67996 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

1 17 CFR 240.15c3–1

2Liquidity 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.

3The 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.

4 15 U.S.C. 78c(a)(42).

5For the purposes of the proposed Rule, ‘‘PassThrough 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.

6Money 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 brokerdealer. 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).

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.

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: rule-comments@sec.gov. 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

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.

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 brokerdealers. 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

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
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67997

8The Basle Accord is a common measurement

system and a minimum standard for capital

adequacy of international banks in the Group of Ten

countries.

9Securities Exchange Act Release No. 32256 (May

4, 1993), 58 FR 27486 (May 10, 1993) (‘‘Concept

Release’’).

10Securities Exchange Act Release No. 33761

(March 15, 1994), 59 FR 13275 (March 21, 1994).

11Securities Exchange Act Release No. 38248

(February 6, 1997), 62 FR 6474 (February 12, 1997).

12Securities Exchange Act Release No. 34–39456

(December 17, 1997).

13 17 CFR 240.15c3–1(c)(2)(vi)(F)(3).

14Appendix I is an example demonstrating how

the haircuts are calculated on a hypothetical

portfolio under the Proposed Amendments.

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

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 brokerdealers calculate market and credit risk

haircuts arising from their proprietary

positions.

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-thecounter (‘‘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

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.

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

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.

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
67998 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

15The zone and sub-zone grid may be found in

section vi(A)(3)(i)(A) of the Proposed Amendments.

16Next 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.

17The 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.

18For 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 subzone disallowance for offsetting swaps would be

equal to the product of $20 million × 0.2%×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 brokerdealer’s short positions in other securities in subzone (ii) for the purposes of calculating the subzone disallowance for other securities.

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.

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 subzones 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 subzone. 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 subzones 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

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 subzone, 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 SubZone 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 subzone 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

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 SubZone 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
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67999

19For 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 ×

0.2%×5% (or $700). The Long Sub-Zone CarryForward Amount would be $3 million × 0.2% (or

$6,000).

20See paragraph (c)(2)(vi)(A)(3)(iii)(A) of the

Proposed Amendments.

21 If in Zone 1, a firm had a $10,000 Long SubZone 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 $4,000×0.25 (or $1,000). The Long Zone CarryForward Amount would be $10,000 less $4,000, or

$6,000.

22See paragraph (c)(2)(vi)(A)(3)(iv)(A) of the

Proposed Amendments.

23 If a broker-dealer had a Long Zone CarryForward 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

$6,000×50% (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.

24Category 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.

25For 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.

26See the text.

Amount for each sub-zone.19 The SubZone Carry-Forward Amounts are used

to calculate the Zone Charge.

b. Zone Charge. Similar to the SubZone 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

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 nonadjacent 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 CarryForward 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 CarryForward Amount.

The Between Zone Charge for nonadjacent 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.

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 brokerdealer’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 nonexchange 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:
68000 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

27 17 CFR 240.15c3–1(c)(vi)(A)(5).

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.

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.

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

200,000×50%= 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

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.

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 subzones 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.

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 mortgagebacked security hedged with a Treasury

security with a similar residual maturity

but with a longer duration.

It has been argued that a mortgagebacked 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
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 68001

30Letter regarding Pass-Through Mortgage

Securities (December 30, 1996).

31Supra note 5.

32The general net capital treatment of forwards

on commodities (other than foreign currencies) is

set forth in Appendix B of Rule 15c3–1. Brokerdealers 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.

33For 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.

34A 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).

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

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.

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.

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-tomarket. 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.

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 PassThrough 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 SubZone Charge, instead of the 5 percent

Sub-Zone Charge applicable to nonswap positions.

6. Repurchase (‘‘Repo’’) and Reverse

Repurchase Agreements (Reverse Repo)

Under the current Rule, a brokerdealer 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

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
68002 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

38See Letter Regarding Ready Marketability of

Noninvestment Grade Debt (February 14, 1994).

39As indicated by a number of studies,

movements in most non-investment grade bonds are

not highly correlated with movements of highquality 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.

40A Eurodollar is U.S. currency held in banks

outside the United States, mainly in Europe, and

commonly used for settling international

transactions.

the Commission seeks comment on how

these instruments could be incorporated

into the Proposed Amendments.

1. Mortgage-Backed Securities and

Certain Non-Qualified Mortgage PassThrough 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 brokerdealers. 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

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.

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, brokerdealers 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.

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 brokerdealer’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
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 68003

41Securities Exchange Release No. 34–39456

(December 17, 1997).

42The 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).

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.

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 valueat-risk models for capital purposes.41

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

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.

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 brokerdealers 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
68004 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

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

45 5 U.S.C. 603.

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

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 brokerdealers. This should allow brokerdealers 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 brokerdealers 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.

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 brokerdealer’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.

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 brokerdealers 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 brokerdealers would have to adjust their

processes and procedures for calculating

net capital and that this would likely

involve amending their computer

information systems.

More specifically, some brokerdealers’ 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 brokerdealers. 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
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 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 brokerdealers’ Fixed Income Products

positions and related hedging practices

while ensuring that registered brokerdealers 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 § 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:

§ 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 (§ 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:

Residual maturity of

product

Percentage fixed

rate

Percentage adjustable

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
68006 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

(c)(2)(vi)(3)(i)(B), (c)(2)(vi)(3)(i)(C) and

(c)(2)(vi)(3)(i)(D) of this section.

Residual maturity Subzone

Subzone

percentage

Zone 1:

1 month or less ............... (i) 0

More than 1 month but

not more than 3

months.

(ii) 0.20

More than 3 months but

not more than 6

months.

(iii) 0.40

More than 6 months but

not more than 1 year.

(iv) 0.70

Zone 2:

More than 1 year but not

more than 2 years.

(v) 1.25

More than 2 years but

not more than 3 years.

(vi) 1.75

More than 3 years but

not more than 4 years.

(vii) 2.25

Residual maturity Subzone

Subzone

percentage

Zone 3:

More than 4 years but

not more than 5 years.

(viii) 2.75

More than 5 years but

not more than 7 years.

(ix) 3.25

More than 7 years but

not more than 10 years.

(x) 3.75

Zone 4:

More than 10 years but

not more than 15 years.

(xi) 4.50

More than 15 years but

not more than 20 years.

(xii) 5.25

More than 20 years ........ (xiii) 6.00

Zone 5:

Deep Discount Bonds

with more than 15

years but not more

than 20 years.

(xiv) 9.00

Residual maturity Subzone

Subzone

percentage

Deep discount bonds

with more than 20

years.

(xv) 12.00

(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 PassThrough 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 = 108% ...................... >103% .............................................................. >102%.

(vii) .............................. >102% but less than or = 105% ...................... >100% but less than or = 103% ...................... >94% but less than or

= 102%.

(viii) ............................. >98% but less than or = 102% ........................ 100% or less .................................................... 94% or less.

(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 Subzone

More than 6 years but not more

than 71⁄2 years.

(x)

More than 71⁄2 years but not more

than 9 years.

(xi)

More than 9 years but not more

than 12 years.

(xii)

More than 12 years but not more

than 15 years.

(xiii)

More than 15 years but not more

than 20 years.

(xiv)

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 (§ 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
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 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 subzone multiplied by the applicable SubZone 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 SubZone Carry-Forward Amounts and

aggregate Short Sub-Zone CarryForward 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 CarryForward 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

Zones Percentage

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 CarryForward Amount.

(B) The Long and Short Zone CarryForward 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 PassThrough 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
68008 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

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 Agreement∧ ................ 1,000,000 Long ............ 30 Days ............ Fixed ............................ 1 i

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.

Line No. Security Fixed or variable Remaining maturity Value Specific market

risk calculation

Specific

market risk

charge

Specific Market Risk Charge (Section 15c3–1(c)(2)(vi)(A)(2))

1 ............. Nonconvertible Debt ......... Variable ..................... 5 Years ...................... $2,500,000 × 2.1%= ..................... $52,500

2 ............. Nonconvertible Debt ......... Variable ..................... 10 Years .................... 1,000,000 × 2.1%= ..................... 21,000

3 ............. Nonconvertible Debt ......... Fixed .......................... 10 Years .................... 1,000,000 × 1.6%= ..................... 16,000
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 68009

Line No. Security Fixed or variable Remaining maturity Value Specific market

risk calculation

Specific

market risk

charge

Total Specific Market

Risk Charge.

.................................... .................................... ........................ .................................... 89,500

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.

Line No. Securities Sub-zone Long positions Short positions Charge calculation

Sub-zone

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 3 X Sub-Zone

Percentage of 0%).

i .............. ........................ 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 X Sub-Zone Percentage of .4%).iii ............ 2,000

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 11 .......................... iv ............ ........................ 200,000

15 ............... Net Position ........................................................... iv ............ ........................ 700,000

16 ............... Sub-Zone Carry Forward (Line 15 X Sub-Zone

Percentage of .7%).

iv ............ ........................ 4,900

17 ............... Treasury ................................................................ v ............. 2,000,000

18 ............... Treasury ................................................................ v ............. 1,500,000 ........................ (2,000,000 +

$1,500,000) X

1.25% X 5%=.

2,188

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 22 X Sub-Zone

Percentage of 1.25%).

v ............. ........................ 150,000

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 27 X Sub-Zone

Percentage of 1.75%).

vi ............ 8,750

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 31 X Sub-Zone

Percentage of 2.75%).

viii .......... ........................ 27,500

33 ............... Treasury ................................................................ x ............. ........................ 2,000,000

34 ............... Pass-Through Mortgage ....................................... x ............. ........................ 2,000,000 ($2,000,000 +

$2,000,000) X

3.75% X 5%=.

7,500
68010 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

Line No. Securities Sub-zone Long positions Short positions Charge calculation

Sub-zone

charge

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 37 X Sub-Zone

Percentage of 3.75%).

x ............. 150,000

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 41 X Sub-Zone

Percentage of 6%).

xiii .......... 30,000

Total SubZone

Charge.

................................................................................ ................ ........................ ........................ ........................... 21,195

As discussed above, the Sub-Zone Carry Forward Amounts (i.e., the remaining unhedged positions after calculation of the SubZone 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.

Line No. Zones Long positions Short positions Zone charge

calculation

Zone

charge

Zone Charge (Section 15c3–1(c)(2)(vi)(A)(3)(iii))

Zone 1

1 ........... Carry Forward From Sub-Zone iii ................................................. $2,000

2 ........... Carry Forward From Sub-Zone iv ................................................. ........................ $4,900 .

3 ........... Total Zone Positions ..................................................................... 2,000 4,900 $2,000×25%= ... $500

4 ........... Less Offsetting Position ................................................................ ........................ 2,000 .

5 ........... Zone Carry Forward Amount ........................................................ ........................ 2,900 .

Zone 2

6 ........... Carry Forward From Sub-Zone v .................................................. ........................ 150,000

7 ........... Carry Forward From Sub-Zone vi ................................................. 8,750 ........................

8 ........... Total Zone Positions ..................................................................... 8,750 150,000 8,750×30%= ..... 2,625

9 ........... Less Offsetting Position ................................................................ ........................ 8,750

10 ........... Zone Carry Forward Amount ........................................................ ........................ 141,250 .

Zone 3

11 ........... Carry Forward From Sub-Zone viii ............................................... ........................ 27,500

12 ........... Carry Forward From Sub-Zone x .................................................. 150,000 ........................

13 ........... Total Zone Positions ..................................................................... 150,000 27,500 27,500×35%= ... 9,625

14 ........... Less Offsetting Position ................................................................ 27,500

15 ........... Zone Carry Forward Amount ........................................................ 122,500 ........................

16 ........... Zone 4

17 ........... Carry Forward From Sub-Zone xiii ............................................... 30,000 ........................

18 ........... Total Zone Positions ..................................................................... 30,000 ........................ $0×40% ............ 0

19 ........... Less Offsetting Position ................................................................ 0 ........................

20 ........... Zone Carry Forward Amount ........................................................ 30,000 ........................

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.

Line No. Between zone Long positions Short positions Between zone calculation

Between

zone charge

Between Zone Charge (Section 15c13–1(c)(2)(vi)(A)(3)(iv))

1 ........... Carry Forward From Zone 1 ................................................ ........................ $2,900
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 68011

Line No. Between zone Long positions Short positions Between zone calculation

Between

zone charge

2 ........... Carry Forward From Zone 2 ................................................ ........................ 141,250 .

3 ........... Total Zone Positions ............................................................ ........................ 144,150 $0×50%= ................... $0

4 ........... Less Offsetting Zone Positions ............................................ ........................ 0 .................................... ....................

5 ........... Between Zone 2 Carry Forward Amount ............................. ........................ 141,250

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 Forward Amount ............................. ........................ 141,250 .................................... ....................

8 ........... Carry Forward From Zone 3 ................................................ $122,500 ........................

9 ........... Total Zone Positions ............................................................ 122,500 141,250 $122,500×60%= ........ 73,500

10 ........... Less Offsetting Zone Positions ............................................ ........................ 122,500

11 ........... Between Zone 2 Carry Forward Amount ............................. ........................ 18,750 .................................... ....................

12 ........... Between Zone 2 Carry Forward ........................................... ........................ 18,750 .................................... ....................

13 ........... Between Zone 4 Carry Forward ........................................... 30,000 ........................ .................................... ....................

14 ........... Total Between Zone Positions ............................................. 30,000 18,750 18,750×90%= ............ 16,875

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

Zone

Charge.

............................................................................................... ........................ ........................ .................................... 90,375

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)(ii) ............................................................ 21,195

Zone Charge ............................................................................... 15c3–1(c)(2)(vi)(A)(3)(iii) ............................................................ 12,750

Between Zone Charge ................................................................ 15c3–1(c)(2)(vi)(A)(3)(iv) ........................................................... 90,375

Zone 1 Residual Charge ............................................................. 15c3–1(c)(2)(vi)(A)(3)(v) ............................................................ 2,900

Zone 4 Residual Charge ............................................................. 15c3–1(c)(2)(vi)(A)(3)(v) ............................................................ 11,250

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

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Part 240

[Release No. 34–39456; File No. S7–32–97]

RIN 3235–AH29

Net Capital Rule

AGENCY: Securities and Exchange

Commission.

ACTION: Concept release; request for

comments.

SUMMARY: The Securities and Exchange

Commission is continuing its study of

its approach to determining net capital

requirements for broker-dealers. As part

of its study, the Commission is

considering the extent to which

statistical models should be used in

setting the capital requirements for a

broker-dealer’s proprietary positions.

Accordingly, the Commission is posing

a number of questions on this subject as

well as soliciting views on other

possible alternatives for establishing net

capital requirements.

DATES: Comments must be received on

or before March 30, 1998.

ADDRESSES: Interested persons should

submit three copies of their written

data, views, and opinions to Jonathan G.

Katz, Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W.,

Washington, D.C. 20549. Comments also

may be submitted electronically at the

following E-mail address: rulecomments@sec.gov. Comment letters

should refer to File No. S7–32–97; this

file number should be included on the

subject line if E-mail is used. All

submissions will be available for public

inspection and copying at 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).