[Federal Register Volume 62, Number 249 (Tuesday, December 30, 1997)]
[Proposed Rules]
[Pages 67940-67995]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33406]
[[Page 67939]]
_______________________________________________________________________
Part II
Securities and Exchange Commission
_______________________________________________________________________
17 CFR Parts 200 et al.
Brokers and Dealers Reporting Requirements; Proposed Rules
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 /
Proposed Rules
[[Page 67940]]
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 200, 240, 249
[Release No. 34-39454; File No. S7-30-97]
RIN 3235-AH16
OTC Derivatives Dealers
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission is publishing for
comment proposed rules and rule amendments under the Securities
Exchange Act of 1934 that would tailor capital, margin, and other
broker-dealer regulatory requirements to a class of registered dealers,
called OTC derivatives dealers, active in over-the-counter derivatives
markets. The proposed regulations for OTC derivatives dealers are
intended to allow securities firms to establish dealer affiliates that
would be able to compete more effectively against banks and foreign
dealers in global over-the-counter markets. Registration as an OTC
derivatives dealer under the proposed rules would be an alternative to
registration as a fully regulated broker-dealer, and would be available
only to entities acting primarily as counterparties in privately
negotiated over-the-counter derivatives transactions.
DATES: Comments should be submitted on or before March 2, 1998.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, Mail Stop 6-9, 450
Fifth Street, N.W., Washington, D.C. 20549. Comments may also be
submitted electronically at the following E-mail address: comments@sec.gov. All comment letters should refer to File No. S7-30-
97. This file number should be included on the subject line if E-mail
is used. Comment letters 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. Comment letters that are
submitted electronically will be posted on the Commission's Internet
web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT:
General: Catherine McGuire, Chief Counsel, Glenn J. Jessee, Special
Counsel, or Patrice Gliniecki, Special Counsel, at (202) 942-0073,
Division of Market Regulation, Securities and Exchange Commission, 450
Fifth Street, N.W., Mail Stop 7-11, Washington, D.C. 20549.
Financial Responsibility and Books and Records: Michael
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, Louis Randazzo, Special Counsel, at (202)
942-0191, Marc Hertzberg, Attorney, at (202) 942-0146, Christopher
Salter, Attorney, at (202) 942-0148, Matt Hughey, Accountant, at (202)
942-0143, or Gary Gregson, Statistician, at (202) 942-4156, Division of
Market Regulation, Securities and Exchange Commission, 450 Fifth
Street, N.W., Mail Stop 2-2, Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission is
publishing for comment proposed Rules 3b-12, 3b-13, 3b-14, 3b-15, 3b-
16, 15a-1, 15b9-2, 15c3-4, 17a-12, 36a1-1, and 36a1-2 1
under the Securities Exchange Act of 1934 (``Exchange
Act'').2 The Commission also proposes to amend Rule 30-3
3 and Exchange Act Rules 8c-1, 15b1-1, 15c2-1, 15c3-1, 15c3-
3, 17a-3, 17a-4, and 17a-11,4 and to revise Form X-17A-5
(FOCUS report).5
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\1\ 17 CFR 240.3b-12, 240.3b-13, 240.3b-14, 240.3b-15, 240.3b-
16, 240.15a-1, 240.15b9-2, 240.15c3-4, 240.17a-12, 240.36a1-1, and
240.36a1-2.
\2\ 15 U.S.C. 78a et seq.
\3\ 17 CFR 200.30-3.
\4\ 17 CFR 240.8c-1, 240.15b1-1, 240.15c2-1, 240.15c3-1,
240.15c3-3, 240.17a-3, 240.17a-4, and 240.17a-11.
\5\ 17 CFR 249.617.
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I. Introduction
Privately negotiated, over-the-counter (``OTC'') derivatives
transactions involving large institutions have come to occupy a
prominent place in global finance. The International Swaps and
Derivatives Association (``ISDA'') estimates that, as of December 31,
1996, the combined notional amount of globally outstanding interest
rate swaps, currency swaps, and interest rate options has grown to
$25.4 trillion.6 This market has reached this size in a
relatively short period of time. In fact, the first major swap
transaction was effected between IBM and the World Bank only 16 years
ago.7
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\6\ ``ISDA Market Survey,'' ISDA Internet web site (http://
www.isda.org).
\7\ See Peter A. Abken, Beyond Plain Vanilla: A Taxonomy of
Swaps, Financial Derivatives Reader (Robert W. Kolb, ed.) (1992) at
265.
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Whether OTC derivatives transactions are structured as interest
rate swaps, foreign currency swaps, equity swaps, basis swaps, total
return swaps, credit derivatives, or options, they share certain
characteristics.8 For example, each has a value or return
related to the value or return of an underlying asset. Asset classes
can consist of securities or virtually any other financial instrument,
financial measure, or physical commodity, such as interest rates,
securities indices, foreign currencies, metals or petroleum, or spreads
between the values of different assets. More importantly, each of these
products can provide their users with a carefully tailored method for
managing a variety of risks.9
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\8\ Swaps are contracts that typically allow the parties to the
contract to exchange cash flows related to the value or performance
of certain assets, rates, or indexes for a specified period of time.
See generally Peter A. Abken, Beyond Plain Vanilla: A Taxonomy of
Swaps, Financial Derivatives Reader (Robert W. Kolb, ed.) (1992).
Most swaps are based on currencies or interest rates. Swaps that
provide for an exchange of values based on the value or performance
of equity securities make up a small, but growing, share of the
swaps market. Options are instruments that generally provide the
holder, in exchange for the payment of a premium, with benefits of
favorable movements in the underlying asset or index with limited or
no exposure to losses from unfavorable price movements. Typically,
OTC options provide for cash settlement, rather than the delivery of
the underlying asset, rate, or index. Credit derivatives function
like options to the extent payments under the contract are made in
the event of a credit event, such as a decline in an issuer's credit
rating or default in performance under a debt obligation.
\9\ See, e.g., Clifford W. Smith, Jr., Charles W. Smithson, and
D. Sykes Wilford, Managing Financial Risk, Financial Derivatives
Reader (Robert W. Kolb, ed.) (1992); Group of Thirty, Derivatives:
Practices and Principles (July 1993); Financial Derivatives: Actions
Needed to Protect the Financial System, United States General
Accounting Office Report (May 1994).
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Relying on developments in financial engineering, dealers and end-
users can identify and isolate different kinds and degrees of risk
present in their portfolios and not only evaluate these risks, but
design derivative instruments to specifically address them. Some OTC
derivatives transactions, for example, are structured to address market
risk--the risk that the value of the underlying asset, rate, or index
will suffer an adverse change in value. Others are designed to address
asset volatility. Still others, based on two or more assets, may
address risks posed by changes in the values of the assets relative to
one another. This is particularly true in the case of foreign currency
swaps, but may also apply where correlations exist between the
performance of different assets. Recently, the financial industry has
developed credit derivatives that address the risks associated with the
default by, or a decline in the rating of, a particular issuer of debt
or other securities.
As new products are developed as a result of dealer creativity and
in response to the needs of end-users,
[[Page 67941]]
some of these products may cross regulatory boundaries. OTC options on
equity securities or on U.S. government securities, for example, are
securities within the definition set forth in Section 3(a)(10) of the
Securities Exchange Act of 1934 (``Exchange Act'').10 Firms
that effect transactions in these or other securities OTC derivative
products are required to register as broker-dealers under Section 15(b)
of the Exchange Act 11 and become subject to all of the
regulations applicable to other securities brokers-dealers, including
Exchange Act rules governing margin and capital. Firms that effect
transactions only in non-securities OTC derivative products are not
subject to U.S. broker-dealer regulation. In addition, because banks
are excluded from the Exchange Act definitions of ``broker'' and
``dealer,'' 12 they may engage in a broad range of
securities and non-securities OTC derivatives activities consistent
with guidance issued by their applicable bank regulators.13
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\10\ 15 U.S.C. 78c(a)(10).
\11\ See 15 U.S.C. 78o(b).
\12\ This bank exclusion from the Exchange Act definitions of
``broker'' and ``dealer'' is available only to those banking
institutions that satisfy the definition of ``bank'' set forth in
Section 3(a)(6) of the Exchange Act [15 U.S.C. Sec. 78c(a)(6)].
\13\ Bank regulators have issued guidance to banks engaging in
derivatives activities. See, e.g., Risk Management of Financial
Derivatives, OCC Banking Circular No. 277 (Oct. 1993); OCC Bulletin
94-31, Questions and Answers For BC-277 (May 1994); OCC Bulletin 96-
43, Credit Derivatives (Aug. 1996); OCC Bulletin 96-25, Fiduciary
Risk Management of Derivatives and Mortgage-backed Securities (Apr.
1996).
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The potential costs of broker-dealer regulation, as applied to OTC
derivatives dealers, have affected the way U.S. securities firms
conduct business in OTC derivatives markets. In many instances, U.S.
firms have decided to locate segments of their OTC derivatives business
in foreign financial centers. The manner in which business
relationships between dealers and their counterparties are structured
has also played a role in the development of offshore locations for OTC
derivatives business.
For example, in order to reduce credit exposure to a single
counterparty, dealers in OTC derivatives markets enter into master
agreements with their counterparties that provide for netting of the
outstanding financial obligations existing between the dealers and
their counterparties. It makes sense, therefore, for dealers to seek to
conduct both securities and non-securities OTC derivatives transactions
with any counterparty through a single legal entity. To the extent a
non-bank dealer's transactions include securities OTC derivative
products, the federal securities laws would require this single legal
entity to be a U.S. registered broker-dealer. Capital and margin
requirements applicable to registered broker-dealers, however, impose
substantial costs on the operation of an OTC derivatives business and
make it difficult for U.S. securities firms to compete effectively with
banks and foreign dealers in OTC derivatives markets.14
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\14\ The Commission's current net capital rule [17 CFR 240.15c3-
1] imposes substantial capital charges in connection with conducting
an OTC derivatives business. For example, under the net capital
rule, broker-dealers holding interest rate swaps must calculate two
potential capital charges for each swap. First, the net capital rule
considers any net interest payment due to be an unsecured
receivable, subject to a 100% capital charge in computing net
capital. Second, a broker-dealer must also take a deduction, or
haircut, on the notional amount of the swap. The size of the haircut
depends on whether the firm has offset the swap. Current margin
requirements also make it difficult for registered broker-dealers to
conduct an OTC derivatives business. Under Section 7 of the Exchange
Act [15 U.S.C. 78g] and Regulation T [12 CFR 220.1], broker-dealers
are prohibited from extending credit on securities other than margin
securities. In general, this means that registered broker-dealers
cannot extend credit in securities OTC derivatives transactions on
terms as favorable as those offered by other dealers.
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While there may be other reasons for U.S. securities firms to
conduct business from foreign financial centers, U.S. securities firms
should not be compelled to move business activities outside of the
United States solely to address competitive disadvantages that result
from Commission regulation. Accordingly, the Commission proposes to
establish a form of limited broker-dealer regulation that would give
U.S. securities firms an opportunity to conduct business in a vehicle
subject to modified regulation appropriate to OTC derivatives markets.
This proposed structure is optional and is designed to allow U.S.
securities firms to establish separate entities capable of acting as
counterparties with respect to both securities and non-securities OTC
derivative products. Capital, margin, and various other requirements
would be tailored to the activities of these entities. These tailored
requirements are intended, in part, to improve the efficiency and
competitiveness of U.S. securities firms active in global OTC
derivatives markets. These improvements should benefit participants in
OTC derivatives markets. OTC derivatives dealers would remain subject
to other rules applicable to fully regulated broker-dealers.
Registration as an OTC derivatives dealer would be an alternative
to registration as a fully regulated broker-dealer under Section 15(b)
of the Exchange Act, and would be available only to entities acting
primarily as counterparties in privately negotiated OTC derivatives
transactions. OTC derivatives dealers would also be allowed to engage
in certain categories of securities activities related to conducting an
OTC derivatives business. For example, OTC derivatives dealers would be
able to enter into transactions for risk management purposes and to
take possession of or sell counterparty collateral. They would also be
permitted to issue securities, including warrants on securities, hybrid
securities products, and structured notes. 15
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\15\ ``Hybrid securities'' are securities products that
typically incorporate payment features that are economically similar
to options, forwards, futures, or swaps involving currencies,
interest rates, commodities, securities, or indices (or any
combination, permutation, or derivative of these underlying assets).
The proposed definition of ``hybrid security'' is discussed in
Section II.A.4. below. Structured notes are notes that, like other
OTC derivative products, provide for a return that is based on the
value or return of an underlying asset.
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The Commission is concerned, however, that OTC derivatives dealers
not take advantage of the modified regulatory requirements under the
limited regulatory structure to engage in a significant degree of
activity better suited to full broker-dealer regulation. Accordingly,
the Commission proposes that OTC derivatives dealers be allowed to
engage only in the securities activities described in the proposed
rules, and that all securities transactions, including securities OTC
derivative transactions, be effected through a fully regulated broker-
dealer.
II. Description of the Proposed Rules and Rule Amendments
A. Definitions
As further detailed below, the proposed rules define five new
terms: (1) OTC derivatives dealer; (2) eligible OTC derivative
instrument; (3) permissible derivatives counterparty; (4) permissible
risk management, arbitrage, and trading transaction; and (5) hybrid
security.
1. Proposed Rule 3b-12; Definition of OTC Derivatives Dealer
The proposed definition of OTC derivatives dealer is intended to
encompass those dealers that are primarily engaged in acting as
counterparty in OTC derivatives transactions. The Commission
recognizes, however, that it would be appropriate to permit entities
that elect to become subject to the limited regulatory system also to
conduct limited securities activities in
[[Page 67942]]
connection with their OTC derivatives business. Accordingly, proposed
Rule 3b-12 would define OTC derivatives dealer to mean any dealer that
limits its securities activities to (1) engaging as a counterparty in
transactions in eligible OTC derivative instruments (as defined in
proposed Rule 3b-13) with permissible derivatives counterparties (as
defined in proposed Rule 3b-14); 16 (2) issuing and
reacquiring issued securities through a fully regulated broker or
dealer; or (3) engaging in other securities transactions which the
Commission designates by order, and in connection with any of these
activities, engaging in permissible risk management, arbitrage, and
trading transactions (as defined in proposed Rule 3b-15) 17
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\16\ Transactions by an OTC derivatives dealer that involve
securities OTC derivative instruments must be effected through a
fully regulated broker-dealer. See infra Section II.C., discussing
proposed Rule 15a-1.
\17\ The Commission expects that the rules being proposed today
would be used by firms that are engaged primarily in the business of
engaging in transactions in eligible OTC derivative instruments with
permissible derivatives counterparties. As discussed in this
release, one purpose of the limited regulatory structure for OTC
derivatives dealers is to make it possible for U.S. securities firms
to better compete in OTC derivatives markets with banks and foreign
dealers. As discussed in Section II.A.4. below, OTC derivatives
dealers would be permitted to engage in certain other securities
activities that are closely related to conducting an OTC derivatives
business. The regulatory structure for OTC derivatives dealers is
not intended to allow securities firms to move substantial
securities activity out of fully regulated broker-dealers into OTC
derivatives dealers in order to take advantage of the modified
capital and margin requirements applicable to these entities. OTC
derivatives dealers would also be prohibited from accepting or
holding customer funds or securities, or acting as a ``dealer'' in
securities. See infra note 24.
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Typically, U.S. firms that engage in securities derivatives
activities are required to register as broker-dealers under Section
15(b) of the Exchange Act 18 and become subject to all of
the regulations that apply to other fully regulated broker-dealers.
Registration as an OTC derivatives dealer would be an alternative to
full broker-dealer registration and would afford securities firms an
opportunity to elect to conduct their activities in a vehicle subject
to modified regulation. OTC derivatives dealers would also be permitted
to engage in any non-securities activity, subject to appropriate
capital treatment, as further discussed below.
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\18\ 15 U.S.C. 78o(b).
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2. Proposed Rule 3b-13; Definition of Eligible OTC Derivative
Instrument.
Proposed Rule 3b-13 sets forth various criteria for determining
whether a particular OTC derivative instrument is part of the class of
instruments in which an OTC derivatives dealer would be eligible to act
as counterparty. As defined in the proposed rule, these instruments
would include any agreement, contract, or transaction that is not part
of a fungible class of agreements, contracts, or transactions that are
standardized as to their material economic terms and that are not
entered into and traded on an exchange or other similar type of
facility. These instruments would be based, in whole or in part, on the
value of, any interest in, any quantitative measure of, or the
occurrence of any event relating to, one or more securities,
commodities, currencies, interest or other rates, indices, or other
assets, or involve certain long-dated forward contracts, specifically
contracts to purchase or sell a security on a firm basis at least one
year following the transaction date. These criteria, the Commission
believes, set reasonable standards that reflect that participants in
the OTC derivatives market are primarily institutions that engage in
privately negotiated transactions based, in part, on an assessment of a
counterparty's credit and its ability to perform under the terms of a
transaction.
The types of instruments that would generally satisfy the criteria
set forth in proposed Rule 3b-13 would include interest rate swaps,
currency swaps, equity swaps, swaps involving physical commodities
(such as metals or petroleum), OTC options on equities (including
equity indices), OTC options on U.S. government securities, OTC debt
options (including options on debt indices), options on physical
commodities, long-dated forwards on securities, and forwards relating
to other types of assets. This list, however, is not intended to be an
exclusive list, and OTC derivatives dealers would be permitted to act
as counterparty in any instrument that meets the requirements of the
proposed rule. As noted above, although OTC derivatives dealers would
be primarily engaged in transactions involving eligible OTC derivative
instruments, under the proposed regulatory system, they would also be
permitted to engage in a limited range of other activities. These are
discussed in Section II.A.4. below.
3. Proposed Rule 3b-14; Definition of Permissible Derivatives
Counterparty
Proposed Rule 3b-14 defines those entities with which OTC
derivatives dealers would be permitted to act as counterparties. As
noted above, one goal underlying the proposal to create a limited
system of broker-dealer regulation is to accommodate an institutional
business that, in many instances, is being conducted offshore and to
make it feasible for U.S. securities firms to combine securities and
non-securities OTC derivatives activities in one entity. Persons who
would be considered to be permissible derivatives counterparties in
transactions with OTC derivatives dealers would be the same persons who
currently are eligible to effect transactions with swaps dealers under
the Commodity Future Trading Commission's swaps exemption set forth at
17 CFR Part 35.19 Such persons generally would include
banks; investment companies; commodity pools with total assets
exceeding $5 million; corporations, partnerships, proprietorships,
organizations, trusts, or other entities that have total assets
exceeding $10 million, or that have net worth exceeding $1 million and
are entering into transactions in connection with the conduct of their
business; employee benefit plans subject to the Employee Retirement
Income Security Act of 1974 with total assets exceeding $5 million;
governmental entities; broker-dealers; futures commission merchants;
and natural persons having total assets exceeding $10 million.
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\19\ Part 35 exempts certain swap agreements from most
provisions of the Commodity Exchange Act [7 U.S.C. 1 et seq.],
provided that the transaction is conducted solely between ``eligible
swap participants,'' as defined in Part 35. The Commission believes
that the proposed definition of ``permissible derivatives
counterparty,'' generally describes participants active in OTC
derivatives markets, but requests comment on this point.
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The Commission is also considering whether to include an additional
class of permissible derivatives counterparty, specifically natural
persons having at least $5 million in total assets who enter into OTC
derivatives transactions to hedge existing or anticipated assets or
liabilities. Persons in this class may include, for example, persons
who acquire significant holdings of equity securities as a result of
starting or operating a business or who own securities with a very low
basis for tax purposes, but do not want to sell their holdings at the
present time. These persons would be able to reduce the risk associated
with being heavily invested in one type of security and diversify their
market exposure by entering into a swap or cash-settled option without
selling their holdings. The Commission specifically solicits comments
on whether to broaden the definition of permissible derivatives
counterparty to include this class of natural persons, or other
categories of institutional investors, and encourages persons who have
entered into OTC derivatives transactions to comment on the risks and
benefits these transactions may
[[Page 67943]]
present. The Commission is also interested in commenters' views whether
factors other than total assets should be considered in determining
which persons should be included in the definition.
4. Proposed Rules 3b-15 and 3b-16; Definition of Permissible Risk
Management, Arbitrage, and Trading Transaction; Definition of Hybrid
Security
Proposed Rule 3b-15 would permit an OTC derivatives dealer to
engage in a limited range of securities activities, described under the
rule as risk management, arbitrage, and trading transactions, in
connection with the dealer's business as a counterparty in eligible OTC
derivative instruments and as an issuer of securities. As discussed
above, the focus of the regulatory system for OTC derivatives dealers
is on providing a regulatory vehicle that would allow securities firms
to establish separate entities through which to operate an OTC
derivatives business. This necessarily includes the ability of OTC
derivatives dealers to take possession of and sell counterparty
collateral, to invest short-term cash balances, to manage risks
associated with their OTC derivatives positions or their issuance of
securities, and to engage in limited financing and arbitrage
transactions.
The Commission recognizes the commercial interests that drive
financial enterprises and the desire to maximize revenues. The
Commission, however, is also concerned that securities firms not be
able to move dealer activity in cash market instruments, such as stocks
and bonds, that is currently conducted through a fully regulated
broker-dealer into an OTC derivatives dealer. One reason is that OTC
derivatives dealers should not be provided with an unfair regulatory
advantage over fully regulated broker-dealers due to the availability
of modified capital and margin requirements. A second reason is the
Commission's view that entities that engage in comprehensive dealer
activity should be subject to full broker-dealer regulation, including
the Commission's existing capital and margin requirements, and be
subject to supervision by a securities self-regulatory organization
(``SRO''). In this instance, the Commission believes it is possible to
satisfy the commercial interests of derivatives dealers in a manner
consistent with sound regulatory policy, and proposes to permit OTC
derivatives dealers to engage in a limited range of securities
activities.20
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\20\ As noted above, under the proposed rules, OTC derivatives
dealers would be permitted to engage in any non-securities activity,
subject to appropriate capital treatment under Exchange Act Rule
15c3-1 [17 CFR 240.15c3-1].
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Under the proposed rule, OTC derivatives dealers would be permitted
to take possession of and sell counterparty collateral and invest
short-term cash balances. It is expected, however, that any securities
trading activity associated with short-term cash management by OTC
derivatives dealers would involve relatively small cash balances and
would not involve over-capitalizing these dealers solely for the
purpose of moving government securities or other trading books into an
OTC derivatives dealer from a fully regulated broker-dealer.
OTC derivatives dealers would also be permitted to manage risks
associated with their OTC derivatives positions. The nature of risk
management activity, however, makes it difficult to determine whether
particular transactions satisfy this requirement. It is no longer
possible, in many instances, to show the relationship between a hedging
transaction and the instrument it is intended to hedge. Instead, all of
the risks in a dealer's portfolio of OTC derivative positions are
aggregated and managed on a daily basis. As a result, it may be
difficult to demonstrate the relationship between trading done for risk
management and the different OTC derivatives positions on a dealer's
books.21 It may also be difficult to distinguish between
trading done for risk management purposes and other trading activity
conducted by a derivatives dealer. Therefore, OTC derivatives dealers
should develop reasonable procedures for ensuring compliance with the
restrictions set forth in the proposed rules and for demonstrating the
relationship between their risk management activities and the OTC
derivatives positions they maintain. Such procedures could include
maintaining clear documentation regarding risk measurement and clearly
identifying transactions effected for risk management purposes.
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\21\ Trading volume and the instruments traded for risk
management purposes also do not provide clear links to the
instruments being hedged. For example, trading volume may increase
as contracts mature or during times of unusual market volatility.
Also, instruments based on one security may be hedged by trading
other securities (or securities derivatives) where a relationship
exists between the value or performance of the two securities. This
relationship may change over time or under different market
conditions.
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Other permissible securities activities would include engaging in
certain financing transactions involving repurchase and reverse
repurchase agreements, buy/sell transactions,22 and lending
and borrowing transactions, as well as entering into certain
transactions for arbitrage purposes.23 Such financing and
arbitrage transactions, however, would have to be limited to
transactions involving securities positions established through the
possession or sale of counterparty collateral, cash management, or
hedging activity. OTC derivatives dealers should also develop
procedures applicable to these types of transactions to ensure
compliance with the restrictions set forth in the proposed rules.
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\22\ A buy/sell transaction is in many respects the economic
equivalent of a repurchase transaction, except that title to the
debt instrument that is the subject of the transaction passes to
another party and it is that party, rather than the original owner,
who receives payments of interest made during the term of the buy/
sell transaction.
\23\ Consistent with the proposed limitations on the securities
activities of OTC derivatives dealers, permissible arbitrage
transactions would be limited to transactions involving closely
related cash market and derivative instruments that are effected
close to one another in time for purposes of taking advantage of
price disparities in different markets. An example would include
transactions involving the purchase or sale of an equity security
and the acquisition of an option on the same equity security that
are effected close together in time, taking into consideration
market liquidity and hours of market operation.
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In some instances it may be difficult for an OTC derivatives dealer
to determine and properly document whether a transaction satisfies one
of the purposes set forth in the proposed rule. In order to avoid
circumstances in which an OTC derivatives dealer inadvertently violates
the proposed rules through its inability to properly document the
purpose of a transaction, OTC derivatives dealers would also be allowed
to engage in a specified number of additional securities transactions
in any calendar year. These transactions would have to relate to
securities positions established through the possession or sale of
counterparty collateral, cash management, or hedging activity, and
firms would be required to maintain and enforces written policies and
procedures reasonably designed to achieve compliance with other
provisions of the proposed rule.24 The
[[Page 67944]]
Commission proposes that the number of additional securities
transactions be set at 150 per calendar year. The Commission requests
comment on the likely uses and effects of this provision, and whether
the number of allowable additional securities transactions should be
more or less than 150.
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\24\ Except to the extent expressly permitted under the proposed
rules, an OTC derivatives dealer would not be permitted to engage
directly or indirectly in any activity that may otherwise cause it
to be a ``dealer'' as defined in Section 3(a)(5) of the Exchange Act
[15 U.S.C. Sec. 78c(a)(5)]. This would include, but not be limited
to, (1) purchasing or selling securities as principal from or to
customers; (2) carrying a dealer inventory in securities (or any
portion of an affiliated broker-dealer's inventory); (3) quoting a
market in or publishing quotes for securities (other than quotes on
one side of the market on a quotations system generally available to
non-broker-dealers, such as a retail screen broker for government
securities) in connection with the purchase or sale of securities
permitted under proposed Rule 3b-15; (4) holding itself out as a
dealer or market-maker or as being otherwise willing to buy or sell
one or more securities on a continuous basis; (5) engaging in
trading in securities for the benefit of others (including any
affiliate), rather than solely for the purpose of the OTC
derivatives dealer's investment, liquidity, or other permissible
trading objective; (6) providing incidental investment advice with
respect to securities; (7) participating in a selling group or
underwriting with respect to securities; or (8) engaging in
purchases or sales of securities from or to an affiliated broker-
dealer except at prevailing market prices.
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As noted above, the proposed rules would also allow OTC derivatives
dealers to issue and reacquire issued securities, including warrants on
securities, hybrid securities, and structured notes. Proposed Rule 3b-
16 defines a hybrid security as a security that incorporates payment
features economically similar to options, forwards, futures, swap
agreements, or collars involving currencies, interest rates,
commodities, securities, or indices (or any combination, permutation,
or derivative of such contract or underlying interest). As discussed in
Section II.C. below, the issuance and repurchase of issued securities,
such as warrants on securities, hybrid securities, and structured
notes, by an OTC derivatives dealer would have to be effected through a
fully regulated broker-dealer.
B. Proposed Amendment to Rule 15b1-1; Registration with the Commission
As discussed above, OTC derivatives dealers would be a part of a
special class of broker-dealers that could elect to register with the
Commission under a limited regulatory structure. Firms that elect to
register as OTC derivatives dealers would register with the Commission
by filing an application for registration on Form BD, the Uniform
Application for Broker-Dealer Registration.25 Under the
proposed amendments to Exchange Act Rule 15b1-1,26 OTC
derivatives dealers would file Form BD with the Central Registration
Depository, a computer system operated by the National Association of
Securities Dealers, Inc. (``NASD''), in accordance with the
instructions contained on the form. In completing Form BD, an OTC
derivatives dealer would respond to Item 10, which asks an applicant to
disclose its planned business activities, by checking ``other'' and
writing in that it proposes to engage solely in the business of an OTC
derivatives dealer.
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\25\ 17 CFR 249.501.
\26\ 17 CFR 240.15b1-1.
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C. Proposed Rule 15a-1; Transactions by OTC Derivatives Dealers
As discussed above in connection with the proposed definition of
``OTC derivatives dealer,'' the Commission expects that OTC derivatives
dealers would be engaged primarily in transactions involving OTC
derivative instruments for which these dealers act as counterparty.
They would also be permitted to engage in any non-securities
transaction, subject to appropriate capital treatment.
As discussed in Section II.A.4. above, because OTC derivatives
dealers would be a class of registered broker-dealers subject to a
lesser degree of regulation, the Commission believes it would be
appropriate to limit the securities activities conducted by these
firms. Consistent with the definition of OTC derivatives dealer in
proposed Rule 3b-12, such an entity would be permitted to (i) act as
counterparty in securities (and non-securities) transactions in
eligible OTC derivative instruments with permissible derivatives
counterparties, (ii) issue and reacquire issued securities, including
warrants on securities, hybrid securities, and structured notes,
through a fully regulated broker-dealer, and (iii) engage in other
securities transactions as the Commission may designate by
order.27 In connection with these activities, OTC
derivatives dealers would also be permitted to engage in permissible
risk management, arbitrage, and trading transactions, as defined in
proposed Rule 3b-15. Proposed Rule 15a-1, however, would require any
securities transaction by an OTC derivatives dealer to be effected
through a fully regulated broker-dealer.28
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\27\ The Commission is also proposing to amend Rule 30-3 [17 CFR
200.30-3] to delegate to the Director of the Division of Market
Regulation its authority to designate additional securities
transactions in which OTC derivatives dealers would be permitted to
engage.
\28\ Exchange Act Rule 10b-10 [17 CFR 240.10b-10] requires
broker-dealers to send a written confirmation of each securities
transaction with a customer at or before completion of the
transaction, containing certain material information about the
transaction. In a securities transaction between an OTC derivatives
dealer and a customer, effected through a fully regulated broker-
dealer, the OTC derivatives dealer and the fully regulated broker-
dealer would each be responsible for sending a confirmation to the
customer under the rule. Certain customers, however, could choose
not to receive two confirmations for each securities transaction
they enter into with an OTC derivatives dealer. Customers,
therefore, could instruct the OTC derivatives dealer and the fully
regulated broker-dealer effecting securities transactions on its
behalf to send one joint confirmation (``joint confirmation'') to
the customer on behalf of both parties.
The customer's instructions to receive a joint confirmation
would have to (1) explicitly state which of the parties (the OTC
derivatives dealer or the fully regulated broker-dealer) is to be
responsible for sending the confirmation; (2) be a separate
instrument from the basic account opening documents with the OTC
derivatives dealer and the fully regulated broker-dealer; (3) not be
a condition of entering into securities transactions with the OTC
derivatives dealer; and (4) not be induced by differential fees or
other costs based on whether such an instruction is provided.
A joint confirmation, sent on behalf of both the OTC derivatives
dealer and the fully regulated broker-dealer effecting the
transaction would have to disclose all of the information required
of either party under the rule, including, but not limited to the
identity of the security, the trade price, and the date and time of
the trade, the identity of each party and its capacity in the
transaction, the fact that the OTC derivatives dealer is not a
member of the Securities Investor Protection Corporation, and any
transaction-related compensation earned by either the fully
regulated broker-dealer or the OTC derivatives dealer in connection
with the transaction. Both the OTC derivatives dealer and the fully
regulated broker-dealer would be considered fully responsible for
the contents of the joint confirmation, regardless of which party is
responsible for sending it to the customer. The customer's
instruction to receive a joint confirmation would not otherwise
affect the obligations of either party to the customer under the
anti-fraud provisions of the federal securities laws.
OTC derivatives dealers and fully regulated broker-dealers
relying upon the written instructions of their customer to send a
joint confirmation would each have to obtain and preserve a copy of
the customer's written instructions, for the period in which they
are relying on those instructions, in an easily accessible place,
and for a period of not less than two years after they no longer
rely on the instructions to send a joint confirmation.
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The requirement that securities transactions be effected through a
fully regulated broker-dealer means that the dealer's counterparties in
these transactions would be considered customers of the fully regulated
broker-dealer. In these transactions, all applicable SRO sales
practices requirements would apply. In addition, all persons having
contact with counterparties would need to be properly qualified
registered representatives of the fully regulated broker-dealer. For
example, in a transaction involving a securities OTC derivative
instrument, such as an OTC option on a U.S. government security, any
person discussing the terms of the transaction with the counterparty
would have to be a registered representative of the fully regulated
broker-dealer. This person, however, could be a dual employee of both
the fully regulated broker-dealer and the OTC derivatives
[[Page 67945]]
dealer, subject to appropriate supervision by both firms.29
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\29\ Fully regulated broker-dealers would be responsible for
supervising only the securities activities of these dual employees.
They would not be responsible for supervising a dual employee's non-
securities OTC derivatives activities conducted on behalf of the OTC
derivatives dealer.
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The requirement that securities OTC derivatives transactions be
effected through a fully regulated broker-dealer is consistent with
existing regulatory requirements that apply to the purchase and sale of
securities and is, in part, designed to ensure that all securities
transactions remain subject to existing sales practice requirements. It
is also intended to prevent an unforeseen regulatory disparity from
arising between OTC derivatives dealers, which would be subject to
modified capital and margin requirements, and other fully regulated
broker-dealers in connection with conducting securities transactions.
D. Exemptions
1. Proposed Rule 36a1-1; Exemption From Section 7 of the Exchange Act
for OTC Derivatives Dealers
OTC derivative markets are credit sensitive. Whether a dealer and a
counterparty will enter into a transaction involving an OTC derivative
instrument depends on their assessment of the other's ability to meet
its financial obligations under the terms of the instrument. The
creditworthiness of the counterparties is also a factor in determining
the price of the transaction. As part of any OTC derivatives
transaction, a dealer may require its counterparty to deposit
collateral with the dealer to provide some assurance of the
counterparty's ability to perform.
Both the ability of the dealer to collect collateral to secure
payment under an OTC derivative instrument, and the amount of
collateral the dealer must collect, will depend on the regulatory
status of the dealer. Federal regulations that govern the collateral,
or margin, that must be collected in connection with securities
transactions set up certain competitive inequalities between OTC
derivatives dealers that are registered broker-dealers and others,
including banks. Registered broker-dealers that extend credit for the
purpose of purchasing or carrying securities are required to comply
with the provisions of Regulation T.30 The margin
requirements for banks are contained in Regulation U.31
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\30\ 12 CFR 220.1.
\31\ 12 CFR 221.1.
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In general, Regulation T limits the flexibility of broker-dealers
to extend credit in securities OTC derivatives transactions by
prohibiting extensions of credit on securities other than margin
securities. Regulation U, however, offers bank dealers greater
flexibility by allowing them to extend credit on collateral other than
margin stock up to the ``good faith'' loan value of the collateral, as
defined in Regulation U.32 This means that under Regulation
U, dealers may extend credit on securities other than margin stock,
including securities OTC derivative instruments.
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\32\ 12 CFR 221.2(f).
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Compliance with the more restrictive requirements of Regulation T
puts broker-dealers at a disadvantage in competing with banks and other
derivatives dealers by preventing them from offering credit in
securities OTC derivatives transactions on terms that are as favorable
as those offered by other dealers. Applying Regulation U to extensions
of credit by OTC derivatives dealers would provide sufficient
safeguards against leverage, while allowing OTC derivatives dealers to
extend credit on the broader range of securities OTC derivative
products that make up their business.
Accordingly, under proposed Rule 36a1-1, OTC derivatives dealers
would be exempted from the margin requirements of Section 7 of the
Exchange Act, as well as Regulation T, in connection with any extension
of credit made by the OTC derivatives dealer in securities transactions
permitted under proposed Rule 15a-1. This exemption, however, would be
conditioned on the OTC derivatives dealer complying with the
requirements of Regulation U. The Commission believes that this
exemption would result in the most appropriate margin regulation for
OTC derivatives dealers and more equal treatment of banks and
securities firms active in OTC derivative markets.33 The
Commission solicits commenters' views regarding the proposed margin
treatment of transactions by OTC derivatives dealers.
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\33\ The proposed exemption from Section 7 [15 U.S.C. 78g] and
Regulation T [12 CFR 220.1] would not be available to extensions of
credit made directly by a fully regulated broker-dealer acting as
agent in a transaction between an OTC derivatives dealer and a
permissible derivatives counterparty. However, OTC derivative
dealers that extend credit in transactions that are required to be
effected through a fully regulated broker-dealer would still be able
to rely on the exemption from Section 7 and Regulation T provided
under proposed Rule 36a1-1.
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The relief proposed under Rule 36a1-1 would apply to extensions of
credit by OTC derivatives dealers. Section 7, however, would also apply
to extensions of credit to OTC derivatives dealers by other lenders.
Credit extended to an OTC derivatives dealer, like credit extended to a
fully regulated broker-dealer, would be exempted from Section 7 if it
satisfies the exemptive provisions contained in Section 7.
Specifically, if a substantial part of the business conducted by an OTC
derivatives dealer consists of transactions with persons other than
brokers or dealers, credit extended to the OTC derivatives dealer would
be exempted from Section 7 under the provisions of Section
7(d)(2)(C)(i).34 To the extent that firms desiring to take
advantage of the proposed regulations applicable to OTC derivatives
dealers do not believe that they would be able to take advantage of the
exemptive provisions of Section 7(d)(2), the Commission solicits
further comment on the proposed business activities of OTC derivatives
dealers, and whether other exemptive relief may be needed to address
borrowing by these firms.
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\34\ 15 U.S.C. 78(g)(d)(2)(C)(i).
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2. Proposed Rule 15b9-2; SRO Exemption for OTC Derivatives Dealers
Proposed Rule 15b9-2 would exempt OTC derivatives dealers from
membership in an SRO, subject to certain conditions. In general,
registered broker-dealers must become members of an SRO.35
This SRO membership requirement ensures that securities transactions
meet SRO sales practice requirements, that employees of SRO member
firms who sell securities satisfy certain minimum, uniform licensing
requirements, that SRO members satisfy maintenance margin and financial
responsibility requirements, and that member firms adhere to certain
principles of trade and business conduct.36
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\35\ See Exchange Act Section 15(b)(8) [15 U.S.C. 78o(b)(8)].
\36\ See Exchange Act Sections 15(b)(8) and 15A(g)(3) [15 U.S.C.
78o(b)(8); 15 U.S.C. 78o-3(g)(3)].
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Because only a part of the business conducted by OTC derivatives
dealers is expected to involve securities transactions, it is not
necessary to require OTC derivatives dealers to become members of an
SRO and be subject to the full range of SRO regulation. All securities
transactions done by an OTC derivatives dealer would be required to be
effected through a fully regulated broker-dealer, and be handled by
properly qualified registered representatives of the fully regulated
broker-dealer. SRO sales practice requirements would also apply to
these securities transactions. The Commission, therefore, proposes to
exempt OTC derivatives dealers from SRO membership, subject to certain
conditions.
[[Page 67946]]
To be eligible for the exemption from SRO membership contained in
proposed Rule 15b9-2, an OTC derivatives dealer would be required to
enter into an agreement with the examining authority designated
pursuant to Section 17(d) of the Exchange Act 37 for one or
more of its registered broker-dealer affiliates. Under this agreement,
the examining authority would agree to conduct a review of the
activities of the OTC derivatives dealer. It would also be required to
report to the Commission any potential violation of the Commission's
rules, and to evaluate the dealer's procedures and controls designed to
prevent violations. SRO examination of OTC derivatives dealers would
provide important benefits to the Commission and the public without
requiring full SRO membership. OTC derivatives dealers would also be
subject to direct examination by Commission staff. The Commission
solicits comment on the proposed exemption from SRO membership.
Alternatively, the Commission solicits comment on whether to require
OTC derivatives dealers to become members of either the NASD or the New
York Stock Exchange. Under this alternative, these SROs would be
authorized to inspect OTC derivatives dealers and to enforce applicable
Commission rules. They would not, however, be permitted to apply or
enforce existing or new SRO rules.
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\37\ 15 U.S.C. 78q(d).
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E. Net Capital Requirements for OTC Derivatives Dealers
1. Reasons for Amending the Net Capital Rule; Overview
The Commission proposes to amend the net capital rule, Exchange Act
Rule 15c3-1,38 as it would apply to OTC derivatives dealers.
In general, the net capital rule requires every registered broker-
dealer to maintain certain specified minimum levels of liquid assets,
or net capital, to enable those firms that fall below the minimum net
capital requirements to liquidate in an orderly fashion without the
need for a formal legal proceeding. The rule is designed to protect the
customers of a broker-dealer from losses that can be incurred upon a
broker-dealer's failure. The rule prescribes different required minimum
levels of capital based upon the nature of the broker-dealer's business
and whether the firm handles customer funds or securities.
---------------------------------------------------------------------------
\38\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------
When calculating its net capital, a broker-dealer must reduce its
capital by certain percentage amounts, or haircuts, based on the market
value of the securities it owns. Discounting the value of a broker-
dealer's proprietary securities positions provides a capital cushion if
the value of these securities positions were to decline. Haircuts also
cover other risks faced by the firm, such as credit and liquidity risk.
The Commission has been told that few swaps and other types of OTC
derivative instruments are booked in registered broker-dealers because
of the way these transactions are treated under the net capital rule.
There are two reasons for this. First, the current net capital rule
requires a firm to subtract most unsecured receivables from its net
worth when calculating its net capital. For example, for an interest
rate swap, the rule requires that the current value of the next net
interest payment due from a counterparty be deducted from the firm's
net worth in calculating its net capital. Also, any unrealized gains on
the swap would have to be deducted. Second, the rule does not allow
broker-dealers to take into account positions that offset their OTC
derivatives positions to the same extent as banks or foreign dealers
using value-at-risk (``VAR'') models.39 This treatment of
OTC derivatives transactions often requires broker-dealers to reserve
more capital with respect to these transactions than banks or foreign
broker-dealers have to reserve.
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\39\ In a companion release being issued at the same time as
this release, the Commission is proposing amendments to the net
capital rule to recognize offsets among additional types of
instruments. Exchange Act Rel. No. 39455 (Dec. 17, 1997).
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The Commission is addressing the current rule's treatment of OTC
derivatives transactions by proposing certain amendments to the rule to
reduce the capital charges on these types of transactions. Under
proposed Appendix F of Rule 15c3-1, OTC derivatives dealers would be
permitted to add back to their net worth any trading gains and
unsecured receivables arising from transactions in eligible OTC
derivative instruments with permissible derivatives
counterparties.40 Appendix F would also allow OTC
derivatives dealers to use VAR models to compute their capital charges
on proprietary positions instead of taking haircuts on them as required
under the current rule. As mentioned above, the current haircut
approach allows limited offsetting among positions in comparison to
using a VAR model to compute capital charges. Allowing OTC derivatives
dealers to use VAR models to compute capital charges on OTC derivative
instruments would enable these dealers to reduce their market risk
capital charges to the extent that they may hold offsetting positions.
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\40\ See infra Section II.E.3.b. for a discussion of proposed
Appendix F.
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2. Reasons for Allowing OTC Derivatives Dealers To Use VAR Models
Currently, several large firms use VAR models as part of their risk
management system. These firms use VAR modelling to analyze, control,
and report the level of market risk from their trading activities. In
general, VAR is an estimate of the maximum potential loss expected over
a fixed time period at a certain probability level. For example, a firm
may use a VAR model with a ten-day holding period and a 99 percentile
criteria to calculate that its $100 million portfolio has a potential
loss of $150,000. In other words, the firm's VAR model has forecasted
that with this portfolio the firm may lose $150,000 during a ten-day
period once every 100 ten-day periods (i.e., with a probability of 1%).
In practice, VAR models aggregate several components of price risk
into a single quantitative measure of the potential for loss. In
addition, VAR is based on a number of underlying mathematical
assumptions and firm specific inputs. For example, VAR models typically
assume normality and that future return distributions and correlations
can be predicted by past returns.41
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\41\ The Commission recognizes that there is a wide variety of
secondary source information discussing both the positive and
negative aspects of VAR. See Philippe Jorion, Value at Risk: The New
Benchmark for Controlling Market Risk (1996) (explaining how to use
VAR to manage market risk); JP Morgan, RiskMetrics-Technical
Document (1994) (providing a detailed description of RiskMetrics,
which is JP Morgan's proprietary statistical model for quantifying
market risk in fixed income and equity portfolios); Tanya Styblo
Beder, VAR: Seductive but Dangerous, Financial Analysts Journal,
September-October 1995, at 12 (giving an extensive analysis of the
different results from applying three common VAR methods to three
model portfolios); Darrell Duffie and Jun Pan, An Overview of Value
at Risk, The Journal of Derivatives, Spring 1997, at 7 (giving a
broad overview of VAR models); Darryll Hendricks, Evaluation of
Value-at-Risk Models Using Historical Data, Federal Reserve Bank of
New York Economic Policy Review, April 1996, at 39 (examining twelve
approaches to VAR modelling on portfolios that do not include
options or other securities with non-linear pricing); and Robert
Litterman, Hot Spots and Hedges, Goldman Sachs Risk Management
Series (1996) (giving a detailed analysis on portfolio risk
management, including how to identify the primary sources of risk
and how to reduce these risks).
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The current rule permits using statistical models only for limited
types of securities.42 The Commission
[[Page 67947]]
believes, however, that a more flexible approach for determining
capital requirements for OTC derivatives dealers would be appropriate
because of the special nature of their business and the additional
financial responsibility requirements that would be applicable to these
firms. The proposed rule requires an OTC derivatives dealer to maintain
a minimum of $100 million in tentative net capital 43 and at
least $20 million in net capital. OTC derivatives dealers would also be
prohibited from accepting or holding customer funds or securities or
generally from owing money or securities to customers in connection
with securities activities. OTC derivatives dealers would, however, be
allowed to hold counterparty collateral or owe money or securities to
counterparties, but only as a result of contractual commitments.
Finally, OTC derivatives dealers would be required to establish risk
management controls pursuant to proposed Rule 15c3-4.
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\42\ See 17 CFR 240.15c3-1a. The Commission recently amended
Appendix A to permit broker-dealers to employ theoretical option
pricing models in determining net capital requirements for listed
options and related positions. Exchange Act Rel. No. 38248 (Feb. 6,
1997), 62 FR 6474 (Feb. 12, 1997).
\43\ For an OTC derivatives dealer that elects to compute its
market risk charges under proposed Appendix F, the term ``tentative
net capital'' would mean the net capital of an OTC derivatives
dealer before the application of the charges for market and credit
risk as computed pursuant to proposed Appendix F and increased by
unsecured receivables (unrealized gains) resulting from eligible OTC
derivative instruments.
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The more flexible capital treatment that would be available to OTC
derivatives dealers under the proposed rules reflect international
efforts to standardize capital requirements. During the past few years,
the Commission has actively participated in several international
undertakings to gain further experience with the use of VAR models to
measure market and credit risk. For example, through its membership in
the International Organization of Securities Commissions (``IOSCO''),
the Commission has been cooperating with the Basle Committee on Banking
Supervision (``Basle Committee'').44 In December 1995, the
Basle Committee amended its Capital Accord 45 to incorporate
market risk capital requirements and approved the use of proprietary
VAR models to determine bank capital requirements for market
risk.46 The Capital Accord recommended a number of
quantitative and qualitative conditions that should apply to a bank's
use of models to ensure that VAR models are prudently used.
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\44\ The Governors of the G-10 countries established the Basle
Committee in 1974 to provide a forum for ongoing cooperation among
member countries on banking supervisory matters.
\45\ The Basle Accord, or Capital Accord, is a common
measurement system and a minimum standard for capital adequacy of
international banks in the G-10 countries.
\46\ In July 1995, IOSCO's Technical Committee issued a paper
stating that further information and analysis was required before
the Technical Committee could consider the use of internal models by
securities firms to set regulatory capital standards for market
risk. Due to the differences between banks and securities firms, the
Technical Committee believed that more work was necessary before
allowing securities firms to use VAR models to establish their
capital requirements. The Implications for Securities Regulators of
the Increased Use of Value At Risk Models by Securities Firms,
Technical Committee of IOSCO, July 1995.
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Rules adopted recently by the Board of Governors of the Federal
Reserve System, the Office of the Comptroller of the Currency, and the
Federal Deposit Insurance Corporation (collectively, the ``U.S. Banking
Agencies'') were designed to implement the Capital Accord for U.S.
banks and bank holding companies.47 Proposed Appendix F is
generally consistent with the U.S. Banking Agencies' rules, and
incorporates the quantitative and qualitative conditions imposed on
banking institutions.
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\47\ Department of the Treasury, Office of the Comptroller of
the Currency Docket No. 96-18, Federal Reserve System, Docket No. R-
0884, Federal Deposit Insurance Corporation, RIN 3064-AB64 (Sept. 6,
1996), 61 FR 47358.
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In a companion release, the Commission is considering whether it
should permit VAR models to be used by broker-dealers other than OTC
derivatives dealers for regulatory capital purposes.48 By
allowing OTC derivatives dealers to use VAR models in calculating their
net capital requirement, the Commission would have a valuable
opportunity to gain experience with the use of these models by entities
within its jurisdiction. This experience would enable the Commission to
reassess its current rules for determining capital charges for market
risk and determine whether more intensive subjective examinations would
be needed to ensure compliance with Commission regulations concerning
the use of models.
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\48\ Exchange Act Rel. No. 39456 (Dec. 17, 1997).
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3. Discussion of Net Capital Requirements
a. Proposed Paragraph 15c3-1(a)(5). Under proposed paragraph (a)(5)
of Rule 15c3-1, OTC derivatives dealers would be required to maintain
tentative net capital of not less than $100 million and net capital of
not less than $20 million. The Commission believes the minimum of $100
million in tentative net capital is necessary to ensure against
excessive leverage and risks other than credit or market risk, all of
which are now factored into the current haircuts, and to provide for a
cushion of capital against severe market disturbances.49
Proposed paragraph (a)(5) would give OTC derivatives dealers the option
of either taking capital charges, or haircuts, computed in accordance
with paragraph (c)(2)(vi) of Rule 15c3-1 or taking capital charges for
market and credit risk computed under proposed Appendix F to Rule 15c3-
1. The Commission requests comment on whether the $100 million
tentative net capital and $20 million net capital requirements would be
adequate to ensure against excessive leverage and risks other than
credit or market risk.
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\49\ To some degree, the multiplication factor applied to a
firm's VAR is designed to provide capital for risks other than
credit or market risk. See infra Section II.E.3.b.iii. for a
discussion of how an OTC derivatives dealer would determine its
appropriate multiplication factor.
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b. Proposed Appendix F. Proposed Appendix F would apply only to OTC
derivatives dealers that elect to be subject to the appendix. OTC
derivatives dealers that elect to be subject to Appendix F would be
required to calculate specific capital charges for market and credit
risk. They would also be required to maintain VAR models that meet
certain minimum qualitative and quantitative requirements.
i. Market Risk. OTC derivatives dealers electing to apply Appendix
F would deduct from their net worth a capital charge for market risk
50 that is computed using one of two methods. First, OTC
derivatives dealers would be able to use the full VAR method to
calculate capital charges for market risk exposure for transactions in
eligible OTC derivative instruments and other proprietary positions of
the OTC derivatives dealer. Under the full VAR method, a market risk
capital charge would be equal to the VAR of its positions multiplied by
a factor specified in Appendix F.51
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\50\ In general, market risk is the risk of adverse price
movements resulting from a change in market prices, interest rates,
volatilities, correlations, or other market factors.
\51\ See infra Section II.E.3.b.iii. for a discussion of how an
OTC derivatives dealer would determine the appropriate
multiplication factor.
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OTC derivatives dealers would be required to obtain authorization
from the Commission before using VAR models. An OTC derivatives dealer
planning to use the full VAR method would send an application to the
Commission describing its VAR model, including whether the firm has
developed its own model and how the qualitative and quantitative
aspects described in Appendix F are
[[Page 67948]]
incorporated into the model.52 The firm's application would
also include a description of the risk management controls adopted by
the firm pursuant to proposed Rule 15c3-4.53
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\52\ See infra Sections II.E.3.b.iii. through iv. for a
description of the qualitative and quantitative requirements.
\53\ See infra Section II.H.3. for a description of the risk
management controls that would be required by proposed Rule 15c3-4.
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Second, an OTC derivatives dealer could use an alternative method
of computing the market risk capital charge for equity instruments and
OTC options and use VAR for its other proprietary positions. This
alternative method would also be used by a firm that does not receive
Commission authorization to use a VAR model for equity instruments.
Under the alternative method, an OTC derivatives dealer would deduct
from its net worth an amount equal to the largest theoretical loss
calculated in accordance with the theoretical pricing model set forth
in Appendix A of Rule 15c3-1.54 The OTC derivatives dealer
would be permitted to use its own theoretical pricing model as long as
it contains the minimum pricing factors set forth in Appendix
A.55
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\54\ 17 CFR 240.15c3-1a. The Commission recently amended
Appendix A to include theoretical pricing models. Exchange Act Rel.
No. 38248 (Feb. 6, 1997), 62 FR 6474 (Feb. 12, 1997).
\55\ 17 CFR 240.15c3-1a(b)(1)(B). The minimum pricing factors in
Appendix A require that a pricing model consider:
(1) The current spot price of the underlying asset;
(2) The exercise price of the option;
(3) The remaining time until the option's expiration;
(4) The volatility of the underlying asset;
(5) Any cash flows associated with ownership of the underlying
asset that can reasonably be expected to occur during the remaining
life of the option; and
(6)The current term structure of interest rates.
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ii. Credit Risk. OTC derivatives dealers electing to apply Appendix
F would deduct from their net worth a capital charge for credit
risk.56 This charge would have two parts and would be
computed on a counterparty by counterparty basis. First, for each
counterparty, OTC derivatives dealers would take a capital charge equal
to the net replacement value in the account of the counterparty (``net
replacement value'') 57 multiplied by 8%, and further
multiplied by a counterparty factor. The counterparty factor would be
based on the counterparty's rating by at least two nationally
recognized statistical rating organizations (``NRSROs'' or ``rating
organizations''). The counterparty factors would range from 20% for
counterparties that are highly rated to 100% for counterparties with
ratings among the lowest rating categories. By using the ratings of the
rating organizations as a basis, the counterparty factors would link
the size of the credit risk capital charge to the perceived risk that
the counterparty may default. A charge of 100% of the net replacement
value would be assessed for counterparties that are in bankruptcy or
whose bonds are in default. The Commission requests comment on
alternatives to relying on the ratings of NRSROs for approximating the
risk that a counterparty may default.
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\56\ In general, credit risk is the risk that a counterparty
will fail to perform its obligations to an OTC derivatives dealer.
\57\ For purposes of calculating credit risk charges, net
replacement value in the account of a counterparty would mean the
aggregate value of all receivables due from that counterparty (which
would be computed by marking the value of such receivables to market
daily), including the effect of legally enforceable netting
agreements and the application of liquid collateral.
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The second part of the credit risk charge would consist of a
concentration charge that would apply when the net replacement value in
the account of any one counterparty exceeds 25% of the OTC derivatives
dealer's tentative net capital. In these situations, the amount of the
concentration charge would also be based on the counterparty's rating
by at least two rating organizations. For counterparties that are
highly rated, the concentration charge would equal 5% of the amount of
the net replacement value in excess of 25% of the OTC derivatives
dealer's tentative net capital. The concentration charge would increase
in relation to the OTC derivatives dealer's exposure to lower rated
counterparties. For example, the concentration charge for
counterparties with ratings among the lowest rating categories would
equal 50% of the amount of the net replacement value in excess of 25%
of the OTC derivatives dealer's tentative net capital. Further, if the
aggregate net replacement values of all counterparties exceeds 300% of
the OTC derivatives dealer's tentative net capital, the OTC derivatives
dealer would deduct 100% of the excess from its net worth. The
Commission requests comment on whether the 300% threshold for
determining an overall concentration charge would result in excessive
concentration risk charges.
If a counterparty is not rated by a rating organization, an OTC
derivatives dealer would be permitted to use its own ratings of the
counterparty to calculate its credit risk charge. In these situations,
however, the OTC derivatives dealer would have to demonstrate that its
ratings criteria and due diligence procedures, including procedures for
the initial analysis and ongoing review of the counterparty, are
equivalent to those used by NRSROs.
iii. Qualitative Requirements for Value-at-Risk Models. OTC
derivatives dealers that elect to apply Appendix F would be required to
have VAR models that meet certain minimum qualitative requirements. The
Commission proposes to establish these minimum requirements to ensure
that the VAR models used for computing market risk capital charges are
the same as those used to perform internal risk management functions.
The qualitative requirements would address four aspects of an OTC
derivatives dealer's risk management system. First, an OTC derivatives
dealer's VAR model would have to be integrated into the OTC derivatives
dealer's daily risk management process. Second, an OTC derivatives
dealer's policies and procedures would have to identify and provide for
appropriate stress tests.58 The OTC derivatives dealer's
policies and procedures would have to identify the procedures to follow
in response to the results of the stress tests and backtests, and the
OTC derivatives dealer would be required to follow these procedures.
Third, an OTC derivatives dealer's VAR model and risk management
systems would be required to undergo both periodic independent reviews
that would be performed by internal audit staff, and annual reviews
that would be conducted by an independent public accountant. Fourth,
OTC derivatives dealers would be required to conduct backtesting.
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\58\ Stress tests are used to evaluate changes in the value of a
firm's portfolio under extreme market conditions. The Commission
expects stress tests to include the core risk factors of: (1)
Parallel yield curve shifts; (2) changes in the steepness of yield
curves; (3) parallel yield curve shifts combined with changes in the
steepness of yield curves; (4) changes in yield volatilities; (5)
changes in the value of equity indices; (6) changes in equity index
volatilities; (7) changes in the value of key currencies (relative
to the U.S. dollar); (8) changes in foreign exchange rate
volatilities; and (9) changes in swap spreads in at least the G-7
countries plus Switzerland. Stress tests should also be designed to
reflect the composition of the firm's portfolio.
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Backtesting would be intended to gauge the accuracy of a dealer's
model by comparing the dealer's projections against actual trading
results. The OTC derivatives dealer would be required to conduct
backtesting by comparing each of its most recent 250 business days'
actual net trading profit or loss with the corresponding daily VAR
measures. In addition, once each quarter, the OTC derivatives dealer
would have to identify the number of exceptions, that is, the number of
business days for which the actual daily net trading loss, if any,
exceeds the corresponding daily VAR measure. The number of exceptions
would determine the multiplication factor the OTC
[[Page 67949]]
derivatives dealer would be required to use for the following quarter,
and which would continue to apply until the next quarter's backtesting
results are obtained or unless the Commission determines that a
different adjustment or other action is appropriate. Depending on the
number of exceptions, the multiplication factors would range from three
to four. Increasing the multiplication factor in response to the number
of backtesting exceptions increases an OTC derivatives dealer's market
risk charge, thus penalizing an OTC derivatives dealer that uses a less
accurate model. Although the multiplication factor would increase an
OTC derivative's dealer's market risk charge and corresponding capital
requirement, the Commission intends that firms work to improve the
accuracy of their models rather than set aside additional capital for
an inaccurate model.
The multiplication factor is intended to cover the additional risks
that would be present in an OTC derivatives dealer's portfolio, other
than market and credit risk. For example, an OTC derivatives dealer
would be subject to legal, liquidity, and operational risk. Operational
risk is generally the risk of human error or deficiencies in the firm's
operating systems, including VAR model. It is difficult to quantify and
develop capital charges specifically for these risks. The Commission,
however, believes that the multiplication factor would be an
appropriate way to account for these other risks facing OTC derivatives
dealers.
iv. Quantitative Requirements for Value-at-Risk Models. Appendix F
would also contain minimum quantitative requirements to address
regulatory concerns. Because broker-dealers generally use VAR models to
measure portfolio volatility on a day-to-day basis, the Commission
would impose certain requirements on VAR models to address regulatory
capital-related concerns where a longer time horizon is appropriate.
For example, OTC derivatives dealers would be required to calculate VAR
measures using a confidence level with a price change equivalent to a
ten-business day movement in rates and prices, rather than a one-day
price movement that is used in many VAR models currently used by firms
for internal risk management purposes.
F. Use of Counterparty Collateral
1. Proposed Amendments to Exchange Act Rules 8c-1 and 15c2-1;
Hypothecation Rules
The Commission proposes to amend Exchange Act Rules 8c-
159 and 15c2-1, 60 which address the
hypothecation of customer securities. The hypothecation rules generally
prohibit a broker-dealer from using its customers' securities as
collateral to finance its own trading, speculating, or underwriting
transactions. More specifically, the rules state three main principles:
first, that a broker or dealer is prohibited from commingling the
securities of different customers as collateral for a loan without the
consent of each customer; second, that a broker or dealer cannot
commingle its customers' securities with its own under the same pledge;
and third, that a broker or dealer can only pledge its customers'
securities up to the value of monies owed to the broker-dealer by its
customers.
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\59\ 17 CFR 240.8c-1.
\60\ 17 CFR 240.15c2-1.
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In privately negotiated OTC derivatives transactions,
counterparties generally agree that assets pledged as collateral may be
used in the business of the OTC derivatives dealer without being
segregated. For this reason, it is not necessary to treat
counterparties as customers of OTC derivatives dealers for purposes of
Exchange Act Rules 8c-1 and 15c2-1, or to apply these rules to
counterparty assets held as collateral by an OTC derivatives dealer.
Accordingly, Rules 8c-1 and 15c2-1 would be amended so that an OTC
derivatives dealer would not be deemed to hold collateral for the
account of any customer when that collateral is received as a result of
the OTC derivatives dealer acting as counterparty in transactions in
eligible OTC derivative instruments and the permissible derivatives
counterparty has consented to the unrestricted use of its collateral
after receiving appropriate disclosure.
2. Proposed Amendments to Exchange Act Rule 15c3-3; Customer Protection
Rule
The Commission also proposes to amend Exchange Act Rule 15c3-
3,61 the Commission's customer protection rule. The customer
protection rule generally prohibits a broker or dealer from using
customers' funds and securities to finance its business. As a result,
this rule helps to ensure that customers can promptly obtain their
funds or securities from a broker-dealer.
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\61\ 17 CFR 240.15c3-3.
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As amended, Rule 15c3-3 would clarify that the term ``customer,''
as used in the rule, is not intended to include a permissible
derivatives counterparty that has consented to the unrestricted use of
its collateral by an OTC derivatives dealer after receiving appropriate
disclosure. As noted previously, counterparties in privately negotiated
OTC derivative transactions generally agree that assets pledged as
collateral may be used in the business of the OTC derivatives dealer
without being segregated.
G. Proposed Rule 36a1-2; Exemption From SIPA
Under proposed Rule 36a1-2, OTC derivatives dealers would be
exempted from the provisions of the Securities Investor Protection Act
of 1970 (``SIPA''),62 including membership in the Securities
Investor Protection Corporation (``SIPC'').63 Under SIPA,
broker-dealers registered under Section 15(b) become SIPC members. The
Commission is concerned that the application of SIPA's liquidation
provisions to an OTC derivatives dealer in bankruptcy could undermine
certain provisions of the bankruptcy code applicable to the dealer's
business.64 The potential application of SIPA to OTC
derivatives dealers would create legal uncertainty about the rights of
counterparties in transactions with registered OTC derivatives dealers
in the event of dealer insolvency.65 This
[[Page 67950]]
uncertainty could impair the ability of securities firms electing to
register OTC derivatives dealers to compete effectively with banks and
foreign dealers, which are not subject to similar legal uncertainty.
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\62\ 15 U.S.C. 78aaa et seq.
\63\ Section 2 of SIPA [15 U.S.C. 78bbb] generally incorporates
SIPA into the Exchange Act.
\64\ The bankruptcy code contains certain exceptions to its
automatic stay provisions that enable a counterparty in a
derivatives transaction to exercise its rights to liquidate a
position (i.e., it preserves a counterparty's contractual
termination, setoff, and collateral foreclosure rights) in the event
of the other counterparty's insolvency. See, e.g., 11 U.S.C. Section
362(b)(6), (7), (17); id. at Sections 555, 556, 559, and 560.
Several of these provisions, however, may be subject to a stay order
under SIPA. See 11 U.S.C. Section 555 (contractual right to
liquidate a securities contract); id. at Section 559 (contractual
right to liquidate a repurchase agreement).
\65\ The Commission believes that the counterparty collateral
that would be held by OTC derivatives dealers should not be
considered customer assets for purposes of SIPA. Congress enacted
SIPA in 1970 primarily to protect the retail customers of a broker-
dealer in the event of its financial difficulty. Congress was
concerned that prior to the enactment of SIPA, public customers
sometimes had encountered difficulty in obtaining their cash
balances or securities from insolvent broker-dealers. Congress
analogized the need for SIPA to the need which prompted
establishment of the Federal Deposit Insurance Corporation. H.R.
Rep. No. 91-1613, 91st Cong., 2d Sess. 2 (1970). The Commission
believes that the type of privately negotiated transactions and
counterparty assets (collateral) involved in the OTC derivatives
business are quite different from the ordinary brokerage business
and customer assets contemplated by SIPA.
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Accordingly, the Commission believes that the purposes of SIPA
would not be promoted by its application to OTC derivatives dealers,
and may in fact result in legal uncertainty for OTC derivatives dealer
counterparties. The Commission therefore believes that exempting OTC
derivatives dealers from SIPA would be necessary or appropriate in the
public interest and consistent with the protection of investors. The
Commission requests comments on the need, appropriateness, and form of
the proposed exemption.
H. Books and Records
1. Proposed Amendments to Exchange Act Rules 17a-3 and 17a-4; Books and
Records to be Maintained by OTC Derivatives Dealers
OTC derivatives dealers, like other broker-dealers that are
registered with the Commission, would be required to comply with the
books and records requirements of Exchange Act Rules 17a-3
66 and 17a-4.67 Section 17(a)(1) of the Exchange
Act 68 requires registered broker-dealers to make, keep,
furnish, and disseminate records and reports that are prescribed by the
Commission as necessary or appropriate in the public interest, for the
protection of investors, or otherwise in furtherance of the purposes of
the Exchange Act. Consistent with the requirements of Section 17(a)(1),
Rules 17a-3 and 17a-4 require all broker-dealers to make and keep
certain records relating to their business activities. These rules
would also apply to OTC derivatives dealers.69
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\66\ 17 CFR 240.17a-3.
\67\ 17 CFR 240.17a-4.
\68\ 15 U.S.C. 78q(a)(1).
\69\ In general, Exchange Act Rule 17a-3 requires broker-dealers
to make records concerning the purchases and sales of securities,
receipts and deliveries of securities, and receipts and
disbursements of cash. In addition, the rule requires broker-dealers
to make and keep ledgers reflecting securities borrowed and
securities received, repurchase and reverse repurchase agreements,
and a record of net capital computations.
Exchange Act Rule 17a-4 specifies how long broker-dealers must
keep the records required to be made under Rule 17a-3 and how long
they must keep other records made in the normal course of business.
Specifically, Rule 17a-4(b) requires broker-dealers to keep trial
balances, internal audit workpapers, and net capital computations
and related workpapers for three years. Rule 17a-4(b) also requires
broker-dealers to keep all written agreements relating to the
broker-dealer's business for three years.
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Currently, Rule 17a-3 does not specifically provide for maintaining
records relating to the full range of activities that would be
conducted by OTC derivatives dealers. For this reason, Rule 17a-3 would
be amended to reflect the activities of OTC derivatives dealers and to
require that OTC derivatives dealers compile a register of all
transactions in eligible OTC derivative instruments. The Commission
also proposes to make technical amendments to Rule 17a-4 to require OTC
derivatives dealers to retain the records required to be made pursuant
to proposed Rules 15c3-4 and 17a-12. As discussed in more detail below,
the records required under Rule 17a-12 would be similar to those
currently required under Rule 17a-5. In part, these records would
include the OTC derivatives dealer's risk management control guidelines
and information supporting data contained in the dealer's annual
audited financial statements. These records would have to be retained
for three years.
2. Proposed Amendments to Exchange Act Rule 17a-11; Notification
Requirements
OTC derivatives dealers would be subject to the provisions of
Exchange Act Rule 17a-11, which requires a broker-dealer to report
capital and other operational problems to the Commission and the
broker-dealer's examining authority within specified time
periods.70 Because Rule 17a-11 provides the Commission with
valuable tools in overseeing the financial and operational health of
broker-dealers, it is appropriate that Rule 17a-11 also apply to OTC
derivatives dealers.
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\70\ 17 CFR 240.17a-11. Under Rule 17a-11, if a broker-dealer's
net capital falls below the required minimum level, the broker-
dealer must provide both the Commission and the broker-dealer's
designated examining authority with notice of such deficiency. A
broker-dealer is also required to give same-day notice if it fails
to make and keep current its books and records pursuant to Rules
17a-3 and 17a-4, and to submit a report within 48 hours detailing
the steps it is taking to correct the problem. In addition, Rule
17a-11 requires a broker-dealer to give notice when it discovers any
material inadequacy in its system of internal controls, or is
notified of this inadequacy by its independent public accountant. In
these instances, the broker-dealer is required to submit a report
detailing steps being taken to correct the inadequacy.
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Rule 17a-11 would be amended to take into consideration the new
tentative net capital requirements that would apply to OTC derivatives
dealers. As a result, if an OTC derivatives dealer's tentative net
capital were to drop below 120 percent of its required minimum, the
dealer would be required to provide notice both to the Commission and
the examining authority responsible for reviewing its activities
pursuant to proposed Rule 15b9-2. Notice would also be required in the
event the OTC derivatives dealer's tentative net capital were to drop
below its required minimum. This notice requirement would provide the
Commission and the examining authority with early warning of an OTC
derivatives dealer's financial or operational problems and allow the
Commission and the examining authority to increase their supervision of
the dealer's operations. It would also give the Commission and the
examining authority time to obtain additional information about the OTC
derivatives dealer's financial condition and to take corrective action,
as necessary.
3. Proposed Rule 15c3-4; Internal Risk Management Control Systems for
OTC Derivatives Dealers
Section 15(c)(3) of the Exchange Act 71 enables the
Commission to adopt rules and regulations regarding the financial
responsibility of broker-dealers that the Commission deems necessary or
appropriate in the public interest or for the protection of investors.
Pursuant to this authority, the Commission is proposing Rule 15c3-4 to
require OTC derivatives dealers to establish a system of internal
controls for monitoring and managing the risks associated with their
business activities.
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\71\ 15 U.S.C. 78o(c)(3).
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Participants in OTC derivatives markets are exposed to various
risks, including (1) operational risk; 72 (2) market risk;
73 (3) credit risk; 74 (4) liquidity risk;
75 and (5) legal risk.76 These risks are due, in
part, to the characteristics of OTC derivative products and the way OTC
derivative markets have evolved in comparison to the markets for equity
securities and listed options. For example,
[[Page 67951]]
individually negotiated OTC derivative products generally are not very
liquid. Also, the absence at this time of a clearing system for OTC
derivative products means that market participants face risks
associated with the financial and legal ability of counterparties to
perform under the terms of specific transactions. The additional
exposure to credit risk, liquidity risk, and other risks makes it
necessary for OTC derivatives market participants to implement a risk
management control system.
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\72\ Operational risk encompasses the risk of loss due to the
breakdown of controls within the firm including, but not limited to,
unidentified limit excesses, unauthorized trading, fraud in trading
or in back office functions, inexperienced personnel, and unstable
and easily accessed computer systems.
\73\ Market risk involves the risk that prices or rates will
adversely change due to economic forces. Such risks include adverse
effects of movements in equity and interest rate markets, currency
exchange rates, and commodity prices. Market risk can also include
the risks associated with the cost of borrowing securities, dividend
risk, and correlation risk.
\74\ Credit risk comprises risk of loss resulting from
counterparty default on loans, swaps, options, and during
settlement.
\75\ Liquidity risk includes the risk that a firm will not be
able to unwind or hedge a position.
\76\ Legal risk arises from possible risk of loss due to an
unenforceable contract or an ultra vires act of a counterparty.
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During the past few years, the importance of operational risk
management controls has been highlighted by the multi-billion dollar
losses experienced by several large financial firms. These losses were
caused by unauthorized and undisclosed employee trading. In each case,
these losses went virtually undetected by management because of the
lack of basic internal controls, including the separation of
responsibility for recording the trades on the firms' books from the
personnel responsible for trading.
Risk management controls within financial institutions promote the
stability of these firms and, consequently, the stability of the entire
financial system. They do this by reducing the risk of significant
losses by a firm, which also reduces the risk that spreading losses
would cause multiple defaults and undermine markets as a whole.
Specifically, internal risk management controls promote stability by
providing two important functions: (1) Protecting against firm specific
risk such as operational, market, credit, legal, and liquidity risks;
and (2) protecting the financial industry from systemic
risk.77
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\77\ Systemic risk encompasses the risk that the failure of one
firm or within one market segment would trigger failures in other
market segments or throughout the financial markets as a whole.
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The specific elements of a risk management system will vary
depending on the size and complexity of a firm's business operations.
As a result, the design and implementation of a system of internal
controls for a particular firm should reflect the circumstances of the
firm. Any well-developed risk management system, however, should
include a risk management strategy, policies and procedures to
accomplish that strategy, risk measurement methodologies, compliance
monitoring and reporting, and on-going assessment of the effectiveness
of the strategies, policies, and procedures.
The Commission recognizes that an individual firm must have the
flexibility to implement specific policies and procedures unique to its
circumstances. As a result, proposed Rule 15c3-4 would establish only
basic elements for the design, implementation, and review of an OTC
derivatives dealer's risk management control system. These elements are
designed to ensure the integrity of the risk management process, to
clarify that the appropriate level of management is authorizing the
types of activity that can be conducted and the level of risk that can
be assumed, and to ensure that the OTC derivatives dealer reviews its
activities for consistency with risk management guidelines.
The proposed rule would require an OTC derivatives dealer to assess
a number of aspects about its business environment when creating its
risk management control system. This assessment is designed to ensure
that the system implemented is appropriate for the individual firm. For
example, an OTC derivatives dealer would need to consider the
sophistication and experience of relevant trading, risk management, and
internal audit personnel, as well as the management philosophy and
culture of the firm.
Despite the need for firms to develop controls appropriate to their
specific circumstances, the proposed rule would also require certain
elements to be included in OTC derivatives dealers' internal control
systems. These elements ensure that internal control systems protect
against risks that are universal to the business of OTC derivatives
dealers. For example, the unit at the firm responsible for monitoring
risk must be separate from and senior to the trading units whose
activity create the risks. This is to ensure the independence of the
risk management process. In addition, personnel responsible for
recording transactions in the books of the OTC derivatives dealer
cannot be the same as those responsible for executing transactions.
This is to ensure that trading losses cannot be hidden.
Finally, the OTC derivatives dealer's management must periodically
review the firm's business activities for consistency with established
risk management guidelines. This will ensure that personnel are
operating within the scope of permissible activity and that the risk
management system will continue to be adequate.
4. Proposed Rule 17a-12; Reports To Be Made by OTC Derivatives Dealers
Exchange Act Rule 17a-5 78 requires all broker-dealers
to file various reports with the Commission. These reports include
periodic Financial Operational Combined Uniform Single Reports (FOCUS),
79 annual audited financial statements, and designations of
accountant. Under proposed Rule 17a-12, similar periodic requirements
would be put into place for OTC derivatives dealers.
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\78\ 17 CFR 240.17a-5. Rule 17a-5 was adopted by the Commission
pursuant to authority under Section 17 of the Exchange Act [15
U.S.C. 78q], and particularly Section 17(e) [15 U.S.C. 78q(e)],
which requires every broker or dealer to file annually with the
Commission a certified balance sheet and income statement, and such
other information concerning its financial condition as the
Commission may prescribe.
\79\ Form X-17A-5 [17 CFR 249.617].
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Proposed Rule 17a-12 would require OTC derivatives dealers to file
quarterly FOCUS reports, and to include in these filings the enhanced
reporting information and the evaluation of risk in relation to capital
provisions of the Framework for Voluntary Oversight of the Derivatives
Policy Group (``DPG''). 80 The DPG credit and market risk
information (Schedules I-V and VI of the proposed FOCUS report) are
intended to enable the Commission to ascertain the nature and scope of
a firm's OTC derivatives activity and to monitor the firm's risk
exposure.
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\80\ See Framework for Voluntary Oversight, Derivatives Policy
Group (Mar. 1995). The firms comprising the DPG consist of the six
U.S. broker-dealers with the largest OTC derivatives affiliates.
This group was organized to respond to the public policy interests
of Congress, federal agencies, and others in the OTC derivatives
activities of unregulated affiliates of SEC-registered broker-
dealers and CFTC-registered futures commission merchants. The
Framework for Voluntary Oversight specifies certain information that
the members of the DPG have voluntarily agreed to submit regarding
their OTC derivatives activities and establishes certain internal
control principles that group members should follow.
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Proposed Rule 17a-12 would also require the OTC derivatives dealer
to file annually its audited financial statements along with a
corresponding audit report. Among other things, the annual audit report
would include a statement of financial condition, a statement of
income, a statement of cash flows, a statement of changes in owners'
equity, and a statement of changes in subordinated liabilities. The
proposed rule establishes guidelines for the content and form of the
annual report, accountant qualifications, the process for designating
an accountant, and audit objectives.
Each of the reports required under proposed Rule 17a-12 would
assist the Commission to monitor the operations
[[Page 67952]]
of OTC derivatives dealers and to enforce their compliance with the
Commission's rules. These reports would also enable the Commission to
review the business activities of OTC derivatives dealers and to
anticipate, where possible, how these dealers may be affected by
significant economic events.
5. Proposed Amendments to Form X-17A-5
Proposed Rule 17a-12 would require that certain conforming changes
be made to Rule 249.617 to require OTC derivatives dealers to file the
appropriate parts of Form X-17A-5, commonly known as the FOCUS report.
These changes would provide for appropriate disclosure of the business
activities of OTC derivatives dealers and the risks associated with
those activities.
Under the proposed amendments to Form X-17A-5, the net capital
computation worksheet would be revised to reflect the proposed net
capital requirements for OTC derivatives dealers. Other changes would
include revising the statement of financial condition and the statement
of income, and eliminating the customer reserve computation and
commission income line items. OTC derivatives dealers would also be
required to include certain information in the quarterly FOCUS filing.
This information would include credit concentration information,
together with a geographic breakdown and a counterparty breakdown as
described in the DPG Framework for Voluntary Oversight. OTC derivatives
dealers would also be required to provide, where applicable, a detailed
summary of all long and short securities and commodities positions,
including all OTC derivatives contracts.
By incorporating the DPG credit and market risk information into
the FOCUS filing requirement for OTC derivatives dealers, the
Commission would be able to ascertain the nature and scope of a firm's
OTC derivatives activity and to monitor the firm's risk exposure. This
information has been valuable to the Commission in understanding the
OTC derivatives business of those firms already participating in the
DPG Framework for Voluntary Oversight program.
III. General Requests for Comment
The Commission solicits comment on its proposal to establish a
limited, optional regulatory system for OTC derivatives dealers. In
particular, the Commission solicits comments on the extent to which
persons eligible to become registered as OTC derivatives dealers
believe this proposed system would address any competitive inequalities
that discourage securities firms from conducting an OTC derivatives
business in the United States. The Commission also solicits comments on
this proposal from derivatives counterparties and other interested
participants in global financial markets. In addition, commenters are
requested to express their views on the application of the Commission's
broker-dealer rules to OTC derivatives dealers and whether additional
amendments or exemptions would be needed for this class of dealers. For
purposes of the Small Business Regulatory Enforcement Fairness Act of
1996, the Commission is also requesting information regarding the
potential impact of the proposed rules on the national economy on an
annual basis. Commenters should provide empirical data to support their
views.
IV. Costs and Benefits of the Proposed Rules and Rule Amendments
To assist the Commission in its evaluation of the costs and
benefits that may result from the proposed limited regulatory system
for OTC derivatives dealers, commenters are requested to provide
analysis and data relating to the costs and benefits associated with
the proposals. 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 rules and rule amendments and the potential benefits
arising from participation in the regulatory scheme.
The Commission has identified certain costs and benefits that would
be associated with the proposed regulatory system for OTC derivatives
dealers. This proposed system would be optional and is designed to
allow U.S. securities firms to establish separate OTC derivatives
dealer affiliates capable of acting as counterparties with respect to
both securities and non-securities OTC derivative products. Capital,
margin, and other broker-dealer regulatory requirements would be
tailored to the activities of these entities. Registration as an OTC
derivatives dealer would be an alternative to registration as a fully
regulated broker-dealer under Section 15(b) of the Exchange Act for
firms combining a business in securities and non-securities OTC
derivative products, and would be available only to entities acting
primarily as counterparties in privately negotiated OTC derivatives
transactions.
It is expected that firms electing to become registered as OTC
derivatives dealers would be able to conduct business more efficiently
and at lower cost than under current Commission rules. This would allow
OTC derivatives dealers to compete more effectively against banks and
foreign dealers in OTC derivatives markets. The Commission expects that
the benefits to OTC derivatives dealers of being able to compete more
effectively in global derivatives markets at a lower cost would
outweigh the potential cost of this limited regulation.
Cost savings would result in several areas. First, firms that
currently conduct securities OTC derivatives activities from registered
broker-dealers and non-securities OTC derivatives activities from
separate, unregistered entities, would be able to combine these
activities in one OTC derivatives dealer. This combination of
operations in one entity would result in a decrease in operational
costs. There would also be a decrease in regulatory costs. OTC
derivatives dealers that register with the Commission would become
subject to tailored capital and other requirements that are intended to
impose lesser regulatory burdens than are imposed on fully regulated
broker-dealers. In addition, OTC derivatives dealers would be exempted
from the margin requirements of Section 7 and Regulation T, provided
these dealers comply with the margin requirements of Regulation U.
Applying Regulation U to extensions of credit by OTC derivatives
dealers would allow them to extend credit on the broader range of
securities OTC derivatives products that make up their business.
The Commission preliminary believes that the proposed rules and
rule amendments would promote both efficiency and capital formation.
The proposed rules and rule amendments should provide broker-dealers
the opportunity to increase operational efficiency by reducing the need
to fractionalize their OTC derivatives business. The Commission,
however, solicits comment on whether the proposal would promote both
efficiency and capital formation.
The proposed limited regulatory system for OTC derivatives dealers
would also result in benefits to regulators and to financial markets.
First, OTC derivatives dealers that register with the Commission would
be subject to the proposed net capital requirements and other financial
responsibility requirements for OTC derivatives dealers. These are
intended
[[Page 67953]]
to ensure against excessive leverage and the risks associated with
conducting an OTC derivatives business, and to provide a cushion of
capital against market declines and other risks. Second, Commission
oversight authority, including proposed reporting and notice
requirements, would enable the Commission to monitor the financial
condition and securities activities of OTC derivatives dealers. Third,
proposed internal risk management control systems are intended to
promote the financial responsibility of OTC derivatives dealers to the
extent they have elected to do business through this type of broker-
dealer. By reducing the risk of significant losses by a single firm,
internal risk management control systems would also reduce the risk
that the problems of one firm would spread, causing defaults by other
firms and undermining securities markets as a whole.
Firms electing to register as OTC derivatives dealers would incur
various costs. As a preliminary matter, there may be costs associated
with combining activities currently conducted in a registered broker-
dealer with activities conducted in other unregistered entities. These
firms would incur the one-time and on-going costs of registration as an
OTC derivatives dealer. These firms would also have the one-time and
on-going costs of making adjustments to risk management practices to
conform with proposed Rule 15c3-4, and of maintaining capital required
by proposed Appendix F to the net capital rule. In addition, these
firms would have the one-time and on-going costs of complying with the
books and records requirements under proposed amendments to Rules 17a-3
and 17a-4. OTC derivatives dealers would incur costs associated with
preparing and submitting FOCUS reports and annual audited financial
statements. This would include the cost of contracting with a certified
public accountant to conduct an annual audit. Moreover, while OTC
derivatives dealers would be exempted from the more restrictive margin
requirements of Regulation T, the dealers would have the one-time and
on-going costs associated with complying with the margin requirements
of Regulation U, including the costs of developing systems for
compliance and the costs associated with subjecting currently
unregulated offshore activities to Regulation U.
V. The Effects on Competition of the Proposed Rules and Rule
Amendments
Section 23(a)(2) of the Exchange Act 81 requires the
Commission, in adopting rules under the Exchange Act, to consider the
impact any rule would have on competition and to not adopt any rule
that would impose a burden on competition not necessary or appropriate
in the public interest. The Commission's preliminary view is that the
proposed rules for OTC derivatives dealers would not have any
anticompetitive effects. These rules are intended to remove substantial
regulatory and economic barriers that impede the ability of U.S.
securities firms to compete effectively in global securities markets.
In particular, by providing OTC derivatives dealers with relief from
certain provisions of the federal securities laws, these rules would
put U.S. securities firms on a level footing with their bank and
foreign dealer competitors.
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\81\ 15 U.S.C. 78w(a)(2).
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As discussed above, the limited regulatory system for OTC
derivatives dealers would be optional, and would be an alternative to
regulation as a fully regulated broker-dealer. OTC derivatives dealers
that elect to register with the Commission in order to conduct both
securities and non-securities OTC derivatives transactions in a single
entity would be subject to modified capital, margin, and other
regulatory requirements. Because of the substantial minimum capital
requirements that would be imposed on OTC derivatives dealers,
regulation as an OTC derivatives dealer would be available only to
large, well-capitalized firms.
In general, major dealers in OTC derivatives markets include the
largest, highest capitalized banks and securities firms. It is
possible, however, that there may be smaller firms participating in
these markets that could not satisfy the minimum capital requirements
for OTC derivatives dealers and, as a result, not be able to take
advantage of the competitive benefits available under the proposed
rules. Nevertheless, these minimum capital requirements for OTC
derivatives dealers are necessary to ensure against excessive leverage
and the risks associated with conducting an OTC derivatives business,
and to provide a cushion of capital against severe market disturbances.
The Commission requests comment on the competitive benefits to OTC
derivatives dealers that may result under the proposed rules. The
Commission also requests comment on any anticompetitive effects that
may result under the proposed rules.
VI. Summary of Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding proposed
rules and rule amendments under the Exchange Act that would tailor
capital, margin, and other broker-dealer regulatory requirements to the
activities of OTC derivatives dealers. The following summarizes the
IRFA.
The proposed rules and rule amendments are intended to improve the
efficiency and competitiveness of U.S. securities firms participating
in global OTC derivatives markets. These improvements would be realized
through a limited regulatory structure that is intended to be
deregulatory and to impose fewer costs on firms conducting an OTC
derivatives business than would be imposed under the Commission's
current rules. In particular, the application of revised capital
requirements and an exemption from the margin provisions of Section 7
of the Exchange Act 82 are expected to make it feasible for
firms to conduct a business involving both securities and non-
securities OTC derivative products within the United States.
---------------------------------------------------------------------------
\82\ 15 U.S.C. 78g.
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A broker-dealer (including any person that would be an OTC
derivatives dealer) generally would be considered a small entity if (i)
it has total capital (net worth plus subordinated liabilities) of less
than $500,000 on the date in the prior fiscal year as of which its
audited financial statements were prepared pursuant to Rule 17a-5(d)
or, if not required to file such statements, a broker-dealer that had
total capital (net worth plus subordinated liabilities) of less than
$500,000 on the last day of the preceding fiscal year (or in the time
that it has been in business, if shorter); and (ii) it is not
affiliated with any person (other than a natural person) that is not a
small business or small organization.83
---------------------------------------------------------------------------
\83\ Exchange Act Rule 0-10 [17 CFR 240.0-10].
---------------------------------------------------------------------------
Under the proposed amendments to Rule 15c3-1, OTC derivatives
dealers would be required to maintain at least $100 million in
tentative net capital and at least $20 million in regulatory net
capital. Based on these minimum capital requirements, the IRFA notes
that no OTC derivatives dealer would be considered a small entity.
Major dealers in OTC derivatives markets tend to be the largest,
highest-capitalized banks and securities firms. The proposed capital
requirements have been tailored
[[Page 67954]]
to this market and are necessary to ensure against excessive leverage
and the risks associated with conducting an OTC derivatives business,
as well as to provide for a cushion of capital against severe market
disturbances. The Commission is not aware of any small entities that
are active as dealers in OTC derivatives markets. In the IRFA, the
Commission requests comment on whether there are small entities that
act as dealers in OTC derivatives markets, and what effect, if any, the
proposed rules and rule amendments would have on their activities.
The Commission also requests comment from persons acting as
counterparties in transactions with persons eligible to become
registered as OTC derivatives dealers. Under proposed Rule 3b-14, the
term ``permissible derivatives counterparty'' would include a range of
financial institutions, corporations, and other institutional entities
with whom OTC derivatives dealers would be permitted to enter into OTC
derivatives transactions. Like OTC derivatives dealers, these
institutional counterparties are frequently large, well-capitalized
entities. The proposed definition may include potential counterparties
that would be considered small entities for purposes of the Regulatory
Flexibility Act (``RFA'').84
---------------------------------------------------------------------------
\84\ 5 U.S.C. 601 et seq.
---------------------------------------------------------------------------
The proposed definition would include various classes of persons,
such as banks, trust companies, saving associations, credit unions,
insurance companies, investment companies, broker-dealers, commodity
pools, futures commission merchants, and governmental entities, without
regard to any minimum financial requirements. The Commission requests
comment regarding the participation of these classes of persons in OTC
derivatives markets, whether any of them would be considered small
entities, and what effect, if any, the proposed rules and rule
amendments would have on their activities.
The proposed definition would also include classes of persons, such
as corporations, partnerships, trusts, and employee benefit plans, that
would have minimum financial requirements for being considered a
permissible derivatives counterparty. In the case of corporations,
partnerships, trusts, and certain other entities described in the
proposed definition, any such entity would be required to have total
assets exceeding $10 million, have obligations under the terms of an
OTC derivatives transaction that are guaranteed by certain classes of
persons described in the rule, or a net worth of $1 million if it
enters into OTC derivatives transactions in connection with the conduct
of its business. Employee benefit plans would be required to have total
assets exceeding $5 million. Alternatively, employee benefit plans
would satisfy the definition if its investment decisions are made by a
bank, trust company, insurance company, investment adviser, or
commodity trading advisor subject to regulation by the Commodity
Futures Trading Commission.
Some of these entities, despite minimum financial requirements, may
be considered small entities for purposes of the RFA. The Commission
requests comment regarding the participation of these classes of
persons in OTC derivatives markets. Commenters should address whether
any of these potential participants in OTC derivatives markets are
likely to be small entities, and what effect, if any, the proposed
rules and rule amendments would have on their activities. The
Commission also requests comment from small entities that would not be
able to satisfy the definition of permissible derivatives counterparty
and, therefore, would not be eligible to engage in transactions with
OTC derivatives dealers. Commenters should indicate what effect, if
any, the proposed rules and rule amendments would have on their
activities.
As explained in the IRFA, none of the recordkeeping, reporting, or
other compliance requirements under the proposed rules and rule
amendments are expected to be unduly burdensome. Under the proposed
amendments to Rule 15c3-1, the Commission would allow OTC derivatives
dealers to use VAR models to calculate their net capital requirements.
Although many dealers active in OTC derivatives markets already use VAR
models, OTC derivatives dealers would be required to bring their use of
models into compliance with the requirements of proposed Rule 15c3-1.
OTC derivatives dealers would also be exempted under proposed Rule
36a1-1 from the provisions of Section 7 of the Exchange Act, provided
they comply with other federal margin requirements applicable to non-
broker-dealer lenders. This exemption is intended to be deregulatory
and to allow OTC derivatives dealers greater flexibility by allowing
them to extend credit on securities other than ``margin stock,''
including securities OTC derivative instruments. These OTC derivative
dealers, however, would be required to implement systems for complying
with the margin requirements applicable to their business.
Under the proposed amendments to Rules 17a-3, 17a-4, 17a-11,
proposed Rule 17a-12, and proposed revisions to Form X-17A-5 (FOCUS
report), OTC derivatives dealers would be required to maintain certain
records regarding their OTC derivatives transactions, and to provide
certain information to the Commission regarding their financial
condition and operations. Any new requirements under these proposed
rules and rule amendments would supplement current requirements that
apply to fully regulated broker-dealers. Compliance with these
requirements would require modification of the existing recordkeeping
systems of dealers that become registered as OTC derivatives dealers.
Under proposed Rule 15c3-4, OTC derivatives dealers would be
required to maintain internal risk management controls. In general,
dealers in OTC derivatives markets already maintain and follow internal
risk management controls. Under proposed Rule 15c3-4, OTC derivatives
dealers would be required to modify their existing controls systems to
the requirements under the rule. It is also expected that OTC
derivatives dealers that elect to register with the Commission under
the proposed amendments to Rule 15b1-1 would maintain general policies
and procedures designed to promote compliance with the Commission
rules, including compliance with the restrictions on the activities of
OTC derivatives dealers described in proposed Rule 15a-1.
As noted in the IRFA, the Commission requests comment on the costs
of coming into compliance with the recordkeeping, reporting, and other
requirements under the proposed rules and rule amendments, and whether
there would be any on-going costs associated with complying with the
rules and rule amendments. Commenters should provide detailed estimates
of these costs. The IRFA also notes that none of the recordkeeping,
reporting, or other compliance requirements under the proposed rules
and rule amendments are expected to apply to counterparties that enter
into transactions with OTC derivatives dealers. The Commission,
however, requests comment regarding the participation of small entities
as counterparties in OTC derivatives markets, and what counterparty
costs, if any, may be associated with the obligations of OTC
derivatives dealers to comply with the proposed rules and rule
amendments.
[[Page 67955]]
As discussed further in the IRFA, the Commission has considered
alternatives to the proposed rules and rule amendments that would
accomplish the stated objectives of improving the efficiency and
competitiveness of U.S. securities firms participating in global OTC
derivatives markets, and making it feasible for these firms to conduct
a business involving securities and non-securities OTC derivative
products within the United States. The proposed rules and rule
amendments accomplish these objectives by tailoring capital, margin,
and other regulatory requirements to the activities of OTC derivatives
dealers. The proposed capital requirements, in particular, provide OTC
derivatives dealers with significant alternatives for computing risk
charges. These requirements do this, while also being intended to
ensure against excessive leverage and risk, and to provide a cushion of
capital against severe market disturbances. Improved competition and
efficiency should benefit participants in OTC derivatives markets.
As noted in the IRFA, the Commission is encouraging the submission
of written comments with respect to any aspect of the IRFA. Comment
specifically is requested whether any small entities would be affected
by the proposed rules and rule amendments, the costs of compliance with
the proposed rules and rule amendments, and suggested alternatives that
would accomplish the objectives of the proposed rules and rule
amendments. After receipt of any comments from interested persons and
preliminary evaluation of the possible compliance costs and effects
upon competition, it may be appropriate to conclude, and for the
Chairman of the Commission to certify, that the proposal does not have
a significant economic impact on a substantial number of small
entities. Comments received will also be considered in the preparation,
if required, of a Final Regulatory Flexibility Analysis if the proposed
rules and rule amendments are adopted. For purposes of the Small
Business Regulatory Enforcement Fairness Act of 1996, the Commission is
also requesting information regarding the potential impact of the
proposed rules and rule amendments on the economy on an annual basis.
Commenters should provide empirical data to support their views. A copy
of the IRFA may be obtained by contacting Glenn J. Jessee, Securities
and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 7-11,
Washington, D.C. 20549.
VII. Paperwork Reduction Act
Certain provisions of the proposed rules and rule amendments
contain ``collection of information'' requirements within the meaning
of the Paperwork Reduction Act of 1995 (44 U.S.C. Sec. 3501 et seq.).
The Commission has submitted them to the Office of Management and
Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5
CFR 1320.11. The titles for the collections of information are: (1)
Appendix F to Rule 15c3-1, Optional Market and Credit Risk Requirements
for OTC Derivatives Dealers; (2) Rule 15c3-4 Internal Risk Management
Control Systems for OTC Derivatives Dealers (New Rule); (3) Rule 17a-3
Records to be Made by Certain Exchange Members, Brokers and Dealers
(OMB Control Number 3235-0033); and (4) Rule 17a-12 Reports to be Made
by OTC Derivatives Dealers (New Rule).
The Commission proposes to implement a limited regulatory system
under the Exchange Act for OTC derivatives dealers. Under the proposed
regulatory structure, OTC derivatives dealers would be permitted to act
primarily as counterparties with respect to certain types of securities
and non-securities OTC derivative instruments, and to issue and
reacquire issued securities, without being required to comply with the
full range of capital, margin, and other regulatory requirements
applicable to other registered broker-dealers.
The collection of information obligations imposed by the proposed
rules and rule amendments would be mandatory. However, it is important
to note that registration as an OTC derivatives dealer would be
voluntary. The information collected, retained, and/or filed pursuant
to the proposed rules and rule amendments would be kept confidential to
the extent permitted by the Freedom of Information Act [5 U.S.C. 552 et
seq.]. An agency may not conduct or sponsor, and a person is not
required to comply with, a collection of information unless it displays
a currently valid OMB control number.
A. Appendix F to Rule 15c3-1, Optional Market and Credit Risk
Requirements for OTC Derivatives Dealers
Rule 15c3-1 requires broker-dealers to maintain minimum levels of
net capital computed in accordance with the rule's provisions. The net
capital reserves are intended to ensure that broker-dealers have
sufficient capital to protect the assets of customers and to meet their
responsibilities to other broker-dealers. The Commission is proposing
to add Appendix F to the rule to provide an alternative net capital
requirement and method for determining net capital for OTC derivatives
dealers.
Under proposed Appendix F's alternative method for determining net
capital requirements, an OTC derivatives dealer would be permitted to
use a VAR model to calculate its net capital requirements. The OTC
derivatives dealer would be required to send notice to the Commission
describing its VAR model, including whether the firm has developed its
own model and how the qualitative and quantitative aspects of Appendix
F of the rule are incorporated into the model. In addition to
developing and submitting a notice describing its model, an OTC
derivatives dealer would be required to maintain its model according to
certain prescribed standards. Maintenance of the model would require an
OTC derivatives dealer to create and maintain certain information and
periodically adjust the model. For example, the OTC derivatives dealer
would be required to conduct backtesting by comparing each of its most
recent 250 business days' actual net trading profit or loss with the
corresponding daily VAR measures. Finally, the OTC derivatives dealer
would be required to submit a description of its risk management
control system implemented pursuant to proposed Rule 15c3-4.
Proposed Appendix F would help to ensure that OTC derivatives
dealers would be able to meet their financial obligations and would
facilitate the monitoring of the financial condition of OTC derivatives
dealers by the Commission. Failure to require the current and proposed
collections of information would undermine the safety and soundness of
OTC derivatives dealers and the securities markets.
It is anticipated that Appendix F would affect approximately six
OTC derivatives dealers. However, it is possible that more than ten OTC
derivatives dealers would be affected. It is anticipated that the six
affected OTC derivatives dealers would each spend an average of
approximately 1,000 hours developing and submitting their VAR model and
the description of their risk management control system to the
Commission. In addition, these OTC derivatives dealers would spend
annually, an average of approximately 1,000 hours each maintaining the
model. Consequently, the total initial burden is estimated to be 6,000
hours and the total annual burden is estimated to be 6,000 hours. The
estimates of the initial and annual burdens are based on discussions
with potential respondents. The retention period for any
[[Page 67956]]
recordkeeping requirement under the rule would be three years.
B. Proposed Rule 15c3-4
Proposed Rule 15c3-4 would establish basic elements governing the
creation, execution, and review of a firm's risk management control
system. These elements are designed to ensure the integrity of the risk
measurement, monitoring, and management process, and to clarify
accountability, at the appropriate organizational level, for defining
the permitted scope of activity and level of risk.
The proposed rule would require an OTC derivatives dealer to
consider a number of issues affecting its business environment when
creating its risk management control system. For example, an OTC
derivatives dealer would need to consider, among other things, the
sophistication and experience of relevant trading, risk management, and
internal audit personnel, as well as the separation of duties among
these personnel, when designing and implementing its internal control
system's guidelines, policies, and procedures. This would help to
ensure that the control system that is implemented would adequately
address the risks posed by the firm's business and the environment in
which it is being conducted. In addition, this would enable an OTC
derivatives dealer to implement specific policies and procedures unique
to its circumstances.
In implementing its policies and procedures, an OTC derivatives
dealer would be required to document and record its system of internal
risk management controls. In particular, an OTC derivatives dealer
would be required to document its consideration of certain issues
affecting its business when designing its internal controls. An OTC
derivatives dealer would also be required to prepare and maintain
written guidelines that discuss its internal control system, including
procedures for determining the scope of authorized activities.
The proposed rule would be an integral part of the Commission's
financial responsibility program for OTC derivatives dealers. The
information to be collected under proposed Rule 15c3-4 would be
essential to the regulation and oversight of OTC derivatives dealers
and their compliance with the Commission's proposed financial
responsibility requirements. More specifically, requiring an OTC
derivatives dealer to document the planning, implementation, and
periodic review of its risk management controls would ensure that all
pertinent issues are considered, that the risk management controls are
implemented properly, and that they continue to adequately address the
risks faced by OTC derivatives dealers.
It is anticipated that the proposed rule would affect approximately
six OTC derivatives dealers. However, it is possible that more than ten
OTC derivatives dealers would be affected. It is estimated that the
average amount of time a firm would spend implementing its risk
management control system would be 2,000 hours. On average, it is
expected that an OTC derivatives dealer would spend approximately 200
hours each year reviewing and updating its risk management control
system. The total initial burden for all OTC derivatives dealers would
be 12,000 hours and the annual burden would be 1,200 hours. The
estimates of the initial and annual burdens are based on discussions
with potential respondents. The retention period for the recordkeeping
requirement under the rule would be three years.
C. Proposed Amendments to Rule 17a-3.
OTC derivatives dealers, like other broker-dealers that are
registered with the Commission, would be required to comply with the
books and records requirements of Exchange Act Rule 17a-3.85
In general, Rule 17a-3 requires broker-dealers to make records
concerning the purchases and sales of securities, receipts and
deliveries of securities, and receipts and disbursements of cash. As
part of the limited regulatory system for OTC derivatives dealers, the
Commission proposes to amend Rule 17a-3 to reflect the business
conducted by OTC derivatives dealers.86 In particular, Rule
17a-3(a)(10) would be amended to require OTC derivatives dealers to
compile a register of all transactions in eligible OTC derivative
instruments. Currently, Rule 17a-3(a)(10) requires broker-dealers to
make a record of all securities puts, calls, spreads, straddles, and
other options in which a member, broker, or dealer has any direct or
indirect interest, but does not address other types of OTC
transactions.
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\85\ 17 CFR 240.17a-3.
\86\ The Commission is authorized by Sections 17(a) [15 U.S.C.
78q(a)] and 23(a) [15 U.S.C. 78w(a)] of the Exchange Act to
promulgate rules and regulations regarding the maintenance and
preservation of books and records of brokers-dealers.
---------------------------------------------------------------------------
Rule 17a-3 is an important part of the Commission's financial
responsibility program for broker-dealers. The information required to
be preserved under the proposed amendment of the rule would be used by
representatives of the Commission and the examining authority
responsible for reviewing the activities of the OTC derivatives dealer
pursuant to proposed Rule 15b9-2 to ensure that OTC derivatives dealers
would be in compliance with applicable Commission rules.
It is anticipated that the proposed rule amendment would affect
approximately six OTC derivatives dealers. However, it is possible that
more than ten OTC derivatives dealers would be affected. The current
estimate of the time required to comply with the existing provisions of
Rule 17a-3 is one hour per broker-dealer per working day. It is
expected that any additional burden under the proposed rule amendment
would be minimal because the information that would be called for under
the proposed amendment to the rule is information a prudent OTC
derivatives dealer would already maintain during the ordinary course of
its business. The proposed amendment to Rule 17a-3 would require each
of the six affected OTC derivatives dealers to spend approximately 52
hours per year collecting the required information. Thus, the
Commission estimates that complying with the proposed amendment to Rule
17a-3 would require an additional 312 hours per year (52 hours per year
multiplied by six affected OTC derivatives dealers). The estimates of
the initial and annual burdens are based on discussions with potential
respondents. The retention period for the recordkeeping requirements
under the rule would be three years.
D. Proposed Rule 17a-12
Proposed Rule 17a-12 would establish the basic periodic reporting
structure for OTC derivatives dealers. The proposed rule would require
OTC derivatives dealers to file quarterly Financial and Operational
Combined Uniform Single Reports (FOCUS).87 OTC derivatives
dealers would be required to include in these quarterly filings the
enhanced reporting information and the evaluation of risk in relation
to capital provisions of the DPG's Framework for Voluntary
Oversight.88 Finally, proposed Rule 17a-12 would require an
OTC derivatives dealer to file annually its audited financial
statements along with a corresponding audit report.
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\87\ Form X-17A-5 [17 CFR 249.617].
\88\ See Framework for Voluntary Oversight, Derivatives Policy
Group (Mar. 1995).
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The proposed rule would be integral part of the Commission's
financial responsibility program for OTC derivatives dealers. The
information to
[[Page 67957]]
be collected under proposed Rule 17a-12 would be essential to the
regulation and oversight of OTC derivatives dealers and would assist
the Commission and the examining authorities responsible for reviewing
the activities of OTC derivatives dealers pursuant to proposed Rule
15b9-2 to monitor and enforce compliance with applicable Commission
rules, including rules pertaining to financial responsibility. These
FOCUS and annual reports would also be intended to be used to evaluate
the activities conducted by OTC derivatives dealers and to anticipate,
where possible, how these dealers could be affected by significant
economic events.
It is anticipated that the proposed rule would affect approximately
six OTC derivatives dealers. However, it is possible that more than ten
OTC derivatives dealers would be affected. It is estimated that the
average amount of time necessary to prepare and file the information
required by the proposed rule would be 180 hours annually per OTC
derivatives dealer. This is based upon an estimated average of four
responses per year and an average of 20 hours spent preparing each
response with an additional 100 hours spent on preparing the annual
audit. This estimate of the annual burden is based on discussions with
potential respondents. The retention period for the recordkeeping
requirements under the rule would be three years.
E. Request for Comments
Written comments are invited on: (a) Whether the proposed
collections of information would be necessary for the proper
performance of the functions of the agency, including whether the
information would have practical utility; (b) the accuracy of the
agency's estimates of the burdens of the proposed collections of
information; (c) ways to enhance the quality, utility, and clarity of
the information to be collected; and (d) ways to minimize the burden of
the collections of information on respondents, including through the
use of automated collection techniques or other forms of information
technology.
Persons wishing to submit comments on the collection of information
requirements should direct them to the following persons: (i) Desk
Officer for the Securities and Exchange Commission, Office of
Information and Regulatory Affairs, Office of Management and Budget,
Room 3208, New Executive Office Building, Washington, D.C. 20503; and
(ii) Jonathan G. Katz, Secretary, Securities and Exchange Commission,
450 Fifth Street, N.W., Washington, D.C. 20549 with reference to File
No. S7-30-97. OMB is required to make a decision concerning the
collections of information between 30 and 60 days after publication, so
a comment to OMB is best assured of having its full effect if OMB
receives it within 30 days of publication.
VIII. Statutory Authority
The Commission is amending Title 17, Chapter II of the Code of
Federal Regulations pursuant to the Securities Exchange Act of 1934 (15
U.S.C. 78a et seq.) (particularly sections 3(b), 15(a), 15(b), 15(c),
17(a), 23, and 36 thereof (15 U.S.C. 78c(b), 78o(a), 78o(b), 78o(c),
78q(a), 78w, and 78mm)).
Text of Proposed Rule Amendments
List of Subjects
17 CFR Part 200
Administrative practice and procedure, Authority delegations
(Government agencies).
17 CFR Parts 240 and 249
Broker-dealers, Reporting and recordkeeping requirements,
Securities.
PART 200--ORGANIZATION; CONDUCT AND ETHICS; AND INFORMATION AND
REQUESTS
1. The authority citation for Part 200 continues to read in part as
follows:
Authority: 15 U.S.C. 77s, 78d-1, 78d-2, 78w, 78ll(d), 79t,
77sss, 80a-37, 80b-11, unless otherwise noted.
* * * * *
2. Section 200.30-3 is amended by adding paragraph (a)(63) to read
as follows:
Sec. 200.30-3(a)(63) Delegation of authority to Director of Division
of Market Regulation.
* * * * *
(a) * * *
(63) Pursuant to Sec. 240.15a-1(a)(1)(iii) of this chapter, to
designate by order other securities transactions in which an OTC
derivatives dealer may engage.
* * * * *
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
3. The general authority citation for Part 240 is revised to read
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), 78mm,
79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11,
unless otherwise noted.
* * * * *
4. By adding Secs. 240.3b-12 through 240.3b-16 to read as follows:
Sec. 240.3b-12 Definition of OTC derivatives dealer.
The term OTC derivatives dealer means any dealer that:
(a) Limits its securities activities to:
(1) Engaging as a counterparty in transactions in eligible OTC
derivative instruments with permissible derivatives counterparties;
(2) Issuing and reacquiring issued securities, including warrants
on securities, hybrid securities, and structured notes, through a
registered broker or dealer (other than an OTC derivatives dealer); or
(3) Engaging in other securities transactions which the Commission
designates by order pursuant to Sec. 240.15a-1(a)(1)(iii); and
(b) In connection with the activities described in paragraph (a) of
this section, engages in permissible risk management, arbitrage, and
trading transactions.
Sec. 240.3b-13 Definition of eligible OTC derivative instrument.
The term eligible OTC derivative instrument means any agreement,
contract, or transaction (or class thereof):
(a) That is not part of a fungible class of agreements, contracts,
or transactions that are standardized as to their material economic
terms;
(b) That is based, in whole or in part, on the value of, any
interest in, any quantitative measure of, or the occurrence of any
event relating to, one or more securities, commodities, currencies,
interest or other rates, indices, or other assets, or that involves the
purchase and sale of a security on a firm basis at least one year
following the transaction date; and
(c) That is not entered into and traded on or through an exchange,
an electronic marketplace, or similar facility supervised or regulated
by the Commission, or any other multilateral transaction execution
facility.
Sec. 240.3b-14 Definition of permissible derivatives counterparty.
The term permissible derivatives counterparty means, and shall be
limited to, the following persons or classes of persons:
(a) A bank or trust company (acting on its own behalf or on behalf
of another permissible derivatives counterparty);
(b) A savings association or credit union;
(c) An insurance company;
(d) An investment company or a foreign person performing a similar
role or function subject as such to foreign regulation, provided that
such investment company or foreign person
[[Page 67958]]
is not formed solely for the specific purpose of constituting a
permissible derivatives counterparty;
(e) A commodity pool formed and operated by a person subject to
regulation under the Commodity Exchange Act (7 U.S.C. 1 et seq.) or a
foreign person performing a similar role or function subject as such to
foreign regulation, provided that such commodity pool or foreign person
is not formed solely for the specific purpose of constituting a
permissible derivatives counterparty and has total assets exceeding $5
million;
(f) A corporation, partnership, proprietorship, organization,
trust, or other entity not formed solely for the specific purpose of
constituting a permissible derivatives counterparty:
(1) Which has total assets exceeding $10 million;
(2) The obligations of which under the terms of a transaction in
eligible OTC derivative instruments are guaranteed or otherwise
supported by a letter of credit or keepwell, support, or other
agreement by any such entity referenced in paragraph (f)(1) of this
section or by an entity referred to in paragraphs (a), (b), (c), (d),
(e), (f) or (h) of this section; or
(3) Which has a net worth of $1 million and enters into
transactions in eligible OTC derivative instruments in connection with
the conduct of its business, or which has a net worth of $1 million and
enters into transactions in eligible OTC derivative instruments to
manage the risk of an asset or liability owned or incurred in the
conduct of its business or reasonably likely to be owned or incurred in
the conduct of its business;
(g) An employee benefit plan subject to the Employee Retirement
Income Security Act of 1974 or a foreign person performing a similar
role or function subject as such to foreign regulation with total
assets exceeding $5 million, or whose investment decisions are made by
a bank, trust company, insurance company, investment adviser, or a
commodity trading adviser subject to regulation under the Commodity
Exchange Act;
(h) Any governmental entity (including the United States, any
state, or any foreign government) or political subdivision thereof, or
any multinational or supranational entity or any instrumentality,
agency, or department of any such entity;
(i) A broker, dealer, or a foreign person performing a similar role
or function subject as such to foreign regulation, acting on its own
behalf or on behalf of another permissible derivatives counterparty;
provided, however, that if such broker or dealer (or foreign person) is
a natural person or proprietorship, the broker or dealer (or foreign
person) must also meet the requirements of either paragraph (f) or (k)
of this section;
(j) A futures commission merchant, floor broker, or floor trader
subject to regulation under the Commodity Exchange Act or a foreign
person performing a similar role or function subject as such to foreign
regulation, acting on its own behalf or on behalf of another
permissible derivatives counterparty; provided, however, that if such
futures commission merchant, floor broker, or floor trader (or foreign
person) is a natural person or proprietorship, the futures commission
merchant, floor broker, or floor trader (or foreign person) must also
meet the requirements of paragraph (f) or (k) of this section; or
(k) Any natural person with total assets exceeding at least $10
million.
Sec. 240.3b-15 Definition of permissible risk management, arbitrage,
and trading transaction.
The term permissible risk management, arbitrage, and trading
transaction means, when used in connection with any transaction engaged
in by, or effected on behalf of, an OTC derivatives dealer, a
transaction involving:
(a) The taking possession of or selling of counterparty collateral;
(b) Cash management;
(c) Hedging an element of market or credit risk associated with one
or more existing or anticipated transactions in eligible OTC derivative
instruments or the issuance of securities, including warrants on
securities, hybrid securities, or structured notes;
(d) Financing, through repurchase and reverse repurchase
transactions, buy/sell transactions, and securities lending and
borrowing transactions, a securities position that is acquired in
connection with a transaction listed in paragraphs (a) through (c) of
this section, or that is designated by the Commission pursuant to
Sec. 240.15a-1(a)(1)(iii);
(e) Arbitrage, provided that arbitrage involving securities shall
be limited to arbitrage of a securities position that is acquired in
connection with a transaction listed in paragraphs (a) through (c) of
this section, or that is designated by the Commission pursuant to
Sec. 240.15a-1(a)(1)(iii); or
(f) Securities trading relating to a securities position that is
acquired in connection with a transaction listed in paragraphs (a)
through (c) of this section, provided that the number of any such
transactions does not exceed 150 transactions in any calendar year, and
provided further that the OTC derivatives dealer engaging in any such
transaction maintains and enforces written policies and procedures
reasonably designed to achieve compliance with the other provisions of
this section.
Sec. 240.3b-16 Definition of hybrid security.
The term hybrid security shall mean a security that incorporates
payment features economically similar to options, forwards, futures,
swap agreements, or collars involving currencies, interest rates,
commodities, securities, or indices (or any combination, permutation,
or derivative of such contract or underlying interest).
5. Section 240.8c-1 is amended by revising paragraph (b)(1) to read
as follows:
Sec. 240.8c1 Hypothecation of customers' securities.
* * * * *
(b) * * *
(1) The term customer shall not be deemed to include any general or
special partner or any director or officer of such member, broker or
dealer, or any participant, as such, in any joint, group or syndicate
account with such member, broker or dealer or with any partner, officer
or director thereof, or a permissible derivatives counterparty as
defined in Sec. 240.3b-14 who has delivered collateral pursuant to a
transaction in an eligible OTC derivative instrument and who has
consented to the unrestricted use of its collateral by an OTC
derivatives dealer after receiving disclosure of the unrestricted use
of the collateral;
* * * * *
6. By adding Sec. 240.15a-1 under the undesignated center heading
``Exemption of Certain Securities From Section 15(a)'' to read as
follows:
Sec. 240.15a-1 Transactions by OTC derivatives dealers.
(a) An OTC derivatives dealer shall not engage in any securities
transaction other than:
(1)(i) Engaging as a counterparty in transactions in eligible OTC
derivative instruments with permissible derivatives counterparties;
(ii) Issuing and reacquiring issued securities, including warrants
on securities, hybrid securities, and structured notes, through a
registered broker or dealer (other than an OTC derivatives dealer); or
(iii) Engaging in other securities transactions which the
Commission designates by order; and
(2) In connection with the transactions described in paragraph
[[Page 67959]]
(a)(1) of this section, engaging in permissible risk management,
arbitrage, and trading transactions.
(b) To the extent an OTC derivatives dealer engages in any
securities transaction listed in paragraph (a) of this section, such
transaction shall be effected through a registered broker or dealer
other than an OTC derivatives dealer.
7. Section 240.15b1-1 is amended to revise paragraph (a) to read as
follows:
Sec. 240.15b1-1 Application for registration of brokers or dealers.
(a) An application for registration of a broker or dealer that is
filed pursuant to Section 15(b) of the Act (15 U.S.C. 78o(b)) shall be
filed on Form BD (Sec. 249.501 of this chapter) in accordance with the
instructions to the form. A broker or dealer that is an OTC derivatives
dealer shall indicate where appropriate on Form BD that the type of
business in which it is engaged is solely that of acting as an OTC
derivatives dealer.
* * * * *
8. By adding Sec. 240.15b9-2 under the underquoted center heading
``registration of brokers and dealers'' to read as follows:
Sec. 240.15b9-2 Exemption from SRO membership for OTC derivatives
dealers.
Any broker or dealer required by Section 15(b)(8) of the Act (15
U.S.C. 78o(b)(8)) to become a member of a registered national
securities association shall be exempt from such requirement, provided
that:
(a) Such broker or dealer is an OTC derivatives dealer; and
(b) Such OTC derivatives dealer enters into an agreement with the
examining authority designated pursuant to Section 17(d) of the Act (15
U.S.C. 78(q)(d)) for one or more of its affiliates that is a registered
broker or dealer by which such examining authority agrees to conduct a
review of such OTC derivatives dealer, report to the Commission any
potential violation of applicable Commission rules, and evaluate the
OTC derivatives dealer's procedures and controls designed to prevent
violations of the Commission's rules.
9. Section 240.15c2-1 is amended to revise paragraph (b)(1) to read
as follows:
Sec. 240.15c2-1 Hypothecation of customers' securities.
* * * * *
(b) * * *
(1) The term customer shall not be deemed to include any general or
special partner or any director or officer of such broker or dealer, or
any participant, as such, in any joint, group or syndicate account with
such broker or dealer or with any partner, officer or director thereof,
or a permissible derivatives counterparty as defined in Sec. 240.3b-14
who has delivered collateral pursuant to a transaction in an eligible
OTC derivative instrument and who has consented to the unrestricted use
of its collateral by a OTC derivatives dealer after receiving
disclosure of the unrestricted use of the collateral;
* * * * *
10. Section 240.15c3-1 is amended to add a sentence following the
first sentence in the introductory text of paragraph (a); add paragraph
(a)(5); redesignate paragraph (c)(12) as paragraph (c)(12)(i) and add
paragraph (c)(12)(ii) and (c)(15) to read as follows:
Sec. 240.15c3-1 Net capital requirements for brokers or dealers.
(a) * * * In lieu of applying paragraphs (a)(1) and (a)(2) of this
section, every dealer meeting the definition of an OTC derivatives
dealer pursuant to Sec. 240.3b-12 under the Securities Exchange Act of
1934 shall maintain net capital pursuant to paragraph (a)(5) of this
section. * * *
* * * * *
(5) A dealer meeting the definition of an OTC derivatives dealer
pursuant to Sec. 240.3b-12 may elect not to apply the provisions of
paragraph (c)(2)(vi) of this section to its securities, money market
instruments, options, or eligible OTC derivative instruments and in
lieu thereof apply the provisions in appendix F of this chapter
(Sec. 240.15c3-1f). An OTC derivatives dealer shall at all times
maintain tentative net capital of not less than $100 million and net
capital of not less than $20 million.
* * * * *
(c) * * *
(12)(i) * * *
(ii) The term examining authority of an OTC derivatives dealer
shall mean for the purposes of Secs. 240.15c3-1 and 240.15c3-1a through
d the examining authority responsible for conducting reviews of the OTC
derivatives dealer pursuant to 240.15b9-2.
* * * * *
(15) The term tentative net capital shall mean the net capital of a
broker or dealer before deducting the securities haircuts computed
pursuant to paragraph (c)(2)(vi) of this section and the charges on
inventory computed pursuant to appendix B of this chapter
(Sec. 240.15c3-1b). However, for an OTC derivatives dealer electing to
use appendix F of this chapter (Sec. 240.15c3-1f), the term ``tentative
net capital'' shall mean the OTC derivatives dealer's net capital
before deducting the charges for market and credit risk as computed
pursuant to appendix F and increased by unrealized trading gains and
unsecured receivables resulting from transactions in eligible OTC
derivative instruments with permissible derivatives counterparties.
* * * * *
11. By adding Section 240.15c3-1f to read as follows:
Sec. 240.15c3-1f Optional Market and Credit Risk Requirements for OTC
Derivatives Dealers (appendix F to 17 CFR 240.15c3-1).
(a) A dealer meeting the definition of an OTC derivatives dealer
pursuant to Sec. 240.3b-12 may elect to compute capital charges for
market and credit risk pursuant to this appendix in place of computing
securities haircuts pursuant to Sec. 240.15c3-1(c)(2)(vi). A dealer may
make this election by filing an application with the Commission stating
whether the firm has developed its own model and describing the
qualitative and quantitative aspects of its internal value-at-risk
(``VAR'') model, which at a minimum must adhere to the criteria set
forth in paragraph (d) of this appendix. The dealer's application shall
also include a description of the risk management controls adopted
pursuant to Sec. 240.15c3-4.
Market Risk
(b) An OTC derivatives dealer electing to apply this appendix F
shall compute a capital requirement for market risk using the Full
Value-at-Risk Method or the Alternative Method as follows:
(1) Full value-at-risk method. An OTC derivatives dealer shall
deduct from net worth an amount for market risk exposure for eligible
OTC derivatives instruments and other positions in its proprietary or
other accounts equal to the VAR of these positions obtained from its
proprietary model, multiplied by the appropriate multiplication factor
in paragraph (d)(1)(iv)(C) of this appendix. The model may not be used
by the dealer for this purpose until the use of the model by the dealer
has been authorized by the Commission.
(2) Alternative method for equities. An OTC derivatives dealer may
choose to use the alternative method to calculate market risk for
equity instruments, including OTC options, or if the Commission does
not approve an OTC derivatives dealer's use of a VAR model for equity
instruments, the OTC derivatives dealer using this appendix must use
the alternative method. Under the alternative method, the deduction for
market risk must be an amount equal to the largest theoretical loss
calculated
[[Page 67960]]
in accordance with the theoretical pricing model set forth in appendix
A of this section (Sec. 240.15c3-1a). The OTC derivatives dealer may
use its own theoretical pricing model as long as it contains the
minimum pricing factors set forth in appendix A.
Credit Risk
(c) The capital requirement for credit risk arising from its
transactions in eligible OTC derivatives instruments shall be:
(1) The net replacement value in the account of the counterparty
(including the effect of legally enforceable netting agreements and the
application of liquid collateral) multiplied by 8% multiplied by the
counterparty factor. The counterparty factors are:
(i) 20% for entities with ratings for senior unsecured long-term
debt or commercial paper in the two highest rating categories by at
least two nationally recognized statistical rating organizations
(``NRSROs'');
(ii) 50% for entities with ratings for senior unsecured long-term
debt in the third and fourth highest ratings categories by at least two
NRSROs; and
(iii) 100% for entities with ratings for senior unsecured long-term
debt below the four highest rating categories.
(2) The net replacement value in the account of the counterparty
(including the effect of legally enforceable netting agreements and the
application of liquid collateral) with senior unsecured long-term debt
in default.
(3) A concentration charge calculated as follows:
(i) Where the net replacement value in the account of any one
counterparty exceeds 25% of the OTC derivatives dealer's tentative net
capital, it must deduct from net worth:
(A) For counterparties with ratings for senior unsecured long-term
debt or commercial paper in the two highest rating categories by at
least two NRSROs, 5% of the amount of the net replacement value in
excess of 25% of the OTC derivatives dealer's tentative net capital;
(B) For counterparties with ratings for senior unsecured long-term
debt in the third and fourth highest rating categories by at least two
NRSROs, 20% of the amount of the net replacement value in excess of 25%
of the OTC derivatives dealer's tentative net capital; and
(C) For counterparties with ratings for senior unsecured long-term
debt below the four highest rating categories, 50% of the amount of the
net replacement value in excess of 25% of the OTC derivatives dealer's
tentative net capital; and
(ii) Where the aggregate of the net replacement values of all
counterparties exceeds 300% of an OTC derivatives dealer's tentative
net capital, it must deduct from net worth 100% of the amount of such
excess.
(4) Counterparties that are not rated by an NRSRO may be rated by
the OTC derivatives dealer upon demonstrating to the Commission that
the OTC derivatives dealer uses ratings criteria equivalent to those
used by NRSROs and that such ratings are current.
VAR Models
(d) An OTC derivatives dealer's VAR model must meet the following
qualitative and quantitative requirements:
(1) Qualitative requirements. An OTC derivatives dealer electing to
apply this appendix F must have a VAR model that meets the following
minimum qualitative requirements:
(i) The OTC derivatives dealer's VAR model must be integrated into
the firm's daily risk management process;
(ii) The OTC derivatives dealer must conduct appropriate stress
tests of the VAR model, and develop procedures to follow in response to
the results of such tests;
(iii) The OTC derivatives dealer must conduct periodic reviews
(which may be performed by internal audit staff) of its VAR model. The
OTC derivatives dealer's VAR model also must be subject to annual
reviews conducted by independent public accountants;
(iv) The OTC derivatives dealer must conduct backtesting of the VAR
model pursuant to the following procedures:
(A) Beginning one year after an OTC derivatives dealer starts to
comply with this appendix, an OTC derivatives dealer must conduct
backtesting by comparing each of its most recent 250 business days'
actual net trading profit or loss with the corresponding daily VAR
measures generated for determining market risk capital charges and
calibrated to a one-day holding period and a 99 percent, one-tailed
confidence level;
(B) Once each quarter, the OTC derivatives dealer must identify the
number of exceptions, that is, the number of business days for which
the actual daily net trading loss, if any, exceeded the corresponding
daily VAR measure; and
(C) An OTC derivatives dealer must use the multiplication factor
indicated in Table 1 of this appendix in determining its capital charge
for market risk until it obtains the next quarter's backtesting
results, unless the Commission determines that a different adjustment
or other action is appropriate.
Table 1.--Multiplication Factor Based on Results of Backtesting
------------------------------------------------------------------------
Multiplication
Number of exceptions factor
------------------------------------------------------------------------
4 or fewer.............................................. 3.00
5....................................................... 3.40
6....................................................... 3.50
7....................................................... 3.65
8....................................................... 3.75
9....................................................... 3.85
10 or more.............................................. 4.00
------------------------------------------------------------------------
(2) Quantitative requirements. An OTC derivatives dealer electing
to apply this Appendix F must have a VAR model that meets the following
quantitative requirements:
(i) The VAR measures must be calculated on a daily basis using a 99
percent, one-tailed confidence level with a price change equivalent to
a ten-business day movement in rates and prices;
(ii) The effective historical observation period for VAR measures
must be at least one year, and the weighted average time lag of the
individual observations cannot be less than six months. Historical data
sets must be updated at least every three months and reassessed
whenever market prices or volatilities are subject to large changes;
(iii) The VAR measures must include the risks arising from the non-
linear price characteristics of options positions and the sensitivity
of the market value of the positions to changes in the volatility of
the underlying rates or prices. An OTC derivatives dealer must measure
the volatility of options positions by different maturities;
(iv) The VAR measures may incorporate empirical correlations within
and across risk categories, provided that the OTC derivatives dealer's
process for measuring correlations is sound. In the event that the VAR
measures do not incorporate empirical correlations across risk
categories, then the OTC derivatives dealer must add the separate VAR
measures for the four major risk categories in paragraph (d)(2)(v) of
this appendix to determine its aggregate VAR measure; and
(v) The OTC derivatives dealer's VAR model must use risk factors
sufficient to measure the market risk inherent in all covered
positions. The risk factors must address interest rate risk, equity
price risk, foreign exchange rate risk, and commodity price risk. For
material exposures in the major currencies and
[[Page 67961]]
markets, modelling techniques must capture spread risk and must
incorporate enough segments of the yield curve to capture differences
in volatility and less than perfect correlation of rates along the
yield curve. An OTC derivatives dealer must provide the Commission with
evidence that the OTC derivatives dealer's VAR model takes account of
specific risk in positions.
12. Section 240.15c3-3 is amended to revise paragraph (a)(1), and
in paragraph (h) to revise the phrase ``Sec. 240.17a-5,'' to read
``Sec. 240.17a-5 or Sec. 240.17a-12,''.
Sec. 240.15c3-3 Customer protection--reserves and custody of
securities.
(a) * * *
(1) The term customer shall mean any person from whom or on whose
behalf a broker or dealer has received or acquired or holds funds or
securities for the account of that person. The term shall not include a
broker or dealer, a municipal securities dealer, or a government
securities broker or government securities dealer. The term shall not
include general partners or directors or principal officers of the
broker or dealer or any other person to the extent that person has a
claim for property or funds which by contract, agreement or
understanding, or by operation of law, is part of the capital of the
broker or dealer or is subordinated to the claims of creditors of the
broker or dealer. The term shall not include a permissible derivatives
counterparty as defined in Sec. 240.3b-14 who has delivered collateral
pursuant to a transaction in an eligible OTC derivative instrument and
who has consented to the unrestricted use of its collateral by an OTC
derivatives dealer after receiving disclosure of the unrestricted use
of the collateral. The term customer shall, however, include another
broker or dealer to the extent that broker or dealer maintains an
omnibus account for the account of customers with the broker or dealer
in compliance with Regulation T (12 CFR part 220).
* * * * *
13. By adding Sec. 240.15c3-4 to read as follows:
Sec. 240.15c3-4 Internal risk management control systems for OTC
derivatives dealers.
(a) An OTC derivatives dealer shall establish and document a system
of internal risk management controls to assist it to manage the risks
associated with its business activities.
(b) An OTC derivatives dealer shall consider the following when
adopting its internal control system guidelines, policies, and
procedures:
(1) The ownership and governance structure of the OTC derivatives
dealer;
(2) The composition of the governing body of the OTC derivatives
dealer;
(3) The management philosophy and culture of the OTC derivatives
dealer;
(4) The scope and nature of established risk management guidelines;
(5) The scope and nature of the permissible OTC derivatives
activities;
(6) The sophistication and experience of relevant trading, risk
management, and internal audit personnel;
(7) The sophistication and functionality of information and
reporting systems; and
(8) The scope and frequency of monitoring, reporting, and auditing
activities.
(c) An OTC derivatives dealer's internal risk management control
system shall include the following elements:
(1) A risk control unit that reports directly to senior management
and is independent from business trading units;
(2) Separation of duties between personnel responsible for entering
into a transaction and those responsible for recording the transaction
in the books and records of the OTC derivatives dealer;
(3) Periodic reviews (which may be performed by internal audit
staff) and annual reviews (which must be conducted by independent
public accountants) of the OTC derivatives dealer's risk management
systems;
(4) Definitions of risk, risk monitoring, and risk management; and
(5) Written guidelines, approved by the OTC derivatives dealer's
governing body, that include and discuss the following:
(i) The OTC derivatives dealer's consideration of the elements in
paragraph (b) of this section;
(ii) The scope, and the procedures for determining the scope of
authorized activities or any nonquantitative limitation on the scope of
authorized activities;
(iii) Any quantitative guidelines for managing the OTC derivatives
dealer's overall risk exposure;
(iv) The type, scope, and frequency of reporting by management on
risk exposures;
(v) The procedures for and the timing of the governing body's
periodic review of the risk monitoring and risk management written
guidelines, systems, and processes;
(vi) The process for monitoring risk independent of the business or
trading units whose activities create the risks being monitored;
(vii) The performance of risk management function by persons
independent from or senior to the business or trading units whose
activities create the risks;
(viii) The authority and resources of the groups or persons
performing the risk monitoring and risk management functions;
(ix) The procedures governing the action management should take
when internal risk management guidelines have been exceeded;
(x) The procedures to monitor and address the risk that an OTC
derivative transaction contract will be unenforceable;
(xi) The procedures requiring the documentation of the principal
terms of OTC derivatives transactions and other relevant information
regarding such transactions; and
(xii) The procedures authorizing specified employees to commit the
OTC derivatives dealer to particular types of transactions.
(d) Management must periodically review, in accordance with written
procedures, the OTC derivatives dealer's business activities for
consistency with risk management guidelines. Management must review the
following:
(1) Whether risks arising from the OTC derivatives dealer's OTC
derivatives activities are consistent with prescribed guidelines;
(2) Whether risk exposure guidelines for each business unit are
appropriate for the business unit;
(3) Whether the data necessary to conduct the risk monitoring and
risk management function as well as the valuation process over the OTC
derivatives dealer's portfolio of products is accessible on a timely
basis and information systems are available to capture, monitor,
analyze, and report relevant data;
(4) Whether procedures are in place to enable management to take
action when internal risk management guidelines have been exceeded;
(5) Whether procedures are in place to monitor and address the risk
that an OTC derivative transaction contract will be unenforceable;
(6) Whether procedures are in place to identify and address any
deficiencies in the operating systems and to contain the extent of
losses arising from unidentified deficiencies;
(7) Whether procedures are in place to authorize specified
employees to commit the OTC derivatives dealer to particular types of
transactions, to specify any quantitative limits on such authority, and
to provide for the oversight of their exercise of such authority;
[[Page 67962]]
(8) Whether procedures are in place to provide for adequate
documentation of the principal terms of OTC derivatives transactions
and other relevant information regarding such transactions;
(9) Whether personnel resources with appropriate expertise are
committed to implementing the risk monitoring and risk management
systems and processes; and
(10) Whether a mechanism is in place for periodic internal and
external review of the risk monitoring and risk management functions.
14. Amend Sec. 240.17a-3, in paragraph (a)(4)(vi) by revising the
phrase ``Rule 17a-13 and Rule 17a-5 hereunder'' to read
``Secs. 240.17a-13, 240.17a-5, and 240.17a-12'', and by adding a
sentence to the end of paragraph (a)(10) to read as follows:
Sec. 240.17a-3 Records to be made by certain exchange members, brokers
and dealers.
(a) * * *
(10) * * * An OTC derivatives dealer shall also keep a record of
all eligible OTC derivative instruments as defined in Sec. 240.3b-13 in
which such OTC derivatives dealer has any direct or indirect interest
or which such dealer has written or guaranteed, containing, at least,
an identification of the security or other instrument and the number of
units involved.
* * * * *
15. Amend Sec. 240.17a-4 as follows:
a. In paragraph (b)(8) introductory text by revising the phrase
``Part IIA'' to read ``Part IIA or Part IIB'' and by revising the
phrase ``Sec. 240.17a-5(i)(xv)'' to read ``Secs. 240.17a-5(d) and
240.17a-12(b)'';
b. In paragraph (b)(8)(xv) by revising the phrase ``Sec. 240.17a-
5'' to read ``Secs. 240.17a-5 and 240.17a-12'';
c. By adding paragraph (b)(10) to read as follows:
d. In paragraph (f)(2)(i) by adding the phrase ``or its examining
authority pursuant to Sec. 240.15b9-2'' after the phrase ``(15 U.S.C.
78q(d))'' and by adding the phrase ``or its examining authority
pursuant to Sec. 240.15b9-2'' after the phrase ``designated examining
authority'';
e. In paragraph (f)(2)(ii)(D) by adding the phrase ``, the
examining authority pursuant to Sec. 240.15b9-2'' after the phrase ``by
the Commission'';
f. In paragraphs (f)(3)(i), (f)(3)(iv)(A), (f)(3)(v)(A), and
(f)(3)(vi) by adding the phrase ``, its examining authority pursuant to
Sec. 240.15b9-2,'' after the phrase ``of the Commission''; and
g. In paragraph (f)(3)(vii) by adding the phrase ``its examining
authority pursuant to Sec. 240.15b9-2 or'' after the phrase ``shall
file with''.
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(10) The records required to be made pursuant to Sec. 240.15c3-4
and the results of the periodic reviews conducted pursuant to
Sec. 240.15c3-4(d).
* * * * *
16. Amend Sec. 240.17a-11 by revising paragraph (b) and paragraph
(c)(3) to read as follows; in paragraph (e) introductory text by adding
the phrase ``or Sec. 240.17a-12(f)(2)'' after the phrase ``240.17a-
5(h)(2)'' and by adding the phrase ``or Sec. 240.17a-12(e)(2)'' after
the phrase ``240.17a-5(g)''; by revising paragraph (f) to read as
follows; in paragraph (g) by adding the phrase ``the examining
authority responsible for conducting reviews of an OTC derivatives
dealer pursuant to Sec. 240.15b9-2,'' after the phrase ``the designated
examining authority of which such broker or dealer is a member,''; and
in paragraph (h) by revising the phrase ``Sec. 240.15c3-3(i) and
Sec. 240.17a5-5(h)(2)'' to read ``Sec. 240.15c3-3(i), Sec. 240.17a-
5(h)(2), and Sec. 240.17a-12(f)(2)''.
Sec. 240.17a-11 Notification provisions for brokers and dealers.
* * * * *
(b)(1) Every broker or dealer whose net capital declines below the
minimum amount required pursuant to Sec. 240.15c3-1 shall give notice
of such deficiency that same day in accordance with paragraph (g) of
this section. The notice shall specify the broker's or dealer's net
capital requirement and its current amount of net capital. If a broker
or dealer is informed by its designated examining authority, its
examining authority pursuant to Sec. 240.15b9-2, or the Commission that
it is, or has been, in violation of Sec. 240.15c3-1 and the broker or
dealer has not given notice of the capital deficiency under this
Sec. 240.17a-11, the broker or dealer, even if it does not agree that
it is, or has been, in violation of Sec. 240.15c3-1, shall give notice
of the claimed deficiency, which notice may specify the broker's or
dealer's reasons for its disagreement.
(2) In addition to the requirements of paragraph (b)(1) of this
section, an OTC derivatives dealer shall also provide notice if its
tentative net capital falls below the minimum amount required pursuant
to Sec. 240.15c3-1. The notice shall specify the OTC derivatives
dealer's net capital requirement, tentative net capital requirement,
its current amount of net capital, and tentative net capital.
(c) * * *
(3) If a computation made by a broker or dealer pursuant to
Sec. 240.15c3-1 shows that its total net capital is less than 120
percent of the broker's or dealer's required minimum net capital. If a
computation made by an OTC derivatives dealer pursuant to
Sec. 240.15c3-1 shows that its total tentative net capital is less than
120 percent of the dealer's required minimum tentative net capital.
* * * * *
(f) Every national securities exchange, national securities
association, or examining authority responsible for conducting reviews
of an OTC derivatives dealer pursuant to Sec. 240.15b9-2 that learns
that a member broker or dealer or an OTC derivatives dealer has failed
to send notice or transmit a report required by paragraphs (b), (c),
(d), or (e) of this section, even after being advised by the securities
exchange, national securities association, or examining authority
responsible for conducting reviews of an OTC derivatives dealer
pursuant to Sec. 240.15b9-2 to send notice or transmit a report, shall
immediately give notice of such failure in accordance with paragraph
(g) of this section.
* * * * *
17. By adding Sec. 240.17a-12 to read as follows:
Sec. 240.17a-12 Reports to be made by certain OTC derivatives dealers.
(a) Filing of quarterly reports. (1) This paragraph (a) shall apply
to every OTC derivatives dealer registered pursuant to Section 15 of
the Act (15 U.S.C. 78o).
(i) Every OTC derivatives dealer shall file Part IIB of Form X-17A-
5 (Sec. 249.617 of this chapter) within 17 business days after the end
of each calendar quarter and within 17 business days after the date
selected for the annual audit of financial statements where said date
is other than the end of the calendar quarter.
(ii) Upon receiving from the Commission or the examining authority
responsible for performing reviews of the OTC derivatives dealer
pursuant to Sec. 240.15b9-2 written notice that additional reporting is
required, an OTC derivatives dealer shall file monthly, or at such
times as shall be specified, Part IIB of Form X-17A-5 (Sec. 249.617 of
this chapter) and such other financial or operational information as
shall be required by the Commission or the examining authority
responsible for performing reviews of the OTC derivatives dealer
pursuant to Sec. 240.15b9-2.
(2) The reports provided for in this paragraph (a) shall be
considered filed when received at the Commission's
[[Page 67963]]
principal office in Washington, D.C., and at the principal office of
the examining authority responsible for performing reviews of the OTC
derivatives dealer pursuant to Sec. 240.15b9-2. All reports filed
pursuant to this paragraph (a) shall be deemed to be confidential.
(3) Upon written application by an OTC derivatives dealer to the
examining authority responsible for performing reviews of the OTC
derivatives dealer pursuant to Sec. 240.15b9-2, the examining authority
may extend the time for filing the information required by this
paragraph (a). The examining authority for the OTC derivatives dealer
shall maintain, in the manner prescribed in Sec. 240.17a-1, a record of
each extension granted.
(b) Annual filing of audited financial statements. (1)(i) Every OTC
derivatives dealer registered pursuant to Section 15 of the Act (15
U.S.C. 78o) shall file annually, on a calendar or fiscal year basis, a
report which shall be audited by an independent public accountant.
Reports pursuant to this paragraph (b) shall be as of the same fixed or
determinable date each year, unless a change is approved in writing by
the examining authority responsible for performing reviews of the OTC
derivatives dealer pursuant to Sec. 240.15b9-2. A copy of such written
approval shall be sent to the Commission's principal office in
Washington, D.C.
(ii) An OTC derivatives dealer succeeding to and continuing the
business of another OTC derivatives dealer need not file a report under
this paragraph (b) as of a date in the fiscal or calendar year in which
the succession occurs if the predecessor OTC derivatives dealer has
filed a report in compliance with this paragraph (b) as of a date in
such fiscal or calendar year.
(2) The annual audited report shall contain a Statement of
Financial Condition (in a format and on a basis which is consistent
with the total reported on the Statement of Financial Condition
contained in Form X-17A-5 (Sec. 249.617 of this chapter), Part IIB, a
Statement of Income, a Statement of Cash Flows, a Statement of Changes
in Stockholders' or Partners' or Sole Proprietor's Equity, and
Statement of Changes in Liabilities Subordinated to Claims of General
Creditors. Such statements shall be in a format which is consistent
with such statements as contained in Form X-17A-5 (Sec. 249.617 of this
chapter), Part IIB. If the Statement of Financial Condition filed in
accordance with instructions to Form X-17A-5 (Sec. 249.617 of this
chapter), Part IIB, is not consolidated, a summary of financial data
for subsidiaries not consolidated in the Part IIB Statement of
Financial Condition as filed by the OTC derivatives dealer shall be
included in the notes to the consolidated statement of financial
condition reported on by the independent public accountant. The summary
financial data shall include the assets, liabilities, and net worth or
stockholders' equity of the unconsolidated subsidiaries.
(3) Supporting schedules shall include, from Part IIB of Form X-
17A-5 (Sec. 249.617 of this chapter), a Computation of Net Capital
under Sec. 240.15c3-1.
(4) A reconciliation, including appropriate explanations, of the
Computation of Net Capital under Sec. 240.15c3-1 contained in the audit
report with the broker's or dealer's corresponding unaudited most
recent Part IIB filing shall be filed with the report when material
differences exist. If no material differences exist, a statement so
indicating shall be filed.
(5) The annual audit report shall be filed not more than sixty (60)
days after the date of the financial statements.
(6) Two copies of the annual audit report shall be filed at the
Commission's principal office in Washington, D.C., and the principal
office of the examining authority responsible for performing reviews of
the OTC derivatives dealer pursuant to Sec. 240.15b9-2.
(c) Nature and form of reports. The financial statements filed
pursuant to paragraph (b) of this section shall be prepared and filed
in accordance with the following requirements:
(1) An audit shall be conducted by a public accountant who shall be
in fact independent as defined in paragraph (f) of this section, and it
shall give an opinion covering the statements filed pursuant to
paragraph (b) of this section.
(2) Attached to the report shall be an oath or affirmation that, to
the best knowledge and belief of the person making such oath or
affirmation the financial statements and schedules are true and correct
and neither the OTC derivatives dealer, nor any partner, officer, or
director, as the case may be, has any significant interest in any
counterparty or in any account classified solely as that of a
counterparty. The oath or affirmation shall be made before a person
duly authorized to administer such oaths or affirmations. If the OTC
derivatives dealer is a sole proprietorship, the oath or affirmation
shall be made by the proprietor; if a partnership, by a general
partner; or if a corporation, by a duly authorized officer.
(3) All of the statements filed pursuant to paragraph (b) of this
section shall be confidential except that they shall be available for
use by any official or employee of the United States or by any other
person to whom the Commission authorizes disclosure of such information
as being in the public interest.
(d) Qualification of accountants. The Commission will not recognize
any person as a certified public accountant who is not duly registered
and in good standing as such under the laws of his place of residence
or principal office. The Commission will not recognize any person as a
public accountant who is not in good standing and entitled to practice
as such under the laws of his place of residence or principal office.
(e) Designation of accountant. (1) Every OTC derivatives dealer
shall file no later than December 10 of each year a statement with the
Commission's principal office in Washington, D.C., and the principal
office of the examining authority responsible for performing reviews of
the OTC derivatives dealer pursuant to Sec. 240.15b9-2. Such statement
shall indicate the existence of an agreement dated no later than
December 1, with an independent public accountant covering a
contractual commitment to conduct the OTC derivatives dealer's annual
audit during the following calendar year.
(2) The agreement may be of a continuing nature, providing for
successive yearly audits, in which case no further filing is required.
If the agreement is for a single audit, or if the continuing agreement
previously filed has been terminated or amended, a new statement must
be filed by the required date.
(3) The statement shall be headed ``Notice pursuant to
Sec. 240.17a-12(e)'' and shall contain the following information:
(i) Name, address, telephone number and registration number of the
OTC derivatives dealer;
(ii) Name, address and telephone number of the accounting firm; and
(iii) The audit date of the OTC derivatives dealer for the year
covered by the agreement.
(4) Notwithstanding the date of filing specified in paragraph
(e)(1) of this section, every OTC derivatives dealer shall file the
notice provided for in paragraph (e) of this section within 30 days
following the effective date of registration as an OTC derivatives
dealer.
(f) Independence of accountant. An accountant shall be independent
in
[[Page 67964]]
accordance with the provisions of Sec. 210.2-01(b) and (c) of this
chapter.
(g) Replacement of accountant. (1) An OTC derivatives dealer shall
file a notice that must be received by the Commission's principal
office in Washington, D.C., and the principal office of the examining
authority responsible for performing reviews of the OTC derivatives
dealer pursuant to Sec. 240.15b9-2 not more than 15 business days
after:
(i) The OTC derivatives dealer has notified the accountant whose
opinion covered the most recent financial statements filed under
paragraph (b) of this section that the accountant's services will not
be utilized in future engagements; or
(ii) The OTC derivatives dealer has notified an accountant who was
engaged to give an opinion covering the financial statements to be
filed under paragraph (b) of this section that the engagement has been
terminated; or
(iii) An accountant has notified the OTC derivatives dealer that it
would not continue under an engagement or give an opinion covering the
financial statements to be filed under paragraph (b) of this section;
or
(iv) A new accountant has been engaged to give an opinion covering
the financial statements to be filed under paragraph (b) of this
section without any notice of termination having been given to or by
the previously engaged accountant.
(2) Such notice shall state the date of notification of the
termination of the engagement or engagement of the new accountant as
applicable and the details of any problems existing during the 24
months (or the period of the engagement, if less) preceding such
termination or new engagement relating to any matter of accounting
principles or practices, financial statement disclosure, auditing scope
or procedure, or compliance with applicable rules of the Commission,
which problems, if not resolved to the satisfaction of the former
accountant, would have caused the former accountant to make reference
to them in connection with the report on the subject matter of the
problems. The problems required to be reported in response to the
preceding sentence include both those resolved to the former
accountant's satisfaction and those not resolved to the former
accountant's satisfaction. Problems contemplated by this section are
those which occur at the decision making level--i.e., between principal
financial officers of the OTC derivatives dealer and personnel of the
accounting firm responsible for rendering its report. The notice shall
also state whether the accountant's report on the financial statements
for any of the past two years contained an adverse opinion or a
disclaimer of opinion or was qualified as to uncertainties, audit
scope, or accounting principles, and describe the nature of each such
adverse opinion, disclaimer of opinion, or qualification. The OTC
derivatives dealer shall also request the former accountant to furnish
the OTC derivatives dealer with a letter addressed to the Commission
stating whether the former accountant agrees with the statements
contained in the notice of the OTC derivatives dealer and, if not,
stating the respects in which the former accountant does not agree. The
OTC derivatives dealer shall file three copies of the notice and the
accountant's letter, one copy of which shall be manually signed by the
sole proprietor, or a general partner or a duly authorized corporate
officer, as appropriate, and by the accountant, respectively.
(h) Audit objectives. (1) The audit shall be made in accordance
with generally accepted auditing standards and shall include a review
of the accounting system, the internal accounting control, internal
management controls, and procedures for safeguarding securities
including appropriate tests thereof for the period since the prior
examination date. The audit shall include all procedures necessary
under the circumstances to enable the independent public accountant to
express an opinion on the statement of financial condition, results of
operations, cash flows, and the Computation of Net Capital under
Sec. 240.15c3-1. The scope of the audit and review of the accounting
system, the internal accounting controls, internal management controls,
and procedures for safeguarding securities shall be sufficient to
provide reasonable assurance that any material inadequacies existing at
the date of the examination in the following are detected:
(i) The accounting system;
(ii) The internal accounting controls; and
(iii) Procedures for safeguarding securities.
(2) A material inadequacy in the accounting system, internal
accounting controls, procedures for safeguarding securities, and
practices and procedures referred to in paragraph (h) of this section
which is expected to be reported under these audit objectives includes
any condition which has contributed substantially to or, if appropriate
corrective action is not taken, could reasonably be expected to:
(i) Inhibit an OTC derivatives dealer from promptly completing
securities transactions or promptly discharging its responsibilities to
counterparties, other brokers and dealers or creditors;
(ii) Result in material financial loss;
(iii) Result in material misstatements of the OTC derivatives
dealer's financial statements;
(iv) Result in violations of the Commission's recordkeeping or
financial responsibility rules to an extent that could reasonably be
expected to result in the conditions described in paragraphs (h)(2)(i),
(ii), or (iii) of this section; or
(v) Result in any matter that would be deemed a reportable
condition under U.S. Generally Accepted Auditing Standards.
(i) Extent and timing of audit procedures. (1) The extent and
timing of audit procedures are matters for the independent public
accountant to determine on the basis of its review and evaluation of
existing internal controls and other audit procedures performed in
accordance with generally accepted auditing standards and the audit
objectives set forth in paragraph (h) of this section. In determining
the extent of testing, consideration shall be given to the materiality
of an area and the possible effect on the financial statements and
schedules of a material misstatement in a related account. The
performance of auditing procedures involves the proper synchronization
of their application and thus comprehends the need to consider
simultaneous performance of procedures in certain areas such as, for
example, securities counts, transfer verification, and customer and
broker confirmation in connection with verification of securities
positions.
(2) If, during the course of the audit or interim work, the
independent public accountant determines that any material inadequacies
exist in the accounting system, internal accounting control, procedures
for safeguarding securities, or as otherwise defined in paragraph
(h)(2) of this section, then the independent public accountant shall
call it to the attention of the chief financial officer of the OTC
derivatives dealer, who shall have a responsibility to inform the
Commission and the examining authority responsible for performing
reviews of the dealer pursuant to Sec. 240.15b9-2 by telegraphic or
facsimile notice within 24 hours thereafter as set forth in
Sec. 240.17a-11(e) and (g). The OTC derivatives dealer shall also
furnish the accountant with a copy of said notice to the Commission by
telegram or facsimile within said 24 hour period. If the accountant
fails to
[[Page 67965]]
receive such notice from the OTC derivatives dealer within said 24 hour
period, or if the accountant disagrees with the statements contained in
the notice of the OTC derivatives dealer, the accountant shall have a
responsibility to inform the Commission and the examining authority
responsible for performing reviews of the OTC derivatives dealer
pursuant to Sec. 240.15b9-2 by report of material inadequacy within 24
hours thereafter as set forth in Sec. 240.17a-11(g). Such report from
the accountant shall, if the OTC derivatives dealer failed to file a
notice, describe any material inadequacies found to exist. If the OTC
derivatives dealer filed a notice, the accountant shall file a report
detailing the aspects, if any, of the OTC derivatives dealer's notice
with which the accountant does not agree.
(j) Accountant's reports, general provisions.--(1) Technical
requirements. The accountant's report shall be dated; be signed
manually; indicate the city and state where issued; and identify
without detailed enumeration the financial statements and schedules
covered by the report.
(2) Representations as to the audit. The accountant's report shall
state whether the audit was made in accordance with generally accepted
auditing standards; state whether the accountant reviewed the
procedures followed for safeguarding securities; and designate any
auditing procedures deemed necessary by the accountant under the
circumstances of the particular case which have been omitted, and the
reason for their omission. Nothing in this section shall be construed
to imply authority for the omission of any procedure which independent
accountants would ordinarily employ in the course of an audit made for
the purpose of expressing the opinions required under this section.
(3) Opinion to be expressed. The accountant's report shall state
clearly the opinion of the accountant:
(i) In respect of the financial statements and schedules covered by
the report and the accounting principles and practices reflected
therein; and
(ii) As to the consistency of the application of the accounting
principles, or as to any changes in such principles which have a
material effect on the financial statements.
(4) Exceptions. Any matters to which the accountant takes exception
shall be clearly identified, the exception thereto specifically and
clearly stated, and, to the extent practicable, the effect of each such
exception on the related financial statements given.
(5) Definitions. For the purpose of this section, the terms audit
(or examination), accountant's report, and certified shall have the
meanings given in Sec. 210.1-02 of this chapter.
(k) Accountant's report on material inadequacies. The OTC
derivatives dealer shall file concurrently with the annual audit report
a supplemental report by the accountant describing any material
inadequacies found to exist or found to have existed since the date of
the previous audit. The supplemental report shall indicate any
corrective action taken or proposed by the OTC derivatives dealer in
regard thereto. If the audit did not disclose any material
inadequacies, the supplemental report shall so state.
(l) Accountant's report on management controls. The OTC derivatives
dealer shall file concurrently with the annual audit report a
supplemental report by the accountant indicating the independent public
accountant's opinion on the OTC derivatives dealer's compliance with
its internal risk management control objectives. The procedures are to
be performed and the report is to be prepared in accordance with U.S.
Generally Accepted Auditing Standards.
(m) Accountant's report on inventory pricing and modeling. (1) The
OTC derivatives dealer shall file concurrently with the annual audit
report a supplemental report by the accountant indicating the results
of the accountant's review of the broker's or dealer's inventory
pricing and modelling procedures. This review shall be conducted in
accordance with procedures agreed to by the OTC derivatives dealer and
by the independent public accountant conducting the review.
(2) The agreed-upon procedures are to be performed and the report
is to be prepared in accordance with the U.S. Generally Accepted
Auditing Standards.
(3) Every OTC derivatives dealer shall file prior to the
commencement of the initial review, the procedures to be performed
pursuant to paragraph (m)(1) of this section with the Commission's
principal office in Washington, D.C., and the principal office of the
examining authority responsible for reviewing the OTC derivatives
dealer pursuant to Sec. 240.15b9-2. Prior to the commencement of each
subsequent review, every OTC derivatives dealer shall file with the
Commission's principal office in Washington, D.C., and with the
examining authority responsible for reviewing the OTC derivatives
dealer pursuant to Sec. 240.15b9-2 notice of changes in the agreed-upon
procedures.
(n) Extensions and exemptions. (1) An examining authority
responsible for performing reviews of an OTC derivatives dealer
pursuant to Sec. 240.15b9-2 may extend the period under paragraph (b)
of this section for filing annual audit reports. The examining
authority responsible for performing reviews of the OTC derivatives
dealer pursuant to Sec. 240.15b9-2 shall maintain, in the manner
prescribed in Sec. 240.17a-1, a record of each extension granted.
(2) On written request of the examining authority responsible for
performing reviews of the OTC derivatives dealer pursuant to
Sec. 240.15b9-2, on written request of the OTC derivatives dealer, or
on its own motion, the Commission may grant an extension of time or an
exemption from any of the requirements of this section either
unconditionally or on specified terms and conditions.
(o) Notification of change of fiscal year. (1) In the event any OTC
derivatives dealer finds it necessary to change its fiscal year, it
must file, with the Commission's principal office in Washington, D.C.,
and the principal office of the examining authority responsible for
performing reviews of the OTC derivatives dealer pursuant to
Sec. 240.15b9-2, a notice of such change.
(2) Such notice shall contain a detailed explanation of the reasons
for the change. Any change in the filing period for the audit report
must be approved by the examining authority responsible for reviewing
the OTC derivatives dealer pursuant to Sec. 240.15b9-2.
(p) Filing requirements. For purposes of filing requirements as
described in Sec. 240.17a-12, such filing shall be deemed to have been
accomplished upon receipt at the Commission's principal office in
Washington, D.C., with duplicate originals simultaneously filed at the
locations prescribed in the particular paragraph of Sec. 240.17a-12
which is applicable.
18. By adding Secs. 240.36a1-1 and 240.36a1-2 to read as follows:
Sec. 240.36a1-1 Exemption from Section 7 for OTC derivative dealers.
(a) Except as provided in paragraph (b) of this section,
transactions by an OTC derivatives dealer shall be exempt from the
provisions of Section 7 of the Act (15 U.S.C. 78g), provided that the
OTC derivatives dealer complies with other federal margin requirements
applicable to non-broker-dealer lenders.
(b) The exemption provided under paragraph (a) of this section
shall not apply to extensions of credit made directly by a registered
broker or dealer
[[Page 67966]]
(other than an OTC derivatives dealer) in connection with transactions
in eligible OTC derivative instruments for which an OTC derivatives
dealer acts as counterparty.
Sec. 240.36a1-2 Exemption from SIPA for OTC derivatives dealers.
OTC derivatives dealers, as defined in Sec. 240.3b-12, shall be
exempted from the provisions of the Securities Investor Protection Act
of 1970 (15 U.S.C. 78aaa et seq.).
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
19. The authority citation for Part 249 continues to read in part
as follows:
Authority: 15 U.S.C. 78a, et seq., unless otherwise noted;
* * * * *
20. Section 249.617 is amended by adding the phrase ``Sec. 240.17a-
12,'' after the phrase ``240.17a-5(a), (b), and (d),''.
21. Form X-17A-5 (referenced in Sec. 249.617) is amended by adding
section IIB to read as follows:
Note: Form X-17A-5 does not, and the amendments will not, appear
in the Code of Federal Regulations. Part IIB of Form X-17A-5 is
attached as Appendix A to this document.
Dated: December 17, 1997.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
Appendix A
[Note: the text of Appendix A does not appear in the Code of Federal
Regulations.]
General Instructions
The FOCUS Report (Form X-17A-5IIB) constitutes the basic
financial and operational report required of OTC derivatives
dealers. Much of the information required by the FOCUS report is the
same or similar to the information required to be reported by
broker-dealers required to file Form X-17A-5 Part II. Consequently,
for those items that appear on both forms, the instructions for X-
17A-5 Part II are to be followed when completing form X-17A-5 Part
IIB. The following instructions apply to new information requests
and to items appearing on both forms that have been altered to
better reflect an OTC derivatives dealer's unique business.
Computation of Net Capital and Required Net Capital
(Under 15c3-1 Appendix F)
Tentative Net Capital
For purposes of paragraph (a)(5), the term ``tentative net
capital'' means the net capital of an OTC derivatives dealer before
the application of either the securities haircuts in paragraph
(c)(2)(vi) of Rule 15c3-1 or the charges for market and credit risk
as computed pursuant to proposed Appendix F and increased by
unsecured receivables (unrealized gains) resulting from eligible OTC
derivative instruments.
Market Risk Exposure
The capital requirement for an OTC derivatives dealer electing
to apply Appendix F of Rule 240.15c3-1 is computed as follows:
(1) Full Value-at-Risk Method. An OTC derivatives dealer shall
deduct from net worth an amount for market risk exposure for
eligible OTC derivatives transactions and other positions in its
proprietary or other accounts equal to the value at risk (``VAR'')
of these positions obtained from its proprietary model, multiplied
by the appropriate multiplication factor. See paragraph (d)(1)(v)(C)
of Appendix F for more information on the multiplication factor. The
proprietary model used to calculate the capital requirement for
market risk must be approved by the Commission prior to its use.
(2) Alternative Method for Equities. An OTC derivatives dealer
may choose to use the alternative method to calculate market risk
for equity instruments, including OTC options, or if the Commission
does not approve an OTC derivatives dealer's use of VAR models for
equity instruments, the OTC derivatives dealer must use the
alternative method. Under the alternative method, the deduction for
market risk will be an amount equal to the largest theoretical loss
calculated in accordance with the theoretical pricing model set
forth in Appendix A of Rule 240.15c3-1. The OTC derivatives dealer
may use its own theoretical pricing model as long as it contains the
minimum pricing factors set forth in Appendix A.
Credit Risk Exposure
The capital requirement for credit risk arising from an OTC
derivatives dealer's eligible OTC derivatives transactions consists
of a counterparty charge and a concentration charge. The
counterparty charge is computed as follows:
(1) the net replacement value for each counterparty (less the
value of any liquid collateral) multiplied by 8% multiplied by the
counterparty factor. The counterparty factors are 20% for entities
with ratings for senior unsecured long term debt or commercial paper
in the two highest rating categories by at least two nationally
recognized statistical rating organization (``NRSROs''); 50% for
entities with ratings for senior unsecured long term debt in the
third and fourth highest ratings categories by at least two NRSROs;
and 100% for entities with ratings for senior unsecured long term
debt below the four highest rating categories.
(2) The net replacement value for each counterparty with senior
unsecured long term debt in default (less any liquid collateral).
The concentration charge is computed as follows: where the net
replacement value in the account of any one counterparty exceeds 25%
of the OTC derivatives dealer's tentative net capital, deduct the
following amounts. For counterparties with ratings for senior
unsecured long term debt or commercial paper in the two highest
rating categories by at least two NRSROs, 5% of the amount of the
net replacement value in excess of 25% of the OTC derivatives
dealer's tentative net capital. For counterparties with ratings for
senior unsecured long term debt in the third and fourth highest
rating categories by at least two NRSROs, 20% of the amount of the
net replacement value in excess of 25% of the OTC derivatives
dealer's tentative net capital. For counterparties with ratings for
senior unsecured long term debt below the four highest rating
categories, 50% of the amount of the net replacement value in excess
of 25% of the OTC derivatives dealer's tentative net capital.
Finally, where the aggregate of the net replacement value of all
counterparties exceeds 300% of an OTC derivative dealer's tentative
net capital, it would deduct from net worth 100% of the amount of
such excess.
Computation of Net Capital and Required Net Capital (alternative)
Tentative Net Capital
For purposes of paragraph (a)(5), the term ``tentative net
capital'' means the net capital of an OTC derivatives dealer before
the application of either the securities haircuts in paragraph
(c)(2)(vi) of Rule 15c3-1 or the charges for market and credit risk
as computed pursuant to proposed Appendix F and increased by
unsecured receivables (unrealized gains) resulting from eligible OTC
derivative instruments.
Credit Risk Exposure
The capital requirement for credit risk arising from an OTC
derivatives dealer's eligible OTC derivatives transactions consists
of a counterparty charge and a concentration charge. The
counterparty charge is computed as follows:
(1) the net replacement value for each counterparty (less the
value of any liquid collateral) multiplied by 8% multiplied by the
counterparty factor. The counterparty factors are 20% for entities
with ratings for senior unsecured long term debt or commercial paper
in the two highest rating categories by at least two nationally
recognized statistical rating organization (``NRSROs''); 50% for
entities with ratings for senior unsecured long term debt in the
third and fourth highest ratings categories by at least two NRSROs;
and 100% for entities with ratings for senior unsecured long term
debt below the four highest rating categories.
(2) The net replacement value for each counterparty with senior
unsecured long term debt in default (less any liquid collateral).
The concentration charge is computed as follows: where the net
deficit in the account of any one counterparty exceeds 50% of the
OTC derivatives dealer's tentative net capital, deduct it from net
worth. For counterparties with ratings for senior unsecured long
term debt or commercial paper in the two highest rating categories
by at least two NRSROs, 5% of the amount of the net deficit in
excess of 25% of the OTC derivatives dealer's tentative net capital.
For counterparties with ratings for senior unsecured long term debt
in the third and fourth highest rating categories by at least two
NRSROs, 20% of the amount of the net deficit in excess of 25% of the
OTC derivatives dealer's tentative net capital. For counterparties
with ratings for senior
[[Page 67967]]
unsecured long term debt below the four highest rating categories,
50% of the amount of the net deficit in excess of 25% of the OTC
derivatives dealer's tentative net capital.
Finally, where the aggregate of the net deficits of all
counterparties exceeds 300% of an OTC derivative dealer's tentative
net capital, it would deduct from net worth 100% of the amount of
such excess.
Aggregate Securities and OTC Derivatives Positions
Provide the following information for each affiliated broker-
dealer as of the end of each quarter. Indicate the name of each
affiliated broker-dealer in a separate column or complete a separate
schedule for each affiliated broker-dealer. In the event a separate
listing of a position, financial instrument or otherwise is required
pursuant to any of the provisions of Section 240.17h-1T, the dealer
should indicate as such in the appropriate section of this schedule.
Where appropriate, indicate long and short positions separately.
BILLING CODE 8010-01-P
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[FR Doc. 97-33406 Filed 12-29-97; 8:45 am]
BILLING CODE 8010-01-C
