```
[Federal Register Volume 62, Number 249 (Tuesday, December 30, 1997)]
[Proposed Rules]
[Pages 67996-68011]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33401]

[[Page 67996]]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-39455; File No. S7-31-97]
RIN 3235-AG18

Net Capital Rule

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
proposing for comment amendments to Rule 15c3-1 (``net capital rule'' 
or ``Rule'') under the Securities Exchange Act of 1934 (``Act''), 
regarding the Commission's capital requirements for broker-dealers. The 
proposed amendments, if adopted, would alter the charges, or 
``haircuts,'' from net worth in computing net capital for certain 
interest rate instruments, including government securities, investment 
grade nonconvertible debt securities, certain mortgage-backed 
securities, money market instruments, and debt-related derivative 
instruments.

DATES: Comments must be received on or before March 30, 1998.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, 
N.W., Stop 10-9, Washington, D.C. 20549. Comments also may be submitted 
electronically at the following E-mail address: [email protected]. 
All comment letters should refer to File No. S7-31-97. All comments 
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. Electronically submitted comment letters will be posted on 
the Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Michael A. 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; 
Christopher M. Salter, Attorney, at 202/942-0148; or Gary Gregson, 
Statistician, at 202/942-4156; Office of Risk Management and Control, 
Division of Market Regulation, Securities and Exchange Commission, 450 
Fifth Street, N.W., Mail Stop 2-2, Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction.

    The Commission's net capital rule, Rule 15c3-1, is intended to 
ensure that broker-dealers have sufficient liquid capital to protect 
the assets of customers and to meet their responsibilities to other 
broker-dealers.1 When calculating the value of their assets 
for the purposes of establishing their net capital under Rule 15c3-1, 
broker-dealers must reduce the market value of the securities they own 
by certain percentages, or haircuts. Reducing the value of securities 
owned by broker-dealers for net capital purposes provides a capital 
cushion against adverse market movements and other risks faced by the 
firms, including liquidity and operational risks.2
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    \1\ 17 CFR 240.15c3-1
    \2\ Liquidity risk is the risk that a firm will not be able to 
unwind or hedge a position. Operational risk is the risk of 
financial loss to the firm from human error or defects in 
maintaining the firm's operating systems.
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    The amendments proposed in this release (the ``Proposed 
Amendments'') would change the haircuts applicable to most interest 
rate instruments held in a broker-dealer's proprietary account. The 
Proposed Amendments are similar in scope to the ``standard approach'' 
adopted by the Basle Committee on Banking Supervision (``Basle 
Committee'') in its amendments to the Basle Capital Accord for market 
risk arising from interest rate products.3 The amendments 
adopted by the Basle Committee are discussed more fully in the text 
below.
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    \3\ The Governors of the G-10 countries established the Basle 
Committee on Banking Supervision in 1974 to provide a forum for 
ongoing cooperation among member countries on banking supervisory 
matters.
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A. Fixed Income Products Proposal

    The Commission is proposing for comment an amendment to the net 
capital rule regarding the method of computing the haircuts applicable 
to interest rate products. The Proposed Amendments would treat most 
types of interest rate products as part of a single portfolio. Under 
the Proposed Amendments, the net capital rule would recognize various 
hedges among a portfolio of government securities,4 
investment grade nonconvertible debt securities (or corporate debt 
securities), Pass-Through Mortgage-Backed Securities,5 
repurchase and reverse repurchase agreements, money market 
instruments,6 and futures and forward contracts on these 
debt instruments, and other types of debt-related derivatives (``Fixed 
Income Products''). Consequently, the Proposed Amendments should better 
match capital charges with actual market risk hedging practices 
employed by broker-dealers. One result of the Proposed Amendments is 
that positions may be moved into a registered broker-dealer from an 
unregistered affiliate to take advantage of the single portfolio 
concept in calculating haircuts, which should reduce capital 
charges.7
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    \4\ 15 U.S.C. 78c(a)(42).
    \5\ For the purposes of the proposed Rule, ``Pass-Through 
Mortgage-Backed Securities'' means any security issued under the 
sponsorship of the United States or any agency thereof that 
represents a pro rata interest or participation in the principal and 
interest cash flows generated by a pool of mortgage loans of which 
at least 95% of the aggregate principal is composed of fixed rate 
residential mortgage loans on one to four family homes, including 
five and seven year mortgage loans with balloon payments at 
maturity. Under the proposed rule, multifamily, adjustable rate, 
commercial, and mobile home mortgage loans are not considered Pass-
Through Mortgage-Backed Securities.
    \6\ Money market instruments are defined in the Proposed 
Amendments as commercial paper rated in one of the three highest 
categories by at least two nationally recognized statistical rating 
organizations, and negotiable certificates of deposit and bankers 
acceptances issued by a bank as defined in Section 3(a)(6) of the 
Act.
    \7\ In a companion release being issued contemporaneously with 
this release, the Commission is proposing a limited regulatory 
system for a class of registered dealers active in over-the-counter 
derivatives markets that will provide additional incentives to move 
positions out of an unregistered affiliate into a registered broker-
dealer. For example, the Commission is proposing to allow these 
dealers to use value-at-risk models for determining market risk 
capital charges. These models would recognize more offsetting among 
positions than the approach being proposed in this release. 
Securities Exchange Act Release No. 34-39454 (December 17, 1997).
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    Haircuts for municipal securities and non-investment grade debt 
securities are not included in the Proposed Amendments. Municipal 
securities would be treated separately under the net capital rule 
because their market price depends on tax issues to a much greater 
extent than other debt instruments. Non-investment grade debt 
securities are excluded from the Proposed Amendments because their 
price movements tend to be based primarily on issuer-specific factors, 
much like equity securities. In addition, the Proposed Amendments will 
not recognize hedges among interest rate instruments denominated in 
different currencies because available evidence suggests that while 
correlations of interest rate products denominated in different 
currencies are generally positive, they are relatively low compared 
with correlations for securities denominated in the same currency. 
Therefore, broker-dealers would be required to separately calculate for 
each currency their haircuts for Fixed Income Products denominated in 
that currency.
    The Commission requests comment regarding the Proposed Amendments, 
and in particular, solicits comment on whether the Proposed Amendments

[[Page 67997]]

comport with how broker-dealers currently hedge their positions in 
interest rate products, what instruments are used to hedge interest 
rate risk, how capital charges for Fixed Income Products will differ 
for particular firms under this proposal from the current Rule, and 
alternative methods of calculating haircuts on interest rate products.

B. Background

    The Commission is proposing for comment the Proposed Amendments as 
the result of its efforts with the Basle Committee and the 
International Organization of Securities Commissions (``IOSCO'') to 
develop a consensus among different countries on the conceptual 
framework underlying capital standards for interest rate instruments. 
In 1988, the Basle Committee adopted its Capital Accord regarding a 
minimum risk-based capital framework for banks. At that time, the 
Capital Accord was designed primarily to deal with the credit risk in a 
bank's loan portfolio, but the Basle Committee recognized that the 
capital adequacy portion of the Capital Accord would have to be 
broadened to cover market risk.8
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    \8\ The Basle Accord is a common measurement system and a 
minimum standard for capital adequacy of international banks in the 
Group of Ten countries.
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    In January 1996, the Basle Committee amended its Capital Accord to 
include a comprehensive system of capital charges based on the market 
risk in a bank's securities trading portfolio. Under the Capital 
Accord, subject to the approval of applicable national banking 
authorities, a bank may choose from two alternative methods for 
calculating its market risk capital requirement. One method bases the 
capital charges on a table of fixed-percentage charges similar to the 
Proposed Amendments. The other method approved by the Basle Committee 
allows certain banks to use value-at-risk models for calculating their 
market risk capital requirements.
    In May 1993, the Commission issued a Concept Release 9 
soliciting comments on alternative methods for computing haircuts on 
derivative financial instruments. Despite that release's focus on 
derivative financial instruments, the Commission intended to commence a 
broader dialogue with the industry regarding how the Rule could better 
reflect the market and credit risks inherent in a broker-dealer's 
proprietary securities portfolio. At that time, the Commission 
envisioned a multi-step revision of the net capital rule that would 
substantially change how broker-dealers calculate market and credit 
risk haircuts arising from their proprietary positions.
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    \9\ Securities Exchange Act Release No. 32256 (May 4, 1993), 58 
FR 27486 (May 10, 1993) (``Concept Release'').
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    In 1995, the Commission received the Framework for Voluntary 
Oversight of the Derivatives Policy Group (``DPG''), consisting of the 
six U.S. securities firms most active in the over-the-counter (``OTC'') 
derivatives market. The DPG agreed to four major subjects of controls: 
management controls, enhanced reporting, evaluation of risk in relation 
to capital, and counterparty relationships. The DPG's evaluation of 
risk envisioned a capital-at-risk computation that would enable the 
Commission to assess the market risk in each firm's OTC derivative 
positions.
    At about the same time, the Commission proposed for comment 
amendments to the net capital rule that would allow broker-dealers to 
use a theoretical option pricing model to determine capital charges for 
listed equity and currency options, and related positions.10 
At that time, the Commission also authorized the Division of Market 
Regulation (``Division'') to issue a no-action letter that permitted 
broker-dealers to use the theoretical option pricing model to calculate 
haircuts for listed options and related positions. In February 1997, 
the Commission adopted final amendments to the net capital rule, 
substantially as proposed, that allow firms to use theoretical option 
pricing models in determining net capital requirements for listed 
options and related positions.11
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    \10\ Securities Exchange Act Release No. 33761 (March 15, 1994), 
59 FR 13275 (March 21, 1994).
    \11\ Securities Exchange Act Release No. 38248 (February 6, 
1997), 62 FR 6474 (February 12, 1997).
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    The Commission has also issued a concept release simultaneously 
with this release that requests comment on how the net capital could be 
amended, including whether statistical models should be used for 
regulatory capital purposes.12 The method for calculating 
haircuts on Fixed Income Products proposed in this release represents 
one alternative for amending the Commission's net capital rule.
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    \12\ Securities Exchange Act Release No. 34-39456 (December 17, 
1997).
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II. Fixed Income Products

A. Current Haircut Treatment of Debt Securities

    Haircut charges on interest rate securities are based on their 
residual times to maturity and credit quality. This results in 
securities with longer residual maturities receiving greater haircuts 
than similar securities with shorter residual maturities. The charges 
on adjustable rate debt securities are based generally on residual 
maturity. The current Rule divides interest rate securities into 
categories and subcategories. The current Rule permits complete or 
partial netting (depending on the type of security) within a 
subcategory, and it permits lesser netting within and between 
categories.
    Haircuts for each type of interest rate security (e.g., government, 
municipal, and nonconvertible debt securities) are computed separately 
from other types of interest rate securities, with limited exceptions, 
restricting a broker-dealer's ability to reduce its haircut on 
offsetting positions among different types of securities. For example, 
the net capital charges for portfolios of government securities tend to 
be lower than for other debt instruments because of significant, if not 
complete, hedging allowances among government securities. The current 
net capital rule recognizes to a lesser extent hedges between corporate 
bonds and government securities.13
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    \13\ 17 CFR 240.15c3-1(c)(2)(vi)(F)(3).
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B. The Proposed Amendments

1. General Description
    Under the Proposed Amendments, a broker-dealer would calculate two 
haircuts on its Fixed Income Products: a General Market Risk Charge and 
a Specific Market Risk Charge.14 General market risk is the 
risk that the price of the Fixed Income Product will change because of 
market-wide changes in interest rates. The General Market Risk Charge 
is intended to cover market risk factors common among different types 
of interest rate instruments. Specific market risk is the risk of an 
adverse price movement for a security which is unique to a particular 
issue, but differs from a credit risk charge based on the risk that a 
counterparty will not be able to fulfill its obligations.
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    \14\ Appendix I is an example demonstrating how the haircuts are 
calculated on a hypothetical portfolio under the Proposed 
Amendments.
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    By separating the haircut for Fixed Income Products into two 
components, the Proposed Amendments recognize offsetting among the 
changing market values of many different types of securities, such as 
government securities and corporate debt, arising from general market-
wide changes in interest rates, and use the Specific Market Risk Charge 
to capture risk that is not offset through these hedges.
2. General Market Risk Charge
    Under the Proposed Amendments haircuts on unhedged positions in 
Fixed Income Products would not change

[[Page 67998]]

significantly from the current net capital rule. However, as noted 
above, Fixed Income Products under the proposal would be treated as 
part of a single portfolio which would allow for greater hedging 
benefits when calculating the General Market Risk Charge than under the 
current Rule. In general, most Fixed Income Products would be slotted 
into five maturity bands, or zones, and fifteen sub-zones based on 
their residual maturity.15 For each sub-zone or zone, there 
would be an associated haircut with offsets across different 
maturities.
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    \15\ The zone and sub-zone grid may be found in section 
vi(A)(3)(i)(A) of the Proposed Amendments.
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    Similar to the current net capital rule, the Proposed Amendments 
would impose progressively larger haircuts as the securities increase 
in maturity. This recognizes that the price volatility of Fixed Income 
Products generally increases as their residual maturity increases. 
Further, the Proposed Amendments assume that short and long term 
interest rates tend to move together and that a movement in the market 
value of a Fixed Income Product with a short residual maturity will, to 
some degree, be offset by the price movement in the market value of an 
opposite position in a Fixed Income Product with a longer residual 
maturity. However, the degree to which prices of Fixed Income Products 
with different maturities move in the same direction after a change in 
interest rates is smaller as their residual maturities get farther 
apart. In other words, the price movements of debt instruments of 
similar residual maturities are more highly correlated than the price 
movements of debt instruments with significantly different residual 
maturities.
    The calculation of the General Market Risk Charge incorporates the 
assumptions described above regarding the correlation of debt 
instruments based on residual maturity. Offsetting positions in Fixed 
Income Products positions with the same residual maturities are subject 
to a haircut. Any remaining amounts not offset within the same sub-zone 
may then be netted against positions with different residual 
maturities, albeit with greater haircuts. Essentially, this method of 
calculating haircuts for a mixed portfolio is designed to account for 
risk across the interest rate curve and the basis risk for those 
securities which are closely related in maturity.
    Prior to calculating the General Market Risk Charge, a broker or 
dealer must place each long or short Fixed Income Product into one of 
15 designated sub-zones. The use of 15 sub-zones provides for a capital 
cushion for offsetting positions with significantly different residual 
maturities and reflects the fact that prices of Fixed Income Products 
tend to move at increasingly different rates when their residual 
maturities are further apart.
    Fixed Income Products, with certain exceptions, are placed into the 
sub-zones based on residual maturity, while certain variable rate 
instruments are categorized by the time to their Next Interest Reset 
Date.16 By categorizing Fixed Income Products other than by 
residual maturity, the Proposed Amendments may more accurately group 
Fixed Income Products with similar market risks into the same sub-zone. 
Mortgage-Backed Pass-Through Securities fit into the sub-zones based on 
their market value relative to par value. Deep discount bonds (which 
include bonds that do not pay current interest) are slotted into one of 
two sub-zones that apply only to deep discount bonds. Each leg of an 
interest rate swap is translated into a synthetic bond with a market 
value equal to the value of the notional coupon and a maturity equal to 
the residual maturity of the swap or the time until the Next Interest 
Reset Date, if appropriate. These synthetic bonds then are placed into 
the sub-zones like any other Fixed Income Product.17
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    \16\ Next Interest Rate Reset Date means the maturity date of 
the instrument or, if earlier, the next date as of which the 
interest rate on the instrument is subject to being either increased 
or decreased, as applicable, by an amount that is at least 0.5% 
greater or lesser than the current interest rate on the instrument. 
The requirement that the rate be able to move by at least 0.5% 
excludes those securities that are at or near their rate cap and 
therefore tend to behave like a fixed rate security.
    \17\ The reasons for slotting these assets into the sub-zones 
other than by residual maturity is explained in further detail in 
Section II.C. of this release.
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    The General Market Risk Charge is defined as the sum of (A) the 
Sub-Zone Charges, (B) the Zone Charges, (C) the Between Zone Charges, 
and (D) the Residual Charge, each of which is described below.
    The percentage haircut for particular sub-zones, or market risk 
weight, ranges from 0 percent for a Fixed Income Product with one month 
or less to maturity to 12 percent for deep discount bonds with more 
than 20 years to maturity. These percentages were developed based on 
two components. The first component is the modified duration of a bond 
with a maturity equal to the mid-point of the respective sub-zone, 
assuming an 8 percent interest rate environment and an 8 percent 
coupon. The second component is an assumed change in yield that is 
designed to cover about two standard deviations of one month's yield 
volatility in most major markets. The two components are multiplied to 
give a percentage weighting factor for each sub-zone.
    a. Sub-Zone Charge. Because most hedged positions among Fixed 
Income Products are not perfect hedges, the Proposed Amendments place a 
charge, the Sub-Zone Charge, on hedged positions to reflect the broker-
dealer's residual exposure to market risk from the hedge. The Sub-Zone 
Charge is calculated in two steps. The first step is to calculate the 
Sub-Zone Charge for offsetting swap positions, and the second step is 
to calculate the Sub-Zone Charge for other offsetting positions within 
the same sub-zone. The Sub-Zone Charge for offsetting swaps is 
calculated separately from other offsetting positions because of the 
significantly higher degree of correlation among offsetting swaps 
positions compared to hedges among other types of debt instruments.
    The Sub-Zone Charge for offsetting swaps applies only to hedged 
positions exclusively between interest rate swaps in the same sub-zone. 
The Sub-Zone Charge for offsetting swap positions is determined by 
multiplying the lesser value of the long or short swap positions in 
each sub-zone by the applicable sub-zone percentage; then multiplying 
that product by one percent. The remaining swap positions are then 
combined with other Fixed Income Product positions in that sub-
zone.18
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    \18\ For example, if a broker-dealer had a $20 million long swap 
position and a short swap position of $30 million in sub-zone (ii), 
the sub-zone disallowance for offsetting swaps would be equal to the 
product of $20 million  x  0.2% x 1% (or $400); the difference 
between the $30 million short position and the $20 million long 
position would be added to the aggregate value of the broker-
dealer's short positions in other securities in sub-zone (ii) for 
the purposes of calculating the sub-zone disallowance for other 
securities.
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    The Sub-Zone Charge for positions other than swaps is calculated by 
multiplying the lesser value of the long or short positions in each 
sub-zone by the applicable sub-zone percentage; and then multiplying 
that product by five percent. The sum of the Sub-Zone Charge for 
offsetting swaps and the Sub-Zone Charge for other positions, for each 
sub-zone, is the total Sub-Zone Charge. The difference between the 
aggregate values of the long and short positions in these Fixed Income 
Products in each sub-zone (the unhedged amount), multiplied by the 
applicable sub-zone percentage, is the Long or Short Sub-Zone Carry-
Forward

[[Page 67999]]

Amount for each sub-zone.19 The Sub-Zone Carry-Forward 
Amounts are used to calculate the Zone Charge.
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    \19\ For example, a broker-dealer that has positions in sub-zone 
(ii) other than swap positions, equal to a long position of $10 
million, a short position of $5 million, and $2 million in a non-
offsetting short swap position that carried forward, the sub-zone 
disallowance would be equal to $7 million  x  0.2% x 5% (or $700). 
The Long Sub-Zone Carry-Forward Amount would be $3 million  x  0.2% 
(or $6,000).
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    b. Zone Charge. Similar to the Sub-Zone Charge, the Zone Charge is 
the haircut on hedged positions within the same zone. Because there 
will be greater disparity among the residual maturities of these 
positions, the percent charge for these offsetting positions is higher 
than the Sub-Zone Charge.
    In calculating the Zone Charge, the Long and Short Sub-Zone Carry 
Forward Amounts for each zone are totaled separately and are identified 
respectively as the Long and Short Zone Positions. The Zone Charge for 
each zone equals the lesser of the Long or Short Zone Positions for 
each Zone multiplied by the percentage set forth in the Rule's Zone 
Charge provisions.20 The difference between the Long and 
Short Zone Positions in each zone (the unhedged amount) is called the 
Long or Short Zone Carry-Forward Amount for that zone and is used to 
calculate the Between Zone Charge.21
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    \20\ See paragraph (c)(2)(vi)(A)(3)(iii)(A) of the Proposed 
Amendments.
    \21\ If in Zone 1, a firm had a $10,000 Long Sub-Zone Carry-
Forward Amount from sub-zone (ii), and a $4,000 Short Sub-Zone 
Carry-Forward Amount from sub-zone (iii), the Zone Charge would be 
$4,000 x 0.25 (or $1,000). The Long Zone Carry-Forward Amount would 
be $10,000 less $4,000, or $6,000.
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    c. Between Zone Charge. The Between Zone Charge is the charge for 
offsetting positions in different zones. As the disparity between the 
residual maturities of the hedged positions grows, the percentage 
charge increases because the positions reflect increasingly imperfect 
hedges. Calculating the Between Zone Charge requires two separate 
computations: one for adjacent zones and the other for non-adjacent 
zones. Because the difference in the residual maturities of offsetting 
positions in non-adjacent zones may be much greater than between 
positions in adjacent zones, the charges are greater for offsetting 
positions in non-adjacent zones.
    The Between Zone Charge for adjacent zones is arrived at by 
multiplying the lesser of the Long or Short Zone Carry-Forward Amounts 
in two adjacent zones by the Between Zone Charge 
percentages.22 The difference between the Long and Short 
Zone Carry-Forward Amount in two adjacent zones (the unhedged amount) 
may be used to offset positions in other adjacent zones. Any remaining 
Long and Short Zone Carry-Forward Amounts not offset by amounts in 
adjacent zones is called the Long or Short Between Zone Carry-Forward 
Amount.
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    \22\ See paragraph (c)(2)(vi)(A)(3)(iv)(A) of the Proposed 
Amendments.
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    The Between Zone Charge for non-adjacent zones is arrived at by 
multiplying the lesser of the Long or Short Between Zone Carry-Forward 
Amounts by the Between Non-Adjacent Zone Charge 
percentages.23 Generally, this permits a substantial amount 
of netting on a weighted basis among positions that vary in maturities, 
some as far apart as twenty years.
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    \23\ If a broker-dealer had a Long Zone Carry-Forward Amount of 
$6,000 from Zone 1 and a Short Zone Carry-Forward Amount of $10,000 
from Zone 2, the Between Zone Disallowance would be $6,000 x 50% (or 
$3,000). The remaining Short Zone Carry-Forward Amount from Zone 2 
($4,000) may be used to offset long amounts in Zone 3 or Zone 4.
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    d. Residual Charge. The Residual Charge consists of any remaining 
Between Zone Carry-Forward Amounts that have not been offset. For the 
purposes of the Proposed Amendments, these are the equivalent of 
unhedged positions.
    The Commission requests comment on the Sub-Zone, Zone, Between Zone 
and Residual Charges, and how these Charges may be modified.
3. Specific Market Risk Charge
    Fixed Income Products, with the exception of government securities 
and synthetic bond positions, are subject to a Specific Market Risk 
Charge. A broker-dealer's total Specific Market Risk Charge is the sum 
of the charges for each individual Fixed Income Product. The Specific 
Market Risk Charge is intended to address issuer-related and liquidity 
risks associated with the underlying instruments. There is no need for 
this Charge for synthetic bonds which do not have identifiable specific 
risks. This Charge, as noted above, has no relationship to a credit 
charge for counterparty risk in derivative non-exchange traded 
instruments.
    The Specific Market Risk Charge is a prescribed percentage of the 
market value of the instrument. The two factors used in determining the 
percentage rate for this Charge are the maturity of the instrument and 
whether its interest rate is fixed or adjustable.
    The Specific Market Risk Charge may not be reduced by offsetting 
positions in different securities of the same issuer or securities of 
different issuers because these securities and issuers may have 
different liquidity and issuer risks which might prevent correlated 
market movements.

C. Treatment of Specific Fixed Income Products

    Provided below is a description of how haircuts are presently 
calculated for the various types of Fixed Income Products affected by 
the proposed amendments and how the haircuts for those Fixed Income 
Products would be calculated under the Proposed Amendments. The 
Commission request comment on the proposed net capital treatment of 
each of the interest rate instruments discussed below.
1. Government Securities
    Currently, the government securities haircut schedule, set forth in 
paragraph (c)(2)(vi)(A) of the Rule, separates government securities 
into four categories and twelve subcategories. Each subcategory 
includes a prescribed band of maturities.24 The haircut for 
each subcategory, assuming no other netting, is the net position in a 
particular subcategory multiplied by a specified percentage, or 
haircut.25 The haircuts for government securities range from 
0 percent for securities with a residual maturity of less than three 
months to 6 percent for securities with a residual maturity of 25 years 
or more. The charge for each category is the net of the aggregate 
charges on the long subcategory positions and the aggregate charges on 
the short subcategory positions in the category plus 50 percent of the 
lesser of the aggregate charges on the long or short 
positions.26 For example, under the current Rule, a firm 
with a $40,000,000 long position in government securities with 16 
months remaining maturity and a $10,000,000 short position in 
government securities with 30 months remaining maturity (both category 
2 government securities), would take the following deduction for 
category 2:
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    \24\ Category 1 covers securities with a residual maturity of 
less than 12 months to maturity. Category 2 covers securities from 1 
year to 3 years. Category 3 covers securities from 3 years to 10 
years. Category 4 covers securities over 10 years.
    \25\ For example, the haircut for a broker-dealer with a $7 
million long position and a $4 million short position in Treasuries 
with remaining maturities between 9 months and one year would be $3 
million multiplied by 1%, or $30,000.
    \26\ See the text.

[[Page 68000]]

----------------------------------------------------------------------------------------------------------------
                             Long                                   Short            Net         %      Haircut 
----------------------------------------------------------------------------------------------------------------
(i) 40,000,000                                                                     40,000,000    1.5     600,000
(ii)                                                             (10,000,000)    (10,000,000)    2.0   (200,000)
                                                                                                     -----------
                                                                                                         400,000
      200,000 x 50%=                                                                                     100,000
                                                                                                     -----------
      Total Deduction                                                                                    500,000
----------------------------------------------------------------------------------------------------------------

This treatment allows partial netting of long and short positions 
within a category. The current Rule also allows further netting of a 
position within one category and one in an adjacent category under 
certain circumstances, and permits the partial netting of certain 
corporate securities with government securities within certain limits. 
In sum, the current Rule permits limited offsets within categories, and 
complete offsets for certain offsetting long and short positions (e.g., 
those in the same subcategory). A broker-dealer that has been 
designated as a primary dealer by the Federal Reserve Bank of New York 
may reduce its haircut charges on government securities by 25 percent 
if it maintains a minimum tentative net capital of at least $50 
million.27
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    \27\ 17 CFR 240.15c3-1(c)(vi)(A)(5).
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    Under the Proposed Amendments, government securities would not be 
subject to a Specific Market Risk Charge. With respect to the General 
Market Risk Charge, under the Proposed Amendments, government 
securities generally would be placed into one of the fifteen sub-zones 
based on residual time to maturity. Because the Proposed Amendments 
adopt a portfolio view for calculating haircuts by allowing all types 
of Fixed Income Products (with certain exceptions) to be combined into 
the same sub-zones, the Proposed Amendments would expand the ability of 
firms to hedge positions in government securities with other types of 
interest rate instruments.
2. Investment Grade Nonconvertible Debt Securities and Money-Market 
Debt Instruments
    The current formula for determining haircuts for investment grade 
nonconvertible debt securities, consisting primarily of corporate debt 
securities, separates bonds into nine different categories based on 
residual maturity.28 To be treated as an investment grade 
nonconvertible debt security, the security must not be traded flat or 
in default as to principal or interest and must be rated in one of the 
four highest rating categories by at least two nationally recognized 
statistical rating organizations. Charges range from 2 percent for 
securities with less than 1 year residual maturity to 9 percent for 
securities with a residual maturity of 25 years or greater. The charge 
is applied to the greater of the long or short position in each 
category. Firms may also partially offset investment grade 
nonconvertible debt securities with government securities or other 
corporate securities with similar residual maturities.
---------------------------------------------------------------------------

    \28\ 17 CFR 240.15c3-1(c)(2)(vi)(F). Paragraph (c)(2)(vii) of 
the Rule regarding non-marketable securities would still apply to 
all inventory.
---------------------------------------------------------------------------

    Under the Proposed Amendments, investment grade nonconvertible debt 
securities as well as commercial paper, bankers acceptances, and 
certificates of deposit would be subject to the Specific Market Risk 
Charge as well as the General Market Risk Charge. The criteria for 
determining whether the paper is investment grade would be the same as 
under the current net capital rule. The Specific Market Risk Charge for 
fixed rate investment grade nonconvertible debt ranges from 0.25 
percent to 1.6 percent. As with government securities, fixed rate 
investment grade nonconvertible debt would be placed into the sub-zones 
based on residual maturity to compute the General Market Risk Charge.
    Adjustable rate investment grade nonconvertible debt would be 
placed into the sub-zones generally based on the time to the Next 
Interest Reset Date if the interest rate on the instrument may be 
either increased or decreased, as applicable, by at least 0.5 percent. 
An adjustable rate investment grade nonconvertible debt instrument that 
is within 0.5 percent of its rate cap would be placed into the sub-
zones based on its residual maturity. That instrument, although 
technically a variable rate instrument, would tend to behave like a 
fixed rate instrument given a change in interest rates.
    Zero coupon and deep discount bonds 29 with residual 
maturities of six years or greater would be slotted, based upon 
residual maturity, into higher sub-zones than their residual 
maturities. Since their prices tend to be more volatile than coupon 
bonds of the same maturity, simply slotting such bonds according to 
residual maturity would underestimate risk and allow offsetting between 
positions that have substantially different risk profiles.
---------------------------------------------------------------------------

    \29\ Deep discount bonds are defined generally as Fixed Income 
Products that either do not pay interest or are priced at 50% or 
less of their par value. See paragraph (c)(2)(vi)(A)(4)(iv) of the 
Proposed Amendments.
---------------------------------------------------------------------------

3. Pass-Through Mortgage-Backed Securities
    Under the current net capital rule, mortgage-backed securities 
issued or guaranteed as to principal or interest by the United States 
or any agency thereof are treated as U.S. Government securities for the 
purposes of calculating haircuts. As with Treasury securities and other 
government securities, the current net capital rule bases the charges 
for mortgage-backed securities on their residual maturity and allows 
the securities to be offset against other government securities with 
similar residual maturities.
    Mortgage-backed securities present particularly difficult net 
capital problems because partial payments of principal are generally 
made on a routine basis and often the entire principal is paid at an 
early stage in the maturity of the instrument. These principal payments 
or probabilities of prepayment drastically change the effective 
maturity of these instruments. Because the current Rule bases the 
charges for mortgage-backed securities on residual maturity rather than 
on criteria that better reflect their price volatility and duration, 
the haircut may overstate the risk on individual positions, and 
understate the risk on positions considered hedged by the Rule which 
may in fact not be adequately hedged. For example, the net capital rule 
may impose a large haircut on a position in mortgage-backed securities 
with a small duration but a long residual maturity but impose no charge 
for a position in the same mortgage-backed security hedged with a 
Treasury security with a similar residual maturity but with a longer 
duration.
    It has been argued that a mortgage-backed security with a 
relatively high coupon rate should experience a significant amount of 
prepayment of principal and, consequently, will tend to act more like a 
security with less time

[[Page 68001]]

to maturity. Based on the apparent correlation between the price of an 
instrument and its probable maturity, the Division issued a no-action 
letter permitting firms to place certain mortgage-backed securities 
into the government securities haircut categories of the current net 
capital rule based on their market price relative to their par 
value.30
---------------------------------------------------------------------------

    \30\ Letter regarding Pass-Through Mortgage Securities (December 
30, 1996).
---------------------------------------------------------------------------

    The proposed rule incorporates this approach and allows firms to 
hedge Pass-Through Mortgage-Backed Securities 31 against 
other Fixed Income Products, consistent with the general intent to 
allow some hedging of all interest rate instruments.
---------------------------------------------------------------------------

    \31\ Supra note 5.
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4. Futures and Forwards
    The current net capital rule provides that capital charges for 
futures contracts are based on the margin requirement of the applicable 
commodity clearing organization, although these positions may be 
inserted into the present grid and treated like securities positions. 
The capital charge for forward contracts on securities is based on the 
underlying instrument.32 There also are allowances made for 
offsetting positions under prescribed circumstances.
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    \32\ The general net capital treatment of forwards on 
commodities (other than foreign currencies) is set forth in Appendix 
B of Rule 15c3-1. Broker-dealers must deduct 20% of the market value 
of uncovered forward contracts to account for market risk. Broker-
dealers incur no market risk deduction if the forward is currently 
registered as deliverable on a contract market and is covered by an 
open futures contract or by a commodity option on a physical. 
Broker-dealers incur a market risk deduction of 10% for other 
forward contracts to purchase or sell commodities which are not 
registered as deliverable that are covered by an open futures 
contract.
---------------------------------------------------------------------------

    As proposed herein, all futures and forwards on Fixed Income 
Products will be included in the General Market Risk sub-zones. A 
future or forward would be incorporated into the grid by inserting into 
the sub-zones any of the instruments deliverable against the future or 
the forward, up to the market value of the future or forward. Once the 
deliverable instrument is placed into a sub-zone, it would be subject 
to the same haircuts and offsets as other Fixed Income Products. 
However, there is no Specific Market Risk Charge for futures and 
forwards on Fixed Income Products.
5. Interest Rate Swaps
    A basic interest rate swap or a ``plain vanilla'' swap involves the 
exchange of specified or determinable cash flows at specified times 
based upon a notional amount. The notional amount is not exchanged but 
is used to calculate the fixed or floating rate interest payments made 
under the swap. Presently, the current net capital rule generally 
treats any net interest payment due from an interest rate swap as an 
unsecured receivable (absent the presence of liquid collateral) that 
must be deducted from the broker-dealer's net worth in arriving at its 
net capital. The broker-dealer also is required to take an additional 
haircut on the notional amount of the swap as the market risk haircut.
    The proposed rule would require that interest rate swaps be placed 
into the General Market Risk sub-zones by converting each side of the 
swap into synthetic bond positions based on the notional amount of the 
swap and the interest rates against which payments are calculated. A 
broker-dealer would calculate the market value of the synthetic bond by 
adjusting the value of the notional amount under the swap for changes 
in interest rates in the same way that a debt security is marked-to-
market. These synthetic bonds then would be placed into the appropriate 
sub-zones. As with all synthetic bond positions, these positions would 
not be subject to Specific Market Risk Charges.
    Any obligation to receive payments under the swap would be 
categorized as a long position; any obligation to make payments under 
the swap would be characterized as a short position.33 A 
position receiving or paying based on a floating interest rate 
generally will be treated as having a maturity equal to the period 
until the Next Interest Reset Date; a position receiving or paying 
based on a fixed rate will be treated as having a maturity equal to the 
residual maturity of the swap.
---------------------------------------------------------------------------

    \33\ For example, an interest rate swap under which a firm is 
receiving payments based on a floating rate interest and paying 
based on a fixed interest rate would be treated as a long position 
in a floating rate instrument with a maturity equivalent to the 
period until the Next Interest Reset Date and a short position in a 
fixed rate instrument with a maturity equivalent to the residual 
life of the swap.
---------------------------------------------------------------------------

    Any interest rate portion of a swap that pays or receives according 
to the value of one or more equity securities (i.e., an equity swap) 
would be slotted into the General Market Risk sub-zones. The equity 
portion of the swap would be treated, for purposes of the net capital 
rule, as an equity security or equity index, as appropriate, with a 
market value equal to the notional value of the swap.
    As noted above, the Sub-Zone Charges, or haircuts, for synthetic 
bond equivalent positions derived from interest rate swaps would be 
calculated separately from other Sub-Zone Charges (e.g., government 
securities and Pass-Through Securities) under the Proposed Amendments. 
Synthetic bond equivalents derived from interest rate swaps, when 
offset against one another, would be subject to a 1 percent Sub-Zone 
Charge, instead of the 5 percent Sub-Zone Charge applicable to non-swap 
positions.
6. Repurchase (``Repo'') and Reverse Repurchase Agreements (Reverse 
Repo)
    Under the current Rule, a broker-dealer does not take a haircut on 
repo or reverse repo transactions 34 to reflect market risk. 
However, a broker-dealer engaging in reverse repo transactions must 
maintain additional net capital if it is holding collateral that far 
exceeds the contract price under the agreement.35 In 
addition, a broker-dealer must also subtract from its net worth any 
deficiency arising under a reverse repo if the market value of the 
securities it holds is less than the contract price.36 For 
repo transactions, Rule 15c3-1 requires a broker-dealer to take a 
deduction from its net worth if it has delivered to the counterparty 
securities in excess of the contract price of the repo, under certain 
circumstances.37
---------------------------------------------------------------------------

    \34\ A repurchase agreement, or repo, is an agreement between a 
buyer and a seller, usually of U.S. government securities, where the 
seller agrees to repurchase the securities from the buyer at an 
agreed upon price and, usually, on a stated date. In a reverse 
repurchase agreement, the broker-dealer has purchased the securities 
from the counterparty and has agreed to resell them at the agreed 
upon price.
    \35\ 17 CFR 240.15c3-1(a)(9).
    \36\ 17 CFR 240.15c3-1(c)(2)(iv)(F)(2).
    \37\ 17 CFR 240.15c3-1(c)(2)(iv)(F)(3).
---------------------------------------------------------------------------

    The Commission is proposing that repos and reverse repos be 
incorporated into the Proposed Amendments by treating each repo and 
reverse repo transaction as a short or long position, respectively, in 
a synthetic bond with a maturity equal to that of the contract or the 
Next Interest Rate Reset Date, whichever is less. This would allow 
repos and reverse repos to act as hedged positions where appropriate. 
In addition, the Commission also requests comments on whether these 
should be marked-to-market daily for net capital purposes in the same 
manner that a Treasury security is marked-to-market for a change in 
interest rates.

D. Product Specific Issues

    Although the Proposed Amendments recognize, for net capital 
purposes, offsetting positions among most types of interest rate 
products, the Commission believes that it is desirable to expand the 
proposal to permit offsetting among additional types of interest rate 
products. Five different types of interest rate products that are not 
included in the proposal are described below, and

[[Page 68002]]

the Commission seeks comment on how these instruments could be 
incorporated into the Proposed Amendments.
1. Mortgage-Backed Securities and Certain Non-Qualified Mortgage Pass-
Through Securities
    As noted, the Commission believes it is desirable to include all 
mortgage securities into a unified haircut methodology to give more 
recognition to hedging strategies employed by broker-dealers. 
Nonetheless, the Commission's proposal does not include certain 
mortgage securities, such as collateralized mortgage obligations 
(``CMOs''), interest-only mortgage securities (``IOs''), principal-only 
mortgage securities (``POs''), and mortgage pass-through securities 
that are not collateralized by level payment loans on one to four 
family homes.
    There have been several alternatives suggested by broker-dealers to 
deal with these securities. One would slot CMOs into the maturity bands 
for interest rate products based on one day less than one-half the 
stated maturity of the CMO. While this proposal may provide adequate 
levels of capital for unhedged positions, the proposal does not appear 
to address the varied hedging strategies associated with CMOs. The 
second suggestion would slot CMO's into the various categories based on 
price, third party prepayment forecast systems, and historical 
volatility for the various classes of CMOs. This method would reflect 
more closely the various hedging strategies involving CMOs, but is both 
complex and based on subjective judgements regarding prepayments of 
principal. A third alternative would be to allow some type of internal 
modelling to serve as the basis for calculating haircuts on these 
instruments. This presents substantial examination burdens and might 
lead to excessive leverage and inadequate capital levels. Each 
alternative, however, deserves consideration, and the Commission 
solicits comment on each of these alternatives.
2. Non-Investment Grade Debt
    The Proposed Amendments also do not include high-yield bonds (also 
known as ``junk'' bonds). Under the current Rule, non-investment grade 
bonds having a ready market are treated as if they were equity 
securities requiring a capital charge of at least 15 percent. In a no-
action letter, the Division stated that whether these securities had a 
ready market depended on the amount of the initial issuance, whether 
the securities can be publicly sold without registration with the 
Commission, and whether there is currently available public 
information.38
---------------------------------------------------------------------------

    \38\ See Letter Regarding Ready Marketability of Noninvestment 
Grade Debt (February 14, 1994).
---------------------------------------------------------------------------

    The Commission preliminarily believes that it is inappropriate to 
permit non-investment grade bonds to be offset, or hedged, with other 
debt instruments because non-investment grade bond prices are much more 
dependent on issuer-specific risk factors, similar to those important 
in the pricing of equity securities, than on general market risk 
factors.39 However, the Commission seeks comment on 
alternative methods of determining haircuts for non-investment grade 
bonds and whether those securities should be used to offset positions 
in other securities.
---------------------------------------------------------------------------

    \39\ As indicated by a number of studies, movements in most non-
investment grade bonds are not highly correlated with movements of 
high-quality bonds. One study found a higher correlation between a 
long-term high-yield (i.e., junk bond) index and the S&P 500 index 
than it found between the high-yield index and U.S. Treasuries or 
investment grade corporate bonds. (See Paul H. Ross, et al., High-
Yield Corporate Bonds: An Asset Class for the Allocation Decision, 
Salomon Brothers (February 1989)). The study found a 0.93 
correlation between AA-rated corporate bonds and U.S. Treasuries, 
but only a 0.45 correlation between the high-yield index and U.S. 
Treasuries. The correlation of the high-yield index with the S&P 500 
was 0.63.
---------------------------------------------------------------------------

3. Interest Rate Instruments Denominated in Foreign Currencies
    Under this proposal, instruments denominated in different 
currencies would not be permitted to be offset against one another. 
Thus, broker-dealers would have to calculate their market risk haircut 
for Fixed Income Products separately for each currency in which those 
instruments are denominated. Available evidence suggests that while 
correlations of interest rate products denominated in different 
currencies are often positive, they are relatively low when compared 
with correlations for securities denominated in the same currency. The 
Commission solicits comment on the appropriateness of permitting 
different currency interest rate instruments to offset one another. The 
Commission also requests comment on methods for addressing the foreign 
exchange risk of these securities.
4. Forward Rate Agreements and Eurodollar Futures
    In a forward rate agreement, two parties agree on a fixed interest 
rate that is to be paid on a notional deposit of a specified maturity 
commencing at a future date. A Eurodollar future is a U.S. dollar 
denominated, cash settled futures contract where the underlying 
instrument is a Eurodollar 40 time deposit commencing on a 
specific forthcoming date. These instruments are commonly used to 
offset future payment streams stemming from obligations of current 
interest rates, including interest rate swaps. The Commission seeks 
comment on how these instruments may be incorporated into the net 
capital rule.
---------------------------------------------------------------------------

    \40\ A Eurodollar is U.S. currency held in banks outside the 
United States, mainly in Europe, and commonly used for settling 
international transactions.
---------------------------------------------------------------------------

5. Fixed Income Options
    Options on U.S. Treasury Securities and certain debt instruments 
issued by agencies of the U.S. Government and options on futures on 
these securities (``Fixed Income Options'') can comprise an important 
element of a broker-dealer's interest rate book. As discussed earlier, 
the Commission recently adopted amendments to the net capital rule that 
permit an options pricing model to be used to determine capital charges 
for listed options and their related positions. The Commission is 
seeking comment on whether it may be possible to use a similar approach 
to determine haircuts on over-the-counter Fixed Income Options.
    One alternative would be to reprice the option, as with listed 
options, after changing the price of the underlying security based on 
specific market ``shocks'' specified by the Commission. For example, 
for domestic interest rate products, the entire universe of underlying 
securities could be represented by the U.S. Treasury yield curve, which 
includes market yields for 3-month to 30-year securities. The broker-
dealer would then subject its Fixed Income Options portfolio to 
different types of shocks. One type of shock could be obtained by 
imposing a parallel shift in the yield curve. A second type of shock 
could be obtained by changing the slope of the yield curve. Third, the 
implied volatilities along the yield curve could also be increased or 
decreased.
    The Commission seeks comment on the feasibility of using an options 
pricing model with prescriptive shocks for over-the-counter Fixed 
Income Options as well as suggestions for other methods for calculating 
haircuts on Fixed Income Options.

E. Non-Model Based Alternatives to the Proposed Amendments

    The Commission believes that the maturity-based Proposed Amendments 
for Fixed Income Products meet two important objectives. First, the 
Proposed Amendments are an objective method for calculating regulatory 
net capital

[[Page 68003]]

whose results apply consistently to all broker-dealers. Second, the 
application and results of the Proposed Amendments can be readily 
verified by examiners and independent auditors. Importantly, the 
Proposed Amendments would differ from the current net capital rule in 
allowing broker-dealers to receive greater hedging benefits among a 
wider variety of interest rate instruments. Nonetheless, the Commission 
is aware that different entities may favor modifications or 
alternatives to the Proposed Amendments. The Commission solicits 
comment on the viability and the advantages and disadvantages of the 
Proposed Amendments, the alternative approaches described below, and 
any alternatives not discussed by the Commission in this release. In a 
separate release, the Commission is soliciting comments on the use of 
value-at-risk models for capital purposes.41
---------------------------------------------------------------------------

    \41\ Securities Exchange Release No. 34-39456 (December 17, 
1997).
---------------------------------------------------------------------------

1. Duration
    One alternative to the Proposed Amendments could be to use duration 
bands, instead of residual maturity bands, in determining the capital 
charges to be applied to specific positions in interest rate products. 
Duration is a mathematical concept which attempts to measure the 
sensitivity of bond prices to general interest rate changes. Generally, 
duration-based formulas express the weighted average time to payment of 
the cash flows of a bond (both interest and principal) where the 
weights are the present values of the cash flows themselves. Each cash 
flow is reduced to its present value. The point in time at which half 
of the cash flows (expressed in present value) would be received is 
commonly referred to as the duration of the bond.42
---------------------------------------------------------------------------

    \42\ The concept of modified duration is also commonly used. 
Modified duration is the price elasticity of a bond (i.e., the 
percentage change in price for a one percent change in yield).
---------------------------------------------------------------------------

    The Commission initially believes that a duration band analysis may 
be too complicated for calculating regulatory capital requirements; it 
requires examiners to re-calculate, on a daily basis, the duration of 
each Fixed Income Product in a firm's portfolio to reflect daily 
changes in interest rates. By basing haircuts on residual maturity 
instead of a daily duration calculation, the current net capital rule 
and the Proposed Amendments are computationally less intensive than a 
duration band approach. Nonetheless, the residual maturity method used 
in the current Rule and the Proposed Amendments are relatively close 
approximations to the duration method in determining capital charges 
for a hedged portfolio.43 Consequently, the nominal increase 
in the precision of the price sensitivity estimate under the duration 
analysis over the residual maturity method may be outweighed by the 
costs associated with the greater complexity of the duration method.
---------------------------------------------------------------------------

    \43\ If two securities have similar durations but different 
residual maturities, under the duration method they would receive a 
comparatively small haircut. Under the Proposed Amendments, the 
security with a longer residual maturity would tend to have a 
greater market value and would receive a comparatively larger 
haircut than the security with the shorter residual maturity. The 
residual amounts available for offset under the Proposed Amendments 
would tend to be roughly equal. Therefore, under the Proposed 
Amendments, the two positions would receive a capital charge similar 
to the charge under the duration method.
---------------------------------------------------------------------------

2. Rolling Time-Band
    One modification to the Proposed Amendments could be to eliminate 
the zones and instead determine offsets according to a ``rolling band 
approach'' between the fifteen different sub-zones, or maturity bands. 
Under this approach, the charge, or degree of offset, between opposite 
positions in different maturity bands would be computed based on the 
number of maturity bands that separate the long and short positions. 
For example, positions in adjacent maturity bands might be subject to a 
20 percent charge, while positions separated by two maturity bands 
might be subject to a 30 percent charge, and so on. There would be a 
limit to how far apart the positions could be in the maturity bands and 
still be subject to an offset. While this approach refines the Proposed 
Amendments, the different ways a particular position could be offset 
may make this haircut calculation more complicated to program and to 
audit.
3. Cash-Flow Buckets
    Another alternative to the Proposed Amendments would be to employ a 
cash flow-based approach. For example, a thirty-year Treasury bond 
would have 61 cash flows: 60 semi-annual interest payments for thirty 
years and a principal payment in the final year. Each cash flow 
theoretically could be inserted into the sub-zone corresponding to the 
time when that payment or receipt would be made. To the extent the 
expected payments and receipts in a particular sub-zone would not 
offset each other completely, a capital charge would be assessed on the 
net position. As with the current proposal, this approach also would 
require a charge on the matched position within a sub-zone to account 
for basis risk.
* * * * *
    The Commission solicits comment on whether the potential benefits 
of each of these approaches outweigh their complexity, and encourages 
commenters to submit analysis or data on the likely costs of the 
alternative approaches. The Commission specifically requests comment on 
how the expected cash flows in Alternative 3 could be determined, 
especially for products whose cash flows are more difficult to predict, 
such as CMOs.

III. Costs and Benefits of the Proposed Rule Amendments and Their 
Effects on Competition

    To assist the Commission in its evaluation of the costs and 
benefits that may result from the Proposed Amendments, commenters are 
requested to provide analyses and data relating to the costs and 
benefits associated with any of the proposals herein. 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 rule changes. 
The Commission estimates that approximately 1,350 broker-dealers will 
be affected by the Proposed Amendments. The Proposed Amendments have 
been tailored to minimize their burden on affected small broker-dealers 
while at the same time protecting the markets and investors. The 
Commission estimates that of the approximately 5,300 small broker-
dealers registered with the Commission, only approximately 370 have 
proprietary positions in Fixed Income Products and are subject to the 
Rule. The Commission believes that the burden imposed upon broker-
dealers will be significantly outweighed by the potential savings to 
broker-dealers from reduced capital requirements and increased 
efficiencies. The Commission requests comment on the extent to which 
the Proposed Amendments will reduce capital requirements. Commenters 
should provide estimates of the reduction in their capital 
requirements.
    The Proposed Amendments provide broker-dealers the opportunity to 
reduce their capital charges. The Proposed Amendments change the 
haircuts applied to Fixed Income Products by combining different 
interest rate instruments into one haircut calculation that recognizes 
hedging among many more types of interest rate products than permitted 
under the current Rule. By recognizing more types of hedging

[[Page 68004]]

techniques, the Proposed Amendments should lower the haircuts for firms 
with well-hedged portfolios of Fixed Income Products and reduce a 
broker-dealer's incentive to fractionalize its business between the 
broker-dealer and its unregistered affiliate. Reducing a broker-
dealer's need to fractionalize its securities business should allow a 
broker-dealer to increase its operational efficiency. Finally, by 
expanding the types of hedging recognized in the Rule, the Proposed 
Amendments should better reflect the hedging strategies currently used 
by broker-dealers.
    The Commission preliminarily believes that the Proposed Amendments 
will promote both efficiency and capital formation. As previously 
discussed, the Proposed Amendments should provide broker-dealers the 
opportunity to increase operational efficiency by reducing the need to 
fractionalize its securities business. In addition, the Proposed 
Amendments should promote capital formation by reducing capital charges 
for well-hedged portfolios and by better reflecting the hedging 
strategies actually used by broker-dealers. This should allow broker-
dealers greater freedom to invest assets or support underwritings thus 
promoting capital formation. Finally, a broker-dealer's operational 
efficiency should be increased as a result of allowing its current 
hedging strategies to be used in its calculation of required capital.
    Section 23(a) of the Exchange Act \44\ requires the Commission, 
when adopting or amending rules under the Exchange Act, to consider the 
impact the rule would have on competition and to refrain from adopting 
any rule that would impose a burden on competition not necessary or 
appropriate in furtherance of the purposes of the Exchange Act. The 
Commission has preliminarily considered the Proposed Amendments in 
light of this standard and believes that, if adopted, they would not 
impede competition. As previously discussed, the net capital rule is 
intended to ensure that broker-dealers have sufficient liquid capital 
to protect the assets of customers and to meet their responsibilities 
to other broker-dealers. When calculating its net capital, a broker-
dealer reduces the market value of the securities it owns by certain 
percentages, or ``haircuts.'' Reducing the value of these securities 
provides a capital cushion should the securities portfolio decline in 
value. The Proposed Amendments change the haircuts applicable to the 
Fixed Income Products for all broker-dealers equally and, therefore, 
does not impede competition. The Proposed Amendments provide the same 
opportunities to all broker-dealers to improve the efficiency of their 
securities business. However, the Commission does recognize that these 
benefits come at the cost of greater computational complexity and it 
requests comment on the competitive impacts of this increased 
complexity.
---------------------------------------------------------------------------

    \44\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

IV. Summary of Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA'') in accordance with the Regulatory Flexibility Act 
(``RFA''). \45\ The analysis set forth in the IRFA relates to the 
Proposed Amendments. The IRFA states that the Proposed Amendments 
continue the Commission's efforts to revise Rule 15c3-1 by lowering 
haircuts on Fixed Income Products for a firm with a well hedged 
portfolio of Fixed Income Products and by reducing a broker-dealer's 
incentive to fractionalize its business between itself and an 
unregistered affiliate. Finally, the IRFA states that by expanding the 
types of hedges recognized in the Rule, the Proposed Amendments should 
better reflect the hedging strategies currently used by broker-dealers.
---------------------------------------------------------------------------

    \45\ 5 U.S.C. 603.
---------------------------------------------------------------------------

    The IRFA sets forth the statutory authority for the Proposed 
Amendments Under Section 15(c)(3) of the Securities Exchange Act of 
1934. \46\ The IRFA also discusses the effect of the Proposed 
Amendments on small entities. Of the approximately 5,300 small broker-
dealers registered with the Commission, approximately 370 are subject 
to the net capital rule that have proprietary positions in Fixed Income 
Products. Accordingly, the IRFA states that the Proposed Amendments 
would have a direct effect on approximately 370 out of 5,300 small 
broker-dealers. The IRFA also states that these small broker-dealers 
would have to adjust their processes and procedures for calculating net 
capital and that this would likely involve amending their computer 
information systems.
---------------------------------------------------------------------------

    \46\ 15 U.S.C. 78o(c)(3)
---------------------------------------------------------------------------

    More specifically, some broker-dealers' computer information 
systems may not have the capability to capture and classify the 
information required to implement the changes as to certain 
instruments. For example, pass-through mortgage-backed securities are 
included in the Proposed Amendments provided that they are based on 
fixed rate residential mortgage loans on one to four family homes. 
Multifamily, adjustable rate, commercial, and mobile home mortgage 
loans are not included in the Proposed Amendments. Consequently, 
broker-dealers may need to modify their computer information systems to 
identify mortgage-backed securities by the criteria necessary to use 
the Proposed Amendments. The IRFA states that the Commission 
preliminarily believes that the modifications needed to comply with the 
Proposed Amendments should not be unduly burdensome, however, it does 
not currently have the information to quantify the costs associated 
with making these changes. Consequently, the IRFA requests comment on 
the costs associated with changing the computer information systems to 
comply with the Proposed Amendments. Commenters should provide detailed 
estimates of the costs to change their computer information systems.
    The IRFA states that the Commission preliminarily believes that 
after affected broker-dealers change their processes, procedures, and 
computer information systems to reflect the Proposed Amendments, there 
will not be any continuing impact on these broker-dealers. However, the 
IRFA requests comments on any ongoing costs associated with complying 
with the Proposed Amendments. Commenters should provide detailed 
estimates of any ongoing costs they expect to incur.
    The IRFA states that the Commission considered whether viable 
alternatives to the proposed rulemaking exist that accomplish the 
stated objectives of applicable statutes and that minimize any 
significant economic impact of proposed rules on small entities. More 
specifically, the Commission considered the following alternatives: (a) 
The establishment of differing compliance or reporting requirements or 
timetables that take into account the resources available to small 
entities; (b) the clarification, consolidation, or simplification of 
compliance and reporting requirements under the rule for small 
entities; (c) the use of performance rather than design standards; and 
(d) an exemption from coverage of the rule, or any part thereof, for 
small entities.
    The Commission believes that it would be inconsistent with the 
purposes of Rule 15c3-1 to exempt small entities from the Proposed 
Amendments or to provide an alternative net capital requirement 
including allowing small entities to continue to use the current 
capital requirements. Rule 15c3-1 is intended to protect the investing 
public by ensuring that broker-dealers have

[[Page 68005]]

sufficient liquid capital to protect the assets of customers and to 
meet their responsibilities to other broker-dealers. The Commission 
believes that the Proposed Amendments will enhance Rule 15c3-1's 
objectives by establishing more precise haircut charges that better 
reflect the risks associated with broker-dealers' Fixed Income Products 
positions and related hedging practices while ensuring that registered 
broker-dealers hold sufficient capital to maintain adequate liquidity 
to satisfy obligations to customers and other broker-dealers.
    The IRFA states that the Commission preliminarily believes that the 
Proposed Amendments will not adversely affect small entities because 
they tend to own relatively few Fixed Income Products. As previously 
discussed, the Commission estimates that of the 5,300 small broker-
dealers registered with the Commission, only 370 have proprietary 
positions in Fixed Income Products. In addition, the Proposed 
Amendments change the haircuts applicable to Fixed Income Products for 
all broker-dealers equally and thus provide the same opportunities to 
all broker-dealers to improve the efficiency of their securities 
business. However, the IRFA does request comment on whether the 
computational complexity of the amendments impedes a small business' 
ability to compete.
    The IRFA includes information concerning the solicitation of 
comments with respect to the IRFA generally, and in particular, the 
cost of compliance with the proposed amendments and the number of small 
entities that would be affected by the Proposed Amendments. In 
addition, the IRFA solicits information for purposes of the Small 
Business Regulatory Enforcement Fairness Act of 1996, regarding the 
potential impact of the Proposed Amendments on the economy on an annual 
basis. Commentators are asked to provide empirical data to support 
their views. A copy of the IRFA may be obtained by contacting 
Christopher M. Salter, Securities and Exchange Commission, 450 Fifth 
Street, N.W., Mail Stop 2-2, Washington, D.C. 20549.

V. Paperwork Reduction Act

    Certain sections of Rule 15c3-1 contain ``collection of 
information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995 (``PRA'') (44 U.S.C. 3501 et seq.). The 
Commission has previously submitted the rule to the Office of 
Management and Budget (``OMB'') for review in accordance with 44 U.S.C. 
3507(d), and OMB has assigned the rule OMB control number 3235-0200. 
Because the proposed rule changes should not materially affect the 
collection of information obligations under the rule, there is no 
requirement that the Commission resubmit the rule with the proposed 
amendments to OMB for review under the PRA.

VI. Statutory Analysis

    Pursuant to the Act and particularly Section 15(c)(3), (15 U.S.C. 
78o(c)(3)) thereof, the Commission is adopting amendments to 
Sec. 240.15c3-1 of Title 17 of the Code of Federal Regulations in the 
manner set forth below.

List of Subjects in 17 CFR Part 240

    Brokers, Reporting and recordkeeping requirements, Securities.

Text of Proposed Rule

    In accordance with the foregoing, Title 17, chapter II, part 240 of 
the Code of Federal Regulations is proposed to be amended as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The authority citation for Part 240 continues to read in part 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), 79q, 
79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless 
otherwise noted.
* * * * *
    2. Section 240.15c3-1 is amended by revising paragraph 
(a)(1)(ii)(C), the introductory text of paragraph (c)(2)(vi), and 
paragraphs (c)(2)(vi)(A), (D)(3), and (G); removing and reserving 
paragraphs (c)(2)(vi)(E) and (F); and adding undesignated section 
headings before paragraphs (c)(2)(vi)(A), (c)(2)(vi)(D)(3) and 
(c)(2)(vi)(G) to read as follows:

Sec. 240.15c3-1.  Net capital requirements for brokers or dealers.

    (a) * * *
    (1) * * *
    (ii) * * *
    (C) Exclude credit balances in accounts representing amounts 
payable for government securities, commercial paper, bankers 
acceptances, certificates of deposit included within the scope of 
paragraph (c)(2)(vi)(A) of this section not yet received from the 
issuer or its agent, and any related debit items from the Exhibit A 
requirements for 3 business days; and
* * * * *
    (c) * * *
    (2) * * *
    (vi) Deducting the percentages of the market value of all 
securities, money market and other instruments, or options in the 
proprietary or other accounts of the broker or dealer or making such 
other charges as are determined pursuant to paragraphs (c)(2)(vi)(A) 
through (M) of this section or set forth in appendix A (Sec. 240.15c3-
1a).
Fixed Income Products
    (A)(1) The charge from market value for all Government Securities; 
Synthetic Bond Positions; nonconvertible debt securities (other than 
municipal securities), that have fixed maturity dates, are not traded 
flat or in default as to principal or interest, and are rated in one of 
the four highest rating categories by at least two nationally 
recognized statistical rating organizations; Money Market Debt 
Instruments; and futures or forward contracts for the purchase or sale 
of instruments covered by this paragraph (c)(2)(vi)(A) shall be equal 
to the sum of the Specific Market Risk Charges specified in paragraph 
(c)(2)(vi)(A)(2) of this section and the General Market Risk Charges 
specified in paragraph (c)(2)(vi)(A)(3) of this section.
    (2) For all Government Securities and all Synthetic Bond Positions, 
the Specific Market Risk Charge shall be zero. For all other securities 
or instruments covered by paragraph (c)(2)(vi)(A) of this section, the 
broker or dealer shall compute a Specific Market Risk Charge equal to 
the market value of the net position in each security multiplied by the 
applicable percentage specified below:

------------------------------------------------------------------------
                                                              Percentage
          Residual maturity of product            Percentage  adjustable
                                                  fixed rate     rate   
------------------------------------------------------------------------
Less than 6 months..............................        0.25        0.75
6 months but less than 2 years..................        1.00        1.50
2 years or more.................................        1.60        2.10
------------------------------------------------------------------------

    (3) The General Market Risk Charge shall be equal to the aggregate 
of the Sub-Zone Charge, the Zone Charge, the Between Zone Charge, and 
the Residual Charge.
    (i) To determine its General Market Risk Charge for securities 
covered by paragraph (c)(2)(vi)(A) of this section, a broker or dealer 
shall place the market value of each security in its appropriate sub-
zone in accordance with the following:
    (A) The market value of each security shall be placed in one of the 
sub-zones listed below based upon its residual maturity, except for 
those instruments described in paragraphs

[[Page 68006]]

(c)(2)(vi)(3)(i)(B), (c)(2)(vi)(3)(i)(C) and (c)(2)(vi)(3)(i)(D) of 
this section.

------------------------------------------------------------------------
                                                               Sub-zone 
           Residual maturity                   Sub-zone       percentage
------------------------------------------------------------------------
Zone 1:                                                                 
  1 month or less......................  (i)                          0 
  More than 1 month but not more than 3  (ii)                      0.20 
   months.                                                              
  More than 3 months but not more than   (iii)                     0.40 
   6 months.                                                            
  More than 6 months but not more than   (iv)                      0.70 
   1 year.                                                              
Zone 2:                                                                 
  More than 1 year but not more than 2   (v)                       1.25 
   years.                                                               
  More than 2 years but not more than 3  (vi)                      1.75 
   years.                                                               
  More than 3 years but not more than 4  (vii)                     2.25 
   years.                                                               
Zone 3:                                                                 
  More than 4 years but not more than 5  (viii)                    2.75 
   years.                                                               
  More than 5 years but not more than 7  (ix)                      3.25 
   years.                                                               
  More than 7 years but not more than    (x)                       3.75 
   10 years.                                                            
Zone 4:                                                                 
  More than 10 years but not more than   (xi)                      4.50 
   15 years.                                                            
  More than 15 years but not more than   (xii)                     5.25 
   20 years.                                                            
  More than 20 years...................  (xiii)                    6.00 
Zone 5:                                                                 
  Deep Discount Bonds with more than 15  (xiv)                     9.00 
   years but not more than 20 years.                                    
  Deep discount bonds with more than 20  (xv)                     12.00 
   years.                                                               
------------------------------------------------------------------------

    (B) An Adjustable Rate Security shall be deemed to have a residual 
maturity equal to the remaining time to the effectiveness of its Next 
Interest Rate Reset Date.
    (C) The market value of a Pass-Through Mortgage-Backed Security 
shall be placed into one of the sub-zones in accordance with the 
following table based on its market value relative to its par value:

                                     Pass-Through Mortgage-Backed Securities                                    
----------------------------------------------------------------------------------------------------------------
               Sub-zone                 30-year pass-throughs    15-year pass-throughs    5- and 7-year balloons
----------------------------------------------------------------------------------------------------------------
(iv).................................  >108%..................  NA.....................  NA.                    
(vi).................................  >105% but less than or   >103%..................  >102%.                 
                                        = 108%.                                                                 
(vii)................................  >102% but less than or   >100% but less than or   >94% but less than or =
                                        = 105%.                  = 103%.                  102%.                 
(viii)...............................  >98% but less than or =  100% or less...........  94% or less.           
                                        102%.                                                                   
(x)..................................  98% or less............  NA.....................  NA.                    
----------------------------------------------------------------------------------------------------------------

    (D) The market value of a Deep Discount Bond with a residual 
maturity of no more than six years shall be placed in one of the sub-
zones in accordance with its residual maturity. The market value of a 
Deep Discount Bond with a residual maturity of more than six years 
shall be placed in one of the sub-zones based upon its residual 
maturity as follows:

------------------------------------------------------------------------
              Residual maturity                        Sub-zone         
------------------------------------------------------------------------
More than 6 years but not more than 7\1/2\    (x)                       
 years.                                                                 
More than 7\1/2\ years but not more than 9    (xi)                      
 years.                                                                 
More than 9 years but not more than 12 years  (xii)                     
More than 12 years but not more than 15       (xiii)                    
 years.                                                                 
More than 15 years but not more than 20       (xiv)                     
 years.                                                                 
More than 20 years..........................  (xv)                      
------------------------------------------------------------------------

    (E) A broker or dealer that has entered into a futures or forward 
contract for the purchase or sale of a security covered by paragraph 
(c)(2)(vi)(A) of this section shall include in one of the sub-zones 
specified in paragraphs (c)(2)(vi)(A)(2) and (3) of this section the 
market value of a long or short position in any security that is 
specified as deliverable under the terms of the contract, in accordance 
with the residual maturity of the security. The market value of any 
positions included pursuant to this paragraph shall be equivalent to 
the market value of the corresponding future or forward contract. The 
provisions of appendix B (Sec. 240.15c3-1b) will in any event apply to 
the positions in futures contracts.
    (F) A broker or dealer that has entered into a Swap Agreement shall 
include it in one or more of the sub-zones as follows. If the broker or 
dealer has entered into a Swap Agreement that obligates it to pay or 
receive scheduled interest cash flows at an adjustable rate of 
interest, the broker or dealer shall include in one of the sub-zones 
the market value of a short or long position, respectively, in a 
Synthetic Bond reflecting a principal amount equal to the notional 
amount of the Swap Agreement with residual maturity equal to the period 
until the effective date of the Next Interest Rate Reset Date. If a 
broker or dealer has entered into a Swap Agreement that obligates it to 
pay or receive scheduled interest cash flows at a fixed interest rate, 
it shall include in one of the sub-zones the market value of a short or 
long position, respectively, in a Synthetic Bond reflecting a principal 
amount equal to the notional amount of the Swap Agreement with residual 
maturity equal to the period until the maturity of the Swap Agreement.
    (G) A broker or dealer that has entered into a repurchase or 
reverse repurchase agreement involving a security covered by paragraph 
(c)(2)(vi)(A) of this section, shall include in one of the sub-zones 
the market value of a short or long position in a Synthetic Bond with a 
principal amount equal to that of the funds received or provided, 
respectively, and a maturity equal to that of the residual maturity of 
the contract or equal to the period until the effective date of the 
Next Interest Rate Reset Date, whichever is less.
    (H) A separate General Market Risk Charge calculation must be made 
for positions denominated in each different currency.
    (ii) Sub-Zone Charge. The Sub-Zone Charge shall equal the sum of 
the charge for offsetting Swap Agreements plus the charge for other 
securities covered by paragraph (c)(2)(vi)(A) of this section for each 
sub-zone calculated as follows:
    (A) The charge for offsetting Swap Agreements shall equal the 
lesser of the

[[Page 68007]]

aggregate long or short swap positions in each sub-zone multiplied by 
the applicable sub-zone percentage set forth in paragraph 
(c)(2)(vi)(A)(3)(i)(A) of this section (the ``Sub-Zone Percentage'') 
multiplied by 1%. The net of all the long and short swap positions in 
each sub-zone (i.e., non-offsetting swap positions) shall be added to 
the long or short position in other securities covered by paragraph 
(c)(2)(vi)(A) of this section in that sub-zone for the purpose of 
calculating the remaining charges in this paragraph.
    (B) The charge for securities other than offsetting Swap Agreements 
in each sub-zone covered by paragraph (c)(2)(vi)(A) of this section 
shall equal the lesser of the aggregate long or short positions in each 
sub-zone (which shall include any non-offsetting swap positions carried 
forward as calculated in accordance with paragraph 
(c)(2)(vi)(A)(3)(ii)(A) of this section) multiplied by the applicable 
Sub-Zone Percentage, multiplied by 5%.
    (C) The Long or Short Sub-Zone Carry-Forward Amount for a sub-zone 
shall equal the net of all sub-zone long or short securities positions 
in that sub-zone multiplied by the applicable Sub-Zone Percentage.
    (iii) Zone Charge. The Zone Charge shall equal the aggregate of the 
charge for each zone calculated as follows:
    (A) The Long and Short Zone Positions for each zone shall equal, 
respectively, the aggregate Long Sub-Zone Carry-Forward Amounts and 
aggregate Short Sub-Zone Carry-Forward Amounts in each zone.
    (B) The Zone Charge for each zone shall equal the lesser of the 
aggregate Long Zone Positions or aggregate Short Zone Positions for 
each zone multiplied by the applicable percentage set forth below:
    Zone 1--25%.
    Zone 2--30%.
    Zone 3--35%.
    Zone 4--40%.
    Zone 5--50%.
    (C) The net of the Long Zone Positions and Short Zone Positions in 
each Zone shall be the Long or Short Zone Carry-Forward Amount for that 
zone.
    (iv) Between Zone Charge. The Between Zone Charge shall equal the 
aggregate of the charges calculated as follows:
    (A) The Between Zone Charge shall equal the lesser of the Long or 
Short Zone Carry-Forward Amounts between the zones described below 
multiplied by the applicable percentages:

------------------------------------------------------------------------
                            Zones                             Percentage
------------------------------------------------------------------------
Between Zone 1 and Zone 2...................................         50 
Between Zone 2 and Zone 3...................................         60 
Between Zone 3 and Zone 4...................................         70 
Between Zone 4 and Zone 5...................................         80 
Between Zone 1 and Zone 3...................................         85 
Between Zone 2 and Zone 4...................................         90 
------------------------------------------------------------------------

    That portion of a Long or Short Zone Carry-Forward Amount used to 
offset a Long or Short Zone Carry-Forward Amount may not be used again 
to offset another Long or Short Zone Carry-Forward Amount.
    (B) The Long and Short Zone Carry-Forward Amounts not offset 
pursuant to (c)(2)(vi)(3)(iv)(A) shall be the Long or Short Between 
Zone Carry-Forward Amounts.
    (v) Residual Charge. The sum of the values of the Long and Short 
Between Zone Carry-Forward Amounts shall be the Residual Charge.
    (4) Definitions. For the purposes of paragraph (c)(2)(vi)(A) of 
this section:
    (i) Government Securities means all securities issued or guaranteed 
as to principal and interest by the United States or any agency 
thereof.
    (ii) Adjustable Rate Security means a security covered by paragraph 
(c)(2)(vi)(A) of this section that has an interest rate that resets 
based upon an index that reflects current U.S. Treasury interest rates 
corresponding to the interest rate reset period of the covered 
security.
    (iii) Pass-Through Mortgage-Backed Security means any security 
issued under the sponsorship of the United States or any agency thereof 
that represents a pro rata interest or participation in the principal 
and interest cash flows generated by a pool of mortgage loans of which 
at least 95% of the aggregate principal is composed of fixed rate 
residential mortgage loans on one-to-four family homes, including five 
and seven year mortgage loans with balloon payments at maturity. 
Multifamily, adjustable rate, commercial, and mobile home mortgage 
loans shall not be considered Pass-Through Mortgage-Backed Securities.
    (iv) Deep Discount Bonds mean all securities covered by paragraph 
(c)(2)(vi)(A) of this section, other than Pass-Through Mortgage-Backed 
Securities, that either do not pay interest or are priced at 50% or 
less of their par value.
    (v) Next Interest Rate Reset Date means, as to any Adjustable Rate 
Instrument, the maturity date of such instrument or, if earlier, the 
next date as of which the interest rate on the instrument is subject to 
being either increased or decreased, as applicable, by an amount that 
is at least 0.5% greater or lesser than the current interest rate on 
the instrument.
    (vi) Synthetic Bond Positions mean hypothetical bond positions that 
are included in the maturity bands specified in paragraph 
(c)(2)(vi)(A)(3) of this section by virtue of paragraphs 
(c)(2)(vi)(A)(3)(i) (F), and (G) of this section.
    (vii) Swap Agreement means a contractual agreement under which a 
broker-dealer is obligated to pay or entitled to receive from a 
counterparty cash flows equal to interest at a predetermined fixed 
rate, or at a floating rate, on a notional principal for the term of 
the Swap Agreement. The interest rate used to calculate parties' 
obligations under the Swap Agreement must be based on an index that 
approximates interest rates for instruments included within the scope 
of paragraph (c)(2)(vi)(A) of this section, and the parties' payment 
obligations cannot be a multiple of that interest rate index.
    (viii) Money Market Debt Instruments mean, in the case of any short 
term promissory note or evidence of indebtedness which has a fixed rate 
of interest or is sold at a discount, and which has a maturity date at 
date of issuance not exceeding nine months exclusive of days of grace, 
or any renewal thereof, the maturity of which is likewise limited and 
is rated in one of the three highest categories by at least two of the 
nationally recognized statistical rating organizations, or in the case 
of any negotiable certificates of deposit or bankers acceptances or 
similar type of instrument issued or guaranteed by any bank as defined 
in Section 3(a)(6) of the Act (15 U.S.C. 78c(a)(6)).
* * * * *
    (D) * * *
Certain Municipal Bond Trusts and Liquid Asset Funds
    (3) In the case of redeemable securities of an investment company 
registered under the Investment Company Act of 1940, which assets are 
in the form of cash or securities or money market instruments that are 
described in paragraphs (c)(2)(vi)(A) through (C) of this section, the 
charge shall be 9% of the market value of the long or short position.
    (E) [Reserved]
    (F) [Reserved]
Convertible Debt Securities
    (G) In the case of a debt security not in default that has a fixed 
rate of interest and a fixed maturity date and that is convertible into 
an equity security, the

[[Page 68008]]

charges shall be as follows: If the market value is 100 percent or more 
of the principal amount, the charge shall be determined as specified in 
paragraph (c)(2)(vi)(J) of this section; if the market value is less 
than the principal amount, the charges shall be determined as specified 
in paragraphs (c)(2)(vi)(A)(2) and (3) of this section based on its 
remaining maturity, provided that the security is rated as required by 
paragraph (c)(2)(vi)(A) of this section.
* * * * *
    Dated: December 17, 1997.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.

Appendix 1--Sample Calculation of Haircuts on Fixed Income Products

    This appendix demonstrates how to calculate the Specific Market 
Risk Charge and the General Market Risk Charge on Fixed Income 
Products under the Proposed Amendments. The example is not intended 
to replicate an actual broker-dealer portfolio or to be used as a 
basis to compare haircuts under the Proposed Amendments to those 
under the current rule, but rather the example is intended to show 
how the Proposed Amendments operate. The first step in calculating 
haircuts under the Proposed Amendments is to calculate the Specific 
Market Risk Charge. Next, calculate the General Market Risk Charge. 
To calculate the General Market Risk Charge, each of the Fixed 
Income Products must be categorized by assigning the position in 
each instrument into one of the 15 sub-zones, reflecting separately 
the long and short positions.

    The following table illustrates how an example portfolio is 
categorized under the Proposed Amendments. Repurchase and 
Reverse Repurchase Agreements are categorized based upon the 
agreements remaining maturity. *Treasury securities are categorized 
into the appropriate sub-zones based upon remaining maturity. 
**Fixed rate interest rate swaps are categorized based upon their 
residual maturity. ***Two of the Nonconvertible Debt securities have 
variable interest rates that reset every two and three years, 
respectively. These securities are placed into maturity sub-zones 
based upon their length of time to the Next Interest Reset Date. 
Futures contracts included in the portfolio are 
categorized based upon the remaining maturity of the Treasury 
security deliverable under the contract and not the length of the 
contract. ``The Pass-Through Mortgage security is placed into the 
appropriate sub-zone based upon its market value relative to par 
which is greater than 98% but less than or equal to 102%.

--------------------------------------------------------------------------------------------------------------------------------------------------------
            Security                  Value        Type of  holding     Remaining  maturity          Interest reset date          Zone       Sub-zone   
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                           Residual Maturity Categorization (Section 15c3-1(c)(2)(vi)(A)(3)(i)                                          
--------------------------------------------------------------------------------------------------------------------------------------------------------
Repurchase Agreement....      $2,000,000  Short..............  30 Days................  Fixed..........................        1  i              
Reverse Repurchase                    1,000,000  Long...............  30 Days................  Fixed..........................        1  i              
 Agreement.                                                                                                                                      
Treasury*......................       1,000,000  Short..............  6 Months...............  Fixed..........................        1  iii            
Treasury*......................       1,500,000  Long...............  6 Months...............  Fixed..........................        1  iii            
Treasury*......................         500,000  Long...............  1 Year.................  Fixed..........................        1  iv             
Treasury*......................       1,000,000  Short..............  1 Year.................  Fixed..........................        1  iv             
Interest Rate Swap**...........       1,000,000  Long...............  8 Months...............  Fixed..........................        1  iv             
Interest Rate Swap**...........       1,200,000  Short..............  11 Months..............  Fixed..........................        1  iv             
Treasury*......................       2,000,000  Long...............  2 Years................  Fixed..........................        2  v              
Treasury*......................       1,500,000  Long...............  2 Years................  Fixed..........................        2  v              
Treasury*......................       1,000,000  Short..............  2 Years................  Fixed..........................        2  v              
Treasury*......................      12,000,000  Short..............  2 Years................  Fixed..........................        2  v              
Nonconvertible Debt***.........       2,500,000  Short..............  5 Years................  Variable (2 Years).............        2  v              
Treasury*......................       2,000,000  Long...............  3 Years................  Fixed..........................        2  vi             
Treasury*......................       2,500,000  Short..............  3 Years................  Fixed..........................        2  vi             
Nonconvertible Debt***.........       1,000,000  Long...............  10 Years...............  Variable (3 Years).............        2  vi             
Treasury*......................       1,000,000  Long...............  5 Years................  Fixed..........................        3  viii           
Future on 5-Year Treasury......       2,000,000  Short..............  180 Days...............  Fixed..........................        3  viii           
Treasury*......................       2,000,000  Short..............  10 Years...............  Fixed..........................        3  x              
Pass-Through Mortgage".........       2,000,000  Short..............  29 Years...............  Fixed..........................        3  x              
Nonconvertible Debt***.........       1,000,000  Long...............  10 Years...............  Fixed..........................        3  x              
Future on 10-Year Treasury.....       7,000,000  Long...............  90 Days................  Fixed..........................        3  x              
Treasury*......................       3,000,000  Long...............  30 Years...............  Fixed..........................        4  xiii           
Treasury*......................       2,500,000  Short..............  30 Years...............  Fixed..........................        4  xiii           
                                ----------------                                                                                                        
    Total......................      54,200,000                                                                                                         
--------------------------------------------------------------------------------------------------------------------------------------------------------
Note: Appendix 1 to the preamble does not appear in the Code of Federal Regulation.                                                                     

    To calculate the Specific Market Risk Charge, a broker-dealer 
first categorizes those instruments subject to the charge into 
maturity categories based upon residual maturity. Note that for 
calculating the Specific Market Risk Charge, Adjustable Rate 
Securities are categorized by remaining maturity, not the time until 
the Next Interest Reset Date. The following demonstrates how the 
Specific Market Risk Charge is calculated for the sample portfolio.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                               Specific 
   Line No.          Security            Fixed or variable            Remaining maturity            Value          Specific market  risk     market risk
                                                                                                                        calculation             charge  
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                              Specific Market Risk Charge (Section 15c3-1(c)(2)(vi)(A)(2))                                              
--------------------------------------------------------------------------------------------------------------------------------------------------------
1.............  Nonconvertible     Variable....................  5 Years.....................      $2,500,000   x  2.1%=...................      $52,500
                 Debt.                                                                                                                                  
2.............  Nonconvertible     Variable....................  10 Years....................       1,000,000   x  2.1%=...................       21,000
                 Debt.                                                                                                                                  
3.............  Nonconvertible     Fixed.......................  10 Years....................       1,000,000   x  1.6%=...................       16,000
                 Debt.                                                                                                                                  
                                                                                                                                            ------------

[[Page 68009]]

                                                                                                                                                        
                    Total          ............................  ............................  ..............  ............................       89,500
                 Specific Market                                                                                                                        
                 Risk Charge.                                                                                                                           
--------------------------------------------------------------------------------------------------------------------------------------------------------

    To calculate the haircut for its Fixed Income Products, a firm 
would first take a haircut for offsetting positions within the same 
sub-zone. Any remaining unhedged positions could then be used to 
offset other residual amounts from other sub-zones within the same 
zone, albeit with a larger haircut. A broker-dealer would then 
offset unhedged amounts between zones. The largest haircut under the 
Proposed Amendments would be imposed on residual positions that 
could not be offset under this procedure. The following demonstrates 
how the Sub-Zone Charges are calculated under the Proposed 
Amendments. This example does not show the application of Appendix B 
of Rule 15c3-1 as it applies to Futures and Forward contracts.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                    Short                                      Sub-zone 
        Line No.                    Securities                 Sub-zone        Long positions     positions         Charge calculation          charge  
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                  Sub-Zone Charge (Section 15c3-1(c)(2)(vi)(A)(3)(ii))                                                  
--------------------------------------------------------------------------------------------------------------------------------------------------------
 1......................  Repurchase Agreement.........  i...................  ..............      $2,000,000                                           
 2......................  Reverse Repurchase Agreement.  i...................      $1,000,000  ..............  X 0% X 5%=..................           $0
                                                                              --------------------------------                                          
 3......................  Net Position.................  i...................  ..............       1,000,000                                           
                                                                                              ================                                          
 4......................  Sub-Zone Carry Forward (Line   i...................  ..............               0                                           
                           3 X Sub-Zone Percentage of                                                                                                   
                           0%).                                                                                                                         
 5......................  Treasury.....................  iii.................  ..............       1,000,000  X .4% X 5%=.................          200
 6......................  Treasury.....................  iii.................       1,500,000                                                           
                                                                              --------------------------------                                          
 7......................  Net Position.................  iii.................         500,000                                                           
                                                                              ================                                                          
 8......................  Sub-one Carry Forward (Line 7  iii.................           2,000                                                           
                           X Sub-Zone Percentage of                                                                                                     
                           .4%).                                                                                                                        
 9......................  Interest Rate Swap...........  iv..................       1,000,000  ..............  X .7% X 1%=.................           70
10......................  Interest Rate Swap...........  iv..................  ..............       1,200,000                                           
                                                                              --------------------------------                                          
11......................  Net Position.................  iv..................  ..............         200,000  ............................             
                                                                                              ================                                          
12......................  Treasury.....................  iv..................         500,000  ..............  X .7% X 5%=.................             
13......................  Treasury.....................  iv..................  ..............       1,000,000  X .7% X 5%=.................          175
14......................  Net Swap Position From Line    iv..................  ..............         200,000                                           
                           11.                                                                                                                          
                                                                              --------------------------------                                          
15......................  Net Position.................  iv..................  ..............         700,000                                           
                                                                                              ================                                          
16......................  Sub-Zone Carry Forward (Line   iv..................  ..............           4,900                                           
                           15 X Sub-Zone Percentage of                                                                                                  
                           .7%).                                                                                                                        
17......................  Treasury.....................  v...................       2,000,000                                                           
18......................  Treasury.....................  v...................       1,500,000  ..............  (2,000,000 + $1,500,000) X          2,188
                                                                                                                1.25% X 5%=.                            
19......................  Treasury.....................  v...................  ..............        1,000,00                                           
20......................  Treasury.....................  v...................  ..............      12,000,000                                           
21......................  Nonconvertible Debt..........  v...................  ..............       2,500,000                                           
                                                                              --------------------------------                                          
22......................  Net Position.................  v...................  ..............      12,000,000                                           
                                                                                              ================                                          
23......................  Sub-Zone Carry Forward (Line   v...................  ..............         150,000                                           
                           22 X Sub-Zone Percentage of                                                                                                  
                           1.25%).                                                                                                                      
24......................  Treasury.....................  vi..................       2,000,000                                                           
25......................  Nonconvertible Debt..........  vi..................       1,000,000                                                           
26......................  Treasury.....................  vi..................  ..............       2,500,000  X 1.75% X 5%=...............        2,188
                                                                              --------------------------------                                          
27......................  Net Position.................  vi..................         500,000                                                           
                                                                              ================                                                          
28......................  Sub-Zone Carry Forward (Line   vi..................           8,750                                                           
                           27 X Sub-Zone Percentage of                                                                                                  
                           1.75%).                                                                                                                      
29......................  Treasury.....................  viii................       1,000,000  ..............  X 2.75% X 5%=...............        1,375
30......................  Future on 5-Year Treasury....  viii................  ..............       2,000,000                                           
                                                                              --------------------------------                                          
31......................  Net Position.................  viii................  ..............       1,000,000                                           
                                                                                              ================                                          
32......................  Sub-Zone Carry Forward (Line   viii................  ..............          27,500                                           
                           31 X Sub-Zone Percentage of                                                                                                  
                           2.75%).                                                                                                                      
33......................  Treasury.....................  x...................  ..............       2,000,000                                           
34......................  Pass-Through Mortgage........  x...................  ..............       2,000,000  ($2,000,000 + $2,000,000) X         7,500
                                                                                                                3.75% X 5%=.                            

[[Page 68010]]

                                                                                                                                                        
35......................  Nonconvertible Debt..........  x...................       1,000,000                                                           
36......................  Future on 10-Year Treasury...  x...................       7,000,000                                                           
                                                                              --------------------------------                                          
37......................  Net Position.................  x...................       4,000,000                                                           
                                                                              ================                                                          
38......................  Sub-Zone Carry Forward (Line   x...................         150,000                                                           
                           37 X Sub-Zone Percentage of                                                                                                  
                           3.75%).                                                                                                                      
39......................  Treasury.....................  xiii................       3,000,000                                                           
40......................  Treasury.....................  xiii................  ..............       2,500,000  X 6% X 5%=..................        7,500
                                                                              --------------------------------                                          
41......................  Net Position.................  xiii................         500,000                                                           
                                                                              ================                                                          
42......................  Sub-Zone Carry Forward (Line   xiii................          30,000                                                           
                           41 X Sub-Zone Percentage of                                                                                                  
                           6%).                                                                                                                         
  Total Sub-Zone Charge.  .............................  ....................  ..............  ..............  ............................       21,195
                                                                                                                                            ------------
--------------------------------------------------------------------------------------------------------------------------------------------------------

    As discussed above, the Sub-Zone Carry Forward Amounts (i.e., 
the remaining unhedged positions after calculation of the Sub-Zone 
Charges) are then used to offset other Sub-Zone Carry Forward 
Amounts from the other sub-zones within the same zone. The following 
demonstrates how the Zone Charges are calculated for the example 
portfolio under the Proposed Amendments.

----------------------------------------------------------------------------------------------------------------
                                                                 Short                                          
    Line No.                Zones           Long positions     positions    Zone charge calculation  Zone charge
----------------------------------------------------------------------------------------------------------------
                                Zone Charge (Section 15c3-1(c)(2)(vi)(A)(3)(iii))                               
----------------------------------------------------------------------------------------------------------------
                           Zone 1                                                                               
 1..............  Carry Forward From Sub-           $2,000                                                      
                   Zone iii.                                                                                    
 2..............  Carry Forward From Sub-   ..............          $4,900  .......................             
                   Zone iv.                                                                                     
                                           --------------------------------                                     
 3..............  Total Zone Positions....           2,000           4,900  $2,000 x 25%=..........         $500
 4..............  Less Offsetting Position  ..............           2,000  .......................             
 5..............  Zone Carry Forward        ..............           2,900  .......................             
                   Amount.                                                                                      
                                           --------------------------------                                     
                           Zone 2                                                                               
 6..............  Carry Forward From Sub-   ..............         150,000                                      
                   Zone v.                                                                                      
 7..............  Carry Forward From Sub-            8,750  ..............                                      
                   Zone vi.                                                                                     
                                           --------------------------------                                     
 8..............  Total Zone Positions....           8,750         150,000  8,750 x 30%=...........        2,625
 9..............  Less Offsetting Position  ..............           8,750                                      
10..............  Zone Carry Forward        ..............         141,250  .......................             
                   Amount.                                                                                      
                                           --------------------------------                                     
                           Zone 3                                                                               
11..............  Carry Forward From Sub-   ..............          27,500                                      
                   Zone viii.                                                                                   
12..............  Carry Forward From Sub-          150,000  ..............                                      
                   Zone x.                                                                                      
                                           --------------------------------                                     
13..............  Total Zone Positions....         150,000          27,500  27,500 x 35%=..........        9,625
14..............  Less Offsetting Position          27,500                                                      
15..............  Zone Carry Forward               122,500  ..............                                      
                   Amount.                                                                                      
                                           --------------------------------                                     
16..............           Zone 4                                                                               
17..............  Carry Forward From Sub-           30,000  ..............                                      
                   Zone xiii.                                                                                   
                                           --------------------------------                                     
18..............  Total Zone Positions....          30,000  ..............  $0 x 40%...............            0
19..............  Less Offsetting Position               0  ..............                                      
                                           --------------------------------                                     
20..............  Zone Carry Forward                30,000  ..............                                      
                   Amount.                                                                                      
                                           --------------------------------                                     
                      Total Zone Charge...  ..............  ..............  .......................       12,750
----------------------------------------------------------------------------------------------------------------

    As discussed above, the Zone Carry Forward Amounts (i.e., the 
remaining unhedged positions after calculation of the Zone Charges) 
are then used to offset Zone Carry Forward Amounts. The following 
demonstrates how the Between Zone Charges are calculated for the 
example portfolio under the Proposed Amendments. In this example, 
the Between Zone Charges are calculated between Zone 1 and Zone 2; 
Zone 2 and Zone 3; and Zone 2 and Zone 4.

----------------------------------------------------------------------------------------------------------------
                                                             Short                                     Between  
   Line No.          Between zone       Long positions     positions      Between zone calculation   zone charge
----------------------------------------------------------------------------------------------------------------
                            Between Zone Charge (Section 15c13-1(c)(2)(vi)(A)(3)(iv))                           
----------------------------------------------------------------------------------------------------------------
 1............  Carry Forward From      ..............          $2,900                                          
                 Zone 1.                                                                                        

[[Page 68011]]

                                                                                                                
 2............  Carry Forward From      ..............         141,250  ...........................             
                 Zone 2.                                                                                        
                                       --------------------------------                                         
 3............  Total Zone Positions..  ..............         144,150  $0 x 50%=..................           $0
 4............  Less Offsetting Zone    ..............               0  ...........................  ...........
                 Positions.                                                                                     
 5............  Between Zone 2 Carry    ..............         141,250                                          
                 Forward Amount.                                                                                
                                       --------------------------------                                         
 6............  Zone 1 Residual Amount  ..............           2,900  ...........................  ...........
                                                                                                                
  Note: The Zone 1 Carry Forward Amount becomes a Between Zone Carry Forward Amount because it does not offset  
with Zone 2 as they are both short positions. The Between Zone 1 Carry Forward Amount is not offset against Zone
3 because the Zone 3 Carry Forward Amount is eliminated through its offset with Zone 2 as calculated below.     
Consequently, the Between Zone 1 Carry Forward Amount becomes a Residual Charge.                                
                                                                                                                
 7............  Between Zone 2 Carry    ..............         141,250  ...........................  ...........
                 Forward Amount.                                                                                
 8............  Carry Forward From            $122,500  ..............                                          
                 Zone 3.                                                                                        
                                       --------------------------------                                         
 9............  Total Zone Positions..         122,500         141,250  $122,500 x 60%=............       73,500
10............  Less Offsetting Zone    ..............         122,500                                          
                 Positions.                                                                                     
                                       --------------------------------                                         
11............  Between Zone 2 Carry    ..............          18,750  ...........................  ...........
                 Forward Amount.                                                                                
12............  Between Zone 2 Carry    ..............          18,750  ...........................  ...........
                 Forward.                                                                                       
13............  Between Zone 4 Carry            30,000  ..............  ...........................  ...........
                 Forward.                                                                                       
14............  Total Between Zone              30,000          18,750  18,750 x 90%=..............       16,875
                 Positions.                                                                                     
15............  Less Offsetting.......          18,750  ..............                                          
16............  Zone 4 Residual Amount          11,250  ..............  ...........................  ...........
                                       --------------------------------                                         
                                                                                                                
  Note: The Zone 4 Carry Forward Amount became a Between Zone Carry Forward Amount when the Zone 3 Carry Forward
Amount was eliminated. The Between Zone 4 Carry Forward Amount is partially offset by the Between Zone 2 Carry  
Forward Amount. Because there are no other Between Zone Carry Forward Amounts to offset against the Between Zone
4 Carry Forward Amount, it becomes a Residual Charge.                                                           
                                                                                                                
Total Between   ......................  ..............  ..............  ...........................       90,375
 Zone Charge.                                                                                                   
                                                                                                    ------------
----------------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------
          Risk charge            Applicable rule section      Haircut   
------------------------------------------------------------------------
                             Total Haircut                              
------------------------------------------------------------------------
Specific Market Charge.........  15c3-1(c)(2)(vi)(A)(2).         $89,500
Sub-Zone Charge................  15c3-1(c)(2)(vi)(A)(3)(          21,195
                                  ii).                                  
Zone Charge....................  15c3-1(c)(2)(vi)(A)(3)(          12,750
                                  iii).                                 
Between Zone Charge............  15c3-1(c)(2)(vi)(A)(3)(          90,375
                                  iv).                                  
Zone 1 Residual Charge.........  15c3-1(c)(2)(vi)(A)(3)(           2,900
                                  v).                                   
Zone 4 Residual Charge.........  15c3-1(c)(2)(vi)(A)(3)(          11,250
                                  v).                                   
                                                         ---------------
    Total Haircut..............  .......................         227,970
                                                         ---------------
    Total Value of Portfolio...  .......................      54,200,000
                                                         ===============
------------------------------------------------------------------------

[FR Doc. 97-33401 Filed 12-29-97; 8:45 am]
BILLING CODE 8010-01-P
```