[Federal Register Volume 61, Number 97 (Friday, May 17, 1996)]
[Notices]
[Pages 24993-24995]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-12471]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37202; File No. SR-NSCC-95-17]
Self-Regulatory Organizations; National Securities Clearing
Corporation; Order Temporarily Approving a Proposed Rule Change to
Establish Additional Procedures for Placing Settling Members on Class A
Surveillance and Collecting Clearing Fund and Other Collateral Deposits
From Settling Members
May 10, 1996.
On December 20, 1995, the National Securities Clearing Corporation
(``NSCC'') filed with the Securities and Exchange Commission
(``Commission'') a proposed rule change (File No. SR-NSCC-95-17)
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') to establish additional procedures for placing settling
members on Class A Surveillance and collecting clearing fund and other
collateral deposits from settling members.\1\ Notice of the proposal
was published in the Federal Register on March 12, 1996.\2\ No comment
letter were received. For the reasons discussed below, the Commission
is temporarily approving the proposed rule change through May 31, 1997.
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\1\ 15 U.S.C. 78s(b)(1) (1988).
\2\ Securities Exchange Act Release No. 36930 (March 6, 1996),
61 FR 10051.
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I. Description of the Proposal
NSCC's Board of Directors has determined that under certain
circumstances settling members who clear securities transactions for
over-the-counter (``OTC'') market makers or who themselves engage in
OTC market making can have their financial viability materially
impacted by such business.\3\ Furthermore, if these settling members
dominate one side of the market in their street-side trading positions,
either directly by participating in OTC market making or indirectly by
clearing transactions for OTC market makers, NSCC believes that the
risk of default by the settling member increases.\4\ In turn, this
could potentially increase NSCC's exposure because NSCC is obligated to
complete defaulting settling members' unsettled trades once NSCC's
trade guarantee attaches.
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\3\ When a market maker, either alone or acting in concert with
other market makers, takes net street-side trading positions (i.e.,
non-retail trading with other broker-dealers) that constitute a
disproportionately large percentage of the total net street-side
buys or net street-side sells in any issue (i.e., the market maker
dominates one side of the market in the issue), the risk of default
by that market maker can increase.
\4\ However, to the extent that market makers' net street-side
trading positions in dominated issues result from legitimate
customer orders, the potential adverse impact on the financial
viability of a settling member and the potential for increased
exposure to NSCC could be mitigated. So long as the customer orders
are legitimate, the risks associated with such positions are borne
among the individual accounts of the market maker's customers and
not concentrated solely in the proprietary accounts of the market
maker.
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The problem is magnified if one or more additional risk factors are
present. These additional risk factors can include, without limitation:
(1) Concentrated short selling in dominated issues;
(2) Undue concentration of securities held in inventory by market
maker(s) for dominated issues;
(3) Dominated issues also being IPOs less than six months past
initial issuance particularly when the current value of the issue is
significantly different from its initial sales price or there is undue
concentration of inventory in the managing underwriter(s); and
(4) Clearing positions of market makers in dominated issues away
from their primary clearing brokers.
Rule 15, Section 3 of NSCC's rules currently provides that any
settling member \5\ shall furnish to NSCC such adequate assurances of
its financial responsibility and operational capability as NSCC may at
any time or from time to time deem necessary or advisable in order to
protect NSCC. Section 4 of Rule 15 states that such adequate assurances
may include, but are not be limited to, increased clearing fund
deposits of settling members. Furthermore, Section III.B.1.o. of
Addendum B to NSCC's rules sets forth the guidelines for determining
when NSCC may place a broker-dealer settling member on Class A
surveillance status.\6\ Pursuant to these guidelines, NSCC may place a
broker-dealer settling member on Class A surveillance if there is any
condition which could materially impact the operational or financial
viability of the settling member which increases or potentially may
increase exposure to NSCC.
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\5\ NSCC Rule 1 defines a ``settling member'' to include any
NSCC member, non-clearing member and, except where a contrary intent
is expressed in NSCC's rules, a special representative.
\6\ Class A Surveillance permits NSCC, among other things, to
increase a settling members clearing fund requirement by an amount
equal to (i) up to 5% of the settling member's CNS long fail
positions, plus (ii) up to 5% of the settling member's short fail
positions, plus (iii) 2.5% or at NSCC's discretion up to 5% of the
settling member's average non-CNS and non-mutual fund services
debits, plus (iv) 2.5% of the settling member's average non-CNS and
non-mutual fund services credits. NSCC Rules and Procedures,
Addendum B, IV(C).
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In order for NSCC to reduce its potential exposure from the OTC
market making activity described above, NSCC is adding Addendum O to
its rules and procedures. Addendum O will permit NSCC to place settling
members on Class A surveillance if they clear for or are themselves OTC
market makers and (i) they do not have sufficient capital or access to
capital to support either potential increases in market making activity
in dominated OTC issues or (ii) there is the presence of the additional
risk factors described above. At its discretion, NSCC may elect not to
place settling members on Class A surveillance if it has obtained
sufficient assurances that a high degree of mitigating circumstances
exist.\7\
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\7\ However, the mere fact that a market maker has a large
customer base may not necessarily constitute the necessary
mitigating circumstances especially if the customers are retail and/
or the market maker has a history of customer complaints or other
adverse regulatory or disciplinary actions. Refer also to note 4.
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Furthermore, NSCC is adopting an interim collateralization policy
which will allow NSCC in its discretion to
[[Page 24994]]
require settling members placed on Class A surveillance that clear for
or are themselves OTC market makers to meet the following special
collateralization requirements:
(1) To the extent that the sum of the absolute dollar values of any
such settling members' net unsettled trading positions in all
securities dominated \8\ by a market maker exceeds such market maker's
excess net capital, NSCC can require the settling member to deposit
with NSCC at such times and in such manner as NSCC may designate,
including an immediate deposit of same-day funds the amount by which
the value of the net unsettled trading positions exceed the market
maker's excess net capital.\9\ In determining the size of net unsettled
trading positions, NSCC may take into account offsetting pending (i.e.,
non-fail) institutional delivery (``ID'') transactions that have been
confirmed and when NSCC deems appropriate, affirmed,\10\ through the ID
system of a clearing agency registered under Section 17A of the Act
(``registered clearing agency'').\11\ In addition, if a market maker's
net unsettled trading positions in dominated issues are cleared by one
or more other settling members, including any settling member on Class
A surveillance, NSCC will have the discretion for purposes of
calculating the special collateral deposit of treating those positions
as if they were all cleared by a settling member on Class A
surveillance.
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\8\ Domination will be determined according to criteria
specified by NSCC from time to time.
\9\ The term ``same-day funds'' refers to payment in funds that
are immediately available and generally are transferred by
electronic means.
\10\ In determining net unsettled trading positions, NSCC in its
discretion under certain circumstances may elect to take into
account offsetting pending confirmed ID transactions only if such
transactions also have been affirmed. Moreover, NSCC may decline to
consider any ID transaction if it has reason to believe that the
institutional counterparty may not or cannot settle such
transaction.
\11\ 15 U.S.C. 78q-1 (1988).
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(2) To the extent that the unsettled positions referred to in
paragraph (1) above are short (i.e., net sells), NSCC in its discretion
may collect more than 100 percent of the amount by which the sum of the
absolute dollar values of the net unsettled trading positions of any
such settling member in all the securities dominated by a market maker
exceeds the market maker's excess net capital.\12\ In lieu of cash
collateral, NSCC may require or accept a book-entry delivery of
securities to NSCC sufficient to cover such short position.
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\12\ For example, if a clearing member's excess net capital is
$100,000 and the value of its OTC market making activities is
$125,000, the rule change permits NSCC to require the clearing
member to deposit an additional $25,000. However, if the clearing
member's OTC market making activity includes short positions, the
rule change will permit NSCC to collect more than $25,000.
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(3) NSCC will reserve the right at all times to accept alternative
arrangements for its protection in any of the above situations. NSCC
may require special collateral deposits with respect to trading
positions in issues dominated by a market maker even when the value of
those positions do not exceed the market maker's excess net capital.
NSCC also may choose to forego collecting such special collateral even
when the value of those positions exceed the market maker's excess net
capital but do not exceed some higher threshold.\13\ NSCC will make
these determinations based on the specific situation and depending
upon, among other things, the presence or absence of additional risk
factors or mitigating circumstances.
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\13\ From time to time, NSCC will determine in its discretion
what such higher threshold shall be.
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The special collateralization requirements described above are
interim measures for settling members on Class A surveillance which
will be in effect until NSCC has gained enough experience in
surveillance of OTC market maker trading activities to impose permanent
special collateralization requirements. Additionally, if there is
concentrated short selling in dominated issues, NSCC will maintain its
right to collect special collateral deposits from the settling members
clearing the short sales without regard to their surveillance status.
Special collateral collected from any settling member pursuant to the
above procedures will be in addition to the settling member's clearing
fund deposit computed in accordance with the formulae set forth in NSCC
Procedure XV or in accordance with the alternative method set forth
below.
Because NSCC believes that its settling members on Class A
surveillance present a higher than normal risk of default and
insolvency, NSCC is proposing that such settling members' clearing fund
deposits be based on the close-out risk presented by their unsettled
positions in NSCC's systems. Therefore, pursuant to Rule 15 as
expressed under Addendum O, NSCC will have the discretion to compute
the continuous net settlement (``CNS'') component of the clearing fund
requirement for any settling member on Class A surveillance in
accordance with the following alternative method rather than the
formulae to calculate clearing fund set forth in NSCC Procedure XV.\14\
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\14\ NSCC Procedure XV contains the formulae usually employed to
calculated clearing members' clearing fund requirements.
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(1) NSCC may calculate on a daily or periodic basis the volatility
of any such settling member's net unsettled trading positions in CNS
eligible issues (``net CNS trading positions''). Such positions shall
be determined after taking into account offsetting pending (i.e., non-
fail) ID transactions that have been confirmed and, when NSCC deems
appropriate, affirmed \15\ through the ID system of a registered
clearing agency. Such calculation will be made in accordance with the
Capital Asset Pricing Model or any other generally accepted portfolio
volatility model, including without limitation, any margining formula
employed by any other registered clearing agency provided, however,
that not less than two standard deviations' volatility shall be
calculated under any model chosen. Such calculation will be made
utilizing such assumptions and based on such historical data as NSCC
deems reasonable and shall cover such range of historical volatility as
NSCC from time to time deems appropriate. If such volatility is
calculated on a periodic basis, it may be expressed as a percentage of
the sum of the absolute values of the firm's net CNS trading positions.
Any such calculations, whether expressed as a dollar value or
percentage, may be rounded as NSCC deems appropriate.
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\15\ Supra note 10.
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(2) NSCC shall have the discretion to exclude from the above
calculations net CNS trading positions in classes of securities whose
volatility is (i) less amenable to statistical analysis such as OTC
bulletin board or pink sheet issues or issues trading below a
designated dollar threshold (e.g., five dollars) or (ii) amenable to
generally accepted statistical analysis only in a complex manner (e.g.,
municipal or corporate bonds). The amount of clearing fund required
with respect to net CNS trading positions in such issues shall be
determined by multiplying the absolute value of such positions by a
percentage designated by NSCC, which percentage may vary depending on
such factors as NSCC deems relevant.
(3) The amounts calculated in accordance with the immediately
preceding two numbered paragraphs will be substituted for the amount
calculated in accordance with paragraph (1)(c) of Sections A.I.(a),
A.II.(a) and A.II.(b) of NSCC's Procedure XV.\16\ In addition, NSCC may
in its discretion reduce or eliminate the amount calculated in
accordance with paragraph (1)(a) of Procedure XV.
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\16\ Supra note 14.
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[[Page 24995]]
(4) NSCC in its discretion also may calculate the total clearing
fund requirement of any settling member on a daily basis instead of a
twenty-day rolling average basis and may collect deficiencies at such
times and in such manner as specified by NSCC from time to time,
including immediate collection of same-day funds.
Nothing in the foregoing rule change will limit NSCC's discretion
with respect to placing settling members on Class A surveillance or
requiring settling members to furnish adequate assurance of financial
responsibility or operational capability as set forth in NSCC's rules
and procedures.
II. Discussion
Section 17A(b)(3)(F) of the Act \17\ requires that the rules of a
clearing agency be designed to assure the safeguarding of securities
and funds which are in the custody or control of the clearing agency
and generally to protect investors and the public interest. The
Commission believes the proposed rule change is consistent with NSCC's
obligations under the Act because it will allow NSCC to take particular
action to protect itself, its members, and investors in situations
where settling members pose an increased risk because of their
involvement in OTC market making.
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\17\ 15 U.S.C. Sec. 78q-1(b)(3)(F) (1988).
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Under the proposal, NSCC will have the authority with respect to
settling members who participate in OTC market making activities or
clear for correspondents that engage in such activity (1) to place such
members on Class A surveillance, (2) to require such members to post
additional collateral with NSCC, and (3) to calculate an alternative
clearing fund requirement for such members when additional risk factors
are present. Collectively, the higher level of surveillance, the
additional level of collateralization, and the alternative clearing
fund requirements should help to ameliorate NSCC's exposure which in
turn should assist NSCC in fulfilling its obligations under the Act to
safeguard securities and funds for which it has control of, is
responsible for and, generally, to protect investors and the public
interest.
The Commission is temporarily approving the proposed rule change
through May 31, 1997, so that NSCC can gain additional experience in
the surveillance of OTC market makers and the risks posed by clearing
such activity. NSCC also will be able to gain experience with the
additional collateralization requirements and alternative clearing
formula requirements for settling members subject to Class A
surveillance prior to permanent imposition of these requirements.
Temporary approval also will afford both the Commission and NSCC an
opportunity to observe whether the additional collateralization and
alternative clearing fund requirements adequately protect NSCC, its
members, and investors from the expected risks of participating in and
clearing OTC market maker activity and whether adjustments to the
procedures are necessary. Prior to filing a proposed rule change
seeking permanent approval of the procedures set forth in this
temporary approval order, NSCC shall present to the Commission a more
detailed report of its findings regarding the adequacy of the controls
and discussing any changes to be made to the procedures. During the
temporary approval period, NSCC will from time to time apprise the
Commission on the operation of the additional collateralization
requirements to enable the Commission to monitor the implementation of
such requirements.
III. Conclusion
On the basis of the foregoing, the Commission finds that the
proposal is consistent with the requirements of the Act and in
particular with the requirements of 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-NSCC-95-17) be, and hereby
is, approved on a temporary basis through May 31, 1997.
For the Commission by the Division of Market Regulation,
pursuant to delegated authority.\18\
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\18\ 17 CFR 200.30-3(a)(12) (1995).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-12471 Filed 5-16-96; 8:45 am]
BILLING CODE 8010-01-M
