[Federal Register Volume 60, Number 244 (Wednesday, December 20, 1995)]
[Notices]
[Pages 65697-65700]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30907]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36587; File No. 600-28]
Self-Regulatory Organizations; Pro-Trade; Notice of Filing of
Application for Exemption From Registration as a Clearing Agency
December 13, 1995.
On September 22, 1994, ProTrade \1\ filed with the Securities and
Exchange Commission (``Commission'') a Form CA-1 requesting exemption
from registration as a clearing agency pursuant to section 17A of the
Securities Exchange Act of 1934 (``Exchange Act'') \2\ and Rule 17Ab2-1
thereunder.\3\ Since the original filing, ProTrade has supplemented the
information provided in its Form CA-1 filing with letters dated October
27, 1994, April 18, 1995, September 26, 1995, and October 2, 1995. The
Commission is publishing this notice to solicit comments on the
proposal from interested persons.
\1\ ProTrade, located in Mercer Island, Washington, was
incorporated under the laws of the State of Washington in January,
1986. Joseph A. Zajac, the company's President, owns 100% of
ProTrade's stock.
\2\ 15 U.S.C. 78q-1 (1988).
\3\ 17 CFR 240.17Ab2-1 (1995).
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I. Introduction
ProTrade proposes to introduce an automated proprietary trading
system (``System'') for over-the-counter option securities. ProTrade's
customers, the users of the System, will be authorized to enter bids
and offers for these options into the System. The System will
electronically match the bids and offers and provide execution.
Instantaneously with each execution, the proceeds of the transaction
will be calculated, and the accounts of the trading parties will be
debited and credited in settlement.
Accordingly, the System will combine into a single electronic
format several functions that usually involve the collective efforts
of: (1) An option broker-dealer, (2) an options exchange, and (3) an
options clearing agency. ProTrade asserts that this unity of functions
will bring new efficiencies to the options marketplace.
ProTrade has represented that its System will not commence
operations before ProTrade: (1) has registered as a broker-dealer
pursuant to the Exchange Act and has become a member of the National
Association of Securities Dealers, Inc. (``NASD''),\4\ (2) has
registered the option securities that are to be traded in the System
pursuant to the Securities Act of 1933 (``Securities Act''),\5\ and (3)
has received a no-action letter from the Division stating that the
Division will not recommend enforcement action if ProTrade does not
register as a securities exchange pursuant to the Exchange Act.\6\
\4\ For the definitions of ``broker'' and ``dealer'' under the
Exchange Act, see Sections 3(a) (4) and (5), 15 U.S.C. 78c(a) (4)
and (5) (1988). See also, Section 15 of the Exchange Act, 15 U.S.C.
78o (1988), for broker-dealer registration requirements.
\5\ 15 U.S.C. 77b(1) (1988). ProTrade's options are
``securities'' as that term is defined in Section 2(1) of the
Securities Act, 15 U.S.C. 77b(1) (1988). As securities, they must be
registered pursuant to Sections 5 and 6 of the Securities Act, 15
U.S.C. 77e and 77f (1988), before they may be traded in interstate
commerce.
The issuer of the options for purposes of the Securities Act
will be ProTrade itself. For the definition of ``issuer,'' see
Section 2(4) of the Securities Act, 15 U.S.C. 77b(4) (1988).
\6\ For definition of ``exchange,'' see Section 3(a)(1) of the
Exchange Act, 15 U.S.C. 78c(a)(1) (1988). See also, Section 6 of the
Exchange Act, 15 U.S.C. 78f (1988), for exchange registration
requirements.
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ProTrade believes that its proposed operations would involve few,
if any, clearing agency activities within the meaning of the Exchange
Act. ProTrade also believes that its proposed registration as a broker-
dealer, coupled with the proposed registration of its options under the
Securities Act, will satisfy the regulatory scheme of the Exchange Act.
ProTrade has stated that such registrations under both the Exchange Act
and the Securities Act would provide the necessary and appropriate
safeguards to protect investors and the public interest.\7\
Accordingly, it is ProTrade's belief that an exemption from
registration as a
[[Page 65698]]
clearing agency under the Exchange Act is warranted.
\7\ ProTrade expects to have a net capital of $250,000, the
amount that ProTrade states it will need to comply with Commission's
uniform net capital rule, Rule 15c3-1, 17 CFR 240.15c3-1 (1995), as
a broker-dealer that holds customers' funds (i.e., a clearing
broker-dealer). The Commission has taken no position on ProTrade's
interpretation of its requirements under the uniform net capital
rule.
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II. Description of Proposal
A. The System
1. Background
ProTrade reports that it has designed and developed the System as a
``stand-along'' electronic operation that integrates order-entry,
trade-matching, and execution functions with the back office functions
of accounting and settlement. ProTrade states that it will interpose
itself between the trading parties of each trade and that it will
guarantee performance to each contraparty. The System will be made
available to a list of qualified customers. As the operator of the
System, ProTrade will derive revenues from customer fees on all
transactions effected in the System.\8\
\8\ ProTrade has stated that it ``will derive most of its
revenues from typical `discount' broker activities, i.e., accepting
orders for listed securities on behalf of customers.'' Letter from
Joseph M. Zajac, President, ProTrade, to Eugene Lopez, Assistant
Director, Division, Commission, at page 2 (October 15, 1993).
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2. Options Securities
The System is designed to process over-the-counter options on
equities, equity indexes, foreign currencies, and interest rates.
ProTrade plans to have two classes, Class A and Class B, of such
options. Class A options will be uncertificated, European-style put and
call options that will be cash settled and that will expire on the last
trading day of the chosen month of expiration.\9\ Class B options will
be uncertificated put and call options that will have no standard terms
and that will be individually negotiated by the trading parties.
\9\ As European-style options, no positions may be exercised
before the expiration date.
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3. Customers
As discussed below under Participation Standards, ProTrade will
screen its prospective customers to determine whether they meet certain
financial and operational standards.\10\ Applicants who fail to meet
ProTrade's standards will be denied customer status and therefore will
be denied access to the System.\11\ In general, ProTrade expects to
have a sophisticated customer base including professional investors and
financial institutions. Each customer will be provided with the
System's proprietary software, which the customer may use on a personal
computer for the purpose of entering orders and for performing other
tasks within the System. ProTrade expects that customers will be able
to connect with the System either by: (1) a dial-up telephone line
using a modem or (2) a leased line. ProTrade will provide each customer
with a unique identification number and a password that will allow
access to the System.
\10\ ProTrade has chosen the term ``customers'' for the users of
its System, as distinct from participants, subscribers, members, or
other similar terms.
\11\ At this time, ProTrade has no written standards or criteria
for acceptance of customers.
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4. Operations
The System will keep a file of its customers' outstanding bids and
offers sorted by price and time of receipt. The bids and offers will be
displayed in a montage or array, and customers will be able to cancel
or modify their orders at any time prior to execution. Bids and offers
at the same price will be anonymously matched by the System and will be
executed on a first-in, first-out basis. The System will accept market
orders, limit orders, stop orders, and market if touched orders.
The System will be designed to calculate balances and to settle
accounts immediately (or within a few seconds) after every execution.
ProTrade states that each order will be individually processed by the
System without netting.\12\ Settlement will consist of book-entry
debits or credits to the customer's account with the customer's account
being part of ProTrade's segregated broker-dealer bank account. As a
means of protection, the System is designed to reject any order unless
the account of the customer that is entering the order has sufficient
equity to satisfy the order's premium payment or has the required
collateral.
\12\ Technically, this described form of post-trade processing
is known as ``trade-for-trade'' clearing, the simplest form of
clearing, which involves accounting for each trade on a contract by
contract basis without netting or at least without the usual types
of netting. This form of clearing contrasts with the more
sophisticated forms of clearing such as ``daily balance order'' or
``continuous net settlement'' where clearing agencies net each of
their participant's trades and each participant's money credits and
debits in each security on a daily basis.
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B. System Safeguards
1. Participation Standards
Customers authorized by ProTrade to use the System will be required
to meet initial and continuing financial and operational standards, as
may be determined by the ProTrade Board of Directors and administered
by ProTrade's management.\13\ Under these standards, customers will be
screened for margin purposes to determine their creditworthiness.
Determining factors will be the customers' financial positions and
their knowledge and experience in trading options and other derivative
products.
\13\ At this time, ProTrade has no financial and operational
standards for customers authorized to use its System.
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ProTrade will require each applicant to disclose, at a minimum, the
following information: (1) Trading experience with options and other
derivatives, (2) annual income and net worth, (3) history of any
account defaults or failures, (4) experience with computers, and (5)
existing accounts with other brokers. ProTrade, when it deems it
necessary, will obtain credit reports on an applicant. Based on its
subjective review of the above criteria, ProTrade may grant or deny
customer privileges. Customers also must agree in writing to comply
with applicable law and with all of ProTrade's rules. ProTrade will
reserve the right to deny access to the System to any person that,
among other things, is the subject of a civil injunction or criminal
conviction for breach of the laws governing securities or commodities
futures.
2. The System's Data Backup
ProTrade reports that it will backup its data daily and that the
System itself will have the ability to regenerate electronically all
transactions since the previous backup. The System also will be
supported by backup hardware that can be put on-line in a matter of
seconds.
While customers will be provided with ProTrade's software, the
customers will be responsible for their own electronic equipment or
hardware. However, if a customer's equipment should break down, the
customer could submit orders by telephone to ProTrade where a ProTrade
employee will enter the orders.
3. Margin Payment/Collection
Once ProTrade has completed its broker-dealer registration,
ProTrade will be subject to Section 7(c) of the Exchange Act, which
governs broker-dealer margin requirements.\14\ As a consequence of
Section 7(c), ProTrade also will be subject to Regulation T of the
Board of Governors of the Federal Reserve System (``Federal Reserve
System''), which governs credit extended by broker-dealers,\15\ and it
will be subject to the NASD's rules governing minimum maintenance
[[Page 65699]]
margin for option securities held in customers' accounts.\16\
\14\ 15 U.S.C. 78g (1988).
\15\ 12 CFR 220 et seq. (1995). See, esp., Sec. 19(f)(2) of
Regulation T, 12 CFR 220.19(f)(2), which in general refers a broker-
dealer's option margin requirements to the maintenance rules of the
broker-dealer's self-regulatory organization (``SRO''). In
ProTrade's case, the SRO would be the NASD.
\16\ ProTrade will be subject to NASD margin requirements on its
customers' accounts and specifically the margin requirements for
options that are not issued by a registered clearing agency. These
requirements are set forth in the NASD Manual, Rules of Fair
Practice, Art. III, Sec. 30(f)(2)(D)(iii).
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ProTrade states that it will treat all of its customers as margin
customers and will require margin collateral for all short positions.
ProTrade indicates that its in-house initial margin requirements will
be higher than the NASD's maintenance margin requirements to insure
that customers have sufficient funds to cover immediate price moves
after they open positions. ProTrade further states that it may reject
customer applicants and that it may suspend active customers if they
are found not to meet margin standards. ProTrade reports that it has
programmed its System to reject any order that would open an option
position if the subject account does not have the necessary funds or
margin and if an existing account were to become undermargined.
ProTrade also states that it may choose to vary customer trading
limits, margin requirements, and position limits according to the
qualifications of each customer.
ProTrade represents that its System is designed to calculate
intraday the margin requirements for each account based upon changes in
any bid or asked prices that affect an account. The System reportedly
will provide ProTrade with real-time reports of under-margined accounts
that will allow prompt margin calls and an enhanced ability to prevent
account defaults.
4. Default
In the event that a customer's default becomes imminent, ProTrade
states that at its discretion it may choose to prevent the default by
assuming the customer's positions itself and by creating a hedged
position in the cash market. However, ProTrade does not guarantee that
it would undertake such bail-out procedures in the face of an imminent
default and states that any such efforts would depend upon the
circumstances.
In the event of the actual occurrence of a customer default,
ProTrade states that it will guarantee full performance to the
contraparties. ProTrade does not plan to create a clearing fund in
support of this guarantee.\17\ ProTrade reports that it is
contemplating the formation of the other risk management facilities
such as: (1) A blanket surety bond to be purchased by ProTrade from an
insurance company or (2) a transactional insurance fee in the form of a
refundable deposit that would be included in the cost of each
trade.\18\
\17\ As a general rule, the Commission has recommended that a
clearing agency have a clearing fund which: (1) Is composed of user
contributions based on a formula applicable to all users; (2) is
held in cash or highly liquid securities; and (3) is limited in
purpose to protecting participants and the clearing agency from
participant defaults and from unusual, significant clearing agency
losses. Securities Exchange Act Release No. 16900 (June 17, 1980),
45 FR 41920 (order approving standards for clearing agency
registration).
However, on one occasion the Commission permitted a clearing
agency, Delta Government Options Corp. (``Delta'') to register and
to operate as a clearing agency without a clearing fund. In Delta's
case, the clearing agency's risk management system was deemed
adequate, despite the lack of a clearing fund, because Delta had the
financial backing of an affiliated corporation and had a substantial
credit facility. Securities Exchange Act Release No. 26450 (January
12, 1989), 54 FR 2010 (order approving Delta's registration as a
clearing agency).
\18\ A transactional insurance fee differs from margin in
several ways. In brief, margin is collateral deposited by a customer
with a broker in connection with the specific purchase of specific
securities, and margin requirements are governed by the Exchange Act
and the rules and regulations thereunder as well as certain rules of
the Federal Reserve Board and the appropriate self-regulatory
organization. Under ProTrade's contemplated transactional insurance
fee program, ProTrade would debit a customer's account a certain
amount in connection with each transaction and later credit that
amount back to the customer's account upon normal settlement of the
transaction. Currently, ProTrade is considering a debit in the
vicinity of 5% of the value of each transaction. As stated above,
ProTrade has not yet decided if it will implement such a program.
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III. Public Interest Statement
ProTrade believes that exemption from clearing agency registration
is critical to its entering the option securities business. ProTrade
maintains that its business plan will provide investors with increased
access to over-the-counter options through an integrated electronic
transaction and margin system, which ProTrade claims will lower trading
costs, create processing efficiencies, ensure more fairness and price
transparency, and provide a complete audit trail.
ProTrade asserts that these efficiencies will eliminate the need
for paperwork, will reduce the time required for order entry and for
post-trade processing, and will shorten settlement cycles. Thus,
ProTrade believes that its System will improve the option marketplace.
IV. Specific Request for Comments
A. Statutory Standards
Section 17A of the Exchange Act directs the Commission to develop a
national clearance and settlement system through, among other things,
the registration and regulation of clearing agencies.\19\ This
statutory scheme contemplates that (1) Clearing agencies will provide
clearance and settlement functions consistent with statutory goals and
(2) as self-regulatory organizations, clearing agencies will exercise
certain regulatory functions in furtherance of other statutory goals.
\19\ 15 U.S.C. 78q-1 (1988).
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In fostering the development of a national clearance and settlement
system generally and in overseeing clearing agencies in particular,
Section 17A authorizes and directs the Commission to promote and
facilitate certain goals with due regard for the public interest, the
protection of investors, the safeguarding of securities and funds, and
the maintenance of fair competition among brokers, dealers, clearing
agencies, and transfer agents.\20\ Furthermore, Section 17A, as amended
by the Market Reform Act of 1990, 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.\21\
\20\ For the legislative history of Section 17A of the Exchange
Act, refer to Report of Senate Committee on Banking, Housing and
Urban Affairs. Securities Acts Amendments of 1975, Report to
Accompany S. 249, S. Rep. NO. 75, 94th Cong., 1st Sess. 4-6 (1975).
\21\ Market Reform Act of 1990, Sec. 5, amending Sec. 17A(a)(2)
of the Exchange Act, 15 U.S.C. 78q-1(a)(2) (1995 Supp.).
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Section 17A(b)(1) of the Exchange Act \22\ authorizes the
Commission to exempt applicants from some or all of the requirements of
Section 17A if it 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.
Historically, the Commission has granted newly registered clearing
agencies temporary exemptions from specific statutory requirements
imposed by Section 17A in a manner that achieves statutory goals.\23\
\22\ 15 U.S.C. 78q-1(b)(1) (1988).
\23\ See, e.g., order approving the temporary registration of
Government Securities Clearing Corporation (``GSCC'') as a clearing
agency where the Commission temporarily exempted GSCC from
compliance with the Section 17A(b)(3)(C) requirement of the Exchange
Act. Securities Exchange Act Release No. 25740 (May 24, 1988), 53 FR
19839.
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The Commission recognizes that clearing agencies pose some safety
and soundness concerns to the marketplace. Accordingly, the Division
has published standards for clearing agency
[[Page 65700]]
registration,\24\ and it has exercised significant continuing oversight
over all aspects of clearing agency operations and functions.\25\ The
market break of October 1989 and the market break of October 1991
demonstrated the central role of clearing agencies in the U.S.
securities markets in reducing risk, improving efficiency, and
fostering investor confidence in the markets.\26\ In light of the
foregoing, the Commission believes that any applicant that requests an
exemption from clearing agency registration should meet standards that
are substantially similar to those standards required of registered
clearing agencies in order to assure that the fundamental goals of
Section 17A of the Exchange Act (i.e., safe and sound clearance and
settlement) will be achieved. Therefore, commentators are invited to
address whether granting the proposed exemption to ProTrade (1) would
further the development of a national clearance and settlement system,
(2) would promote linked and coordinated clearing facilities (among
options, futures, and other financial instruments), and (3) would
promote the maintenance of fair competition.
\24\ Securities Exchange Act Release No. 16900 (June 17, 1980)
45 FR 41920 (order approving standards for clearing agency
registration).
\25\ Securities Exchange Act Release No. 20221 (September 23,
1983), 48 FR 45167 (omnibus order granting full registration as
clearing agencies to The Depository Trust Company, Midwest Clearing
Corporation, Midwest Securities Trust Company, National Securities
Clearance Corporation, The Options Clearing Corporation, Pacific
Securities Depository, Philadelphia Depository Trust Company, and
Stock Clearing Corporation of Philadelphia).
\26\ Division of Market Regulation, The October 1987 Market
Break (February 1988), Chap. 10 (``Clearance and Settlement''), esp.
pp. 10-48 to 10-56; Division of Market Regulation, Market Analysis
of October 13 and October 16, 1989, pp. 118-173 (December 1990).
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Specifically, ProTrade's application raises the question of whether
the establishment of multiple unlinked securities clearing agencies is
consistent with Section 17A of the Act. One of the benefits of a single
clearing agency is centralized default administration. Conversely, the
introduction of multiple options clearing agencies, including options
clearing operations that may seem de minimis relative to the overall
market may have a fragmentation effect that could increase the risks
entailed in liquidating defaulting customers. Commentators should
discuss applicable law as well as the costs and benefits of single
versus multiple clearing facilities for option securities, including
whether the risk exposure to individual clearing organizations would be
increased by the fragmentation of the clearing function. Commentators
also should discuss the effects that stress to the marketplace (e.g.,
high volume and high volatility) possibly could have on such a multiple
clearing agency system.
B. Fair Competition
Section 17A of the Exchange Act requires the Commission, in
exercising its authority under that section, to have due regard for the
maintenance of fair competition among clearing agencies.\27\ In
addition, no clearing agency may be registered or granted an exemption
from registration, if its rules ``impose any burden on competition not
necessary or appropriate in furtherance of the purposes'' of the
federal securities laws.\28\ Therefore, the Commission must consider an
applicant's likely effect on competition in its review of any
application for registration as a clearing agency or for an exemption
from such registration and must balance any benefits or hindrances to
competition against any effects on the other statutory goals.\29\
\27\ 15 U.S.C. 78q-1(a)(2) (1988).
\28\ 15 U.S.C. 78q-1(b)(3)(I) (1988).
\29\ In Bradford National Clearing Corporation v. Securities and
Exchange Commission, 950 F.2d 1085, 1105 (D.C. Cir. 1978), the court
said:
[T]o the extent the legislative history provides any guidance to
the Commission in taking competitive concerns into consideration in
its deliberations on the national clearing system, it merely
requires the [Commission] to ``balance'' those concerns against all
others that are relevant under the statute.
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The Commission invites commentators to address whether an exemption
from registration as a clearing agency for ProTrade would result in
increased competition among option broker-dealers and among options
clearing agencies and whether such competition would, for example,
result in the development of improved systems capabilities, the
offering of new services, and the lowering of prices to customers. The
Commission also invites commentators to address whether the proposal
would impose any burden on competition that is inappropriate under the
Exchange Act.
V. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing application by February 16, 1995.
Such written data, view, and arguments will be considered by the
Commission in deciding whether to grant ProTrade's request for an
exemption from registration as a clearing agency. Persons desiring to
make written submissions should file six copies thereof with the
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549. Reference should be made to File No. 600-28.
Copies of the application and all written comments will be made
available for inspection and copying at the Commission's Public
Reference Room, 450 Fifth Street, NW., Washington, DC 20549.
For the Commission by the Division of Market Regulation,
pursuant to delegated authority.\30\
\30\ 17 CFR 200.30-3(a)(16) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-30907 Filed 12-19-95; 8:45 am]
BILLING CODE 8010-01-M
