[Federal Register Volume 62, Number 249 (Tuesday, December 30, 1997)]
[Proposed Rules]
[Pages 67996-68011]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33401]
[[Page 67996]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-39455; File No. S7-31-97]
RIN 3235-AG18
Net Capital Rule
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing for comment amendments to Rule 15c3-1 (``net capital rule''
or ``Rule'') under the Securities Exchange Act of 1934 (``Act''),
regarding the Commission's capital requirements for broker-dealers. The
proposed amendments, if adopted, would alter the charges, or
``haircuts,'' from net worth in computing net capital for certain
interest rate instruments, including government securities, investment
grade nonconvertible debt securities, certain mortgage-backed
securities, money market instruments, and debt-related derivative
instruments.
DATES: Comments must be received on or before March 30, 1998.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,
N.W., Stop 10-9, Washington, D.C. 20549. Comments also may be submitted
electronically at the following E-mail address: rule-comments@sec.gov.
All comment letters should refer to File No. S7-31-97. All comments
received will be available for public inspection and copying in the
Commission's Public Reference Room, 450 Fifth Street, N.W., Washington,
D.C. 20549. Electronically submitted comment letters will be posted on
the Commission's Internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at 202/942-0132; Peter R. Geraghty, Assistant Director, at
202/942-0177; Thomas K. McGowan, Special Counsel, at 202/942-4886;
Christopher M. Salter, Attorney, at 202/942-0148; or Gary Gregson,
Statistician, at 202/942-4156; Office of Risk Management and Control,
Division of Market Regulation, Securities and Exchange Commission, 450
Fifth Street, N.W., Mail Stop 2-2, Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION:
I. Introduction.
The Commission's net capital rule, Rule 15c3-1, is intended to
ensure that broker-dealers have sufficient liquid capital to protect
the assets of customers and to meet their responsibilities to other
broker-dealers.1 When calculating the value of their assets
for the purposes of establishing their net capital under Rule 15c3-1,
broker-dealers must reduce the market value of the securities they own
by certain percentages, or haircuts. Reducing the value of securities
owned by broker-dealers for net capital purposes provides a capital
cushion against adverse market movements and other risks faced by the
firms, including liquidity and operational risks.2
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\1\ 17 CFR 240.15c3-1
\2\ Liquidity risk is the risk that a firm will not be able to
unwind or hedge a position. Operational risk is the risk of
financial loss to the firm from human error or defects in
maintaining the firm's operating systems.
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The amendments proposed in this release (the ``Proposed
Amendments'') would change the haircuts applicable to most interest
rate instruments held in a broker-dealer's proprietary account. The
Proposed Amendments are similar in scope to the ``standard approach''
adopted by the Basle Committee on Banking Supervision (``Basle
Committee'') in its amendments to the Basle Capital Accord for market
risk arising from interest rate products.3 The amendments
adopted by the Basle Committee are discussed more fully in the text
below.
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\3\ The Governors of the G-10 countries established the Basle
Committee on Banking Supervision in 1974 to provide a forum for
ongoing cooperation among member countries on banking supervisory
matters.
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A. Fixed Income Products Proposal
The Commission is proposing for comment an amendment to the net
capital rule regarding the method of computing the haircuts applicable
to interest rate products. The Proposed Amendments would treat most
types of interest rate products as part of a single portfolio. Under
the Proposed Amendments, the net capital rule would recognize various
hedges among a portfolio of government securities,4
investment grade nonconvertible debt securities (or corporate debt
securities), Pass-Through Mortgage-Backed Securities,5
repurchase and reverse repurchase agreements, money market
instruments,6 and futures and forward contracts on these
debt instruments, and other types of debt-related derivatives (``Fixed
Income Products''). Consequently, the Proposed Amendments should better
match capital charges with actual market risk hedging practices
employed by broker-dealers. One result of the Proposed Amendments is
that positions may be moved into a registered broker-dealer from an
unregistered affiliate to take advantage of the single portfolio
concept in calculating haircuts, which should reduce capital
charges.7
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\4\ 15 U.S.C. 78c(a)(42).
\5\ For the purposes of the proposed Rule, ``Pass-Through
Mortgage-Backed Securities'' means any security issued under the
sponsorship of the United States or any agency thereof that
represents a pro rata interest or participation in the principal and
interest cash flows generated by a pool of mortgage loans of which
at least 95% of the aggregate principal is composed of fixed rate
residential mortgage loans on one to four family homes, including
five and seven year mortgage loans with balloon payments at
maturity. Under the proposed rule, multifamily, adjustable rate,
commercial, and mobile home mortgage loans are not considered Pass-
Through Mortgage-Backed Securities.
\6\ Money market instruments are defined in the Proposed
Amendments as commercial paper rated in one of the three highest
categories by at least two nationally recognized statistical rating
organizations, and negotiable certificates of deposit and bankers
acceptances issued by a bank as defined in Section 3(a)(6) of the
Act.
\7\ In a companion release being issued contemporaneously with
this release, the Commission is proposing a limited regulatory
system for a class of registered dealers active in over-the-counter
derivatives markets that will provide additional incentives to move
positions out of an unregistered affiliate into a registered broker-
dealer. For example, the Commission is proposing to allow these
dealers to use value-at-risk models for determining market risk
capital charges. These models would recognize more offsetting among
positions than the approach being proposed in this release.
Securities Exchange Act Release No. 34-39454 (December 17, 1997).
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Haircuts for municipal securities and non-investment grade debt
securities are not included in the Proposed Amendments. Municipal
securities would be treated separately under the net capital rule
because their market price depends on tax issues to a much greater
extent than other debt instruments. Non-investment grade debt
securities are excluded from the Proposed Amendments because their
price movements tend to be based primarily on issuer-specific factors,
much like equity securities. In addition, the Proposed Amendments will
not recognize hedges among interest rate instruments denominated in
different currencies because available evidence suggests that while
correlations of interest rate products denominated in different
currencies are generally positive, they are relatively low compared
with correlations for securities denominated in the same currency.
Therefore, broker-dealers would be required to separately calculate for
each currency their haircuts for Fixed Income Products denominated in
that currency.
The Commission requests comment regarding the Proposed Amendments,
and in particular, solicits comment on whether the Proposed Amendments
[[Page 67997]]
comport with how broker-dealers currently hedge their positions in
interest rate products, what instruments are used to hedge interest
rate risk, how capital charges for Fixed Income Products will differ
for particular firms under this proposal from the current Rule, and
alternative methods of calculating haircuts on interest rate products.
B. Background
The Commission is proposing for comment the Proposed Amendments as
the result of its efforts with the Basle Committee and the
International Organization of Securities Commissions (``IOSCO'') to
develop a consensus among different countries on the conceptual
framework underlying capital standards for interest rate instruments.
In 1988, the Basle Committee adopted its Capital Accord regarding a
minimum risk-based capital framework for banks. At that time, the
Capital Accord was designed primarily to deal with the credit risk in a
bank's loan portfolio, but the Basle Committee recognized that the
capital adequacy portion of the Capital Accord would have to be
broadened to cover market risk.8
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\8\ The Basle Accord is a common measurement system and a
minimum standard for capital adequacy of international banks in the
Group of Ten countries.
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In January 1996, the Basle Committee amended its Capital Accord to
include a comprehensive system of capital charges based on the market
risk in a bank's securities trading portfolio. Under the Capital
Accord, subject to the approval of applicable national banking
authorities, a bank may choose from two alternative methods for
calculating its market risk capital requirement. One method bases the
capital charges on a table of fixed-percentage charges similar to the
Proposed Amendments. The other method approved by the Basle Committee
allows certain banks to use value-at-risk models for calculating their
market risk capital requirements.
In May 1993, the Commission issued a Concept Release 9
soliciting comments on alternative methods for computing haircuts on
derivative financial instruments. Despite that release's focus on
derivative financial instruments, the Commission intended to commence a
broader dialogue with the industry regarding how the Rule could better
reflect the market and credit risks inherent in a broker-dealer's
proprietary securities portfolio. At that time, the Commission
envisioned a multi-step revision of the net capital rule that would
substantially change how broker-dealers calculate market and credit
risk haircuts arising from their proprietary positions.
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\9\ Securities Exchange Act Release No. 32256 (May 4, 1993), 58
FR 27486 (May 10, 1993) (``Concept Release'').
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In 1995, the Commission received the Framework for Voluntary
Oversight of the Derivatives Policy Group (``DPG''), consisting of the
six U.S. securities firms most active in the over-the-counter (``OTC'')
derivatives market. The DPG agreed to four major subjects of controls:
management controls, enhanced reporting, evaluation of risk in relation
to capital, and counterparty relationships. The DPG's evaluation of
risk envisioned a capital-at-risk computation that would enable the
Commission to assess the market risk in each firm's OTC derivative
positions.
At about the same time, the Commission proposed for comment
amendments to the net capital rule that would allow broker-dealers to
use a theoretical option pricing model to determine capital charges for
listed equity and currency options, and related positions.10
At that time, the Commission also authorized the Division of Market
Regulation (``Division'') to issue a no-action letter that permitted
broker-dealers to use the theoretical option pricing model to calculate
haircuts for listed options and related positions. In February 1997,
the Commission adopted final amendments to the net capital rule,
substantially as proposed, that allow firms to use theoretical option
pricing models in determining net capital requirements for listed
options and related positions.11
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\10\ Securities Exchange Act Release No. 33761 (March 15, 1994),
59 FR 13275 (March 21, 1994).
\11\ Securities Exchange Act Release No. 38248 (February 6,
1997), 62 FR 6474 (February 12, 1997).
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The Commission has also issued a concept release simultaneously
with this release that requests comment on how the net capital could be
amended, including whether statistical models should be used for
regulatory capital purposes.12 The method for calculating
haircuts on Fixed Income Products proposed in this release represents
one alternative for amending the Commission's net capital rule.
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\12\ Securities Exchange Act Release No. 34-39456 (December 17,
1997).
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II. Fixed Income Products
A. Current Haircut Treatment of Debt Securities
Haircut charges on interest rate securities are based on their
residual times to maturity and credit quality. This results in
securities with longer residual maturities receiving greater haircuts
than similar securities with shorter residual maturities. The charges
on adjustable rate debt securities are based generally on residual
maturity. The current Rule divides interest rate securities into
categories and subcategories. The current Rule permits complete or
partial netting (depending on the type of security) within a
subcategory, and it permits lesser netting within and between
categories.
Haircuts for each type of interest rate security (e.g., government,
municipal, and nonconvertible debt securities) are computed separately
from other types of interest rate securities, with limited exceptions,
restricting a broker-dealer's ability to reduce its haircut on
offsetting positions among different types of securities. For example,
the net capital charges for portfolios of government securities tend to
be lower than for other debt instruments because of significant, if not
complete, hedging allowances among government securities. The current
net capital rule recognizes to a lesser extent hedges between corporate
bonds and government securities.13
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\13\ 17 CFR 240.15c3-1(c)(2)(vi)(F)(3).
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B. The Proposed Amendments
1. General Description
Under the Proposed Amendments, a broker-dealer would calculate two
haircuts on its Fixed Income Products: a General Market Risk Charge and
a Specific Market Risk Charge.14 General market risk is the
risk that the price of the Fixed Income Product will change because of
market-wide changes in interest rates. The General Market Risk Charge
is intended to cover market risk factors common among different types
of interest rate instruments. Specific market risk is the risk of an
adverse price movement for a security which is unique to a particular
issue, but differs from a credit risk charge based on the risk that a
counterparty will not be able to fulfill its obligations.
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\14\ Appendix I is an example demonstrating how the haircuts are
calculated on a hypothetical portfolio under the Proposed
Amendments.
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By separating the haircut for Fixed Income Products into two
components, the Proposed Amendments recognize offsetting among the
changing market values of many different types of securities, such as
government securities and corporate debt, arising from general market-
wide changes in interest rates, and use the Specific Market Risk Charge
to capture risk that is not offset through these hedges.
2. General Market Risk Charge
Under the Proposed Amendments haircuts on unhedged positions in
Fixed Income Products would not change
[[Page 67998]]
significantly from the current net capital rule. However, as noted
above, Fixed Income Products under the proposal would be treated as
part of a single portfolio which would allow for greater hedging
benefits when calculating the General Market Risk Charge than under the
current Rule. In general, most Fixed Income Products would be slotted
into five maturity bands, or zones, and fifteen sub-zones based on
their residual maturity.15 For each sub-zone or zone, there
would be an associated haircut with offsets across different
maturities.
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\15\ The zone and sub-zone grid may be found in section
vi(A)(3)(i)(A) of the Proposed Amendments.
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Similar to the current net capital rule, the Proposed Amendments
would impose progressively larger haircuts as the securities increase
in maturity. This recognizes that the price volatility of Fixed Income
Products generally increases as their residual maturity increases.
Further, the Proposed Amendments assume that short and long term
interest rates tend to move together and that a movement in the market
value of a Fixed Income Product with a short residual maturity will, to
some degree, be offset by the price movement in the market value of an
opposite position in a Fixed Income Product with a longer residual
maturity. However, the degree to which prices of Fixed Income Products
with different maturities move in the same direction after a change in
interest rates is smaller as their residual maturities get farther
apart. In other words, the price movements of debt instruments of
similar residual maturities are more highly correlated than the price
movements of debt instruments with significantly different residual
maturities.
The calculation of the General Market Risk Charge incorporates the
assumptions described above regarding the correlation of debt
instruments based on residual maturity. Offsetting positions in Fixed
Income Products positions with the same residual maturities are subject
to a haircut. Any remaining amounts not offset within the same sub-zone
may then be netted against positions with different residual
maturities, albeit with greater haircuts. Essentially, this method of
calculating haircuts for a mixed portfolio is designed to account for
risk across the interest rate curve and the basis risk for those
securities which are closely related in maturity.
Prior to calculating the General Market Risk Charge, a broker or
dealer must place each long or short Fixed Income Product into one of
15 designated sub-zones. The use of 15 sub-zones provides for a capital
cushion for offsetting positions with significantly different residual
maturities and reflects the fact that prices of Fixed Income Products
tend to move at increasingly different rates when their residual
maturities are further apart.
Fixed Income Products, with certain exceptions, are placed into the
sub-zones based on residual maturity, while certain variable rate
instruments are categorized by the time to their Next Interest Reset
Date.16 By categorizing Fixed Income Products other than by
residual maturity, the Proposed Amendments may more accurately group
Fixed Income Products with similar market risks into the same sub-zone.
Mortgage-Backed Pass-Through Securities fit into the sub-zones based on
their market value relative to par value. Deep discount bonds (which
include bonds that do not pay current interest) are slotted into one of
two sub-zones that apply only to deep discount bonds. Each leg of an
interest rate swap is translated into a synthetic bond with a market
value equal to the value of the notional coupon and a maturity equal to
the residual maturity of the swap or the time until the Next Interest
Reset Date, if appropriate. These synthetic bonds then are placed into
the sub-zones like any other Fixed Income Product.17
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\16\ Next Interest Rate Reset Date means the maturity date of
the instrument or, if earlier, the next date as of which the
interest rate on the instrument is subject to being either increased
or decreased, as applicable, by an amount that is at least 0.5%
greater or lesser than the current interest rate on the instrument.
The requirement that the rate be able to move by at least 0.5%
excludes those securities that are at or near their rate cap and
therefore tend to behave like a fixed rate security.
\17\ The reasons for slotting these assets into the sub-zones
other than by residual maturity is explained in further detail in
Section II.C. of this release.
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The General Market Risk Charge is defined as the sum of (A) the
Sub-Zone Charges, (B) the Zone Charges, (C) the Between Zone Charges,
and (D) the Residual Charge, each of which is described below.
The percentage haircut for particular sub-zones, or market risk
weight, ranges from 0 percent for a Fixed Income Product with one month
or less to maturity to 12 percent for deep discount bonds with more
than 20 years to maturity. These percentages were developed based on
two components. The first component is the modified duration of a bond
with a maturity equal to the mid-point of the respective sub-zone,
assuming an 8 percent interest rate environment and an 8 percent
coupon. The second component is an assumed change in yield that is
designed to cover about two standard deviations of one month's yield
volatility in most major markets. The two components are multiplied to
give a percentage weighting factor for each sub-zone.
a. Sub-Zone Charge. Because most hedged positions among Fixed
Income Products are not perfect hedges, the Proposed Amendments place a
charge, the Sub-Zone Charge, on hedged positions to reflect the broker-
dealer's residual exposure to market risk from the hedge. The Sub-Zone
Charge is calculated in two steps. The first step is to calculate the
Sub-Zone Charge for offsetting swap positions, and the second step is
to calculate the Sub-Zone Charge for other offsetting positions within
the same sub-zone. The Sub-Zone Charge for offsetting swaps is
calculated separately from other offsetting positions because of the
significantly higher degree of correlation among offsetting swaps
positions compared to hedges among other types of debt instruments.
The Sub-Zone Charge for offsetting swaps applies only to hedged
positions exclusively between interest rate swaps in the same sub-zone.
The Sub-Zone Charge for offsetting swap positions is determined by
multiplying the lesser value of the long or short swap positions in
each sub-zone by the applicable sub-zone percentage; then multiplying
that product by one percent. The remaining swap positions are then
combined with other Fixed Income Product positions in that sub-
zone.18
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\18\ For example, if a broker-dealer had a $20 million long swap
position and a short swap position of $30 million in sub-zone (ii),
the sub-zone disallowance for offsetting swaps would be equal to the
product of $20 million x 0.2% x 1% (or $400); the difference
between the $30 million short position and the $20 million long
position would be added to the aggregate value of the broker-
dealer's short positions in other securities in sub-zone (ii) for
the purposes of calculating the sub-zone disallowance for other
securities.
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The Sub-Zone Charge for positions other than swaps is calculated by
multiplying the lesser value of the long or short positions in each
sub-zone by the applicable sub-zone percentage; and then multiplying
that product by five percent. The sum of the Sub-Zone Charge for
offsetting swaps and the Sub-Zone Charge for other positions, for each
sub-zone, is the total Sub-Zone Charge. The difference between the
aggregate values of the long and short positions in these Fixed Income
Products in each sub-zone (the unhedged amount), multiplied by the
applicable sub-zone percentage, is the Long or Short Sub-Zone Carry-
Forward
[[Page 67999]]
Amount for each sub-zone.19 The Sub-Zone Carry-Forward
Amounts are used to calculate the Zone Charge.
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\19\ For example, a broker-dealer that has positions in sub-zone
(ii) other than swap positions, equal to a long position of $10
million, a short position of $5 million, and $2 million in a non-
offsetting short swap position that carried forward, the sub-zone
disallowance would be equal to $7 million x 0.2% x 5% (or $700).
The Long Sub-Zone Carry-Forward Amount would be $3 million x 0.2%
(or $6,000).
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b. Zone Charge. Similar to the Sub-Zone Charge, the Zone Charge is
the haircut on hedged positions within the same zone. Because there
will be greater disparity among the residual maturities of these
positions, the percent charge for these offsetting positions is higher
than the Sub-Zone Charge.
In calculating the Zone Charge, the Long and Short Sub-Zone Carry
Forward Amounts for each zone are totaled separately and are identified
respectively as the Long and Short Zone Positions. The Zone Charge for
each zone equals the lesser of the Long or Short Zone Positions for
each Zone multiplied by the percentage set forth in the Rule's Zone
Charge provisions.20 The difference between the Long and
Short Zone Positions in each zone (the unhedged amount) is called the
Long or Short Zone Carry-Forward Amount for that zone and is used to
calculate the Between Zone Charge.21
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\20\ See paragraph (c)(2)(vi)(A)(3)(iii)(A) of the Proposed
Amendments.
\21\ If in Zone 1, a firm had a $10,000 Long Sub-Zone Carry-
Forward Amount from sub-zone (ii), and a $4,000 Short Sub-Zone
Carry-Forward Amount from sub-zone (iii), the Zone Charge would be
$4,000 x 0.25 (or $1,000). The Long Zone Carry-Forward Amount would
be $10,000 less $4,000, or $6,000.
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c. Between Zone Charge. The Between Zone Charge is the charge for
offsetting positions in different zones. As the disparity between the
residual maturities of the hedged positions grows, the percentage
charge increases because the positions reflect increasingly imperfect
hedges. Calculating the Between Zone Charge requires two separate
computations: one for adjacent zones and the other for non-adjacent
zones. Because the difference in the residual maturities of offsetting
positions in non-adjacent zones may be much greater than between
positions in adjacent zones, the charges are greater for offsetting
positions in non-adjacent zones.
The Between Zone Charge for adjacent zones is arrived at by
multiplying the lesser of the Long or Short Zone Carry-Forward Amounts
in two adjacent zones by the Between Zone Charge
percentages.22 The difference between the Long and Short
Zone Carry-Forward Amount in two adjacent zones (the unhedged amount)
may be used to offset positions in other adjacent zones. Any remaining
Long and Short Zone Carry-Forward Amounts not offset by amounts in
adjacent zones is called the Long or Short Between Zone Carry-Forward
Amount.
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\22\ See paragraph (c)(2)(vi)(A)(3)(iv)(A) of the Proposed
Amendments.
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The Between Zone Charge for non-adjacent zones is arrived at by
multiplying the lesser of the Long or Short Between Zone Carry-Forward
Amounts by the Between Non-Adjacent Zone Charge
percentages.23 Generally, this permits a substantial amount
of netting on a weighted basis among positions that vary in maturities,
some as far apart as twenty years.
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\23\ If a broker-dealer had a Long Zone Carry-Forward Amount of
$6,000 from Zone 1 and a Short Zone Carry-Forward Amount of $10,000
from Zone 2, the Between Zone Disallowance would be $6,000 x 50% (or
$3,000). The remaining Short Zone Carry-Forward Amount from Zone 2
($4,000) may be used to offset long amounts in Zone 3 or Zone 4.
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d. Residual Charge. The Residual Charge consists of any remaining
Between Zone Carry-Forward Amounts that have not been offset. For the
purposes of the Proposed Amendments, these are the equivalent of
unhedged positions.
The Commission requests comment on the Sub-Zone, Zone, Between Zone
and Residual Charges, and how these Charges may be modified.
3. Specific Market Risk Charge
Fixed Income Products, with the exception of government securities
and synthetic bond positions, are subject to a Specific Market Risk
Charge. A broker-dealer's total Specific Market Risk Charge is the sum
of the charges for each individual Fixed Income Product. The Specific
Market Risk Charge is intended to address issuer-related and liquidity
risks associated with the underlying instruments. There is no need for
this Charge for synthetic bonds which do not have identifiable specific
risks. This Charge, as noted above, has no relationship to a credit
charge for counterparty risk in derivative non-exchange traded
instruments.
The Specific Market Risk Charge is a prescribed percentage of the
market value of the instrument. The two factors used in determining the
percentage rate for this Charge are the maturity of the instrument and
whether its interest rate is fixed or adjustable.
The Specific Market Risk Charge may not be reduced by offsetting
positions in different securities of the same issuer or securities of
different issuers because these securities and issuers may have
different liquidity and issuer risks which might prevent correlated
market movements.
C. Treatment of Specific Fixed Income Products
Provided below is a description of how haircuts are presently
calculated for the various types of Fixed Income Products affected by
the proposed amendments and how the haircuts for those Fixed Income
Products would be calculated under the Proposed Amendments. The
Commission request comment on the proposed net capital treatment of
each of the interest rate instruments discussed below.
1. Government Securities
Currently, the government securities haircut schedule, set forth in
paragraph (c)(2)(vi)(A) of the Rule, separates government securities
into four categories and twelve subcategories. Each subcategory
includes a prescribed band of maturities.24 The haircut for
each subcategory, assuming no other netting, is the net position in a
particular subcategory multiplied by a specified percentage, or
haircut.25 The haircuts for government securities range from
0 percent for securities with a residual maturity of less than three
months to 6 percent for securities with a residual maturity of 25 years
or more. The charge for each category is the net of the aggregate
charges on the long subcategory positions and the aggregate charges on
the short subcategory positions in the category plus 50 percent of the
lesser of the aggregate charges on the long or short
positions.26 For example, under the current Rule, a firm
with a $40,000,000 long position in government securities with 16
months remaining maturity and a $10,000,000 short position in
government securities with 30 months remaining maturity (both category
2 government securities), would take the following deduction for
category 2:
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\24\ Category 1 covers securities with a residual maturity of
less than 12 months to maturity. Category 2 covers securities from 1
year to 3 years. Category 3 covers securities from 3 years to 10
years. Category 4 covers securities over 10 years.
\25\ For example, the haircut for a broker-dealer with a $7
million long position and a $4 million short position in Treasuries
with remaining maturities between 9 months and one year would be $3
million multiplied by 1%, or $30,000.
\26\ See the text.
[[Page 68000]]
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Long Short Net % Haircut
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(i) 40,000,000 40,000,000 1.5 600,000
(ii) (10,000,000) (10,000,000) 2.0 (200,000)
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400,000
200,000 x 50%= 100,000
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Total Deduction 500,000
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This treatment allows partial netting of long and short positions
within a category. The current Rule also allows further netting of a
position within one category and one in an adjacent category under
certain circumstances, and permits the partial netting of certain
corporate securities with government securities within certain limits.
In sum, the current Rule permits limited offsets within categories, and
complete offsets for certain offsetting long and short positions (e.g.,
those in the same subcategory). A broker-dealer that has been
designated as a primary dealer by the Federal Reserve Bank of New York
may reduce its haircut charges on government securities by 25 percent
if it maintains a minimum tentative net capital of at least $50
million.27
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\27\ 17 CFR 240.15c3-1(c)(vi)(A)(5).
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Under the Proposed Amendments, government securities would not be
subject to a Specific Market Risk Charge. With respect to the General
Market Risk Charge, under the Proposed Amendments, government
securities generally would be placed into one of the fifteen sub-zones
based on residual time to maturity. Because the Proposed Amendments
adopt a portfolio view for calculating haircuts by allowing all types
of Fixed Income Products (with certain exceptions) to be combined into
the same sub-zones, the Proposed Amendments would expand the ability of
firms to hedge positions in government securities with other types of
interest rate instruments.
2. Investment Grade Nonconvertible Debt Securities and Money-Market
Debt Instruments
The current formula for determining haircuts for investment grade
nonconvertible debt securities, consisting primarily of corporate debt
securities, separates bonds into nine different categories based on
residual maturity.28 To be treated as an investment grade
nonconvertible debt security, the security must not be traded flat or
in default as to principal or interest and must be rated in one of the
four highest rating categories by at least two nationally recognized
statistical rating organizations. Charges range from 2 percent for
securities with less than 1 year residual maturity to 9 percent for
securities with a residual maturity of 25 years or greater. The charge
is applied to the greater of the long or short position in each
category. Firms may also partially offset investment grade
nonconvertible debt securities with government securities or other
corporate securities with similar residual maturities.
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\28\ 17 CFR 240.15c3-1(c)(2)(vi)(F). Paragraph (c)(2)(vii) of
the Rule regarding non-marketable securities would still apply to
all inventory.
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Under the Proposed Amendments, investment grade nonconvertible debt
securities as well as commercial paper, bankers acceptances, and
certificates of deposit would be subject to the Specific Market Risk
Charge as well as the General Market Risk Charge. The criteria for
determining whether the paper is investment grade would be the same as
under the current net capital rule. The Specific Market Risk Charge for
fixed rate investment grade nonconvertible debt ranges from 0.25
percent to 1.6 percent. As with government securities, fixed rate
investment grade nonconvertible debt would be placed into the sub-zones
based on residual maturity to compute the General Market Risk Charge.
Adjustable rate investment grade nonconvertible debt would be
placed into the sub-zones generally based on the time to the Next
Interest Reset Date if the interest rate on the instrument may be
either increased or decreased, as applicable, by at least 0.5 percent.
An adjustable rate investment grade nonconvertible debt instrument that
is within 0.5 percent of its rate cap would be placed into the sub-
zones based on its residual maturity. That instrument, although
technically a variable rate instrument, would tend to behave like a
fixed rate instrument given a change in interest rates.
Zero coupon and deep discount bonds 29 with residual
maturities of six years or greater would be slotted, based upon
residual maturity, into higher sub-zones than their residual
maturities. Since their prices tend to be more volatile than coupon
bonds of the same maturity, simply slotting such bonds according to
residual maturity would underestimate risk and allow offsetting between
positions that have substantially different risk profiles.
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\29\ Deep discount bonds are defined generally as Fixed Income
Products that either do not pay interest or are priced at 50% or
less of their par value. See paragraph (c)(2)(vi)(A)(4)(iv) of the
Proposed Amendments.
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3. Pass-Through Mortgage-Backed Securities
Under the current net capital rule, mortgage-backed securities
issued or guaranteed as to principal or interest by the United States
or any agency thereof are treated as U.S. Government securities for the
purposes of calculating haircuts. As with Treasury securities and other
government securities, the current net capital rule bases the charges
for mortgage-backed securities on their residual maturity and allows
the securities to be offset against other government securities with
similar residual maturities.
Mortgage-backed securities present particularly difficult net
capital problems because partial payments of principal are generally
made on a routine basis and often the entire principal is paid at an
early stage in the maturity of the instrument. These principal payments
or probabilities of prepayment drastically change the effective
maturity of these instruments. Because the current Rule bases the
charges for mortgage-backed securities on residual maturity rather than
on criteria that better reflect their price volatility and duration,
the haircut may overstate the risk on individual positions, and
understate the risk on positions considered hedged by the Rule which
may in fact not be adequately hedged. For example, the net capital rule
may impose a large haircut on a position in mortgage-backed securities
with a small duration but a long residual maturity but impose no charge
for a position in the same mortgage-backed security hedged with a
Treasury security with a similar residual maturity but with a longer
duration.
It has been argued that a mortgage-backed security with a
relatively high coupon rate should experience a significant amount of
prepayment of principal and, consequently, will tend to act more like a
security with less time
[[Page 68001]]
to maturity. Based on the apparent correlation between the price of an
instrument and its probable maturity, the Division issued a no-action
letter permitting firms to place certain mortgage-backed securities
into the government securities haircut categories of the current net
capital rule based on their market price relative to their par
value.30
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\30\ Letter regarding Pass-Through Mortgage Securities (December
30, 1996).
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The proposed rule incorporates this approach and allows firms to
hedge Pass-Through Mortgage-Backed Securities 31 against
other Fixed Income Products, consistent with the general intent to
allow some hedging of all interest rate instruments.
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\31\ Supra note 5.
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4. Futures and Forwards
The current net capital rule provides that capital charges for
futures contracts are based on the margin requirement of the applicable
commodity clearing organization, although these positions may be
inserted into the present grid and treated like securities positions.
The capital charge for forward contracts on securities is based on the
underlying instrument.32 There also are allowances made for
offsetting positions under prescribed circumstances.
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\32\ The general net capital treatment of forwards on
commodities (other than foreign currencies) is set forth in Appendix
B of Rule 15c3-1. Broker-dealers must deduct 20% of the market value
of uncovered forward contracts to account for market risk. Broker-
dealers incur no market risk deduction if the forward is currently
registered as deliverable on a contract market and is covered by an
open futures contract or by a commodity option on a physical.
Broker-dealers incur a market risk deduction of 10% for other
forward contracts to purchase or sell commodities which are not
registered as deliverable that are covered by an open futures
contract.
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As proposed herein, all futures and forwards on Fixed Income
Products will be included in the General Market Risk sub-zones. A
future or forward would be incorporated into the grid by inserting into
the sub-zones any of the instruments deliverable against the future or
the forward, up to the market value of the future or forward. Once the
deliverable instrument is placed into a sub-zone, it would be subject
to the same haircuts and offsets as other Fixed Income Products.
However, there is no Specific Market Risk Charge for futures and
forwards on Fixed Income Products.
5. Interest Rate Swaps
A basic interest rate swap or a ``plain vanilla'' swap involves the
exchange of specified or determinable cash flows at specified times
based upon a notional amount. The notional amount is not exchanged but
is used to calculate the fixed or floating rate interest payments made
under the swap. Presently, the current net capital rule generally
treats any net interest payment due from an interest rate swap as an
unsecured receivable (absent the presence of liquid collateral) that
must be deducted from the broker-dealer's net worth in arriving at its
net capital. The broker-dealer also is required to take an additional
haircut on the notional amount of the swap as the market risk haircut.
The proposed rule would require that interest rate swaps be placed
into the General Market Risk sub-zones by converting each side of the
swap into synthetic bond positions based on the notional amount of the
swap and the interest rates against which payments are calculated. A
broker-dealer would calculate the market value of the synthetic bond by
adjusting the value of the notional amount under the swap for changes
in interest rates in the same way that a debt security is marked-to-
market. These synthetic bonds then would be placed into the appropriate
sub-zones. As with all synthetic bond positions, these positions would
not be subject to Specific Market Risk Charges.
Any obligation to receive payments under the swap would be
categorized as a long position; any obligation to make payments under
the swap would be characterized as a short position.33 A
position receiving or paying based on a floating interest rate
generally will be treated as having a maturity equal to the period
until the Next Interest Reset Date; a position receiving or paying
based on a fixed rate will be treated as having a maturity equal to the
residual maturity of the swap.
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\33\ For example, an interest rate swap under which a firm is
receiving payments based on a floating rate interest and paying
based on a fixed interest rate would be treated as a long position
in a floating rate instrument with a maturity equivalent to the
period until the Next Interest Reset Date and a short position in a
fixed rate instrument with a maturity equivalent to the residual
life of the swap.
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Any interest rate portion of a swap that pays or receives according
to the value of one or more equity securities (i.e., an equity swap)
would be slotted into the General Market Risk sub-zones. The equity
portion of the swap would be treated, for purposes of the net capital
rule, as an equity security or equity index, as appropriate, with a
market value equal to the notional value of the swap.
As noted above, the Sub-Zone Charges, or haircuts, for synthetic
bond equivalent positions derived from interest rate swaps would be
calculated separately from other Sub-Zone Charges (e.g., government
securities and Pass-Through Securities) under the Proposed Amendments.
Synthetic bond equivalents derived from interest rate swaps, when
offset against one another, would be subject to a 1 percent Sub-Zone
Charge, instead of the 5 percent Sub-Zone Charge applicable to non-swap
positions.
6. Repurchase (``Repo'') and Reverse Repurchase Agreements (Reverse
Repo)
Under the current Rule, a broker-dealer does not take a haircut on
repo or reverse repo transactions 34 to reflect market risk.
However, a broker-dealer engaging in reverse repo transactions must
maintain additional net capital if it is holding collateral that far
exceeds the contract price under the agreement.35 In
addition, a broker-dealer must also subtract from its net worth any
deficiency arising under a reverse repo if the market value of the
securities it holds is less than the contract price.36 For
repo transactions, Rule 15c3-1 requires a broker-dealer to take a
deduction from its net worth if it has delivered to the counterparty
securities in excess of the contract price of the repo, under certain
circumstances.37
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\34\ A repurchase agreement, or repo, is an agreement between a
buyer and a seller, usually of U.S. government securities, where the
seller agrees to repurchase the securities from the buyer at an
agreed upon price and, usually, on a stated date. In a reverse
repurchase agreement, the broker-dealer has purchased the securities
from the counterparty and has agreed to resell them at the agreed
upon price.
\35\ 17 CFR 240.15c3-1(a)(9).
\36\ 17 CFR 240.15c3-1(c)(2)(iv)(F)(2).
\37\ 17 CFR 240.15c3-1(c)(2)(iv)(F)(3).
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The Commission is proposing that repos and reverse repos be
incorporated into the Proposed Amendments by treating each repo and
reverse repo transaction as a short or long position, respectively, in
a synthetic bond with a maturity equal to that of the contract or the
Next Interest Rate Reset Date, whichever is less. This would allow
repos and reverse repos to act as hedged positions where appropriate.
In addition, the Commission also requests comments on whether these
should be marked-to-market daily for net capital purposes in the same
manner that a Treasury security is marked-to-market for a change in
interest rates.
D. Product Specific Issues
Although the Proposed Amendments recognize, for net capital
purposes, offsetting positions among most types of interest rate
products, the Commission believes that it is desirable to expand the
proposal to permit offsetting among additional types of interest rate
products. Five different types of interest rate products that are not
included in the proposal are described below, and
[[Page 68002]]
the Commission seeks comment on how these instruments could be
incorporated into the Proposed Amendments.
1. Mortgage-Backed Securities and Certain Non-Qualified Mortgage Pass-
Through Securities
As noted, the Commission believes it is desirable to include all
mortgage securities into a unified haircut methodology to give more
recognition to hedging strategies employed by broker-dealers.
Nonetheless, the Commission's proposal does not include certain
mortgage securities, such as collateralized mortgage obligations
(``CMOs''), interest-only mortgage securities (``IOs''), principal-only
mortgage securities (``POs''), and mortgage pass-through securities
that are not collateralized by level payment loans on one to four
family homes.
There have been several alternatives suggested by broker-dealers to
deal with these securities. One would slot CMOs into the maturity bands
for interest rate products based on one day less than one-half the
stated maturity of the CMO. While this proposal may provide adequate
levels of capital for unhedged positions, the proposal does not appear
to address the varied hedging strategies associated with CMOs. The
second suggestion would slot CMO's into the various categories based on
price, third party prepayment forecast systems, and historical
volatility for the various classes of CMOs. This method would reflect
more closely the various hedging strategies involving CMOs, but is both
complex and based on subjective judgements regarding prepayments of
principal. A third alternative would be to allow some type of internal
modelling to serve as the basis for calculating haircuts on these
instruments. This presents substantial examination burdens and might
lead to excessive leverage and inadequate capital levels. Each
alternative, however, deserves consideration, and the Commission
solicits comment on each of these alternatives.
2. Non-Investment Grade Debt
The Proposed Amendments also do not include high-yield bonds (also
known as ``junk'' bonds). Under the current Rule, non-investment grade
bonds having a ready market are treated as if they were equity
securities requiring a capital charge of at least 15 percent. In a no-
action letter, the Division stated that whether these securities had a
ready market depended on the amount of the initial issuance, whether
the securities can be publicly sold without registration with the
Commission, and whether there is currently available public
information.38
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\38\ See Letter Regarding Ready Marketability of Noninvestment
Grade Debt (February 14, 1994).
---------------------------------------------------------------------------
The Commission preliminarily believes that it is inappropriate to
permit non-investment grade bonds to be offset, or hedged, with other
debt instruments because non-investment grade bond prices are much more
dependent on issuer-specific risk factors, similar to those important
in the pricing of equity securities, than on general market risk
factors.39 However, the Commission seeks comment on
alternative methods of determining haircuts for non-investment grade
bonds and whether those securities should be used to offset positions
in other securities.
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\39\ As indicated by a number of studies, movements in most non-
investment grade bonds are not highly correlated with movements of
high-quality bonds. One study found a higher correlation between a
long-term high-yield (i.e., junk bond) index and the S&P 500 index
than it found between the high-yield index and U.S. Treasuries or
investment grade corporate bonds. (See Paul H. Ross, et al., High-
Yield Corporate Bonds: An Asset Class for the Allocation Decision,
Salomon Brothers (February 1989)). The study found a 0.93
correlation between AA-rated corporate bonds and U.S. Treasuries,
but only a 0.45 correlation between the high-yield index and U.S.
Treasuries. The correlation of the high-yield index with the S&P 500
was 0.63.
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3. Interest Rate Instruments Denominated in Foreign Currencies
Under this proposal, instruments denominated in different
currencies would not be permitted to be offset against one another.
Thus, broker-dealers would have to calculate their market risk haircut
for Fixed Income Products separately for each currency in which those
instruments are denominated. Available evidence suggests that while
correlations of interest rate products denominated in different
currencies are often positive, they are relatively low when compared
with correlations for securities denominated in the same currency. The
Commission solicits comment on the appropriateness of permitting
different currency interest rate instruments to offset one another. The
Commission also requests comment on methods for addressing the foreign
exchange risk of these securities.
4. Forward Rate Agreements and Eurodollar Futures
In a forward rate agreement, two parties agree on a fixed interest
rate that is to be paid on a notional deposit of a specified maturity
commencing at a future date. A Eurodollar future is a U.S. dollar
denominated, cash settled futures contract where the underlying
instrument is a Eurodollar 40 time deposit commencing on a
specific forthcoming date. These instruments are commonly used to
offset future payment streams stemming from obligations of current
interest rates, including interest rate swaps. The Commission seeks
comment on how these instruments may be incorporated into the net
capital rule.
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\40\ A Eurodollar is U.S. currency held in banks outside the
United States, mainly in Europe, and commonly used for settling
international transactions.
---------------------------------------------------------------------------
5. Fixed Income Options
Options on U.S. Treasury Securities and certain debt instruments
issued by agencies of the U.S. Government and options on futures on
these securities (``Fixed Income Options'') can comprise an important
element of a broker-dealer's interest rate book. As discussed earlier,
the Commission recently adopted amendments to the net capital rule that
permit an options pricing model to be used to determine capital charges
for listed options and their related positions. The Commission is
seeking comment on whether it may be possible to use a similar approach
to determine haircuts on over-the-counter Fixed Income Options.
One alternative would be to reprice the option, as with listed
options, after changing the price of the underlying security based on
specific market ``shocks'' specified by the Commission. For example,
for domestic interest rate products, the entire universe of underlying
securities could be represented by the U.S. Treasury yield curve, which
includes market yields for 3-month to 30-year securities. The broker-
dealer would then subject its Fixed Income Options portfolio to
different types of shocks. One type of shock could be obtained by
imposing a parallel shift in the yield curve. A second type of shock
could be obtained by changing the slope of the yield curve. Third, the
implied volatilities along the yield curve could also be increased or
decreased.
The Commission seeks comment on the feasibility of using an options
pricing model with prescriptive shocks for over-the-counter Fixed
Income Options as well as suggestions for other methods for calculating
haircuts on Fixed Income Options.
E. Non-Model Based Alternatives to the Proposed Amendments
The Commission believes that the maturity-based Proposed Amendments
for Fixed Income Products meet two important objectives. First, the
Proposed Amendments are an objective method for calculating regulatory
net capital
[[Page 68003]]
whose results apply consistently to all broker-dealers. Second, the
application and results of the Proposed Amendments can be readily
verified by examiners and independent auditors. Importantly, the
Proposed Amendments would differ from the current net capital rule in
allowing broker-dealers to receive greater hedging benefits among a
wider variety of interest rate instruments. Nonetheless, the Commission
is aware that different entities may favor modifications or
alternatives to the Proposed Amendments. The Commission solicits
comment on the viability and the advantages and disadvantages of the
Proposed Amendments, the alternative approaches described below, and
any alternatives not discussed by the Commission in this release. In a
separate release, the Commission is soliciting comments on the use of
value-at-risk models for capital purposes.41
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\41\ Securities Exchange Release No. 34-39456 (December 17,
1997).
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1. Duration
One alternative to the Proposed Amendments could be to use duration
bands, instead of residual maturity bands, in determining the capital
charges to be applied to specific positions in interest rate products.
Duration is a mathematical concept which attempts to measure the
sensitivity of bond prices to general interest rate changes. Generally,
duration-based formulas express the weighted average time to payment of
the cash flows of a bond (both interest and principal) where the
weights are the present values of the cash flows themselves. Each cash
flow is reduced to its present value. The point in time at which half
of the cash flows (expressed in present value) would be received is
commonly referred to as the duration of the bond.42
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\42\ The concept of modified duration is also commonly used.
Modified duration is the price elasticity of a bond (i.e., the
percentage change in price for a one percent change in yield).
---------------------------------------------------------------------------
The Commission initially believes that a duration band analysis may
be too complicated for calculating regulatory capital requirements; it
requires examiners to re-calculate, on a daily basis, the duration of
each Fixed Income Product in a firm's portfolio to reflect daily
changes in interest rates. By basing haircuts on residual maturity
instead of a daily duration calculation, the current net capital rule
and the Proposed Amendments are computationally less intensive than a
duration band approach. Nonetheless, the residual maturity method used
in the current Rule and the Proposed Amendments are relatively close
approximations to the duration method in determining capital charges
for a hedged portfolio.43 Consequently, the nominal increase
in the precision of the price sensitivity estimate under the duration
analysis over the residual maturity method may be outweighed by the
costs associated with the greater complexity of the duration method.
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\43\ If two securities have similar durations but different
residual maturities, under the duration method they would receive a
comparatively small haircut. Under the Proposed Amendments, the
security with a longer residual maturity would tend to have a
greater market value and would receive a comparatively larger
haircut than the security with the shorter residual maturity. The
residual amounts available for offset under the Proposed Amendments
would tend to be roughly equal. Therefore, under the Proposed
Amendments, the two positions would receive a capital charge similar
to the charge under the duration method.
---------------------------------------------------------------------------
2. Rolling Time-Band
One modification to the Proposed Amendments could be to eliminate
the zones and instead determine offsets according to a ``rolling band
approach'' between the fifteen different sub-zones, or maturity bands.
Under this approach, the charge, or degree of offset, between opposite
positions in different maturity bands would be computed based on the
number of maturity bands that separate the long and short positions.
For example, positions in adjacent maturity bands might be subject to a
20 percent charge, while positions separated by two maturity bands
might be subject to a 30 percent charge, and so on. There would be a
limit to how far apart the positions could be in the maturity bands and
still be subject to an offset. While this approach refines the Proposed
Amendments, the different ways a particular position could be offset
may make this haircut calculation more complicated to program and to
audit.
3. Cash-Flow Buckets
Another alternative to the Proposed Amendments would be to employ a
cash flow-based approach. For example, a thirty-year Treasury bond
would have 61 cash flows: 60 semi-annual interest payments for thirty
years and a principal payment in the final year. Each cash flow
theoretically could be inserted into the sub-zone corresponding to the
time when that payment or receipt would be made. To the extent the
expected payments and receipts in a particular sub-zone would not
offset each other completely, a capital charge would be assessed on the
net position. As with the current proposal, this approach also would
require a charge on the matched position within a sub-zone to account
for basis risk.
* * * * *
The Commission solicits comment on whether the potential benefits
of each of these approaches outweigh their complexity, and encourages
commenters to submit analysis or data on the likely costs of the
alternative approaches. The Commission specifically requests comment on
how the expected cash flows in Alternative 3 could be determined,
especially for products whose cash flows are more difficult to predict,
such as CMOs.
III. Costs and Benefits of the Proposed Rule Amendments and Their
Effects on Competition
To assist the Commission in its evaluation of the costs and
benefits that may result from the Proposed Amendments, commenters are
requested to provide analyses and data relating to the costs and
benefits associated with any of the proposals herein. In particular,
the Commission requests comments on the potential costs for any
necessary modifications to accounting, information management, and
recordkeeping systems required to implement the proposed rule changes.
The Commission estimates that approximately 1,350 broker-dealers will
be affected by the Proposed Amendments. The Proposed Amendments have
been tailored to minimize their burden on affected small broker-dealers
while at the same time protecting the markets and investors. The
Commission estimates that of the approximately 5,300 small broker-
dealers registered with the Commission, only approximately 370 have
proprietary positions in Fixed Income Products and are subject to the
Rule. The Commission believes that the burden imposed upon broker-
dealers will be significantly outweighed by the potential savings to
broker-dealers from reduced capital requirements and increased
efficiencies. The Commission requests comment on the extent to which
the Proposed Amendments will reduce capital requirements. Commenters
should provide estimates of the reduction in their capital
requirements.
The Proposed Amendments provide broker-dealers the opportunity to
reduce their capital charges. The Proposed Amendments change the
haircuts applied to Fixed Income Products by combining different
interest rate instruments into one haircut calculation that recognizes
hedging among many more types of interest rate products than permitted
under the current Rule. By recognizing more types of hedging
[[Page 68004]]
techniques, the Proposed Amendments should lower the haircuts for firms
with well-hedged portfolios of Fixed Income Products and reduce a
broker-dealer's incentive to fractionalize its business between the
broker-dealer and its unregistered affiliate. Reducing a broker-
dealer's need to fractionalize its securities business should allow a
broker-dealer to increase its operational efficiency. Finally, by
expanding the types of hedging recognized in the Rule, the Proposed
Amendments should better reflect the hedging strategies currently used
by broker-dealers.
The Commission preliminarily believes that the Proposed Amendments
will promote both efficiency and capital formation. As previously
discussed, the Proposed Amendments should provide broker-dealers the
opportunity to increase operational efficiency by reducing the need to
fractionalize its securities business. In addition, the Proposed
Amendments should promote capital formation by reducing capital charges
for well-hedged portfolios and by better reflecting the hedging
strategies actually used by broker-dealers. This should allow broker-
dealers greater freedom to invest assets or support underwritings thus
promoting capital formation. Finally, a broker-dealer's operational
efficiency should be increased as a result of allowing its current
hedging strategies to be used in its calculation of required capital.
Section 23(a) of the Exchange Act \44\ requires the Commission,
when adopting or amending rules under the Exchange Act, to consider the
impact the rule would have on competition and to refrain from adopting
any rule that would impose a burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act. The
Commission has preliminarily considered the Proposed Amendments in
light of this standard and believes that, if adopted, they would not
impede competition. As previously discussed, the net capital rule is
intended to ensure that broker-dealers have sufficient liquid capital
to protect the assets of customers and to meet their responsibilities
to other broker-dealers. When calculating its net capital, a broker-
dealer reduces the market value of the securities it owns by certain
percentages, or ``haircuts.'' Reducing the value of these securities
provides a capital cushion should the securities portfolio decline in
value. The Proposed Amendments change the haircuts applicable to the
Fixed Income Products for all broker-dealers equally and, therefore,
does not impede competition. The Proposed Amendments provide the same
opportunities to all broker-dealers to improve the efficiency of their
securities business. However, the Commission does recognize that these
benefits come at the cost of greater computational complexity and it
requests comment on the competitive impacts of this increased
complexity.
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\44\ 15 U.S.C. 78w(a)(2).
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IV. Summary of Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA'') in accordance with the Regulatory Flexibility Act
(``RFA''). \45\ The analysis set forth in the IRFA relates to the
Proposed Amendments. The IRFA states that the Proposed Amendments
continue the Commission's efforts to revise Rule 15c3-1 by lowering
haircuts on Fixed Income Products for a firm with a well hedged
portfolio of Fixed Income Products and by reducing a broker-dealer's
incentive to fractionalize its business between itself and an
unregistered affiliate. Finally, the IRFA states that by expanding the
types of hedges recognized in the Rule, the Proposed Amendments should
better reflect the hedging strategies currently used by broker-dealers.
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\45\ 5 U.S.C. 603.
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The IRFA sets forth the statutory authority for the Proposed
Amendments Under Section 15(c)(3) of the Securities Exchange Act of
1934. \46\ The IRFA also discusses the effect of the Proposed
Amendments on small entities. Of the approximately 5,300 small broker-
dealers registered with the Commission, approximately 370 are subject
to the net capital rule that have proprietary positions in Fixed Income
Products. Accordingly, the IRFA states that the Proposed Amendments
would have a direct effect on approximately 370 out of 5,300 small
broker-dealers. The IRFA also states that these small broker-dealers
would have to adjust their processes and procedures for calculating net
capital and that this would likely involve amending their computer
information systems.
---------------------------------------------------------------------------
\46\ 15 U.S.C. 78o(c)(3)
---------------------------------------------------------------------------
More specifically, some broker-dealers' computer information
systems may not have the capability to capture and classify the
information required to implement the changes as to certain
instruments. For example, pass-through mortgage-backed securities are
included in the Proposed Amendments provided that they are based on
fixed rate residential mortgage loans on one to four family homes.
Multifamily, adjustable rate, commercial, and mobile home mortgage
loans are not included in the Proposed Amendments. Consequently,
broker-dealers may need to modify their computer information systems to
identify mortgage-backed securities by the criteria necessary to use
the Proposed Amendments. The IRFA states that the Commission
preliminarily believes that the modifications needed to comply with the
Proposed Amendments should not be unduly burdensome, however, it does
not currently have the information to quantify the costs associated
with making these changes. Consequently, the IRFA requests comment on
the costs associated with changing the computer information systems to
comply with the Proposed Amendments. Commenters should provide detailed
estimates of the costs to change their computer information systems.
The IRFA states that the Commission preliminarily believes that
after affected broker-dealers change their processes, procedures, and
computer information systems to reflect the Proposed Amendments, there
will not be any continuing impact on these broker-dealers. However, the
IRFA requests comments on any ongoing costs associated with complying
with the Proposed Amendments. Commenters should provide detailed
estimates of any ongoing costs they expect to incur.
The IRFA states that the Commission considered whether viable
alternatives to the proposed rulemaking exist that accomplish the
stated objectives of applicable statutes and that minimize any
significant economic impact of proposed rules on small entities. More
specifically, the Commission considered the following alternatives: (a)
The establishment of differing compliance or reporting requirements or
timetables that take into account the resources available to small
entities; (b) the clarification, consolidation, or simplification of
compliance and reporting requirements under the rule for small
entities; (c) the use of performance rather than design standards; and
(d) an exemption from coverage of the rule, or any part thereof, for
small entities.
The Commission believes that it would be inconsistent with the
purposes of Rule 15c3-1 to exempt small entities from the Proposed
Amendments or to provide an alternative net capital requirement
including allowing small entities to continue to use the current
capital requirements. Rule 15c3-1 is intended to protect the investing
public by ensuring that broker-dealers have
[[Page 68005]]
sufficient liquid capital to protect the assets of customers and to
meet their responsibilities to other broker-dealers. The Commission
believes that the Proposed Amendments will enhance Rule 15c3-1's
objectives by establishing more precise haircut charges that better
reflect the risks associated with broker-dealers' Fixed Income Products
positions and related hedging practices while ensuring that registered
broker-dealers hold sufficient capital to maintain adequate liquidity
to satisfy obligations to customers and other broker-dealers.
The IRFA states that the Commission preliminarily believes that the
Proposed Amendments will not adversely affect small entities because
they tend to own relatively few Fixed Income Products. As previously
discussed, the Commission estimates that of the 5,300 small broker-
dealers registered with the Commission, only 370 have proprietary
positions in Fixed Income Products. In addition, the Proposed
Amendments change the haircuts applicable to Fixed Income Products for
all broker-dealers equally and thus provide the same opportunities to
all broker-dealers to improve the efficiency of their securities
business. However, the IRFA does request comment on whether the
computational complexity of the amendments impedes a small business'
ability to compete.
The IRFA includes information concerning the solicitation of
comments with respect to the IRFA generally, and in particular, the
cost of compliance with the proposed amendments and the number of small
entities that would be affected by the Proposed Amendments. In
addition, the IRFA solicits information for purposes of the Small
Business Regulatory Enforcement Fairness Act of 1996, regarding the
potential impact of the Proposed Amendments on the economy on an annual
basis. Commentators are asked to provide empirical data to support
their views. A copy of the IRFA may be obtained by contacting
Christopher M. Salter, Securities and Exchange Commission, 450 Fifth
Street, N.W., Mail Stop 2-2, Washington, D.C. 20549.
V. Paperwork Reduction Act
Certain sections of Rule 15c3-1 contain ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'') (44 U.S.C. 3501 et seq.). The
Commission has previously submitted the rule to the Office of
Management and Budget (``OMB'') for review in accordance with 44 U.S.C.
3507(d), and OMB has assigned the rule OMB control number 3235-0200.
Because the proposed rule changes should not materially affect the
collection of information obligations under the rule, there is no
requirement that the Commission resubmit the rule with the proposed
amendments to OMB for review under the PRA.
VI. Statutory Analysis
Pursuant to the Act and particularly Section 15(c)(3), (15 U.S.C.
78o(c)(3)) thereof, the Commission is adopting amendments to
Sec. 240.15c3-1 of Title 17 of the Code of Federal Regulations in the
manner set forth below.
List of Subjects in 17 CFR Part 240
Brokers, Reporting and recordkeeping requirements, Securities.
Text of Proposed Rule
In accordance with the foregoing, Title 17, chapter II, part 240 of
the Code of Federal Regulations is proposed to be amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
1. The authority citation for Part 240 continues to read in part as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee,
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78k, 78k-1,
78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 79q,
79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless
otherwise noted.
* * * * *
2. Section 240.15c3-1 is amended by revising paragraph
(a)(1)(ii)(C), the introductory text of paragraph (c)(2)(vi), and
paragraphs (c)(2)(vi)(A), (D)(3), and (G); removing and reserving
paragraphs (c)(2)(vi)(E) and (F); and adding undesignated section
headings before paragraphs (c)(2)(vi)(A), (c)(2)(vi)(D)(3) and
(c)(2)(vi)(G) to read as follows:
Sec. 240.15c3-1. Net capital requirements for brokers or dealers.
(a) * * *
(1) * * *
(ii) * * *
(C) Exclude credit balances in accounts representing amounts
payable for government securities, commercial paper, bankers
acceptances, certificates of deposit included within the scope of
paragraph (c)(2)(vi)(A) of this section not yet received from the
issuer or its agent, and any related debit items from the Exhibit A
requirements for 3 business days; and
* * * * *
(c) * * *
(2) * * *
(vi) Deducting the percentages of the market value of all
securities, money market and other instruments, or options in the
proprietary or other accounts of the broker or dealer or making such
other charges as are determined pursuant to paragraphs (c)(2)(vi)(A)
through (M) of this section or set forth in appendix A (Sec. 240.15c3-
1a).
Fixed Income Products
(A)(1) The charge from market value for all Government Securities;
Synthetic Bond Positions; nonconvertible debt securities (other than
municipal securities), that have fixed maturity dates, are not traded
flat or in default as to principal or interest, and are rated in one of
the four highest rating categories by at least two nationally
recognized statistical rating organizations; Money Market Debt
Instruments; and futures or forward contracts for the purchase or sale
of instruments covered by this paragraph (c)(2)(vi)(A) shall be equal
to the sum of the Specific Market Risk Charges specified in paragraph
(c)(2)(vi)(A)(2) of this section and the General Market Risk Charges
specified in paragraph (c)(2)(vi)(A)(3) of this section.
(2) For all Government Securities and all Synthetic Bond Positions,
the Specific Market Risk Charge shall be zero. For all other securities
or instruments covered by paragraph (c)(2)(vi)(A) of this section, the
broker or dealer shall compute a Specific Market Risk Charge equal to
the market value of the net position in each security multiplied by the
applicable percentage specified below:
------------------------------------------------------------------------
Percentage
Residual maturity of product Percentage adjustable
fixed rate rate
------------------------------------------------------------------------
Less than 6 months.............................. 0.25 0.75
6 months but less than 2 years.................. 1.00 1.50
2 years or more................................. 1.60 2.10
------------------------------------------------------------------------
(3) The General Market Risk Charge shall be equal to the aggregate
of the Sub-Zone Charge, the Zone Charge, the Between Zone Charge, and
the Residual Charge.
(i) To determine its General Market Risk Charge for securities
covered by paragraph (c)(2)(vi)(A) of this section, a broker or dealer
shall place the market value of each security in its appropriate sub-
zone in accordance with the following:
(A) The market value of each security shall be placed in one of the
sub-zones listed below based upon its residual maturity, except for
those instruments described in paragraphs
[[Page 68006]]
(c)(2)(vi)(3)(i)(B), (c)(2)(vi)(3)(i)(C) and (c)(2)(vi)(3)(i)(D) of
this section.
------------------------------------------------------------------------
Sub-zone
Residual maturity Sub-zone percentage
------------------------------------------------------------------------
Zone 1:
1 month or less...................... (i) 0
More than 1 month but not more than 3 (ii) 0.20
months.
More than 3 months but not more than (iii) 0.40
6 months.
More than 6 months but not more than (iv) 0.70
1 year.
Zone 2:
More than 1 year but not more than 2 (v) 1.25
years.
More than 2 years but not more than 3 (vi) 1.75
years.
More than 3 years but not more than 4 (vii) 2.25
years.
Zone 3:
More than 4 years but not more than 5 (viii) 2.75
years.
More than 5 years but not more than 7 (ix) 3.25
years.
More than 7 years but not more than (x) 3.75
10 years.
Zone 4:
More than 10 years but not more than (xi) 4.50
15 years.
More than 15 years but not more than (xii) 5.25
20 years.
More than 20 years................... (xiii) 6.00
Zone 5:
Deep Discount Bonds with more than 15 (xiv) 9.00
years but not more than 20 years.
Deep discount bonds with more than 20 (xv) 12.00
years.
------------------------------------------------------------------------
(B) An Adjustable Rate Security shall be deemed to have a residual
maturity equal to the remaining time to the effectiveness of its Next
Interest Rate Reset Date.
(C) The market value of a Pass-Through Mortgage-Backed Security
shall be placed into one of the sub-zones in accordance with the
following table based on its market value relative to its par value:
Pass-Through Mortgage-Backed Securities
----------------------------------------------------------------------------------------------------------------
Sub-zone 30-year pass-throughs 15-year pass-throughs 5- and 7-year balloons
----------------------------------------------------------------------------------------------------------------
(iv)................................. >108%.................. NA..................... NA.
(vi)................................. >105% but less than or >103%.................. >102%.
= 108%.
(vii)................................ >102% but less than or >100% but less than or >94% but less than or =
= 105%. = 103%. 102%.
(viii)............................... >98% but less than or = 100% or less........... 94% or less.
102%.
(x).................................. 98% or less............ NA..................... NA.
----------------------------------------------------------------------------------------------------------------
(D) The market value of a Deep Discount Bond with a residual
maturity of no more than six years shall be placed in one of the sub-
zones in accordance with its residual maturity. The market value of a
Deep Discount Bond with a residual maturity of more than six years
shall be placed in one of the sub-zones based upon its residual
maturity as follows:
------------------------------------------------------------------------
Residual maturity Sub-zone
------------------------------------------------------------------------
More than 6 years but not more than 7\1/2\ (x)
years.
More than 7\1/2\ years but not more than 9 (xi)
years.
More than 9 years but not more than 12 years (xii)
More than 12 years but not more than 15 (xiii)
years.
More than 15 years but not more than 20 (xiv)
years.
More than 20 years.......................... (xv)
------------------------------------------------------------------------
(E) A broker or dealer that has entered into a futures or forward
contract for the purchase or sale of a security covered by paragraph
(c)(2)(vi)(A) of this section shall include in one of the sub-zones
specified in paragraphs (c)(2)(vi)(A)(2) and (3) of this section the
market value of a long or short position in any security that is
specified as deliverable under the terms of the contract, in accordance
with the residual maturity of the security. The market value of any
positions included pursuant to this paragraph shall be equivalent to
the market value of the corresponding future or forward contract. The
provisions of appendix B (Sec. 240.15c3-1b) will in any event apply to
the positions in futures contracts.
(F) A broker or dealer that has entered into a Swap Agreement shall
include it in one or more of the sub-zones as follows. If the broker or
dealer has entered into a Swap Agreement that obligates it to pay or
receive scheduled interest cash flows at an adjustable rate of
interest, the broker or dealer shall include in one of the sub-zones
the market value of a short or long position, respectively, in a
Synthetic Bond reflecting a principal amount equal to the notional
amount of the Swap Agreement with residual maturity equal to the period
until the effective date of the Next Interest Rate Reset Date. If a
broker or dealer has entered into a Swap Agreement that obligates it to
pay or receive scheduled interest cash flows at a fixed interest rate,
it shall include in one of the sub-zones the market value of a short or
long position, respectively, in a Synthetic Bond reflecting a principal
amount equal to the notional amount of the Swap Agreement with residual
maturity equal to the period until the maturity of the Swap Agreement.
(G) A broker or dealer that has entered into a repurchase or
reverse repurchase agreement involving a security covered by paragraph
(c)(2)(vi)(A) of this section, shall include in one of the sub-zones
the market value of a short or long position in a Synthetic Bond with a
principal amount equal to that of the funds received or provided,
respectively, and a maturity equal to that of the residual maturity of
the contract or equal to the period until the effective date of the
Next Interest Rate Reset Date, whichever is less.
(H) A separate General Market Risk Charge calculation must be made
for positions denominated in each different currency.
(ii) Sub-Zone Charge. The Sub-Zone Charge shall equal the sum of
the charge for offsetting Swap Agreements plus the charge for other
securities covered by paragraph (c)(2)(vi)(A) of this section for each
sub-zone calculated as follows:
(A) The charge for offsetting Swap Agreements shall equal the
lesser of the
[[Page 68007]]
aggregate long or short swap positions in each sub-zone multiplied by
the applicable sub-zone percentage set forth in paragraph
(c)(2)(vi)(A)(3)(i)(A) of this section (the ``Sub-Zone Percentage'')
multiplied by 1%. The net of all the long and short swap positions in
each sub-zone (i.e., non-offsetting swap positions) shall be added to
the long or short position in other securities covered by paragraph
(c)(2)(vi)(A) of this section in that sub-zone for the purpose of
calculating the remaining charges in this paragraph.
(B) The charge for securities other than offsetting Swap Agreements
in each sub-zone covered by paragraph (c)(2)(vi)(A) of this section
shall equal the lesser of the aggregate long or short positions in each
sub-zone (which shall include any non-offsetting swap positions carried
forward as calculated in accordance with paragraph
(c)(2)(vi)(A)(3)(ii)(A) of this section) multiplied by the applicable
Sub-Zone Percentage, multiplied by 5%.
(C) The Long or Short Sub-Zone Carry-Forward Amount for a sub-zone
shall equal the net of all sub-zone long or short securities positions
in that sub-zone multiplied by the applicable Sub-Zone Percentage.
(iii) Zone Charge. The Zone Charge shall equal the aggregate of the
charge for each zone calculated as follows:
(A) The Long and Short Zone Positions for each zone shall equal,
respectively, the aggregate Long Sub-Zone Carry-Forward Amounts and
aggregate Short Sub-Zone Carry-Forward Amounts in each zone.
(B) The Zone Charge for each zone shall equal the lesser of the
aggregate Long Zone Positions or aggregate Short Zone Positions for
each zone multiplied by the applicable percentage set forth below:
Zone 1--25%.
Zone 2--30%.
Zone 3--35%.
Zone 4--40%.
Zone 5--50%.
(C) The net of the Long Zone Positions and Short Zone Positions in
each Zone shall be the Long or Short Zone Carry-Forward Amount for that
zone.
(iv) Between Zone Charge. The Between Zone Charge shall equal the
aggregate of the charges calculated as follows:
(A) The Between Zone Charge shall equal the lesser of the Long or
Short Zone Carry-Forward Amounts between the zones described below
multiplied by the applicable percentages:
------------------------------------------------------------------------
Zones Percentage
------------------------------------------------------------------------
Between Zone 1 and Zone 2................................... 50
Between Zone 2 and Zone 3................................... 60
Between Zone 3 and Zone 4................................... 70
Between Zone 4 and Zone 5................................... 80
Between Zone 1 and Zone 3................................... 85
Between Zone 2 and Zone 4................................... 90
------------------------------------------------------------------------
That portion of a Long or Short Zone Carry-Forward Amount used to
offset a Long or Short Zone Carry-Forward Amount may not be used again
to offset another Long or Short Zone Carry-Forward Amount.
(B) The Long and Short Zone Carry-Forward Amounts not offset
pursuant to (c)(2)(vi)(3)(iv)(A) shall be the Long or Short Between
Zone Carry-Forward Amounts.
(v) Residual Charge. The sum of the values of the Long and Short
Between Zone Carry-Forward Amounts shall be the Residual Charge.
(4) Definitions. For the purposes of paragraph (c)(2)(vi)(A) of
this section:
(i) Government Securities means all securities issued or guaranteed
as to principal and interest by the United States or any agency
thereof.
(ii) Adjustable Rate Security means a security covered by paragraph
(c)(2)(vi)(A) of this section that has an interest rate that resets
based upon an index that reflects current U.S. Treasury interest rates
corresponding to the interest rate reset period of the covered
security.
(iii) Pass-Through Mortgage-Backed Security means any security
issued under the sponsorship of the United States or any agency thereof
that represents a pro rata interest or participation in the principal
and interest cash flows generated by a pool of mortgage loans of which
at least 95% of the aggregate principal is composed of fixed rate
residential mortgage loans on one-to-four family homes, including five
and seven year mortgage loans with balloon payments at maturity.
Multifamily, adjustable rate, commercial, and mobile home mortgage
loans shall not be considered Pass-Through Mortgage-Backed Securities.
(iv) Deep Discount Bonds mean all securities covered by paragraph
(c)(2)(vi)(A) of this section, other than Pass-Through Mortgage-Backed
Securities, that either do not pay interest or are priced at 50% or
less of their par value.
(v) Next Interest Rate Reset Date means, as to any Adjustable Rate
Instrument, the maturity date of such instrument or, if earlier, the
next date as of which the interest rate on the instrument is subject to
being either increased or decreased, as applicable, by an amount that
is at least 0.5% greater or lesser than the current interest rate on
the instrument.
(vi) Synthetic Bond Positions mean hypothetical bond positions that
are included in the maturity bands specified in paragraph
(c)(2)(vi)(A)(3) of this section by virtue of paragraphs
(c)(2)(vi)(A)(3)(i) (F), and (G) of this section.
(vii) Swap Agreement means a contractual agreement under which a
broker-dealer is obligated to pay or entitled to receive from a
counterparty cash flows equal to interest at a predetermined fixed
rate, or at a floating rate, on a notional principal for the term of
the Swap Agreement. The interest rate used to calculate parties'
obligations under the Swap Agreement must be based on an index that
approximates interest rates for instruments included within the scope
of paragraph (c)(2)(vi)(A) of this section, and the parties' payment
obligations cannot be a multiple of that interest rate index.
(viii) Money Market Debt Instruments mean, in the case of any short
term promissory note or evidence of indebtedness which has a fixed rate
of interest or is sold at a discount, and which has a maturity date at
date of issuance not exceeding nine months exclusive of days of grace,
or any renewal thereof, the maturity of which is likewise limited and
is rated in one of the three highest categories by at least two of the
nationally recognized statistical rating organizations, or in the case
of any negotiable certificates of deposit or bankers acceptances or
similar type of instrument issued or guaranteed by any bank as defined
in Section 3(a)(6) of the Act (15 U.S.C. 78c(a)(6)).
* * * * *
(D) * * *
Certain Municipal Bond Trusts and Liquid Asset Funds
(3) In the case of redeemable securities of an investment company
registered under the Investment Company Act of 1940, which assets are
in the form of cash or securities or money market instruments that are
described in paragraphs (c)(2)(vi)(A) through (C) of this section, the
charge shall be 9% of the market value of the long or short position.
(E) [Reserved]
(F) [Reserved]
Convertible Debt Securities
(G) In the case of a debt security not in default that has a fixed
rate of interest and a fixed maturity date and that is convertible into
an equity security, the
[[Page 68008]]
charges shall be as follows: If the market value is 100 percent or more
of the principal amount, the charge shall be determined as specified in
paragraph (c)(2)(vi)(J) of this section; if the market value is less
than the principal amount, the charges shall be determined as specified
in paragraphs (c)(2)(vi)(A)(2) and (3) of this section based on its
remaining maturity, provided that the security is rated as required by
paragraph (c)(2)(vi)(A) of this section.
* * * * *
Dated: December 17, 1997.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
Appendix 1--Sample Calculation of Haircuts on Fixed Income Products
This appendix demonstrates how to calculate the Specific Market
Risk Charge and the General Market Risk Charge on Fixed Income
Products under the Proposed Amendments. The example is not intended
to replicate an actual broker-dealer portfolio or to be used as a
basis to compare haircuts under the Proposed Amendments to those
under the current rule, but rather the example is intended to show
how the Proposed Amendments operate. The first step in calculating
haircuts under the Proposed Amendments is to calculate the Specific
Market Risk Charge. Next, calculate the General Market Risk Charge.
To calculate the General Market Risk Charge, each of the Fixed
Income Products must be categorized by assigning the position in
each instrument into one of the 15 sub-zones, reflecting separately
the long and short positions.
The following table illustrates how an example portfolio is
categorized under the Proposed Amendments. Repurchase and
Reverse Repurchase Agreements are categorized based upon the
agreements remaining maturity. *Treasury securities are categorized
into the appropriate sub-zones based upon remaining maturity.
**Fixed rate interest rate swaps are categorized based upon their
residual maturity. ***Two of the Nonconvertible Debt securities have
variable interest rates that reset every two and three years,
respectively. These securities are placed into maturity sub-zones
based upon their length of time to the Next Interest Reset Date.
Futures contracts included in the portfolio are
categorized based upon the remaining maturity of the Treasury
security deliverable under the contract and not the length of the
contract. ``The Pass-Through Mortgage security is placed into the
appropriate sub-zone based upon its market value relative to par
which is greater than 98% but less than or equal to 102%.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Security Value Type of holding Remaining maturity Interest reset date Zone Sub-zone
--------------------------------------------------------------------------------------------------------------------------------------------------------
Residual Maturity Categorization (Section 15c3-1(c)(2)(vi)(A)(3)(i)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Repurchase Agreement.... $2,000,000 Short.............. 30 Days................ Fixed.......................... 1 i
Reverse Repurchase 1,000,000 Long............... 30 Days................ Fixed.......................... 1 i
Agreement.
Treasury*...................... 1,000,000 Short.............. 6 Months............... Fixed.......................... 1 iii
Treasury*...................... 1,500,000 Long............... 6 Months............... Fixed.......................... 1 iii
Treasury*...................... 500,000 Long............... 1 Year................. Fixed.......................... 1 iv
Treasury*...................... 1,000,000 Short.............. 1 Year................. Fixed.......................... 1 iv
Interest Rate Swap**........... 1,000,000 Long............... 8 Months............... Fixed.......................... 1 iv
Interest Rate Swap**........... 1,200,000 Short.............. 11 Months.............. Fixed.......................... 1 iv
Treasury*...................... 2,000,000 Long............... 2 Years................ Fixed.......................... 2 v
Treasury*...................... 1,500,000 Long............... 2 Years................ Fixed.......................... 2 v
Treasury*...................... 1,000,000 Short.............. 2 Years................ Fixed.......................... 2 v
Treasury*...................... 12,000,000 Short.............. 2 Years................ Fixed.......................... 2 v
Nonconvertible Debt***......... 2,500,000 Short.............. 5 Years................ Variable (2 Years)............. 2 v
Treasury*...................... 2,000,000 Long............... 3 Years................ Fixed.......................... 2 vi
Treasury*...................... 2,500,000 Short.............. 3 Years................ Fixed.......................... 2 vi
Nonconvertible Debt***......... 1,000,000 Long............... 10 Years............... Variable (3 Years)............. 2 vi
Treasury*...................... 1,000,000 Long............... 5 Years................ Fixed.......................... 3 viii
Future on 5-Year Treasury...... 2,000,000 Short.............. 180 Days............... Fixed.......................... 3 viii
Treasury*...................... 2,000,000 Short.............. 10 Years............... Fixed.......................... 3 x
Pass-Through Mortgage"......... 2,000,000 Short.............. 29 Years............... Fixed.......................... 3 x
Nonconvertible Debt***......... 1,000,000 Long............... 10 Years............... Fixed.......................... 3 x
Future on 10-Year Treasury..... 7,000,000 Long............... 90 Days................ Fixed.......................... 3 x
Treasury*...................... 3,000,000 Long............... 30 Years............... Fixed.......................... 4 xiii
Treasury*...................... 2,500,000 Short.............. 30 Years............... Fixed.......................... 4 xiii
----------------
Total...................... 54,200,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Note: Appendix 1 to the preamble does not appear in the Code of Federal Regulation.
To calculate the Specific Market Risk Charge, a broker-dealer
first categorizes those instruments subject to the charge into
maturity categories based upon residual maturity. Note that for
calculating the Specific Market Risk Charge, Adjustable Rate
Securities are categorized by remaining maturity, not the time until
the Next Interest Reset Date. The following demonstrates how the
Specific Market Risk Charge is calculated for the sample portfolio.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Specific
Line No. Security Fixed or variable Remaining maturity Value Specific market risk market risk
calculation charge
--------------------------------------------------------------------------------------------------------------------------------------------------------
Specific Market Risk Charge (Section 15c3-1(c)(2)(vi)(A)(2))
--------------------------------------------------------------------------------------------------------------------------------------------------------
1............. Nonconvertible Variable.................... 5 Years..................... $2,500,000 x 2.1%=................... $52,500
Debt.
2............. Nonconvertible Variable.................... 10 Years.................... 1,000,000 x 2.1%=................... 21,000
Debt.
3............. Nonconvertible Fixed....................... 10 Years.................... 1,000,000 x 1.6%=................... 16,000
Debt.
------------
[[Page 68009]]
Total ............................ ............................ .............. ............................ 89,500
Specific Market
Risk Charge.
--------------------------------------------------------------------------------------------------------------------------------------------------------
To calculate the haircut for its Fixed Income Products, a firm
would first take a haircut for offsetting positions within the same
sub-zone. Any remaining unhedged positions could then be used to
offset other residual amounts from other sub-zones within the same
zone, albeit with a larger haircut. A broker-dealer would then
offset unhedged amounts between zones. The largest haircut under the
Proposed Amendments would be imposed on residual positions that
could not be offset under this procedure. The following demonstrates
how the Sub-Zone Charges are calculated under the Proposed
Amendments. This example does not show the application of Appendix B
of Rule 15c3-1 as it applies to Futures and Forward contracts.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Short Sub-zone
Line No. Securities Sub-zone Long positions positions Charge calculation charge
--------------------------------------------------------------------------------------------------------------------------------------------------------
Sub-Zone Charge (Section 15c3-1(c)(2)(vi)(A)(3)(ii))
--------------------------------------------------------------------------------------------------------------------------------------------------------
1...................... Repurchase Agreement......... i................... .............. $2,000,000
2...................... Reverse Repurchase Agreement. i................... $1,000,000 .............. X 0% X 5%=.................. $0
--------------------------------
3...................... Net Position................. i................... .............. 1,000,000
================
4...................... Sub-Zone Carry Forward (Line i................... .............. 0
3 X Sub-Zone Percentage of
0%).
5...................... Treasury..................... iii................. .............. 1,000,000 X .4% X 5%=................. 200
6...................... Treasury..................... iii................. 1,500,000
--------------------------------
7...................... Net Position................. iii................. 500,000
================
8...................... Sub-one Carry Forward (Line 7 iii................. 2,000
X Sub-Zone Percentage of
.4%).
9...................... Interest Rate Swap........... iv.................. 1,000,000 .............. X .7% X 1%=................. 70
10...................... Interest Rate Swap........... iv.................. .............. 1,200,000
--------------------------------
11...................... Net Position................. iv.................. .............. 200,000 ............................
================
12...................... Treasury..................... iv.................. 500,000 .............. X .7% X 5%=.................
13...................... Treasury..................... iv.................. .............. 1,000,000 X .7% X 5%=................. 175
14...................... Net Swap Position From Line iv.................. .............. 200,000
11.
--------------------------------
15...................... Net Position................. iv.................. .............. 700,000
================
16...................... Sub-Zone Carry Forward (Line iv.................. .............. 4,900
15 X Sub-Zone Percentage of
.7%).
17...................... Treasury..................... v................... 2,000,000
18...................... Treasury..................... v................... 1,500,000 .............. (2,000,000 + $1,500,000) X 2,188
1.25% X 5%=.
19...................... Treasury..................... v................... .............. 1,000,00
20...................... Treasury..................... v................... .............. 12,000,000
21...................... Nonconvertible Debt.......... v................... .............. 2,500,000
--------------------------------
22...................... Net Position................. v................... .............. 12,000,000
================
23...................... Sub-Zone Carry Forward (Line v................... .............. 150,000
22 X Sub-Zone Percentage of
1.25%).
24...................... Treasury..................... vi.................. 2,000,000
25...................... Nonconvertible Debt.......... vi.................. 1,000,000
26...................... Treasury..................... vi.................. .............. 2,500,000 X 1.75% X 5%=............... 2,188
--------------------------------
27...................... Net Position................. vi.................. 500,000
================
28...................... Sub-Zone Carry Forward (Line vi.................. 8,750
27 X Sub-Zone Percentage of
1.75%).
29...................... Treasury..................... viii................ 1,000,000 .............. X 2.75% X 5%=............... 1,375
30...................... Future on 5-Year Treasury.... viii................ .............. 2,000,000
--------------------------------
31...................... Net Position................. viii................ .............. 1,000,000
================
32...................... Sub-Zone Carry Forward (Line viii................ .............. 27,500
31 X Sub-Zone Percentage of
2.75%).
33...................... Treasury..................... x................... .............. 2,000,000
34...................... Pass-Through Mortgage........ x................... .............. 2,000,000 ($2,000,000 + $2,000,000) X 7,500
3.75% X 5%=.
[[Page 68010]]
35...................... Nonconvertible Debt.......... x................... 1,000,000
36...................... Future on 10-Year Treasury... x................... 7,000,000
--------------------------------
37...................... Net Position................. x................... 4,000,000
================
38...................... Sub-Zone Carry Forward (Line x................... 150,000
37 X Sub-Zone Percentage of
3.75%).
39...................... Treasury..................... xiii................ 3,000,000
40...................... Treasury..................... xiii................ .............. 2,500,000 X 6% X 5%=.................. 7,500
--------------------------------
41...................... Net Position................. xiii................ 500,000
================
42...................... Sub-Zone Carry Forward (Line xiii................ 30,000
41 X Sub-Zone Percentage of
6%).
Total Sub-Zone Charge. ............................. .................... .............. .............. ............................ 21,195
------------
--------------------------------------------------------------------------------------------------------------------------------------------------------
As discussed above, the Sub-Zone Carry Forward Amounts (i.e.,
the remaining unhedged positions after calculation of the Sub-Zone
Charges) are then used to offset other Sub-Zone Carry Forward
Amounts from the other sub-zones within the same zone. The following
demonstrates how the Zone Charges are calculated for the example
portfolio under the Proposed Amendments.
----------------------------------------------------------------------------------------------------------------
Short
Line No. Zones Long positions positions Zone charge calculation Zone charge
----------------------------------------------------------------------------------------------------------------
Zone Charge (Section 15c3-1(c)(2)(vi)(A)(3)(iii))
----------------------------------------------------------------------------------------------------------------
Zone 1
1.............. Carry Forward From Sub- $2,000
Zone iii.
2.............. Carry Forward From Sub- .............. $4,900 .......................
Zone iv.
--------------------------------
3.............. Total Zone Positions.... 2,000 4,900 $2,000 x 25%=.......... $500
4.............. Less Offsetting Position .............. 2,000 .......................
5.............. Zone Carry Forward .............. 2,900 .......................
Amount.
--------------------------------
Zone 2
6.............. Carry Forward From Sub- .............. 150,000
Zone v.
7.............. Carry Forward From Sub- 8,750 ..............
Zone vi.
--------------------------------
8.............. Total Zone Positions.... 8,750 150,000 8,750 x 30%=........... 2,625
9.............. Less Offsetting Position .............. 8,750
10.............. Zone Carry Forward .............. 141,250 .......................
Amount.
--------------------------------
Zone 3
11.............. Carry Forward From Sub- .............. 27,500
Zone viii.
12.............. Carry Forward From Sub- 150,000 ..............
Zone x.
--------------------------------
13.............. Total Zone Positions.... 150,000 27,500 27,500 x 35%=.......... 9,625
14.............. Less Offsetting Position 27,500
15.............. Zone Carry Forward 122,500 ..............
Amount.
--------------------------------
16.............. Zone 4
17.............. Carry Forward From Sub- 30,000 ..............
Zone xiii.
--------------------------------
18.............. Total Zone Positions.... 30,000 .............. $0 x 40%............... 0
19.............. Less Offsetting Position 0 ..............
--------------------------------
20.............. Zone Carry Forward 30,000 ..............
Amount.
--------------------------------
Total Zone Charge... .............. .............. ....................... 12,750
----------------------------------------------------------------------------------------------------------------
As discussed above, the Zone Carry Forward Amounts (i.e., the
remaining unhedged positions after calculation of the Zone Charges)
are then used to offset Zone Carry Forward Amounts. The following
demonstrates how the Between Zone Charges are calculated for the
example portfolio under the Proposed Amendments. In this example,
the Between Zone Charges are calculated between Zone 1 and Zone 2;
Zone 2 and Zone 3; and Zone 2 and Zone 4.
----------------------------------------------------------------------------------------------------------------
Short Between
Line No. Between zone Long positions positions Between zone calculation zone charge
----------------------------------------------------------------------------------------------------------------
Between Zone Charge (Section 15c13-1(c)(2)(vi)(A)(3)(iv))
----------------------------------------------------------------------------------------------------------------
1............ Carry Forward From .............. $2,900
Zone 1.
[[Page 68011]]
2............ Carry Forward From .............. 141,250 ...........................
Zone 2.
--------------------------------
3............ Total Zone Positions.. .............. 144,150 $0 x 50%=.................. $0
4............ Less Offsetting Zone .............. 0 ........................... ...........
Positions.
5............ Between Zone 2 Carry .............. 141,250
Forward Amount.
--------------------------------
6............ Zone 1 Residual Amount .............. 2,900 ........................... ...........
Note: The Zone 1 Carry Forward Amount becomes a Between Zone Carry Forward Amount because it does not offset
with Zone 2 as they are both short positions. The Between Zone 1 Carry Forward Amount is not offset against Zone
3 because the Zone 3 Carry Forward Amount is eliminated through its offset with Zone 2 as calculated below.
Consequently, the Between Zone 1 Carry Forward Amount becomes a Residual Charge.
7............ Between Zone 2 Carry .............. 141,250 ........................... ...........
Forward Amount.
8............ Carry Forward From $122,500 ..............
Zone 3.
--------------------------------
9............ Total Zone Positions.. 122,500 141,250 $122,500 x 60%=............ 73,500
10............ Less Offsetting Zone .............. 122,500
Positions.
--------------------------------
11............ Between Zone 2 Carry .............. 18,750 ........................... ...........
Forward Amount.
12............ Between Zone 2 Carry .............. 18,750 ........................... ...........
Forward.
13............ Between Zone 4 Carry 30,000 .............. ........................... ...........
Forward.
14............ Total Between Zone 30,000 18,750 18,750 x 90%=.............. 16,875
Positions.
15............ Less Offsetting....... 18,750 ..............
16............ Zone 4 Residual Amount 11,250 .............. ........................... ...........
--------------------------------
Note: The Zone 4 Carry Forward Amount became a Between Zone Carry Forward Amount when the Zone 3 Carry Forward
Amount was eliminated. The Between Zone 4 Carry Forward Amount is partially offset by the Between Zone 2 Carry
Forward Amount. Because there are no other Between Zone Carry Forward Amounts to offset against the Between Zone
4 Carry Forward Amount, it becomes a Residual Charge.
Total Between ...................... .............. .............. ........................... 90,375
Zone Charge.
------------
----------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------
Risk charge Applicable rule section Haircut
------------------------------------------------------------------------
Total Haircut
------------------------------------------------------------------------
Specific Market Charge......... 15c3-1(c)(2)(vi)(A)(2). $89,500
Sub-Zone Charge................ 15c3-1(c)(2)(vi)(A)(3)( 21,195
ii).
Zone Charge.................... 15c3-1(c)(2)(vi)(A)(3)( 12,750
iii).
Between Zone Charge............ 15c3-1(c)(2)(vi)(A)(3)( 90,375
iv).
Zone 1 Residual Charge......... 15c3-1(c)(2)(vi)(A)(3)( 2,900
v).
Zone 4 Residual Charge......... 15c3-1(c)(2)(vi)(A)(3)( 11,250
v).
---------------
Total Haircut.............. ....................... 227,970
---------------
Total Value of Portfolio... ....................... 54,200,000
===============
------------------------------------------------------------------------
[FR Doc. 97-33401 Filed 12-29-97; 8:45 am]
BILLING CODE 8010-01-P
