organized in a manner that effectively
establishes operational and audit controls while fostering director
independence.58 As in the example set forth in the Standards
Release, CCOS meets these standards by keeping its Board of Directors
informed of its operations and the impact that new or expanded services
or volume increases would have on its processing capacity. CCOS also
will keep its Board of Directors informed by reporting on periodic risk
assessments of CCOS's operations, automated data processing systems,
and facilities and by supervising the establishment, maintenance and
updating of safeguards.59 The Commission is satisfied that CCOS's
organizational and processing capacity meets the requirements of the
Act, explained in the Standards Release, by providing a necessary flow
of information to its Board of Directors which will allow it to oversee
management's performance and to assure the operational capability and
integrity of CCOS.
\58\Standards Release, supra note 53.
\59\For a detailed description of the Commission's policy on
self-regulatory organization systems reviews, refer to Securities
Exchange Act Release No. 29185 (May 9, 1991), 56 FR 22490 [File No.
S7-12-91] (release setting forth the Commission's second automation
review policy statement [``ARP II'']).
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ii. Financial Reports
Participants that have made clearing fund contributions or have
money or securities in a clearing agency's system should receive
timely, audited annual financial statements. CCOS meets the
requirements regarding financial reports, and the distribution of
financial statements will enable CCOS's Board of Directors and
participants to remain apprised of the clearing agency's financial
condition and the adequacy and accuracy of its records.60 By
making the financial statements available, CCOS is assisting the
Commission and other appropriate regulatory agencies in the discharge
of their regulatory responsibilities by facilitating access to
important information that is necessary in evaluating the safety and
soundness of clearing agencies.
\60\CCOS Rule 214 states that within 60 days after the end of
each of the Corporation's fiscal years, CCOS shall deliver to each
participant unconsolidated audited financial statements for the
fiscal year then ended covered by a report prepared by CCOS's
independent public accountants. CCOS Rule 214 also states that upon
request by any participant, CCOS shall deliver unconsolidated,
unaudited quarterly financial statements.
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b. Fair Representation
Section 17A(b)(3)(C) of the Act requires that the rules of a
clearing agency provide for fair representation of the clearing
agency's shareholders or members and participants in the selection of
the clearing agency's directors and administration of the clearing
agency's affairs. This section contemplates that users of a clearing
agency have a significant voice in the direction of the affairs of the
clearing agency.
CCOS is a privately owned for profit corporation run for the
benefit of its sole shareholder, BOTCC. Therefore, the Board of
Directors of CCOS will be selected from members of the Board of
Governors of BOTCC, and the officers of CCOS will be elected by the
Board of Directors. While CCOS participants will have the opportunity
to provide input to the CCOS Board through the CCOS Participant's
Advisory Committee, this committee is only advisory in nature and its
advice or recommendations is not binding on CCOS.61
\61\As provided in CCOS Rule 501, the Participant's Advisory
Committee will be comprised of three to ten participants who may
advise CCOS on matters pertaining to the operation of CCOS. The
purpose of the Participant's Advisory Committee is to provide
representation to participants on matters which are of concern to
them. In addition, participants will have prior notice of changes to
rules that may affect their rights, obligations, or clearing
requirements. CCOS will accept comments from participants with
respect to any such changes; however, the Participant's Advisory
Committee serves only in an advisory capacity and any advice or
recommendation of the Committee is not binding on CCOS.
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The Commission believes that neither the method in which CCOS's
directors are selected nor the method for participant input meets the
requirements of fair representation under Section 17A(b)(3)(C) of the
Act but that the request for an exemption is appropriate in this
context, as it was in the context of Delta Government Options Corp.
CCOS expects that if its clearing volumes grow, it will file with the
Commission for full registration as a clearing agency. At that time,
the Commission will reevaluate whether CCOS's methods for assuring
participants representation in the selection of its Board of Directors
and in the administration of its affairs is consistent with the Act. If
in its reevaluation the Commission believes that because of changed
circumstances an exemption that does not comport with the fair
representation requirement is no longer justified, the Commission will
modify the conditions or terminate CCOS's clearing agency
exemption.62
\62\Because CCOS is being granted full exemption from
registration as a clearing agency, a specific exemption is not being
issued with regard to fair representation. Rather, the exemption
from these requirements is included within the grant of a complete
exemption from registration as a clearing agency.
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c. Financial Risk Management
Commenters expressed concern about the financial resources
available to CCOS in the event of liquidity problems. Because CCOS will
rely on BOTCC for certain liquidity resources and because BOTCC's
capital and credit lines are committed to its futures business,
commenters expressed concern that a shortfall could occur if a member
common to BOTCC and CCOS were to fail. In response, BOTCC has agreed to
dedicate specific credit and financial resources to CCOS, and CCOS and
BOTCC have established a framework for allocating losses between the
two entities. As a condition to its exemption, CCOS has agreed to
evaluate
[[Page 65083]]
its capital and liquidity resources periodically, and BOTCC has agreed
to supplement, in consultation with the Commission and the CFTC, CCOS's
liquid resources as necessary to meet prudential standards.
In addition to its financial resources, CCOS has facilities to
identify its potential financial exposure from its participants and to
collect margin deposits or other collateral adequate to address that
exposure. As discussed above, CCOS in conjunction with BOTCC will
calculate margin requirements and collect margin deposits from its
participants for open positions. CCOS will obtain information from its
participants regarding their financial condition and will have the
authority to collect additional margin or collateral if it deems it
appropriate. CCOS and BOTCC also will cooperate in sharing risk
management information, to the extent possible, with securities and
futures clearing organizations where CCOS and BOTCC members also are
members.
The Commission believes that entering into additional information
sharing agreements is an area in which CCOS should explore in order to
help ensure the safety and soundness of the clearance and settlement
system and to promote financial risk management. The Commission
recommends that CCOS become a part of the information sharing system
established between all of the commodities clearing houses.63 In
addition, the Commission encourages CCOS to pursue obtaining membership
in the Securities Clearing Group (``SCG'').64 The Commission
believes that CCOS's membership in both of these information sharing
systems should permit CCOS and other clearing organizations to be more
aware of common member risks and to implement effective crisis
management procedures if needed.
\63\Since 1980, the Chicago Mercantile Exchange (``CME'') and
BOTCC have been sharing original margin and pay/collect information.
In 1987, an information sharing agreement was executed between all
U.S. commodity clearing houses. The Options Clearing Corporation
(``OCC'') became a party to this information sharing agreement in
1993. Letter from Dennis Dutterer, Executive Vice President and
General Counsel/Secretary, BOTCC, to Margaret R. Blake, Attorney,
Division of Market Regulation, Commission (May 5, 1995). Pursuant to
the information sharing agreement, each commodity clearing house and
the OCC send its margin requirements and daily cash flow information
to BOTCC every night. The following morning, BOTCC sends the
information back to the clearing houses so they can compare the
margin account excesses, deficits, and cash flows.
\64\The SCG was established in 1989 as a result of developments
surrounding the October 1987 Market Break and subsequent studies on
the causes of the Market Break. The stated purpose of the SCG is to
increase cooperation and coordination among securities clearing
entities and to facilitate the sharing of certain clearance and
settlement information regarding surveillance and member risk
monitoring. While SCG membership is limited to registered clearing
agencies, the Commission encourages SCG to review its membership
standards and consider whether certain clearing agencies with
conditional registration exemptions should be eligible for
membership.
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The Commission believes that CCOS's rules and procedures are
adequately designed to protect CCOS and its participants against
financial losses associated with its services. CCOS's financial risk
management initiatives, including its initial capitalization, its twice
daily margin collection,65 and its committed credit facility, are
aimed at preventing financial loss by participants and CCOS.66 As
a result, the Commission believes that CCOS's rules and procedures and
the methods by which CCOS proposes to safeguard the financial security
of its clearing facilities adequately satisfies the requirements of the
Act.
\65\Supra note 28. The Commission believes that the method by
which CCOS converts government securities to futures equivalents in
its margin calculations is a prudent risk management measure.
\66\As discussed above, CCOS will begin operations with an
initial capitalization of $2 million and BOTCC's commitment to
provide additional capital as necessary to cover CCOS's continuing
costs of operations. CCOS will calculate margin requirements at
least twice daily and will collect margin deficiencies from
participants on T and on T+1 while retaining the authority to
collect additional margin at any time. CCOS will establish a
committed credit facility guaranteed by BOTCC. The credit facility
initially will be $5 million and will be increased in increments of
$5 million for each $1 billion increase in CCOS's daily average net
settlements over a 90 day period.
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d. Participation standards
Section 17A(b)(3)(B) of the Act enumerates certain categories of
persons that a clearing agency's rules must authorize as potentially
eligible for access to clearing agency membership and services. Section
17A(b)(4)(B) of the Act contemplates that a registered clearing agency
have financial responsibility, operational capability, experience, and
competency standards that are used to accept, deny, or condition
participation of any participant or any category of participants
enumerated in Section 17A(b)(3)(B). The Commission believes that an
exempt clearing agency should impose the same standards. In addition,
the Act recognizes that a clearing agency may discriminate among
persons in the admission to or the use of the clearing agency if such
discrimination is based on standards of financial responsibility,
operational capability, experience and competence.
CCOS Rule 301 requires each member to maintain personnel and
facilities adequate to ensure the expeditious and orderly transaction
of business with CCOS or other participants. In addition, CCOS Rule 302
requires participants in CCOS to meet initial and continuing financial
and operational standards as determined by the CCOS Board of Directors
and administered by CCOS management.67 Participation in CCOS will
be open to members of BOTCC and members of the CBOT that are affiliated
with members of BOTCC.68 The Board of Directors also may approve
access by other clearing agencies that are regulated by the Commission
or are excepted from regulation by the Commission.69
\67\CCOS will monitor each participant's financial condition as
measured by its financial stability, the level and quality of its
earnings, and other generally accepted measures of liquidity,
capital adequacy, and profitability.
\68\BOTCC's by-laws require BOTCC members to be CBOT members,
approved by the CBOT board of directors for BOTCC membership. In
addition, the BOTCC board of directors sets, from time to time,
BOTCC membership requirements, including, but not limited to,
financial and operational requirements, continuing compliance with
CBOT and BOTCC rules, financial and other reporting, and such other
factors as the BOTCC board may consider necessary or appropriate in
assessing an applicant's suitability for participation in BOTCC.
BOTCC also has the authority to require additional capital on a
discretionary basis and parental guarantees on member proprietary
positions. See, e.g., BOTCC By-Law 401.
BOTCC's minimum financial requirements for BOTCC corporate
futures commission merchants (``FCM'') include the greater of a
specified amount of capital or a percentage of funds required to be
segregated and secured pursuant to the Commodities Exchange Act, 7
U.S.C. Secs. 1, et seq. (1988), combined with non-customer margin
requirements for proprietary trading. Once admitted, a clearing
member may operate below the initial minimum, but must maintain a
specific minimum amount of capital with no formal action taken
(Level I). When the clearing member's initial minimum falls below
the Level I minimum, but remains above the Level II minimum, the
clearing member is subject to detailed financial analysis with a
written report provided to senior management recommending no action
or a change in status to Level III. At Level III the clearing member
must maintain a minimum amount of capital and is immediately subject
to 125% of normal margin requirements and provision of pro forma
weekly capital computations for one month. If the capital ratios do
not meet Level I standards by the next month, the clearing member
will be moved to Level IV status. The Risk Management Committee is
notified when the firm is subject to Level III requirements. When
the clearing member falls below the Level III minimum they will be
immediately subject to 150% of normal margin requirements. A formal
report will be prepared for the Risk Management Committee outlining
the problem with a recommendation for appropriate action which may
include a further increase in margin requirements, restrictions on
business activities or suspension or termination of clearing
privileges. Letter from Dennis A. Dutterer, General Counsel, BOTCC,
to Margaret R. Blake, Attorney, Division of Market Regulation,
Commission (May 1, 1995).
\69\Clearing agencies that are granted access to CCOS's services
are not considered participants of CCOS for the purposes of CCOS's
Rules except to the extent determined by the Board of Directors.
Following Commission approval of its application and upon receipt of
a bona fide request for access, CCOS will prepare and submit to the
Commission for review, rules providing broader access to CCOS
services for persons other than those currently envisioned by the
CCOS Rules, consistent with the requirements of Section 17A of the
Act.
[[Page 65084]]
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The Commission believes that temporarily exempting CCOS from
Sections 17A(b)(3)(B) and 17A(b)(4)(B) of the Act is appropriate. CCOS
rules do not meet the requirements of Section 17A(b)(3)(B) of the Act
with regard to participants because CCOS rules do not provide for
membership by all of the enumerated categories of persons. In addition,
CCOS rules do not specify applicant and member financial standards as
contemplated in Section 17A(b)(4)(B) of the Act.70 Financial and
operational membership standards depend on factors that CCOS will
develop based on the scope of CCOS's operations. CCOS's Board of
Directors will review these factors from time to time and establish
membership standards based on its findings. Presently, however, the
participant standards have not been determined as required by the Act,
and an exemption from participation requirements is appropriate.
\70\CCOS Rule 302 and Rule 309 anticipate the determination of
participant financial standards by the Board of Directors. At this
time, however, the standards remain undefined.
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C. Comments and the Commission's Responses
1. Fragmentation of the Clearance and Settlement of Government
Securities
Some commenters believe that approval of CCOS's exemption
application will result in fragmentation of the clearance and
settlement of government securities and will preclude one account
settlement. These commenters believe allowing CCOS to settle government
securities trades in a manner not effectively integrated with the
existing registered clearing corporation process would be deleterious
to the systemic risk management currently provided by GSCC by causing
lowered overall netting capability, incomplete management of the risk
exposure presented by individual firms, and impairment of crisis
management. The commenters argue that government securities
transactions will operate in the safest and most efficient manner if
participants have all of their government securities trades netted,
margined, and settled through one central facility (``one account
settlement'').71
\71\One-account settlement enables a market participant to
settle all of its trades through one clearing agency regardless of
the location of the other parties to the trades and regardless of
the markets in which the trades were executed.
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Although commenters fear fragmentation in the clearance and
settlement of government securities, the clearance and settlement of
government securities transactions already is subject to diverse
clearing arrangements. While GSCC is the only registered clearing
agency providing clearance and settlement services in the government
securities market, it is not the sole government securities clearing
facility. Banks currently clear and settle substantial amounts of
government securities transfers among themselves through the Federal
Reserve System's book-entry wire system without any involvement by
GSCC. Furthermore, BOTCC provides clearance and settlement services for
futures and options on government securities including the physical
delivery of government securities to satisfy futures delivery
obligations.
Section 17A(a)(2) of the Act directs the Commission, having due
regard for the maintenance of fair competition among clearing agencies,
to facilitate the establishment of linked or coordinated facilities for
clearance and settlement of transactions in securities, securities
options, contracts of sale for future delivery and options thereon, and
commodity options.72 Moreover, the requirement in Section
17A(b)(3)(B)(ii) that clearing agencies admit other clearing agencies
as participants appears to indicate that Congress, and the Commission
which worked with Congress in developing the 1975 Amendments,73
contemplated a national system for the clearance and settlement of
securities transactions in which there could be multiple clearing
agencies serving a securities market.
\72\Standards Release, supra note 53.
\73\Securities Acts Amendments of 1975, Pub. L. No. 94-29
Sec. 17A(a), 89 Stat. 97.
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Where more than one clearing agency for a market exists, the
Commission believes that the linking of these clearing agencies, such
as the envisioned linkage of CCOS, BOTCC, and GSCC, promotes
competition and innovation while still allowing for one-account
settlement. The Commission believes that one-account settlement can be
achieved in a multiple-clearing agency environment through the use of
interclearing agency links and interfaces.74
\74\In the Commission release addressing conditions for the
National Securities Clearing Corporation's (``NSCC'') approval as a
clearing agency, the Commission stated that ``even though a broker-
dealer would be able to achieve one account processing through any
one of the clearing corporation components of the National System, a
broker-dealer would be able to use more than one clearing
corporation if the broker-dealer chose to do so.'' Later in that
same release the Commission stated, ``The development and expansion
of interfaces during the past year, particularly the establishment
of regional interfaces for the processing of over-the-counter
transactions, has made one-account processing almost universally
available.'' Securities Exchange Act Release No. 12954 (November 3,
1976), 41 FR 49722.
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The approach to one-account processing for the clearance and
settlement of government securities transactions advocated by GSCC,
where one clearing agency compares, nets, and settles all trades in
government securities, is not the approach taken by the Commission when
establishing the National System for clearance and settlement. The
Commission believes that rather than mandate centralized clearance and
settlement in the government securities market, it should encourage the
coordination of any competing systems through economically efficient
linkages that ultimately will foster both competition and investor
confidence. For these reasons, the Commission, as a part of its
granting CCOS an exemption from clearing agency registration, is urging
CCOS, BOTCC, and GSCC to develop settlement interface and cross-
margining programs.75
\75\Supra note 45.
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2. Illusory Regulatory Oversight
As stated above, BOTCC will be the sole shareholder and will act as
the facilities manager for the CCOS operations. Because of the
relationship between CCOS and BOTCC, some commenters expressed concern
that the Commission would be unable to oversee appropriately the
operations of CCOS. Furthermore, these commenters stated that the
Commission's regulatory authority over CCOS would be illusory because
CCOS would be controlled and operated by BOTCC. These commenters stated
that CCOS is merely a shell for BOTCC and that approval of CCOS's
application will allow BOTCC to provide clearance and settlement
services for government securities. Finally, several commenters noted
their concern with and objection to CCOS performing the services of a
registered clearing agency without the federal oversight imposed upon
all other registered clearing agencies. These commenters argued that
for the safety and soundness of the national clearance and settlement
system, CCOS should be subject to the same standards and requirements
as all other registered clearing agencies.
Under the proposal, CCOS will share office space and staff with
BOTCC, and BOTCC will perform all margin calculations and collection
and payment
[[Page 65085]]
functions for CCOS. Sharing office space and staff among clearing
agencies and contracting out certain clearing agency functions is not
unusual.76
\76\In 1988, GSCC began operations with a facilities management
agreement with NSCC whereby NSCC provides GSCC with the necessary
administrative and technical services. GSCC continues to share staff
and office space with its affiliates, NSCC and International
Securities Clearing Corporation. In fact, NSCC and GSCC do not
operate their own clearance and settlement systems; instead, they
contract that function out to the Securities Industry Automation
Corporation.
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The standards established for registration of a clearing agency
that hires a facility manager to perform data or other processing
functions requires the clearing agency to maintain appropriate
procedures to insure the prompt and accurate clearance and settlement
of securities transactions.77 The clearing agency also should
assure itself that the facilities manager complies with all of the
appropriate safeguards set forth in the Standards Release. The
Standards Release also requires any such clearing agency to assure
itself that its facility manager will cooperate fully with clearing
agency auditors, Commission examiners, independent public accountants,
and any other appropriate regulatory agency to the same extent as a
clearing agency which conducts its own processing functions.
\77\Standards Release, supra note 53.
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The Commission's experience with facilities management arrangements
is that the Commission can carry out its clearing agency oversight
responsibilities through its jurisdiction over the clearing agencies.
Facilities managers cannot, for example, unilaterally make systems
changes that would alter the rules of the clearing agency or the rights
and obligations of clearing agency participants without having those
changes filed by the clearing agency with the Commission.78 To the
extent that the Commission needs access to a facilities manager's
premises or personnel, the Commission expects and has found clearing
agencies and their facilities managers to be cooperative with
Commission staff.79
\78\As discussed below, because CCOS will operate under an
exemption from registration as a clearing agency, it will not file
rule changes under the Section 19(b) process. Rather, CCOS will have
to file amendments to its Form CA-1 exemption application and
request modification of its exemptive order to change its rules or
procedures.
\79\The Commission generally has not required that facilities
management contracts specifically grant the Commission unlimited
access to a facilities manager's premises. If in the future the
Commission perceives a need for express authority for such access,
it will revisit the issue at that time.
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Regarding commenters' concerns about the need for uniform federal
oversight, in granting its application for exemption the Commission is
requiring CCOS to meet basically the same standards as those registered
clearing agencies must meet, and believes that CCOS has set forth a
plan to enable it to meet those standards.80 CCOS recognizes that
it must comply with the regulatory standards governing the operations
of clearing agencies in a manner consistent with its operational
structure and with the specific services it will offer. CCOS has
represented that it intends to comply fully with all relevant
regulatory requirements applicable to other clearing agencies.81
\80\Id.
\81\Letters from John C. Hiatt, President and Chief Executive
Officer, BOTCC, to Jonathan G. Katz, Secretary, Commission (May 23
and June 22, 1994).
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3. Fair Competition
Some commenters believe that the approval of CCOS's application
will not promote fair competition among clearing agencies as
contemplated by Section 17A of the Act because CCOS will have exclusive
access to cross-margining with BOTCC with respect to government
securities. The Commission recognizes that to promote competition among
clearing agencies, the benefits of CCOS's operations (e.g., greater
access to the government securities market by persons other than
primary dealers, the development of improved systems capabilities and
new services, and perhaps lower prices to participants) must not
``impose any burden on competition not necessary or appropriate in
furtherance of the purposes'' of the federal securities laws.82
\82\15 U.S.C. 78q-1(b)(3)(I) (1988).
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Since approval of the first cross-margining program in 1988,\83\
the Commission repeatedly has found that cross-margining programs are
consistent with clearing agency responsibilities under Section 17A of
the Act. As the Commission has previously noted, cross-margining
programs, among other things, tend to enhance clearing member and
systemic liquidity both in times of normal trading and in times of
stress.\84\ Under routine trading, clearing members that participate in
cross-margining programs have lower margin requirements which help
clearing members manage their cash flows by increasing available cash
to be used for other purposes. In times of market stress and high
volatility, lower margin requirements could prove crucial in
maintaining the liquidity of clearing members and thus could enhance
liquidity in the market as a whole. By enhancing market liquidity,
cross-margining arrangements remove impediments to and help perfect the
mechanism of a national system for the prompt and accurate clearance
and settlement of securities transactions.\85\
\83\Securities Exchange Act Release No. 26153 (October 3, 1988),
53 FR 39567 (approving nonproprietary cross-margining program
between OCC and ICC).
\84\E.g., Securities Exchange Act Release Nos. 30413 (February
26, 1992), 57 FR 7830 (order approving OCC/Kansas City Board of
Trade Clearing Corporation cross-margining program for proprietary
positions); 29991 (November 26, 1991), 56 FR 61458 (order approving
expansion of OCC/CME cross-margining program to include positions
held for market professionals); 29888 (October 31, 1991), 56 FR
56680 (order approving OCC/BOTCC cross-margining program for
proprietary positions); 27296 (September 26, 1989), 54 FR 41195
(order approving OCC/CME cross-margining program for proprietary
positions).
\85\Shortly after the 1987 market break, then Treasury Secretary
Nicholas F. Brady referred to the clearance and settlement system as
the weakest link in the nation's financial system and noted that
improvements to the clearance and settlement system, such as those
provided by cross-margining arrangements, would ``help ensure that a
securities market failure does not become a credit market failure.''
The Market Reform Act of 1989: Joint Hearings on S. 648 before the
Subcomm. on Securities and the Senate Comm. on Banking, Housing and
Urban Affairs, 101st Cong., 1st Sess. 225 (Oct. 26, 1989) (statement
of Nicholas F. Brady, Secretary of the Treasury).
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Because CCOS and BOTCC have proposed a cross-margining plan between
themselves, the Commission has encouraged CCOS, BOTCC, and GSCC to
create and implement a cross-margin arrangement so that fair
competition in the clearing of government securities will exist. The
Commission believes that competition among clearing agencies should not
be based on margin levels but should be based on technology, services,
or product types offered by the competing clearing agencies. Therefore,
the Commission views the implementation of a cross-margining
arrangement among CCOS, BOTCC, and GSCC as vital to the satisfaction of
the statutory goals of Section 17A of the Act. Towards this end, CCOS,
BOTCC, and GSCC have entered into negotiations regarding cross-
margining and linkage agreements. However, because such an agreement
has not yet been finalized, the Commission believes it is appropriate
to allow CCOS to begin operations with certain limits in place prior to
the implementation of cross-margining and linkage agreements.\86\
\86\Supra note 45.
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D. Conditions
This Order exempts CCOS from registration as a clearing agency
under Section 17A of the Act subject to certain conditions which the
Commission believes are appropriate for an entity operating under an
exemptive framework. As explained in detail below, these conditions
include:
[[Page 65086]]
1. Establishment of acceptable linkage and cross-margining
agreements between CCOS, BOTCC, and GSCC;
2. The Commission's access to CCOS and related BOTCC facilities
and records in order to inspect CCOS's operations and to insure
CCOS's compliance with the federal securities laws and this Order;
3. The requirement that all proposed material changes to CCOS's
rules, operations, and systems be submitted as proposed amendments
to its Form CA-1;
4. The requirement that CCOS notify the Commission of
participant defaults;
5. The establishment of sound automation review programs
including system change notification procedures and system outage
notification procedures; and
6. Until the establishment of acceptable linkage and cross-
margining agreements between CCOS, BOTCC, and GSCC, the requirement
that CCOS limit its activity to no more than $3 billion net daily
settlement for government securities and $12 billion for dollar
rolls.
1. Linkage and Cross-Margining
Throughout this Order, the Commission has emphasized the importance
of linkage and cross-margining agreements between CCOS, BOTCC, and
GSCC. While the Commission recognizes that such agreements will entail
substantial negotiations among the parties, the Commission also
recognizes the importance of allowing CCOS to begin operations without
further delay.\87\ Therefore, the Commission is approving CCOS's
application for exemption and will allow CCOS to commence operating
with a volume cap of $3 billion net daily settlement for government
securities and $12 billion for dollar rolls.\88\ During CCOS's initial
period of operation, the Commission anticipates that CCOS, BOTCC, and
GSCC will finalize linkage and cross-margining agreements pursuant to
the Commission's recommendations at which time CCOS will be permitted
to proceed to its exemptive limits of $6 billion and $24 billion.\89\
Either upon CCOS's request or by its own initiative, the Commission may
review whether the current volume limitations should be modified or
removed. Such review may be conducted even if the linkage and cross-
margining agreements among CCOS, BOTCC, and GSCC have not been
finalized.
\87\As noted, a joint user committee established by the Boards
of Directors of GSCC, BOTCC, and CCOS will provide to the respective
Boards within three months of formation of the committee a report of
its analysis and proposed resolutions to the outstanding linkage and
cross-margining issues. The Commission expects prompt action with
regard to the establishment of linkage and cross-margining
facilities, and if necessary, the Commission will use its authority
under the Act to direct that such facilities be established. Supra
notes 45-46 and accompanying text.
\88\These amounts are half of the maximum daily net settlement
amounts agreed to by CCOS and the Division, as discussed in note 35.
The Commission believes these limits are large enough to allow CCOS
to begin effective operations while it works with GSCC to develop
linkage and cross-margining facilities to advance efficient
clearance and settlement.
\89\These are the maximum average daily net settlements agreed
to by CCOS and the Division during the exemptive period. In
addition, limits on CCOS's clearing capacity must be considered in
light of the limits to be placed on CBB as a government securities
broker. CCOS will be limited to clearing $6 billion in net daily
cash securities and $24 billion in dollar rolls on an average basis
over a ninety-day period. Supra note 35.
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2. Inspection
As noted above, pursuant to this Order the Commission has the
authority to inspect at any time the operations of CCOS in order to
insure its compliance with its obligations to safeguard securities and
funds and to provide prompt and accurate clearance and settlement of
securities transactions. As facilities manager for CCOS, BOTCC's
facilities and operations as they pertain to CCOS are also subject to
inspection by the Commission in order that the Commission may assure
itself that BOTCC's operations with regard to CCOS are in compliance
with the safety and soundness requirements set forth in the Act. The
Commission expects to coordinate any inspections of BOTCC with the
CFTC.
3. Rule Changes
Under Section 19(b)(1) of the Act,\90\ a registered clearing agency
as a self-regulatory organization must file proposed rule changes with
the Commission for approval. The Commission uses the rule filing
process as a method to monitor and regulate the operations of clearing
agencies. Because CCOS is not a registered clearing agency, amendments
to its rules need not be made through use of the Section 19(b) process.
As a condition to this Order, however, should CCOS desire to amend its
rules, it must submit proposed amendments to its Form CA-1 for
Commission review.\91\ The Commission believes that this method of
notifying the Commission of proposed changes at CCOS will allow the
Commission to conduct a thorough examination of each proposed change
and its potential effects on CCOS and the clearance and settlement of
government securities. Submission by CCOS of a proposed amendment to
its Form CA-1 each time it proposes to make a change in its rules,
operations, or systems is an appropriate method by which the Commission
can exercise its regulatory responsibilities with regard to CCOS.
\90\15 U.S.C. Sec. 78s(b)(1) (1988).
\91\CCOS will be required to amend its CA-1 application for any
proposed changes to its stated policies, practices, or
interpretations as that phrase is defined in Rule 19b-4 (17 CFR
240.19b-4).
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4. Notice of Defaults
CCOS will be required to notify the Commission of any defaults by
participants so that the Commission can monitor the situation and
determine if all appropriate methods of recovery are being utilized.
Failure by a participant or user could create or exacerbate systemic
risks. Prompt notification should help facilitate cooperation and
coordination among regulators and market participants.
5. Automation Review
CCOS also will be required to establish a sound automation review
program based upon the Commission's second automation review policy
statement (``ARP II'').\92\ The automation review program should
include appropriate planning processes (i.e., contingency planning and
security assessment), independent reviews by CCOS of its systems,
notification to the Commission of significant systems changes, and
procedures for timely notification of significant system outages. The
Commission believes the automation review program is essential for the
safety and soundness of CCOS's operations and the national market
system because it will require, among other things, CCOS to evaluate
regularly its processes related to the capacity and vulnerabilities of
its automated systems.
\92\Securities Exchange Act Release Nos. 27445 (November 16,
1989) [54 FR 48704] (``ARP I''), and 29185 (May 9, 1991) [56 FR
22489], (``ARP II'').
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6. Limits on Activity
The Commission believes that until acceptable linkage and cross-
margining plans are in place, CCOS's clearing activity should be
limited to one half of the maximum daily net settlement amounts agreed
to by CCOS and the Division. These limit amounts are no more than $3
billion in net daily settlement for government securities, and $12
billion for dollar rolls. Once the linkage and cross-margining plans
are in place, CCOS's activity may proceed to the full amounts agreed to
in this Order.
The Commission reserves the right to modify by order the terms,
scope, or conditions of CCOS's exemption from registration as a
clearing agency, including such terms, scope, or condition that the
Commission may issue in the future regarding amendments to CCOS's Form
CA-1, if the Commission determines that such modification is
appropriate for the
[[Page 65087]]
protection of investors or in the public interest. Furthermore, the
Commission reserves the right to suspend or revoke this exemption or to
censure or impose limitations upon the activities, functions, and
operations of CCOS if the Commission finds that CCOS has violated or is
unable to comply with any of the provisions set forth in this Order or
in its own rules or that CCOS has failed without reasonable
justification to enforce compliance with any provision of its own rules
by one of its participants.
IV. Conclusion
The Commission finds that CCOS's application for exemption from
registration as a clearing agency meets the standards and requirements
deemed appropriate for such an exemption including those standards set
forth under Section 17A of the Act.
It is therefore ordered, pursuant to Section 19(a)(1) of the Act,
that the application for exemption from registration as a clearing
agency filed by the Clearing Corporation for Options and Securities
(File No. 600-27) be, and hereby is, approved subject to the conditions
listed in this Order.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-30660 Filed 12-15-95; 8:45 am]
BILLING CODE 8010-01-P '
