OFFICIAL SEAL OF THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

OFFICIAL LETTERHEAD STATIONERY 

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

WASHINGTON, D.C. 20551 

ADDRESS OFFICIAL CORRESPONDENCE TO THE BOARD 

October 24, 2006 

John A. Buchman, Esq. 

General Counsel 

E*TRADE Bank 

671 North Glebe Road 

Arlington, Virginia 22203 

Dear Mr. Buchman: 

This is in response to the request by E*TRADE Bank (“Bank”), 

Arlington, Virginia, for an exemption from section 23A of the Federal Reserve 

Act and the Board’s Regulation W to permit Bank’s parent company, E*TRADE 

Financial Corporation (“ETFC”), New York, New York, to contribute to Bank 

all its equity interest in E*TRADE Clearing LLC (“Clearing”), New York, 

New York. [Footnote 1. Begin text of Footnote 1. 12 U.S.C. section 371c; 

12 CFR part 223. End Footnote 1.] Bank also has requested an exemption that 

would permit Clearing, after it becomes a wholly owned subsidiary of Bank, to 

continue to make margin loans to customers, the proceeds of which would be 

transferred to affiliates of Bank. 

Background 

ETFC is a publicly traded savings and loan holding company 

supervised by the Office of Thrift Supervision (“OTS”). ETFC’s principal 

subsidiaries include (i) Bank, an OTS-regulated federal savings association; 

(ii) E*Trade Securities (“Securities”), New York, New York, an SEC-registered 

broker-dealer that acts primarily as an introducing broker for ETFC’s retail 

investor client base; (iii) Clearing, an SEC-registered broker-dealer that performs 

traditional clearing, settlement, and related functions and extends margin credit 

primarily in connection with securities transactions by clients of ETFC; and 
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(iv) E*Trade Capital Markets and E*Trade Capital Markets—Execution Services 

(the “Affiliated Market Makers”), New York, New York, SEC-registered brokerdealers that make markets in a wide variety of securities and act as introducing 

brokers to ETFC’s institutional investor client base (when acting as introducing 

brokers, together with Securities, the “Affiliated Introducing Brokers”). 

A principal function of Clearing is to clear and settle securities 

transactions and provide related back-office services for the brokerage customers 

of the Affiliated Introducing Brokers. Clearing also provides margin loans to 

customers of the Affiliated Introducing Brokers. Clearing currently funds its 

margin loans using customers’ free credit balances and the proceeds of borrowings 

from affiliated and unaffiliated lenders. [Footnote 2. Begin text of Footnote 2. 

A free credit balance is cash held in a brokerage account that the customer, 

without restriction, may withdraw or use to acquire additional securities. 

End Footnote 2.] Clearing does not currently receive any extensions of credit 

or other funding from Bank, and Bank does not make any margin loans to 

Clearing’s customers. Clearing does not engage in securities dealing, market 

making, or underwriting; and Clearing does not purchase securities for its own 

account except in very limited circumstances. 

The Affiliated Introducing Brokers clear and settle substantially all of 

their customer securities transactions through Clearing. In addition, although the 

Affiliated Introducing Brokers route customer orders to several different market 

centers and market makers in the ordinary course of business, the majority of 

customer orders are routed to the Affiliated Market Makers. [Footnote 3. Begin 

text of Footnote 3. [redacted text of footnote] End Footnote 3.] 

As part of an internal reorganization, ETFC now proposes to 

contribute all its equity interest in Clearing to Bank. Bank has filed a notice with 

the OTS and the Federal Deposit Insurance Corporation (“FDIC”) to acquire 

Clearing from ETFC and establish it as a wholly owned operating subsidiary. The 

OTS has expressed no concerns about the reorganization, and the FDIC has no 

objection to granting the requested section 23A exemptions. 
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Bank anticipates that the proposed reorganization would result in cost 

savings and financial benefits to ETFC by reducing Bank’s interest-rate risk (and 

associated hedging costs), lowering the funding costs for Clearing, and integrating 

the balance sheets of Bank and Clearing for bank regulatory capital purposes. 

Legal Background 

Section 23A and Regulation W limit the amount of “covered 

transactions” between a bank (including a federal savings association) and any 

single affiliate to 10 percent of the bank’s capital stock and surplus and limit the 

amount of covered transactions between a bank and all its affiliates to 20 percent 

of the bank’s capital stock and surplus. “Covered transactions” include a bank’s 

purchase of assets from an affiliate and a bank’s extension of credit to an affiliate. 

The statute and regulation also require a bank to secure its extensions of credit to, 

and certain other covered transactions with, affiliates with prescribed amounts of 

collateral. 

In addition, section 23A and Regulation W contain an attribution rule, 

which provides that a transaction between a bank and a third party will be treated 

as a transaction between the bank and an affiliate to the extent that the proceeds of 

the transaction are used for the benefit of, or are transferred to, an affiliate of the 

bank. The attribution rule is intended, among other things, to prevent a bank from 

evading the restrictions in the statute and rule by using intermediaries and to limit 

the exposure that a bank has to customers of its affiliates. [Footnote 4. Begin text 

of Footnote 4. See 67 Federal Register 76,576 (December 12, 2002). End Footnote 4

Section 23A and Regulation W also specifically authorize the Board 

to exempt, in its discretion, transactions or relationships from the requirements of 

the statute and rule if the Board finds such exemptions to be in the public interest 

and consistent with the purposes of section 23A. 

The Reorganization Exemption 

Regulation W provides that a bank’s acquisition of securities issued 

by a company that was an affiliate of the bank before the acquisition is treated as 

a purchase of assets by the bank from an affiliate if (i) the company becomes an 
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operating subsidiary of the bank as a result of the transaction and (ii) the company 

has liabilities at the time of the acquisition. [Footnote 5. Begin text of Footnote 5. 

12 CFR 223.31(a). End Footnote 5.] Clearing is currently an affiliate of Bank. 

Clearing would be an operating subsidiary of Bank immediately after the 

reorganization, and Clearing would have liabilities at the time of the 

reorganization. Accordingly, ETFC’s contribution of all the equity interests 

of Clearing to Bank would be an asset purchase subject to the quantitative and 

qualitative limitations of section 23A and Regulation W. The value of the covered 

transaction under Regulation W would be approximately $6.5 billion – the total 

liabilities of Clearing at the time of the reorganization. Because the capital stock 

and surplus of Bank is approximately $2.2 billion, Bank’s quantitative limit per 

affiliate is approximately $220 million, and the proposed covered transaction 

would exceed Bank’s quantitative limits under section 23A and Regulation W. 

Bank has requested that the Board exempt the reorganization from 

section 23A and Regulation W. Although the Board has routinely granted 

exemptions for one-time corporate reorganizations, [Footnote 6. Begin text 

of Footnote 6. See, e.g., Board letters dated December 22, 2004, to Winthrop 

N. Brown, Esq. (HSBC Bank); and February 27, 2003, and August 28, 2001, to 

Carl Howard, Esq. (Citigroup). End Footnote 6.] the Board has not previously 

approved a section 23A exemption request that primarily facilitated the transfer 

of an SEC-regulated broker-dealer or of a company principally engaged in 

securities clearing when the transferred company would become a subsidiary 

of a bank. 

The reorganization would expose Bank to the credit, market, and 

operational risks associated with securities clearing. Securities clearing activities 

generate counterparty credit risks for the clearing firm. When a clearing firm 

clears a securities transaction on behalf of a customer, the firm commits on the 

trade date to the relevant securities clearinghouse either (i) to pay for the securities 

on the settlement date in the case of a purchase of securities by the firm’s customer 

or (ii) to deliver the securities on the settlement date in the case of a sale of 

securities by the customer. In other words, the clearing firm must either advance 

funds or securities on the settlement date regardless of whether the firm’s customer 

has provided the funds or delivered the securities to the clearing firm. Because of 

fluctuations in securities prices, the clearing firm may not be able to make itself 
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whole if a customer fails to deliver. Securities clearing firms are also exposed to 

substantial levels of operational risk. 

The reorganization also would result in a substantial portion of 

Bank’s assets residing in an SEC-regulated broker-dealer operating subsidiary. 

SEC-regulated broker-dealers are subject to the SEC’s prudential supervision and 

regulatory capital requirements. As a result, Bank may be unable to withdraw 

resources from Clearing if Bank suffers losses unrelated to Clearing. Bank is 

unlikely to have the same access to the capital invested in Clearing as Bank would 

have to the capital invested in an unregulated subsidiary. 

Although the type of entity proposed to become an operating 

subsidiary of Bank raises novel issues, the proposal is generally consistent with 

Board precedent. As in previous cases reviewed by the Board, the proposed 

transaction is part of a one-time internal reorganization. In addition, ETFC has 

committed that none of the assets transferred to Bank will be low-quality assets 

within the meaning of section 23A and Regulation W. ETFC also has committed 

that, for a two-year period following consummation of the proposal, it will make 

quarterly cash contributions to Bank equal to the full book value plus any writedowns taken by Bank of any transferred asset that becomes a low-quality asset 

during the quarter. Moreover, as discussed below, ETFC has committed that, 

without a time limit, the Affiliated Introducing Brokers will indemnify Clearing for 

all losses incurred by Clearing on margin loans made to their respective customers. 

This perpetual margin-loan indemnity goes well beyond the traditional two-year 

buyback commitment that the Board typically requires from holding companies in 

connection with internal reorganization exemptions. 

Clearing also has taken steps to mitigate the risk of its securities 

clearing activities. Most importantly, Clearing only provides clearing services 

to introducing brokers that either require customers to have sufficient cash or 

securities in their accounts before executing a cash transaction or operate on a 

“delivery versus payment” basis. Moreover, in the event of loss upon customer 

default, Clearing has access to several accounts that the Affiliated Introducing 

Brokers have established with Clearing to indemnify Clearing for such losses. 

In addition, although Clearing provides clearing and settlement services to two 

unaffiliated broker-dealers, these broker-dealers execute securities transactions 

only for others rather than for their own account. As a condition of the 

reorganization exemption, Clearing must continue to refrain from clearing 

securities transactions for broker-dealers trading for their own accounts. 
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Furthermore, Bank is well capitalized and well managed and would 

remain so on consummation of the proposal. Even if Bank deconsolidates Clearing 

and deducts from its tier 1 capital its equity investment in Clearing to reflect the 

difficulties Bank may have in withdrawing resources from Clearing if Bank is in 

financial distress, Bank would remain well capitalized. [Footnote 7. Begin text 

of Footnote 7. Bank also would remain well capitalized if Bank consolidated 

Clearing but deducted an amount from its tier 1 capital equal to the amount of 

Clearing’s SEC capital requirement. End Footnote 7.] As a condition of this 

exemption, Bank must remain well capitalized based on both (i) full consolidation 

of Clearing and (ii) deconsolidation of Clearing and deduction of Bank’s 

investment in Clearing (that is, a full deduction of Clearing’s assets from Bank’s 

balance sheet and a full deduction of Bank’s investment in Clearing from Bank’s 

tier 1 capital). [Footnote 8. Begin text of Footnote 8. In determining Bank’s 

risk-based capital ratios under the “deconsolidate and deduct” approach, 

Clearing’s off-balance-sheet exposures also would not be included in Bank’s 

risk-weighted assets. End Footnote 8.] As a final condition of the reorganization 

exemption, Clearing must inform its customers that customer funds held at 

Clearing are not covered by FDIC insurance to avoid customer confusion after 

Clearing becomes a subsidiary of Bank. 

The Margin-Loan Exemption 

As noted above, section 23A and Regulation W impose quantitative 

and qualitative limits on covered transactions between a bank and its affiliates 

and on covered transactions between a bank and any third party to the extent that 

the proceeds of the transactions are used for the benefit of, or transferred to, an 

affiliate of the bank. If Clearing becomes an operating subsidiary of Bank (and, 

accordingly, part of Bank for section 23A purposes), Clearing’s margin loans will 

generate covered transactions in the two situations discussed below. Clearing has 

requested exemptions for both of these covered transactions on an ongoing basis 

because it would be unable to continue its current volume of margin lending 

without the exemptions. 

The first covered transaction would occur when Clearing makes a 

margin loan to a customer who uses the loan proceeds to purchase securities from 
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an Affiliated Market Maker, which will fill the order with securities from its 

inventory. In this case, the proceeds of Clearing’s loan would be transferred to 

both (i) the Affiliated Market Maker, which would receive most of the proceeds of 

the loan as consideration for its sale of securities out of inventory to the customer, 

and (ii) the Affiliated Introducing Broker, which would receive a brokerage 

commission out of the loan proceeds. The second covered transaction would occur 

when Clearing makes a margin loan to a customer who uses the loan proceeds to 

purchase ETFC common stock in the secondary market (from a dealer other than 

the Affiliated Market Makers). In this case, a small portion of the proceeds of 

Clearing’s loan would be transferred to the Affiliated Introducing Broker in the 

form of a brokerage commission. [Footnote 9. Begin text of Footnote 9. 

Clearing’s margin loans for the purchase of ETFC common stock would generate 

covered transactions only to the extent that a portion of the proceeds of the loan 

flow to an Affiliated Introducing Broker as a commission. Because customers are 

only allowed to use a Clearing margin loan to buy affiliate-issued securities in the 

secondary market, the proceeds of these loans would never flow to the affiliated 

issuer of the securities. In addition, because neither Affiliated Market Maker 

makes a market in ETFC common stock (or any other affiliate-issued security), 

the proceeds of these loans would never flow to the Affiliated Market Makers. 

End Footnote 9.] 

As discussed above, section 23A and Regulation W limit the amount 

of covered transactions between a bank and any single affiliate to 10 percent of the 

bank’s capital stock and surplus and limit the amount of covered transactions 

between a bank and all its affiliates to 20 percent of the bank’s capital stock and 

surplus. As of June 30, 2006, Bank’s capital stock and surplus was approximately 

$2.2 billion, which would limit the Bank’s covered transactions with a single 

affiliate to $220 million and with all affiliates to $440 million. Given that 

Clearing’s margin-loan portfolio was approximately $6.7 billion as of June 30, 

2006, and that Bank expects approximately [XXX] percent of its margin loans to 

generate covered transactions, [Footnote 10. Begin text of Footnote 10. [redacted 

text of footnote] End Footnote 10.] Bank’s $[XXX] of margin-loan covered 
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transactions after the reorganization would represent about [XXX] percent of the 

bank’s capital stock and surplus. Accordingly, Bank has requested an exemption 

from the quantitative limits of section 23A and Regulation W for these ongoing 

transactions. 

The principal affiliate risk to Bank from Clearing’s margin-loan 

covered transactions is that Clearing might relax its margin-credit underwriting 

standards or lower its price of margin credit to generate revenues for, or otherwise 

provide support to, affiliates. In particular, Clearing could have incentives to 

extend imprudent margin credit to generate additional transaction fees for the 

Affiliated Market Makers or additional brokerage commissions for the Affiliated 

Introducing Brokers. Clearing also could have incentives to extend credit to help 

the Affiliated Market Makers liquidate undesirable inventory positions. 

In evaluating these potential risks, the Board has considered that 

(i) margin lending is a low-risk, highly collateralized form of lending; (ii) the 

bank’s credit exposure would be to thousands of unaffiliated investors (not to an 

affiliate); (iii) Clearing must abide by the best-execution rule under federal 

securities laws, which would help prevent Clearing from routing customer trades to 

an Affiliated Market Maker unless such routing produces the highest quality 

transaction for the customer; and (iv) the Affiliated Market Makers deal in highly 

liquid securities and rarely maintain overnight positions. 

Regulations governing the extension of margin loans by an 

SEC-registered broker-dealer (such as Clearing) mitigate the credit and market 

risks of those loans. The amount of leverage available to the customer is limited 

by the Board’s Regulation T (12 CFR part 220) and the margin-maintenance rule 

of the New York Stock Exchange (NYSE Rule 431). [Footnote 11. Begin text 

of Footnote 11. If the broker-dealer is not a member of the NYSE, the marginmaintenance rule of the NASD (NASD Rule 2520) generally would apply instead. 

Both rules impose the same leverage limitations. End Footnote 11.] For example, 

a customer who purchases $100 of equity securities in a margin account may borrow 

only 

in the margin account, the loan will be 200 percent collateralized at the time of the 

purchase of the securities because the market value of the securities is twice that 

of the margin loan. If, on a daily basis, the equity in the account falls below the 

required NYSE margin maintenance of 25 percent – that is, if the value of the 
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collateral falls below 133 percent of the loan – the customer is required to post 

additional cash or securities as collateral to eliminate the margin deficiency. 

[Footnote 12. Begin text of Footnote 12. The initial margin requirements of 

Regulation T, as well as the margin-maintenance requirements of the NYSE, 

for debt securities and options may differ from those applicable to equity securities. 

End Footnote 12.] If the customer does not meet the margin call within the required 

time, the broker-dealer must sell sufficient securities in the account to increase the 

account equity to the required maintenance level. 

Regulation T margin loans are typically collateralized by liquid and 

readily marketable securities and can be terminated on demand at any time by the 

broker-dealer lender. In addition, because of special provisions in the U.S. 

Bankruptcy Code for certain securities financing transactions, the collateral for 

a Regulation T margin loan should be available to the broker-dealer for prompt 

liquidation even in the event of the borrower’s bankruptcy. [Footnote 13. Begin 

text of Footnote 13. See Section 901(b) of the Bankruptcy Abuse Prevention and 

Consumer Protection Act of 2005; H.R. Rep. 109-31, 109th Cong., 1st Sess., p. 119 

(2005); In re Weisberg, 136 F.3d 655, 659 (9th Cir. 1998). End Footnote 13.] As 

noted above, Bank estimates that its average annual write-offs of margin loans have 

amounted to [XXX] percent during the last five years. [Footnote 14. Begin text of 

Footnote 14. [redacted text of footnote] End Footnote 14.]14 

The risk of loss is further mitigated by the fact that Clearing’s 

introducing brokers are required, under their respective clearing agreements, 

to cover losses incurred by Clearing on margin loans made to their customers. 

Each clearing agreement provides Clearing with three levels of protection against 

margin-loan losses. First, the introducing broker is required to maintain an escrow 

deposit account with Clearing to ensure payment for Clearing’s clearing services 

and also to ensure that Clearing does not suffer losses on margin loans to the 

introducing broker’s customers. Second, the clearing agreement provides that 

Clearing may net any margin-loan losses from the substantial amounts Clearing 

owes the introducing broker on a periodic basis. Finally, Clearing would have an 

unsecured claim against the introducing broker for any residual margin-loan losses. 
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Furthermore, the additional risks that result from affiliate involvement 

in Clearing’s margin-loan covered transactions are minimal. Importantly, the 

margin-loan covered transactions are not loans directly to an affiliate. As a 

consequence, Clearing does not have direct affiliate credit risk; rather, Clearing’s 

credit risk is dispersed among thousands of unaffiliated investors. 

Moreover, because ETFC does not provide investment advice to its 

securities brokerage customers, Clearing and the Affiliated Introducing Brokers 

would not be in a position to direct customers to purchase certain securities to 

help liquidate the specific inventory of an Affiliated Market Maker or to purchase 

additional securities more generally to generate commissions for its affiliates. In 

addition, because Clearing and Securities are SEC-registered broker-dealers and 

members of the NASD, they must comply with the best-execution rule, which 

prohibits them from steering orders to the Affiliated Market Makers if it is not 

in a 

Rule 2320(a). End Footnote 15.] Finally, [redacted text] [Footnote 16. Begin text 

of Footnote 16. [redacted text of footnote] End Footnote 16.] [Redacted text] 

[Footnote 17. Begin text of Footnote 17. [redacted text of footnote] End 

Footnote 17.] [Redacted text] [Footnote 18. Begin text of Footnote 18. [redacted 

text of footnote] End Footnote 18.] 

Although margin lending does involve some risk, the Board has 

granted exemptions from section 23A and Regulation W for similar highly 
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collateralized securities-financing transactions with affiliates. In particular, the 

Board has provided exemptions for securities-borrowing and securities-lending 

transactions between a bank and an affiliate.[Footnote 19. Begin text of 

Footnote 19. See Board letters dated June 7, 2005, to John H. Huffstutler, Esq. 

(Bank of America Corporation); May 5, 2005, to Michael M. Wiseman, Sullivan 

& Cromwell LLP (The Bank of New York Company); and October 31, 2001, to 

Marjorie Gross, Esq. (J.P. Morgan Chase & Co.). End Footnote 19.] In this case, 

the risks are mitigated in part by the fact that the margin-loan covered transactions 

expose the bank to the diversified credit risk of thousands of unaffiliated borrowers 

rather than to a single borrower and that the margin-loan covered transactions 

generally are subject to a higher margin-maintenance requirement than in the 

securities-borrowing and securities-lending transactions. 

The Board also notes that section 23A and Regulation W contain 

an exemption for the purchase by a bank from an affiliate of assets that have a 

readily identifiable and publicly available market quotation. This statutory 

exemption does not apply by its terms to Bank’s margin-loan covered transactions 

because the bank is making a loan to fund a third party’s purchase of an asset from 

an affiliate rather than directly purchasing an asset from an affiliate. Nevertheless, 

this exemption evidences a Congressional intent not to impede bank-affiliate 

transactions involving liquid assets. 

Approval of this request for an ongoing exemption is subject to the 

condition that the exemption applies only to margin loans (i) made by Clearing 

(not Bank or any other affiliate); (ii) subject to the initial margin requirements of 

Regulation T; and (iii) subject to the ongoing margin-maintenance requirements of 

NYSE Rule 431. Because Clearing would have significant levels of margin-loan 

covered transactions after the reorganization, the exemption also would be 

conditioned on Bank’s remaining well capitalized based both on a full 

consolidation of Clearing and a deconsolidation of Clearing and deduction of 

Bank’s investment in Clearing (as discussed above). 

Conclusion 

Granting the exemptions would benefit the public because cost and 

operational efficiencies would result from Bank’s maintaining Clearing as a 

subsidiary. ETFC has stated that it would be able to pass on a portion of those 
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savings to customers in the form of lower brokerage commissions, higher yields on 

deposit products, additional product innovation, or enhanced product functionality 

and customer service. 

In light of these considerations and all the facts presented, the 

transactions appear to be consistent with safe and sound banking practices and the 

purposes of section 23A. Accordingly, the Board hereby grants the requested 

exemptions, subject to the conditions and limits discussed above and in your 

correspondence with the Board. 

The determinations above are specifically conditioned on compliance 

by ETFC and Bank with all the commitments and representations made to the 

Board in connection with the exemption requests. These commitments and 

representations are deemed to be conditions imposed in writing by the Board in 

connection with granting the requests and, as such, may be enforced in proceedings 

under applicable law. The determinations are based on the specific facts and 

circumstances of the transactions described in your correspondence and this letter. 

Any material change in those facts and circumstances or failure by ETFC or Bank 

to observe any of the commitments or representations may result in a different 

determination or in the revocation of the exemptions. 

Very truly yours, 

(signed) 

Robert deV. Frierson 

Deputy Secretary of the Board 

cc: Federal Reserve Bank of Richmond 

Office of Thrift Supervision 

Federal Deposit Insurance Corporation