04-2456. Self-Regulatory Organizations; Fixed Income Clearing Corporation; Order Approving Proposed Rule Change To Amend the Criteria Used To Place Members on Surveillance Status

January 30, 2004.

I. Introduction

On March 20, 2003, the Fixed Income Clearing Corporation (“FICC”) filed with the Securities and Exchange Commission (“Commission”) and on June 3 and 18, 2003, amended the proposed rule change SR-FICC-2003-03 pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”).^[1] Notice of the proposal was published in the Federal Register on October 30, 2003.^[2] No comment letters were received. For the reasons discussed below, the Commission is approving the proposed rule change.

II. Description

Under the current rules of both the Government Securities Division (“GSD”) and the Mortgage-Backed Securities Division (“MBSD”) of FICC, management has the ability to place a member in a surveillance status class depending on whether the member satisfies one or more of the enumerated financial and operational criteria in the specific class. Once placed on surveillance status, FICC closely monitors the member's condition. The current criteria for placing members on surveillance status are broadly written and capture many FICC members that pose minimal financial or operational risk to FICC. This creates administrative burdens for FICC staff, who must more closely monitor these members that pose minimal risk, that is not necessary to protect FICC.

To remedy this problem, FICC has developed new criteria for placing members on surveillance. Specifically, all domestic broker-dealers and banks ^[3] that are GSD netting members and/or MBSD clearing members will be assigned a rating that is generated by entering financial data of the member into a matrix (“Matrix”) developed by credit risk staff.^[4] Those members with a “weak” rating (deemed to pose a relatively higher degree of risk to FICC) will be placed on an internal “watch list” and will be monitored more closely by credit risk staff.^[5] The consequences of being put on the “watch list” will be the same as is currently the case with surveillance status in the GSD's rules and will include possibly requiring the member on “watch list” status to submit additional financial reports and data and/or make additional clearing or participants fund deposits.^[6]

All other categories of netting and clearing members, including non-U.S. netting members and comparison-only members, will not be included in the Matrix process because these members possess characteristics that prevent use of the Matrix to effectively evaluate their risk to FICC. However, these members will be monitored by credit risk staff using financial criteria deemed relevant by FICC.^[7] Based on this monitoring, such Members may also be placed on the “watch list” if they experience a financial change that presents risk to FICC. Some examples include failure to meet minimum financial requirements or experiencing a significant decrease in equity (for GSD members) or net asset value (for MBSD members). Members placed on the “watch list” in this way will also be monitored more closely by credit risk staff.

The GSD will continue, in accordance with its current procedures, to place GSD netting members on the “watch list” for failure to comply with operational standards and requirements.^[8] MBSD expects to implement a similar provision, as outlined in these rule changes, soon.

III. Discussion

Section 17A(b)(3)(F) of the Act requires that the rules of a clearing agency be designed to facilitate the safeguarding of securities and funds which are in its custody or control or for which it is responsible.^[9] The Commission finds that FICC's proposed rule change is consistent with this requirement because it will improve FICC's member surveillance process which will better enable FICC to safeguard the securities and funds which are in its custody or control or for which it is responsible.

IV. Conclusion

On the basis of the foregoing, the Commission finds that the proposed rule change is consistent with the requirements of the Act and in particular section 17A of the Act and the rules and regulations thereunder.

It is therefore ordered, pursuant to section 19(b)(2) of the Act, that the proposed rule change (File No. SR-FICC-2003-03) be and hereby is approved.

For the Commission by the Division of Market Regulation, pursuant to delegated authority.¹⁰

Jill M. Peterson,

Assistant Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(1).

2.  Securities Exchange Act Release No. 48689 (October 24, 2003), 68 FR 61844.

3.  The following categories of GSD members will receive ratings: Category 1 and 2 Dealer Netting Members, Category 1 and 2 Inter-Dealer Broker Netting Members, and Bank Netting Members. At MBSD, Comparison and Clearing System Participants that are either banks or broker-dealers will be rated. Domestic broker-dealers and domestic banks are the only member types to which the Matrix will be applicable because (i) they represent the majority of the members of FICC and (ii) their financial reports contain information that lends them to the Matrix approach.

4.  FICC's approach to the analysis of members is based on a thorough quantitative analysis. A broker-dealer member's rating on the Matrix will be based on factors including size (i.e., total excess net capital), capital, leverage, liquidity, and profitability. Banks will be reviewed based on size, capital, asset quality, earnings, and liquidity.

5.  Members will also be evaluated based on their compliance with certain “parameter breaks” which will be determined based on applicable monthly and/or quarterly exception reports generated by credit risk staff. A member may be placed on the “watch list” for parameter breaks in areas such as excess net capital, excess liquid capital, aggregate indebtedness, leverage ratio, or other financial requirements.

6.  The MBSD's rules do not currently provide for surveillance status, but the MBSD has the right under certain circumstances to require additional financial reports and increased participants fund contribution.

7.  Credit risk staff will monitor these members by reviewing similar criteria as the criteria used for members included in the Matrix. FICC will file a proposed rule change should it decide to use a more applicable Matrix process to evaluate these members.

8.  The GSD currently monitors the comparison rates of members. Currently, low comparison rates can result in a member being placed on Class 1 surveillance status. Under the rule change, low comparison rates may result in a GSD member being placed on the “watch list.” Both the GSD and the MBSD may monitor for other operational factors in the future such as failing to timely submit trade data on a frequent basis.

9.  15 U.S.C. 78q-1(b)(3)(F).

10.  17 CFR 200.30-3(a)(12).