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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

January 10, 2005 **Interpretive Letter #1014**

**February 2005**

**12 USC 24(7)**

Subject: National Bank Participation in the Loss Allocation System of
the Government Securities Division ("GSD") of the Fixed Income Clearing
Corporation ("FICC")

Dear **\[ \]**:

This letter responds to your request on behalf of the GSD of the FICC, a
New York based clearing corporation, concerning the ability of national
banks to participate as netting members in its current loss allocation
system ("LAS"). FICC's GSD provides services to its financial
institution members with respect to the clearing, netting and settlement
of U.S. Government securities transactions. For the reasons discussed
below, we believe that it is legally permissible for national banks to
be members of the GSD and participate in its current LAS.

#### I. Background

##### 

##### FICC

The FICC is a clearing agency registered with, and supervised and
regulated by, the Securities and Exchange Commission ("SEC"). The FICC
was formed by the merger of the Government Securities Clearing
Corporation ("GSCC")[^1] and the MSB Clearing Corporation. FICC is
divided into the GSD and the Mortgage-Backed Securities Division. These
two divisions offer their own product specific services to their own
members, with each maintaining separate rules and a separate collateral
margin pool.

The GSD clears, nets, settles and manages the risks for its member firms
(brokers, dealers, banks and other financial institutions) arising from
a broad range of U.S. Government securities transactions. In addition,
the GSD offers its services to correspondent firms that clear U.S.
Government securities transactions through its members. The transactions
processed by the GSD include original authorizing purchases of Treasury
and Freddie Mac securities, buy/sell and repo transactions in Treasury
and Government Agency securities, and General Collateral Finance Repo
transactions in U.S. Government and U.S. Government Agency securities as
well as certain mortgage-backed securities.[^2] The GSD has offered
these services to market participants, including national banks, since
1989.

The GSD is part of the core infrastructure of the U.S. Government
securities marketplace. By providing sophisticated, automated trade
comparison, netting and settlement services, the GSD ensures the timely,
accurate and cost-efficient completion of transactions for its netting
members.[^3] The GSD's risk management process helps minimize the risks
arising from the process of clearing and settling U.S. Government
securities transactions.

FICC represents that the GSD's bank netting members are significant
participants in the U.S. Government securities market and important GSD
members. For example, in June 2004 the various bank members of GSD, in
the aggregate, submitted transactions for processing with a par value of
approximately \$1.6 trillion, most of which went into the GSD\'s netting
system. FICC asserts that it is important to the efficient functioning
of this marketplace that key players, such as the GSD's bank netting
members, continue to participate in the GSD.

##### GSD's LAS

The GSD has several risk protection measures, which include the
imposition of minimum financial, and other admission standards,[^4]
ongoing financial surveillance of members,[^5] the maintenance of
clearing fund margin ("Clearing Fund"),[^6] and the collection and
pass-through of mark-to market amounts. Moreover, the FICC has loss
sharing arrangements (cross-margining[^7] and cross-guaranty[^8]
arrangements) in place with other clearing corporations whereby a loss
from a common member on one clearing corporation might be covered by a
profit at another clearing corporation. FICC asserts that loss
allocation (which would occur only if a member became insolvent and the
mark-to-market amount and margin it provided and the monies available
from these other loss sharing arrangements were not sufficient to cover
liquidation losses) is a highly unlikely event. The LAS provisions that
govern the GSD netting member firms are generally found in Rule 4 of the
FICC GSD Rulebook. FICC represents that in the 15-year history of the
GSD's netting system, not a single netting member has ever been declared
insolvent, let alone caused a loss that triggered the LAS.

##### FICC's GSD Member Liability under the LAS

The FICC's GSD Rulebook provides that a netting member is in default if
insolvent and describes the actions the FICC's GSD may take in
response.[^9] A defaulting member's loss is first covered by liquidating
the defaulting member's netted security positions and applying the
defaulting member's Clearing Fund deposit.[^10] If the Clearing Fund
deposit is insufficient to satisfy the loss, and the defaulting member
is a cross-margining participant or a common member of a clearing
corporation with which FICC has a cross-guaranty agreement, the FICC
will apply any amounts available under the applicable cross-margining
guaranty or cross-guaranty agreement to the loss.[^11] The GSD will
allocate any remaining loss to the netting members.

In general, the GSD\'s loss allocation rules impose loss allocation
obligations only on those netting members that engaged in recent
counterparty trading activity with the defaulting member ("recent
counterparties").[^12] The GSD will mutualize loss, and thus impose loss
allocation obligations on netting members that are not recent
counterparties, only if a recent counterparty fails to pay its loss
allocation obligation or if a loss allocation exceeds an applicable
cap.[^13] Where the GSD mutualizes loss allocation obligations, a
netting member can either pay the amount of the loss or provide the GSD
with notice of its election to terminate its membership.[^14] If a
netting member elects to terminate its membership, its loss allocation
liability is limited to its Required Fund Deposit. [^15] As a result, a
member may cap its contingent liability for mutualized loss at the
member's Required Fund Deposit.

GSD netting members may freely elect to terminate membership in the GSD.
The FICC requests that members provide it with written notice at least
10 business days prior to terminating membership in the GSD.[^16] The
termination is not effective until accepted by the FICC. Thus, if the
FICC proposed a rule change, for example, that provided that members
were subject to unlimited liability for a defaulting member's losses,
members could terminate membership in the GSD. A member that terminates
membership in the GSD is liable for the member's obligations that arose
under GSD Rules prior to the termination of membership.[^17]

#### II. Discussion

National banking law permits national banks, their operating
subsidiaries, and their branches to engage in clearing and execution
activities as activities that are part of the business of banking
because the activities are functionally equivalent to bank permissible
credit and financial intermediation activities.[^18]

Clearing is a form of extending credit, one of the main functions of
banking institutions.[^19] A clearing agent substitutes its credit for
that of its customers. A clearing agent is liable to a clearinghouse for
performance on all submitted contracts, and assumes, with respect to the
exchange, clearinghouse, and counterparties, the risk of default. The
clearing function is akin to two other traditional bank credit
functions, providing bankers' acceptances and letters of credit. The
credit function provided by a national bank in its clearing capacity is
part of the business of banking, because a principal business of a bank
is to extend credit.[^20]

National bank clearing and execution activities are functionally
equivalent to the primary role of banks as financial intermediaries. The
role of a bank is to act as an intermediary, facilitating the flow of
money and credit among different parts of the economy.[^21] The role of
a bank intermediary takes many forms: providing payments transmission
services, borrowing from savers and lending to users and participating
in the capital markets, as here. As the recognized intermediaries
between other, non‑bank participants in the financial markets and the
payment systems, banks possess the expertise to effect transactions
between parties and to manage their own intermediation position. Hence,
national bank clearing and execution activities are permissible as part
of bank authorized financial intermediary activities.[^22]

The OCC has opined that national banks and their operating subsidiaries
and branches may engage in clearing and execution activities both
domestically and abroad.[^23] In fact, the OCC previously determined
that it was permissible for national banks to invest in the GSD in order
to take advantage of the services offered by the corporation.[^24] The
permissibility of contributing to a default fund was not addressed in
OCC Interpretive Letter 421. However, a national bank's provision of a
default fund contribution to cover potential defaults, as a necessary
precondition to engaging in bank permissible clearing and execution
activities, is incidental to these activities.[^25] The OCC has
determined that default fund contributions are, under these
circumstances, permissible guaranties.[^26]

The National Bank Act is itself silent on the authority of national
banks to provide guaranties.[^27] There is no express power, nor any
express prohibition, concerning guaranties. And, the Supreme Court has
never held that guaranties are *per se* impermissible for national
banks. [^28] Instead, the Court has upheld a national bank's power to
make guaranties given the specific facts under consideration.[^29] Lower
courts have tended to generalize these cases, however, in stating that
national banks may not provide guaranties.[^30]

OCC Interpretive Ruling 7.1017 clarifies that that a national bank may
provide a guaranty if the bank has a substantial interest in the
transaction at issue. [^31] A "substantial interest" exists if the
guaranty provided by the bank is "incidental" [^32] to another of its
authorized activities.[^33] The nexus between the bank permissible
transaction and the guaranty provides the "substantial interest" for the
bank. The OCC has determined that a national bank's provision of a
default fund contribution to cover potential defaults as a necessary
precondition to engaging in bank permissible clearing and execution
activities, meets the substantial interest test and is incidental to
these activities. [^34] A national bank has a substantial interest in
providing such guaranties to enable it to retain the ability to engage
in bank permissible clearing and execution services, and therefore the
guaranty is incidental to banking. Thus, a national bank may contribute
to a default fund to guaranty its obligations and those of other
exchange members consistent with the requirements of OCC Interpretive
Ruling 7.7010.

**III. Conclusion**

It is legally permissible for national banks to participate in the GSD's
LAS. OCC Interpretive Letter 421 permits national banks to take
advantage of the services offered by the GSD. Moreover, OCC Interpretive
Letter 929 concludes that clearing and exchange activities, and the
provision of funds to cover member defaults in connection with these
activities, are permissible activities for national banks. Accordingly,
national banks may be netting members of the GSD and participate in its
LAS.

I trust the foregoing is responsive to your inquiry. If you have
additional questions, please do not hesitate to contact Tena M.
Alexander, Special Counsel, Securities & Corporate Practices Division at
(202) 874-5210.

Sincerely,

/s/ Daniel P. Stipano

Daniel P. Stipano

Acting Chief Counsel

[^1]: The GSCC was the predecessor to the FICC's GSD. "GSD" in this
    letter refers to both the GSCC and the GSD.

[^2]: The GSD must maintain a master file list of securities that the
    FICC has designated as eligible for netting. FICC GSD Rulebook, Rule
    30. As of October 19, 2004, there were 14,941 netting eligible
    securities identified on that list. A predominant number of those
    securities would appear to qualify as Type I securities under 12
    C.F.R. Part 1. 12 C.F.R. § 1.2(j). A national bank may deal in,
    underwrite, purchase and sell Type I securities in unlimited
    amounts. 12 C.F.R. § 1.3(a).

[^3]: The FICC's GSD has two basic types of members -- netting members
    and comparison only members.

    "Netting Members" are members of the comparison and netting systems.
    Netting members have their trades netted and settled through GSD
    and, therefore, have securities and funds obligations to the GSD.
    "Comparison-only members" do not have their trades netted and
    settled through GSD, but benefit from the GSD's automated, binding
    comparison of trades.

[^4]: Bank netting member applicants must, for example, have a level of
    equity capital as of the end of the month prior to the effective
    date of its membership, determined in accordance with generally
    accepted accounting principles, of at least \$100 million and its
    capital level and ratios must meet the applicable minimum levels
    required by the appropriate regulatory agency. FICC GSD Rulebook,
    Rule 3, Section 2.

[^5]: The FICC monitors members and may place them on a watch list based
    on ratings assigned according to the FICC's credit risk rating
    matrix or for failure to comply with certain operational standards
    and requirements. FICC GSD Rulebook, Rule 4, Section 3. Members
    assigned a "weak" rating, or deemed to pose a relatively higher
    degree of risk to the FICC will be placed on its internal watch list
    and monitored more closely by credit risk staff. A member will
    continue to be included on the watch list until the condition that
    resulted in placement on the list has sufficiently improved so that
    the FICC determines that close monitoring is no longer warranted.
    FICC GSD Rulebook, Rule 4, Section 3; 69 Fed. Reg. 5624.

       

[^6]: FICC netting members are required to maintain deposits in a
    Clearing Fund account. Each member's required deposit is calculated
    daily to ensure enough funds are on hand to cover the risks
    associated with that member's activities. The purposes served by the
    Clearing Fund are to: \[1\] have on deposit from each netting member
    assets sufficient to satisfy any losses that may otherwise be
    incurred by the FICC (and ultimately its members) as a result of the
    default by the member and the resultant close-out of that member's
    settlement positions, \[2\] maintain a total asset amount sufficient
    to satisfy potential losses to the FICC and its members resulting
    from the failure of more than one member (and the failure of such
    member's counterparties to pay their pro-rata allocation of loss),
    and \[3\] ensure that the FICC has sufficient liquidity at all times
    to meet its payment and delivery obligations. Overview of the GSD of
    the FICC. (Aug. 16, 2004), at p. 67 - 8.

[^7]: FICC has established cross-margining arrangements with other
    clearing organizations ("Participating COs"). Each FICC netting
    member signs an agreement under which it agrees to be bound by these
    cross-margining arrangements, which allow the FICC or the
    Participating CO to apply the member's margin collateral to satisfy
    any obligation of the FICC to the Participating CO, or vice versa,
    that results from a default of the member. Overview of the GSD of
    the FICC. (Aug. 16, 2004), at p. 74.

[^8]: FICC has entered into a multilateral netting contract and limited
    cross-guaranty agreement with the Depository Trust Company (DTC),
    National Securities Clearing Corporation (NSCC), Emerging Markets
    Clearing Corporation (EMCC) and the Options Clearing Corporation,
    under which these clearing agencies have agreed to make payment to
    each other for any remaining unsatisfied obligations of a common
    defaulting participant to the extent that they have excess resources
    of the defaulting participant. Overview of the GSD of the FICC.
    (Aug. 16, 2004), at p. 92; 2003 Fixed Income Clearing Corporation
    Annual Financial Statement. FICC is a wholly owned subsidiary of the
    Depository Trust & Clearing Corporation (DTCC). DTC, NSCC and EMCC
    are also principal operating subsidiaries of DTCC. 2003 Fixed Income
    Clearing Corporation Annual Financial Statement.

[^9]: FICC GSD Rulebook, Rules 1, 4, 22, and 43.

[^10]: FICC GSD Rulebook, Rule 4, Section 8.

[^11]: *Id.*

[^12]: In general, "recent counterparty trading activity" includes the
    netting activity with a defaulting member that occurred however many
    business days immediately prior to the day of default as are
    necessary to find at least five times the dollar value amount of the
    defaulting member's securities that are liquidated by the FICC. FICC
    GSD Rulebook, Rule 4, Section 8(f); Overview of the GSD of the FICC.
    (Aug. 16, 2004), at pp. 90 -- 92.

[^13]: FICC GSD Rulebook, Rule 4, Section 8.

[^14]: FICC GSD Rulebook, Rule 4, Section 8(e) and (h); Rule 2, Section
    10.

[^15]: ^?^ *Id;* The "Required Fund Deposit" is the minimum level of
    deposit to the Clearing Fund that is required to be made and
    maintained by a netting member. Each netting member must deposit a
    minimum cash contribution of \$100,000 or 10% of the total amount of
    the Clearing Fund up to a maximum of \$500,000. FICC GSD Rulebook,
    Rule 4, Section 2(b)(ii).

[^16]: FICC GSD Rulebook, Rule 2, Section 11.

[^17]: *Id.*

[^18]: Courts have affirmed OCC interpretations that an activity is
    within the scope of the "business of banking" if it:

    \[1\] is functionally equivalent to or a logical outgrowth of a
    traditional banking activity; \[2\] would respond to customer needs
    or otherwise benefit the bank or its customers; and \[3\] involves
    risks similar to those already assumed by banks. *See, e.g.,
    Merchant Bank v. State Bank*, 77 U.S. 604 (1871); *M & M Leasing
    Corp. v. Seattle First Nat'l Bank*, 563 F.2d 1377, 1382 (9th Cir.
    1977), *cert. denied*, 436 U.S. 956 (1978); *American Insurance
    Ass'n. v. Clarke*, 865 F.2d 278, 282 (2d Cir. 1988). In *IAA v.
    Hawke*, 211 F.3d 638 (D.C. Cir. 2000), the court expressed the
    position that the "logical outgrowth" rationale needed to be kept
    within bounds, but endorsed the "functional equivalent" component of
    the test.

[^19]: *See* OCC Interpretive Letter No. 494 (Dec. 29, 1989).

[^20]: *Id.*

[^21]: *See, e.g*., OCC No-Objection Letter No. 90-1 (February 16,
    1990); OCC No-Objection Letter No. 87-5 (July 20, 1977).

[^22]: *See* OCC Interpretive Letter 892 (September 8, 2000).

[^23]: *See, e.g.,* OCC Interpretive Letter No. 929 (Feb. 11, 2002)*;*
    OCC Interpretive Letter No. 494, *supra*; OCC Interpretive Letter
    No. 421, *supra*; OCC Interpretive Letter No. 384 (May 19, 1987);
    OCC Interpretive Letter No. 380, *supra*; OCC Interpretive Letter
    No. 372 (Nov. 7, 1986).

[^24]: OCC Interpretive Letter No. 421 (March 14, 1988). In that letter,
    the OCC focused on the ability of a national bank to hold stock in
    the corporation and discussed the corporation's activities only to a
    very limited extent. The current LAS was not in place at that time.

[^25]: *See e.g.,* OCC Interpretive Letter 929, *supra*

[^26]: *Id.*

[^27]: 12 U.S.C. § 24 (Seventh).

[^28]: *See, e.g., Texas & Pacific Rwy. v. Potorff,* 291 U.S. 245 (1934)
    (national bank has no authority to secure a private deposit); *First
    N.B. of Aiken v. Mott Iron Works,* 258 U.S. 240 (1922) (declining to
    void a bank's guarantee of contract performance, and holding bank
    liable since it received the benefit of the guarantee); *Citizens
    Central N.B. v. Appleton,* 216 U.S. 196 (1910)(declining to void one
    national bank's guarantee to another bank, but deciding based on a
    theory of implied contract); *Merchants N.B. v. Wehrmann,* 202 U.S.
    295 (1906) (national bank may not assume unlimited liability as a
    partner); *Logan City N.B. v. Townsend,* 139 U.S. 67 (1891)
    (declining to accept national bank defense that it had no authority
    to guarantee a contract and holding bank liable since it benefited
    from the contract); *Cook County N.B. v. U.S.,* 107 U.S. 445 (1883)
    (not within implied or express powers of national bank to provide
    the U.S. a priority of payment of claims arising from bank's
    insolvency).

[^29]: *See Peoples Bank of Belleville v. Manufacturers N.B. of
    Chicago,* 101 U.S. 181 (1880) (guarantee of notes held within powers
    of a national bank when the transaction was in substance an
    "indorsement"); *Cochran v. U.S.,* 157 U.S. 286 (1895) (contract of
    guarantee held within implied powers of a national bank).

[^30]: *See, e.g.,* *Dunn v. McCoy,* 113 F.2d 587 (9th Cir. 1940);
    *Kimen v. Atlas Exchange N.B.*, 92 F.2d 615 (7th Cir. 1937)
    (invalidating bank sale of bonds to a customer and simultaneous
    guarantee to repurchase the bonds at any time in the future at par);
    *Border N.B. v. American N. B.*, 282 F. 73 (5th Cir. 1922 (upholding
    as letter of credit, rather than an impermissible guarantee, an
    agreement covering the purchase and shipment of 200 tons of sugar);
    *Bowen v. Needles N.B.,* 94 F. 925 (9th Cir. 1899), *cert. denied,*
    176 U.S. 682 (1900) (invalidating bank guarantee of payment of
    customer's checks, in full knowledge that the customer had no funds
    on deposit with the bank).

[^31]: 12 C.F.R. § 7.1017.

[^32]: Incidental activities are activities that are permissible for
    national banks, not because they are part of the powers expressly
    authorized for bank or the "business of banking," but rather because
    they are "convenient" or "useful" to those activities. *See*
    *NationsBank v. Variable Annuity Life Insurance Co.,* 513 U.S. 2251
    (1995); *Arnold Tours, Inc. v. Camp*, 472 F.2d 427 (1^st^ Cir.
    1972); OCC Interpretive Letter No. 742 (Aug. 19, 1996); OCC
    Interpretive Letter No. 737 (August 19, 1996); OCC Interpretive
    Letter No. 494, *supra.*

[^33]: *See, e.g.,* *Dunn v. McCoy,* 113 F.2d 587 (9th Cir. 1940); OCC
    Interpretive Letter No. 376, *supra*.

[^34]: *See e.g.,* OCC Interpretive Letter 929, *supra*