67940 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

1 17 CFR 240.3b–12, 240.3b–13, 240.3b–14,

240.3b–15, 240.3b–16, 240.15a–1, 240.15b9–2,

240.15c3–4, 240.17a–12, 240.36a1–1, and 240.36a1–

2.

2 15 U.S.C. 78a et seq.

3 17 CFR 200.30–3.

4 17 CFR 240.8c–1, 240.15b1–1, 240.15c2–1,

240.15c3–1, 240.15c3–3, 240.17a–3, 240.17a–4, and

240.17a–11.

5 17 CFR 249.617.

6 ‘‘ISDA Market Survey,’’ ISDA Internet web site

(http://www.isda.org).

7See Peter A. Abken, Beyond Plain Vanilla: A

Taxonomy of Swaps, Financial Derivatives Reader

(Robert W. Kolb, ed.) (1992) at 265.

8Swaps are contracts that typically allow the

parties to the contract to exchange cash flows

related to the value or performance of certain assets,

rates, or indexes for a specified period of time. See

generally Peter A. Abken, Beyond Plain Vanilla: A

Taxonomy of Swaps, Financial Derivatives Reader

(Robert W. Kolb, ed.) (1992). Most swaps are based

on currencies or interest rates. Swaps that provide

for an exchange of values based on the value or

performance of equity securities make up a small,

but growing, share of the swaps market. Options are

instruments that generally provide the holder, in

exchange for the payment of a premium, with

benefits of favorable movements in the underlying

asset or index with limited or no exposure to losses

from unfavorable price movements. Typically, OTC

options provide for cash settlement, rather than the

delivery of the underlying asset, rate, or index.

Credit derivatives function like options to the

extent payments under the contract are made in the

event of a credit event, such as a decline in an

issuer’s credit rating or default in performance

under a debt obligation.

9See, e.g., Clifford W. Smith, Jr., Charles W.

Smithson, and D. Sykes Wilford, Managing

Financial Risk, Financial Derivatives Reader (Robert

W. Kolb, ed.) (1992); Group of Thirty, Derivatives:

Practices and Principles (July 1993); Financial

Derivatives: Actions Needed to Protect the

Financial System, United States General

Accounting Office Report (May 1994).

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Parts 200, 240, 249

[Release No. 34–39454; File No. S7–30–97]

RIN 3235–AH16

OTC Derivatives Dealers

AGENCY: Securities and Exchange

Commission.

ACTION: Proposed rule.

SUMMARY: The Securities and Exchange

Commission is publishing for comment

proposed rules and rule amendments

under the Securities Exchange Act of

1934 that would tailor capital, margin,

and other broker-dealer regulatory

requirements to a class of registered

dealers, called OTC derivatives dealers,

active in over-the-counter derivatives

markets. The proposed regulations for

OTC derivatives dealers are intended to

allow securities firms to establish dealer

affiliates that would be able to compete

more effectively against banks and

foreign dealers in global over-thecounter markets. Registration as an OTC

derivatives dealer under the proposed

rules would be an alternative to

registration as a fully regulated brokerdealer, and would be available only to

entities acting primarily as

counterparties in privately negotiated

over-the-counter derivatives

transactions.

DATES: Comments should be submitted

on or before March 2, 1998.

ADDRESSES: Comments should be

submitted in triplicate to Jonathan G.

Katz, Secretary, Securities and Exchange

Commission, Mail Stop 6–9, 450 Fifth

Street, N.W., Washington, D.C. 20549.

Comments may also be submitted

electronically at the following E-mail

address: rule-comments@sec.gov. All

comment letters should refer to File No.

S7–30–97. This file number should be

included on the subject line if E-mail is

used. Comment letters 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. Comment

letters that are submitted electronically

will be posted on the Commission’s

Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT:

General: Catherine McGuire, Chief

Counsel, Glenn J. Jessee, Special

Counsel, or Patrice Gliniecki, Special

Counsel, at (202) 942–0073, Division of

Market Regulation, Securities and

Exchange Commission, 450 Fifth Street,

N.W., Mail Stop 7–11, Washington, D.C.

20549.

Financial Responsibility and Books

and Records: Michael 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,

Louis Randazzo, Special Counsel, at

(202) 942–0191, Marc Hertzberg,

Attorney, at (202) 942–0146,

Christopher Salter, Attorney, at (202)

942–0148, Matt Hughey, Accountant, at

(202) 942–0143, or Gary Gregson,

Statistician, at (202) 942–4156, Division

of Market Regulation, Securities and

Exchange Commission, 450 Fifth Street,

N.W., Mail Stop 2–2, Washington, D.C.

20549.

SUPPLEMENTARY INFORMATION: The

Securities and Exchange Commission is

publishing for comment proposed Rules

3b–12, 3b–13, 3b–14, 3b–15, 3b–16,

15a–1, 15b9–2, 15c3–4, 17a–12, 36a1–1,

and 36a1–2 1 under the Securities

Exchange Act of 1934 (‘‘Exchange

Act’’).2 The Commission also proposes

to amend Rule 30–3 3 and Exchange Act

Rules 8c–1, 15b1–1, 15c2–1, 15c3–1,

15c3–3, 17a–3, 17a–4, and 17a–11,4 and

to revise Form X–17A–5 (FOCUS

report).5

I. Introduction

Privately negotiated, over-the-counter

(‘‘OTC’’) derivatives transactions

involving large institutions have come

to occupy a prominent place in global

finance. The International Swaps and

Derivatives Association (‘‘ISDA’’)

estimates that, as of December 31, 1996,

the combined notional amount of

globally outstanding interest rate swaps,

currency swaps, and interest rate

options has grown to $25.4 trillion.6

This market has reached this size in a

relatively short period of time. In fact,

the first major swap transaction was

effected between IBM and the World

Bank only 16 years ago.7

Whether OTC derivatives transactions

are structured as interest rate swaps,

foreign currency swaps, equity swaps,

basis swaps, total return swaps, credit

derivatives, or options, they share

certain characteristics.8 For example,

each has a value or return related to the

value or return of an underlying asset.

Asset classes can consist of securities or

virtually any other financial instrument,

financial measure, or physical

commodity, such as interest rates,

securities indices, foreign currencies,

metals or petroleum, or spreads between

the values of different assets. More

importantly, each of these products can

provide their users with a carefully

tailored method for managing a variety

of risks.9

Relying on developments in financial

engineering, dealers and end-users can

identify and isolate different kinds and

degrees of risk present in their portfolios

and not only evaluate these risks, but

design derivative instruments to

specifically address them. Some OTC

derivatives transactions, for example,

are structured to address market risk—

the risk that the value of the underlying

asset, rate, or index will suffer an

adverse change in value. Others are

designed to address asset volatility. Still

others, based on two or more assets,

may address risks posed by changes in

the values of the assets relative to one

another. This is particularly true in the

case of foreign currency swaps, but may

also apply where correlations exist

between the performance of different

assets. Recently, the financial industry

has developed credit derivatives that

address the risks associated with the

default by, or a decline in the rating of,

a particular issuer of debt or other

securities.

As new products are developed as a

result of dealer creativity and in

response to the needs of end-users,
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67941

10 15 U.S.C. 78c(a)(10).

11See 15 U.S.C. 78o(b).

12This bank exclusion from the Exchange Act

definitions of ‘‘broker’’ and ‘‘dealer’’ is available

only to those banking institutions that satisfy the

definition of ‘‘bank’’ set forth in Section 3(a)(6) of

the Exchange Act [15 U.S.C. § 78c(a)(6)].

13Bank regulators have issued guidance to banks

engaging in derivatives activities. See, e.g., Risk

Management of Financial Derivatives, OCC Banking

Circular No. 277 (Oct. 1993); OCC Bulletin 94–31,

Questions and Answers For BC–277 (May 1994);

OCC Bulletin 96–43, Credit Derivatives (Aug. 1996);

OCC Bulletin 96–25, Fiduciary Risk Management of

Derivatives and Mortgage-backed Securities (Apr.

1996).

14The Commission’s current net capital rule [17

CFR 240.15c3–1] imposes substantial capital

charges in connection with conducting an OTC

derivatives business. For example, under the net

capital rule, broker-dealers holding interest rate

swaps must calculate two potential capital charges

for each swap. First, the net capital rule considers

any net interest payment due to be an unsecured

receivable, subject to a 100% capital charge in

computing net capital. Second, a broker-dealer must

also take a deduction, or haircut, on the notional

amount of the swap. The size of the haircut

depends on whether the firm has offset the swap.

Current margin requirements also make it difficult

for registered broker-dealers to conduct an OTC

derivatives business. Under Section 7 of the

Exchange Act [15 U.S.C. 78g] and Regulation T [12

CFR 220.1], broker-dealers are prohibited from

extending credit on securities other than margin

securities. In general, this means that registered

broker-dealers cannot extend credit in securities

OTC derivatives transactions on terms as favorable

as those offered by other dealers.

15 ‘‘Hybrid securities’’ are securities products that

typically incorporate payment features that are

economically similar to options, forwards, futures,

or swaps involving currencies, interest rates,

commodities, securities, or indices (or any

combination, permutation, or derivative of these

underlying assets). The proposed definition of

‘‘hybrid security’’ is discussed in Section II.A.4.

below. Structured notes are notes that, like other

OTC derivative products, provide for a return that

is based on the value or return of an underlying

asset.

some of these products may cross

regulatory boundaries. OTC options on

equity securities or on U.S. government

securities, for example, are securities

within the definition set forth in Section

3(a)(10) of the Securities Exchange Act

of 1934 (‘‘Exchange Act’’).10 Firms that

effect transactions in these or other

securities OTC derivative products are

required to register as broker-dealers

under Section 15(b) of the Exchange

Act 11 and become subject to all of the

regulations applicable to other securities

brokers-dealers, including Exchange Act

rules governing margin and capital.

Firms that effect transactions only in

non-securities OTC derivative products

are not subject to U.S. broker-dealer

regulation. In addition, because banks

are excluded from the Exchange Act

definitions of ‘‘broker’’ and ‘‘dealer,’’ 12

they may engage in a broad range of

securities and non-securities OTC

derivatives activities consistent with

guidance issued by their applicable

bank regulators.13

The potential costs of broker-dealer

regulation, as applied to OTC

derivatives dealers, have affected the

way U.S. securities firms conduct

business in OTC derivatives markets. In

many instances, U.S. firms have decided

to locate segments of their OTC

derivatives business in foreign financial

centers. The manner in which business

relationships between dealers and their

counterparties are structured has also

played a role in the development of

offshore locations for OTC derivatives

business.

For example, in order to reduce credit

exposure to a single counterparty,

dealers in OTC derivatives markets

enter into master agreements with their

counterparties that provide for netting

of the outstanding financial obligations

existing between the dealers and their

counterparties. It makes sense,

therefore, for dealers to seek to conduct

both securities and non-securities OTC

derivatives transactions with any

counterparty through a single legal

entity. To the extent a non-bank dealer’s

transactions include securities OTC

derivative products, the federal

securities laws would require this single

legal entity to be a U.S. registered

broker-dealer. Capital and margin

requirements applicable to registered

broker-dealers, however, impose

substantial costs on the operation of an

OTC derivatives business and make it

difficult for U.S. securities firms to

compete effectively with banks and

foreign dealers in OTC derivatives

markets.14

While there may be other reasons for

U.S. securities firms to conduct business

from foreign financial centers, U.S.

securities firms should not be

compelled to move business activities

outside of the United States solely to

address competitive disadvantages that

result from Commission regulation.

Accordingly, the Commission proposes

to establish a form of limited brokerdealer regulation that would give U.S.

securities firms an opportunity to

conduct business in a vehicle subject to

modified regulation appropriate to OTC

derivatives markets.

This proposed structure is optional

and is designed to allow U.S. securities

firms to establish separate entities

capable of acting as counterparties with

respect to both securities and nonsecurities OTC derivative products.

Capital, margin, and various other

requirements would be tailored to the

activities of these entities. These

tailored requirements are intended, in

part, to improve the efficiency and

competitiveness of U.S. securities firms

active in global OTC derivatives

markets. These improvements should

benefit participants in OTC derivatives

markets. OTC derivatives dealers would

remain subject to other rules applicable

to fully regulated broker-dealers.

Registration as an OTC derivatives

dealer would be an alternative to

registration as a fully regulated brokerdealer under Section 15(b) of the

Exchange Act, and would be available

only to entities acting primarily as

counterparties in privately negotiated

OTC derivatives transactions. OTC

derivatives dealers would also be

allowed to engage in certain categories

of securities activities related to

conducting an OTC derivatives

business. For example, OTC derivatives

dealers would be able to enter into

transactions for risk management

purposes and to take possession of or

sell counterparty collateral. They would

also be permitted to issue securities,

including warrants on securities, hybrid

securities products, and structured

notes. 15

The Commission is concerned,

however, that OTC derivatives dealers

not take advantage of the modified

regulatory requirements under the

limited regulatory structure to engage in

a significant degree of activity better

suited to full broker-dealer regulation.

Accordingly, the Commission proposes

that OTC derivatives dealers be allowed

to engage only in the securities activities

described in the proposed rules, and

that all securities transactions,

including securities OTC derivative

transactions, be effected through a fully

regulated broker-dealer.

II. Description of the Proposed Rules

and Rule Amendments

A. Definitions

As further detailed below, the

proposed rules define five new terms:

(1) OTC derivatives dealer; (2) eligible

OTC derivative instrument; (3)

permissible derivatives counterparty; (4)

permissible risk management, arbitrage,

and trading transaction; and (5) hybrid

security.

1. Proposed Rule 3b–12; Definition of

OTC Derivatives Dealer

The proposed definition of OTC

derivatives dealer is intended to

encompass those dealers that are

primarily engaged in acting as

counterparty in OTC derivatives

transactions. The Commission

recognizes, however, that it would be

appropriate to permit entities that elect

to become subject to the limited

regulatory system also to conduct

limited securities activities in
67942 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

16Transactions by an OTC derivatives dealer that

involve securities OTC derivative instruments must

be effected through a fully regulated broker-dealer.

See infra Section II.C., discussing proposed Rule

15a–1.

17The Commission expects that the rules being

proposed today would be used by firms that are

engaged primarily in the business of engaging in

transactions in eligible OTC derivative instruments

with permissible derivatives counterparties. As

discussed in this release, one purpose of the limited

regulatory structure for OTC derivatives dealers is

to make it possible for U.S. securities firms to better

compete in OTC derivatives markets with banks

and foreign dealers. As discussed in Section II.A.4.

below, OTC derivatives dealers would be permitted

to engage in certain other securities activities that

are closely related to conducting an OTC

derivatives business. The regulatory structure for

OTC derivatives dealers is not intended to allow

securities firms to move substantial securities

activity out of fully regulated broker-dealers into

OTC derivatives dealers in order to take advantage

of the modified capital and margin requirements

applicable to these entities. OTC derivatives dealers

would also be prohibited from accepting or holding

customer funds or securities, or acting as a ‘‘dealer’’

in securities. See infra note 24.

18 15 U.S.C. 78o(b).

19Part 35 exempts certain swap agreements from

most provisions of the Commodity Exchange Act [7

U.S.C. 1 et seq.], provided that the transaction is

conducted solely between ‘‘eligible swap

participants,’’ as defined in Part 35. The

Commission believes that the proposed definition

of ‘‘permissible derivatives counterparty,’’ generally

describes participants active in OTC derivatives

markets, but requests comment on this point.

connection with their OTC derivatives

business. Accordingly, proposed Rule

3b–12 would define OTC derivatives

dealer to mean any dealer that limits its

securities activities to (1) engaging as a

counterparty in transactions in eligible

OTC derivative instruments (as defined

in proposed Rule 3b–13) with

permissible derivatives counterparties

(as defined in proposed Rule 3b–14); 16

(2) issuing and reacquiring issued

securities through a fully regulated

broker or dealer; or (3) engaging in other

securities transactions which the

Commission designates by order, and in

connection with any of these activities,

engaging in permissible risk

management, arbitrage, and trading

transactions (as defined in proposed

Rule 3b–15) 17

Typically, U.S. firms that engage in

securities derivatives activities are

required to register as broker-dealers

under Section 15(b) of the Exchange

Act 18 and become subject to all of the

regulations that apply to other fully

regulated broker-dealers. Registration as

an OTC derivatives dealer would be an

alternative to full broker-dealer

registration and would afford securities

firms an opportunity to elect to conduct

their activities in a vehicle subject to

modified regulation. OTC derivatives

dealers would also be permitted to

engage in any non-securities activity,

subject to appropriate capital treatment,

as further discussed below.

2. Proposed Rule 3b–13; Definition of

Eligible OTC Derivative Instrument.

Proposed Rule 3b–13 sets forth

various criteria for determining whether

a particular OTC derivative instrument

is part of the class of instruments in

which an OTC derivatives dealer would

be eligible to act as counterparty. As

defined in the proposed rule, these

instruments would include any

agreement, contract, or transaction that

is not part of a fungible class of

agreements, contracts, or transactions

that are standardized as to their material

economic terms and that are not entered

into and traded on an exchange or other

similar type of facility. These

instruments would be based, in whole

or in part, on the value of, any interest

in, any quantitative measure of, or the

occurrence of any event relating to, one

or more securities, commodities,

currencies, interest or other rates,

indices, or other assets, or involve

certain long-dated forward contracts,

specifically contracts to purchase or sell

a security on a firm basis at least one

year following the transaction date.

These criteria, the Commission believes,

set reasonable standards that reflect that

participants in the OTC derivatives

market are primarily institutions that

engage in privately negotiated

transactions based, in part, on an

assessment of a counterparty’s credit

and its ability to perform under the

terms of a transaction.

The types of instruments that would

generally satisfy the criteria set forth in

proposed Rule 3b–13 would include

interest rate swaps, currency swaps,

equity swaps, swaps involving physical

commodities (such as metals or

petroleum), OTC options on equities

(including equity indices), OTC options

on U.S. government securities, OTC

debt options (including options on debt

indices), options on physical

commodities, long-dated forwards on

securities, and forwards relating to other

types of assets. This list, however, is not

intended to be an exclusive list, and

OTC derivatives dealers would be

permitted to act as counterparty in any

instrument that meets the requirements

of the proposed rule. As noted above,

although OTC derivatives dealers would

be primarily engaged in transactions

involving eligible OTC derivative

instruments, under the proposed

regulatory system, they would also be

permitted to engage in a limited range

of other activities. These are discussed

in Section II.A.4. below.

3. Proposed Rule 3b–14; Definition of

Permissible Derivatives Counterparty

Proposed Rule 3b–14 defines those

entities with which OTC derivatives

dealers would be permitted to act as

counterparties. As noted above, one goal

underlying the proposal to create a

limited system of broker-dealer

regulation is to accommodate an

institutional business that, in many

instances, is being conducted offshore

and to make it feasible for U.S.

securities firms to combine securities

and non-securities OTC derivatives

activities in one entity. Persons who

would be considered to be permissible

derivatives counterparties in

transactions with OTC derivatives

dealers would be the same persons who

currently are eligible to effect

transactions with swaps dealers under

the Commodity Future Trading

Commission’s swaps exemption set

forth at 17 CFR Part 35.19 Such persons

generally would include banks;

investment companies; commodity

pools with total assets exceeding $5

million; corporations, partnerships,

proprietorships, organizations, trusts, or

other entities that have total assets

exceeding $10 million, or that have net

worth exceeding $1 million and are

entering into transactions in connection

with the conduct of their business;

employee benefit plans subject to the

Employee Retirement Income Security

Act of 1974 with total assets exceeding

$5 million; governmental entities;

broker-dealers; futures commission

merchants; and natural persons having

total assets exceeding $10 million.

The Commission is also considering

whether to include an additional class

of permissible derivatives counterparty,

specifically natural persons having at

least $5 million in total assets who enter

into OTC derivatives transactions to

hedge existing or anticipated assets or

liabilities. Persons in this class may

include, for example, persons who

acquire significant holdings of equity

securities as a result of starting or

operating a business or who own

securities with a very low basis for tax

purposes, but do not want to sell their

holdings at the present time. These

persons would be able to reduce the risk

associated with being heavily invested

in one type of security and diversify

their market exposure by entering into

a swap or cash-settled option without

selling their holdings. The Commission

specifically solicits comments on

whether to broaden the definition of

permissible derivatives counterparty to

include this class of natural persons, or

other categories of institutional

investors, and encourages persons who

have entered into OTC derivatives

transactions to comment on the risks

and benefits these transactions may
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67943

20As noted above, under the proposed rules, OTC

derivatives dealers would be permitted to engage in

any non-securities activity, subject to appropriate

capital treatment under Exchange Act Rule 15c3–

1 [17 CFR 240.15c3–1].

21Trading volume and the instruments traded for

risk management purposes also do not provide clear

links to the instruments being hedged. For example,

trading volume may increase as contracts mature or

during times of unusual market volatility. Also,

instruments based on one security may be hedged

by trading other securities (or securities derivatives)

where a relationship exists between the value or

performance of the two securities. This relationship

may change over time or under different market

conditions.

22A buy/sell transaction is in many respects the

economic equivalent of a repurchase transaction,

except that title to the debt instrument that is the

subject of the transaction passes to another party

and it is that party, rather than the original owner,

who receives payments of interest made during the

term of the buy/sell transaction.

23Consistent with the proposed limitations on the

securities activities of OTC derivatives dealers,

permissible arbitrage transactions would be limited

to transactions involving closely related cash

market and derivative instruments that are effected

close to one another in time for purposes of taking

advantage of price disparities in different markets.

An example would include transactions involving

the purchase or sale of an equity security and the

acquisition of an option on the same equity security

that are effected close together in time, taking into

consideration market liquidity and hours of market

operation.

24Except to the extent expressly permitted under

the proposed rules, an OTC derivatives dealer

would not be permitted to engage directly or

indirectly in any activity that may otherwise cause

it to be a ‘‘dealer’’ as defined in Section 3(a)(5) of

the Exchange Act [15 U.S.C. § 78c(a)(5)]. This

would include, but not be limited to, (1) purchasing

or selling securities as principal from or to

customers; (2) carrying a dealer inventory in

securities (or any portion of an affiliated brokerdealer’s inventory); (3) quoting a market in or

publishing quotes for securities (other than quotes

on one side of the market on a quotations system

Continued

present. The Commission is also

interested in commenters’ views

whether factors other than total assets

should be considered in determining

which persons should be included in

the definition.

4. Proposed Rules 3b–15 and 3b–16;

Definition of Permissible Risk

Management, Arbitrage, and Trading

Transaction; Definition of Hybrid

Security

Proposed Rule 3b–15 would permit an

OTC derivatives dealer to engage in a

limited range of securities activities,

described under the rule as risk

management, arbitrage, and trading

transactions, in connection with the

dealer’s business as a counterparty in

eligible OTC derivative instruments and

as an issuer of securities. As discussed

above, the focus of the regulatory system

for OTC derivatives dealers is on

providing a regulatory vehicle that

would allow securities firms to establish

separate entities through which to

operate an OTC derivatives business.

This necessarily includes the ability of

OTC derivatives dealers to take

possession of and sell counterparty

collateral, to invest short-term cash

balances, to manage risks associated

with their OTC derivatives positions or

their issuance of securities, and to

engage in limited financing and

arbitrage transactions.

The Commission recognizes the

commercial interests that drive financial

enterprises and the desire to maximize

revenues. The Commission, however, is

also concerned that securities firms not

be able to move dealer activity in cash

market instruments, such as stocks and

bonds, that is currently conducted

through a fully regulated broker-dealer

into an OTC derivatives dealer. One

reason is that OTC derivatives dealers

should not be provided with an unfair

regulatory advantage over fully

regulated broker-dealers due to the

availability of modified capital and

margin requirements. A second reason

is the Commission’s view that entities

that engage in comprehensive dealer

activity should be subject to full brokerdealer regulation, including the

Commission’s existing capital and

margin requirements, and be subject to

supervision by a securities selfregulatory organization (‘‘SRO’’). In this

instance, the Commission believes it is

possible to satisfy the commercial

interests of derivatives dealers in a

manner consistent with sound

regulatory policy, and proposes to

permit OTC derivatives dealers to

engage in a limited range of securities

activities.20

Under the proposed rule, OTC

derivatives dealers would be permitted

to take possession of and sell

counterparty collateral and invest shortterm cash balances. It is expected,

however, that any securities trading

activity associated with short-term cash

management by OTC derivatives dealers

would involve relatively small cash

balances and would not involve overcapitalizing these dealers solely for the

purpose of moving government

securities or other trading books into an

OTC derivatives dealer from a fully

regulated broker-dealer.

OTC derivatives dealers would also be

permitted to manage risks associated

with their OTC derivatives positions.

The nature of risk management activity,

however, makes it difficult to determine

whether particular transactions satisfy

this requirement. It is no longer

possible, in many instances, to show the

relationship between a hedging

transaction and the instrument it is

intended to hedge. Instead, all of the

risks in a dealer’s portfolio of OTC

derivative positions are aggregated and

managed on a daily basis. As a result,

it may be difficult to demonstrate the

relationship between trading done for

risk management and the different OTC

derivatives positions on a dealer’s

books.21 It may also be difficult to

distinguish between trading done for

risk management purposes and other

trading activity conducted by a

derivatives dealer. Therefore, OTC

derivatives dealers should develop

reasonable procedures for ensuring

compliance with the restrictions set

forth in the proposed rules and for

demonstrating the relationship between

their risk management activities and the

OTC derivatives positions they

maintain. Such procedures could

include maintaining clear

documentation regarding risk

measurement and clearly identifying

transactions effected for risk

management purposes.

Other permissible securities activities

would include engaging in certain

financing transactions involving

repurchase and reverse repurchase

agreements, buy/sell transactions,22 and

lending and borrowing transactions, as

well as entering into certain transactions

for arbitrage purposes.23 Such financing

and arbitrage transactions, however,

would have to be limited to transactions

involving securities positions

established through the possession or

sale of counterparty collateral, cash

management, or hedging activity. OTC

derivatives dealers should also develop

procedures applicable to these types of

transactions to ensure compliance with

the restrictions set forth in the proposed

rules.

In some instances it may be difficult

for an OTC derivatives dealer to

determine and properly document

whether a transaction satisfies one of

the purposes set forth in the proposed

rule. In order to avoid circumstances in

which an OTC derivatives dealer

inadvertently violates the proposed

rules through its inability to properly

document the purpose of a transaction,

OTC derivatives dealers would also be

allowed to engage in a specified number

of additional securities transactions in

any calendar year. These transactions

would have to relate to securities

positions established through the

possession or sale of counterparty

collateral, cash management, or hedging

activity, and firms would be required to

maintain and enforces written policies

and procedures reasonably designed to

achieve compliance with other

provisions of the proposed rule.24 The
67944 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

generally available to non-broker-dealers, such as a

retail screen broker for government securities) in

connection with the purchase or sale of securities

permitted under proposed Rule 3b–15; (4) holding

itself out as a dealer or market-maker or as being

otherwise willing to buy or sell one or more

securities on a continuous basis; (5) engaging in

trading in securities for the benefit of others

(including any affiliate), rather than solely for the

purpose of the OTC derivatives dealer’s investment,

liquidity, or other permissible trading objective; (6)

providing incidental investment advice with

respect to securities; (7) participating in a selling

group or underwriting with respect to securities; or

(8) engaging in purchases or sales of securities from

or to an affiliated broker-dealer except at prevailing

market prices.

25 17 CFR 249.501.

26 17 CFR 240.15b1–1.

27The Commission is also proposing to amend

Rule 30–3 [17 CFR 200.30–3] to delegate to the

Director of the Division of Market Regulation its

authority to designate additional securities

transactions in which OTC derivatives dealers

would be permitted to engage.

28Exchange Act Rule 10b–10 [17 CFR 240.10b–

10] requires broker-dealers to send a written

confirmation of each securities transaction with a

customer at or before completion of the transaction,

containing certain material information about the

transaction. In a securities transaction between an

OTC derivatives dealer and a customer, effected

through a fully regulated broker-dealer, the OTC

derivatives dealer and the fully regulated brokerdealer would each be responsible for sending a

confirmation to the customer under the rule.

Certain customers, however, could choose not to

receive two confirmations for each securities

transaction they enter into with an OTC derivatives

dealer. Customers, therefore, could instruct the OTC

derivatives dealer and the fully regulated brokerdealer effecting securities transactions on its behalf

to send one joint confirmation (‘‘joint

confirmation’’) to the customer on behalf of both

parties.

The customer’s instructions to receive a joint

confirmation would have to (1) explicitly state

which of the parties (the OTC derivatives dealer or

the fully regulated broker-dealer) is to be

responsible for sending the confirmation; (2) be a

separate instrument from the basic account opening

documents with the OTC derivatives dealer and the

fully regulated broker-dealer; (3) not be a condition

of entering into securities transactions with the

OTC derivatives dealer; and (4) not be induced by

differential fees or other costs based on whether

such an instruction is provided.

A joint confirmation, sent on behalf of both the

OTC derivatives dealer and the fully regulated

broker-dealer effecting the transaction would have

to disclose all of the information required of either

party under the rule, including, but not limited to

the identity of the security, the trade price, and the

date and time of the trade, the identity of each party

and its capacity in the transaction, the fact that the

OTC derivatives dealer is not a member of the

Securities Investor Protection Corporation, and any

transaction-related compensation earned by either

the fully regulated broker-dealer or the OTC

derivatives dealer in connection with the

transaction. Both the OTC derivatives dealer and

the fully regulated broker-dealer would be

considered fully responsible for the contents of the

joint confirmation, regardless of which party is

responsible for sending it to the customer. The

customer’s instruction to receive a joint

confirmation would not otherwise affect the

obligations of either party to the customer under the

anti-fraud provisions of the federal securities laws.

OTC derivatives dealers and fully regulated

broker-dealers relying upon the written instructions

of their customer to send a joint confirmation

would each have to obtain and preserve a copy of

the customer’s written instructions, for the period

in which they are relying on those instructions, in

an easily accessible place, and for a period of not

less than two years after they no longer rely on the

instructions to send a joint confirmation.

Commission proposes that the number

of additional securities transactions be

set at 150 per calendar year. The

Commission requests comment on the

likely uses and effects of this provision,

and whether the number of allowable

additional securities transactions should

be more or less than 150.

As noted above, the proposed rules

would also allow OTC derivatives

dealers to issue and reacquire issued

securities, including warrants on

securities, hybrid securities, and

structured notes. Proposed Rule 3b–16

defines a hybrid security as a security

that incorporates payment features

economically similar to options,

forwards, futures, swap agreements, or

collars involving currencies, interest

rates, commodities, securities, or

indices (or any combination,

permutation, or derivative of such

contract or underlying interest). As

discussed in Section II.C. below, the

issuance and repurchase of issued

securities, such as warrants on

securities, hybrid securities, and

structured notes, by an OTC derivatives

dealer would have to be effected

through a fully regulated broker-dealer.

B. Proposed Amendment to Rule

15b1–1; Registration with the

Commission

As discussed above, OTC derivatives

dealers would be a part of a special class

of broker-dealers that could elect to

register with the Commission under a

limited regulatory structure. Firms that

elect to register as OTC derivatives

dealers would register with the

Commission by filing an application for

registration on Form BD, the Uniform

Application for Broker-Dealer

Registration.25 Under the proposed

amendments to Exchange Act Rule

15b1–1,26 OTC derivatives dealers

would file Form BD with the Central

Registration Depository, a computer

system operated by the National

Association of Securities Dealers, Inc.

(‘‘NASD’’), in accordance with the

instructions contained on the form. In

completing Form BD, an OTC

derivatives dealer would respond to

Item 10, which asks an applicant to

disclose its planned business activities,

by checking ‘‘other’’ and writing in that

it proposes to engage solely in the

business of an OTC derivatives dealer.

C. Proposed Rule 15a–1; Transactions

by OTC Derivatives Dealers

As discussed above in connection

with the proposed definition of ‘‘OTC

derivatives dealer,’’ the Commission

expects that OTC derivatives dealers

would be engaged primarily in

transactions involving OTC derivative

instruments for which these dealers act

as counterparty. They would also be

permitted to engage in any nonsecurities transaction, subject to

appropriate capital treatment.

As discussed in Section II.A.4. above,

because OTC derivatives dealers would

be a class of registered broker-dealers

subject to a lesser degree of regulation,

the Commission believes it would be

appropriate to limit the securities

activities conducted by these firms.

Consistent with the definition of OTC

derivatives dealer in proposed Rule 3b–

12, such an entity would be permitted

to (i) act as counterparty in securities

(and non-securities) transactions in

eligible OTC derivative instruments

with permissible derivatives

counterparties, (ii) issue and reacquire

issued securities, including warrants on

securities, hybrid securities, and

structured notes, through a fully

regulated broker-dealer, and (iii) engage

in other securities transactions as the

Commission may designate by order.27

In connection with these activities, OTC

derivatives dealers would also be

permitted to engage in permissible risk

management, arbitrage, and trading

transactions, as defined in proposed

Rule 3b–15. Proposed Rule 15a–1,

however, would require any securities

transaction by an OTC derivatives

dealer to be effected through a fully

regulated broker-dealer.28

The requirement that securities

transactions be effected through a fully

regulated broker-dealer means that the

dealer’s counterparties in these

transactions would be considered

customers of the fully regulated brokerdealer. In these transactions, all

applicable SRO sales practices

requirements would apply. In addition,

all persons having contact with

counterparties would need to be

properly qualified registered

representatives of the fully regulated

broker-dealer. For example, in a

transaction involving a securities OTC

derivative instrument, such as an OTC

option on a U.S. government security,

any person discussing the terms of the

transaction with the counterparty would

have to be a registered representative of

the fully regulated broker-dealer. This

person, however, could be a dual

employee of both the fully regulated

broker-dealer and the OTC derivatives
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67945

29Fully regulated broker-dealers would be

responsible for supervising only the securities

activities of these dual employees. They would not

be responsible for supervising a dual employee’s

non-securities OTC derivatives activities conducted

on behalf of the OTC derivatives dealer.

30 12 CFR 220.1.

31 12 CFR 221.1.

32 12 CFR 221.2(f).

33The proposed exemption from Section 7 [15

U.S.C. 78g] and Regulation T [12 CFR 220.1] would

not be available to extensions of credit made

directly by a fully regulated broker-dealer acting as

agent in a transaction between an OTC derivatives

dealer and a permissible derivatives counterparty.

However, OTC derivative dealers that extend credit

in transactions that are required to be effected

through a fully regulated broker-dealer would still

be able to rely on the exemption from Section 7 and

Regulation T provided under proposed Rule

36a1–1.

34 15 U.S.C. 78(g)(d)(2)(C)(i).

35See Exchange Act Section 15(b)(8) [15 U.S.C.

78o(b)(8)].

36See Exchange Act Sections 15(b)(8) and

15A(g)(3) [15 U.S.C. 78o(b)(8); 15 U.S.C. 78o–

3(g)(3)].

dealer, subject to appropriate

supervision by both firms.29

The requirement that securities OTC

derivatives transactions be effected

through a fully regulated broker-dealer

is consistent with existing regulatory

requirements that apply to the purchase

and sale of securities and is, in part,

designed to ensure that all securities

transactions remain subject to existing

sales practice requirements. It is also

intended to prevent an unforeseen

regulatory disparity from arising

between OTC derivatives dealers, which

would be subject to modified capital

and margin requirements, and other

fully regulated broker-dealers in

connection with conducting securities

transactions.

D. Exemptions

1. Proposed Rule 36a1–1; Exemption

From Section 7 of the Exchange Act for

OTC Derivatives Dealers

OTC derivative markets are credit

sensitive. Whether a dealer and a

counterparty will enter into a

transaction involving an OTC derivative

instrument depends on their assessment

of the other’s ability to meet its financial

obligations under the terms of the

instrument. The creditworthiness of the

counterparties is also a factor in

determining the price of the transaction.

As part of any OTC derivatives

transaction, a dealer may require its

counterparty to deposit collateral with

the dealer to provide some assurance of

the counterparty’s ability to perform.

Both the ability of the dealer to collect

collateral to secure payment under an

OTC derivative instrument, and the

amount of collateral the dealer must

collect, will depend on the regulatory

status of the dealer. Federal regulations

that govern the collateral, or margin,

that must be collected in connection

with securities transactions set up

certain competitive inequalities between

OTC derivatives dealers that are

registered broker-dealers and others,

including banks. Registered brokerdealers that extend credit for the

purpose of purchasing or carrying

securities are required to comply with

the provisions of Regulation T.30 The

margin requirements for banks are

contained in Regulation U.31

In general, Regulation T limits the

flexibility of broker-dealers to extend

credit in securities OTC derivatives

transactions by prohibiting extensions

of credit on securities other than margin

securities. Regulation U, however, offers

bank dealers greater flexibility by

allowing them to extend credit on

collateral other than margin stock up to

the ‘‘good faith’’ loan value of the

collateral, as defined in Regulation U.32

This means that under Regulation U,

dealers may extend credit on securities

other than margin stock, including

securities OTC derivative instruments.

Compliance with the more restrictive

requirements of Regulation T puts

broker-dealers at a disadvantage in

competing with banks and other

derivatives dealers by preventing them

from offering credit in securities OTC

derivatives transactions on terms that

are as favorable as those offered by other

dealers. Applying Regulation U to

extensions of credit by OTC derivatives

dealers would provide sufficient

safeguards against leverage, while

allowing OTC derivatives dealers to

extend credit on the broader range of

securities OTC derivative products that

make up their business.

Accordingly, under proposed Rule

36a1–1, OTC derivatives dealers would

be exempted from the margin

requirements of Section 7 of the

Exchange Act, as well as Regulation T,

in connection with any extension of

credit made by the OTC derivatives

dealer in securities transactions

permitted under proposed Rule 15a–1.

This exemption, however, would be

conditioned on the OTC derivatives

dealer complying with the requirements

of Regulation U. The Commission

believes that this exemption would

result in the most appropriate margin

regulation for OTC derivatives dealers

and more equal treatment of banks and

securities firms active in OTC derivative

markets.33 The Commission solicits

commenters’ views regarding the

proposed margin treatment of

transactions by OTC derivatives dealers.

The relief proposed under Rule 36a1–

1 would apply to extensions of credit by

OTC derivatives dealers. Section 7,

however, would also apply to

extensions of credit to OTC derivatives

dealers by other lenders. Credit

extended to an OTC derivatives dealer,

like credit extended to a fully regulated

broker-dealer, would be exempted from

Section 7 if it satisfies the exemptive

provisions contained in Section 7.

Specifically, if a substantial part of the

business conducted by an OTC

derivatives dealer consists of

transactions with persons other than

brokers or dealers, credit extended to

the OTC derivatives dealer would be

exempted from Section 7 under the

provisions of Section 7(d)(2)(C)(i).34 To

the extent that firms desiring to take

advantage of the proposed regulations

applicable to OTC derivatives dealers do

not believe that they would be able to

take advantage of the exemptive

provisions of Section 7(d)(2), the

Commission solicits further comment

on the proposed business activities of

OTC derivatives dealers, and whether

other exemptive relief may be needed to

address borrowing by these firms.

2. Proposed Rule 15b9–2; SRO

Exemption for OTC Derivatives Dealers

Proposed Rule 15b9–2 would exempt

OTC derivatives dealers from

membership in an SRO, subject to

certain conditions. In general, registered

broker-dealers must become members of

an SRO.35 This SRO membership

requirement ensures that securities

transactions meet SRO sales practice

requirements, that employees of SRO

member firms who sell securities satisfy

certain minimum, uniform licensing

requirements, that SRO members satisfy

maintenance margin and financial

responsibility requirements, and that

member firms adhere to certain

principles of trade and business

conduct.36

Because only a part of the business

conducted by OTC derivatives dealers is

expected to involve securities

transactions, it is not necessary to

require OTC derivatives dealers to

become members of an SRO and be

subject to the full range of SRO

regulation. All securities transactions

done by an OTC derivatives dealer

would be required to be effected

through a fully regulated broker-dealer,

and be handled by properly qualified

registered representatives of the fully

regulated broker-dealer. SRO sales

practice requirements would also apply

to these securities transactions. The

Commission, therefore, proposes to

exempt OTC derivatives dealers from

SRO membership, subject to certain

conditions.
67946 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

37 15 U.S.C. 78q(d).

38 17 CFR 240.15c3–1.

39 In a companion release being issued at the same

time as this release, the Commission is proposing

amendments to the net capital rule to recognize

offsets among additional types of instruments.

Exchange Act Rel. No. 39455 (Dec. 17, 1997).

40See infra Section II.E.3.b. for a discussion of

proposed Appendix F.

41The Commission recognizes that there is a wide

variety of secondary source information discussing

both the positive and negative aspects of VAR. See

Philippe Jorion, Value at Risk: The New Benchmark

for Controlling Market Risk (1996) (explaining how

to use VAR to manage market risk); JP Morgan,

RiskMetrics-Technical Document (1994) (providing

a detailed description of RiskMetrics, which is JP

Morgan’s proprietary statistical model for

quantifying market risk in fixed income and equity

portfolios); Tanya Styblo Beder, VAR: Seductive but

Dangerous, Financial Analysts Journal, SeptemberOctober 1995, at 12 (giving an extensive analysis of

the different results from applying three common

VAR methods to three model portfolios); Darrell

Duffie and Jun Pan, An Overview of Value at Risk,

The Journal of Derivatives, Spring 1997, at 7 (giving

a broad overview of VAR models); Darryll

Hendricks, Evaluation of Value-at-Risk Models

Using Historical Data, Federal Reserve Bank of New

York Economic Policy Review, April 1996, at 39

(examining twelve approaches to VAR modelling on

portfolios that do not include options or other

securities with non-linear pricing); and Robert

Litterman, Hot Spots and Hedges, Goldman Sachs

Risk Management Series (1996) (giving a detailed

analysis on portfolio risk management, including

how to identify the primary sources of risk and how

to reduce these risks).

42See 17 CFR 240.15c3–1a. The Commission

recently amended Appendix A to permit brokerdealers to employ theoretical option pricing models

in determining net capital requirements for listed

options and related positions. Exchange Act Rel.

No. 38248 (Feb. 6, 1997), 62 FR 6474 (Feb. 12,

1997).

To be eligible for the exemption from

SRO membership contained in proposed

Rule 15b9–2, an OTC derivatives dealer

would be required to enter into an

agreement with the examining authority

designated pursuant to Section 17(d) of

the Exchange Act 37 for one or more of

its registered broker-dealer affiliates.

Under this agreement, the examining

authority would agree to conduct a

review of the activities of the OTC

derivatives dealer. It would also be

required to report to the Commission

any potential violation of the

Commission’s rules, and to evaluate the

dealer’s procedures and controls

designed to prevent violations. SRO

examination of OTC derivatives dealers

would provide important benefits to the

Commission and the public without

requiring full SRO membership. OTC

derivatives dealers would also be

subject to direct examination by

Commission staff. The Commission

solicits comment on the proposed

exemption from SRO membership.

Alternatively, the Commission solicits

comment on whether to require OTC

derivatives dealers to become members

of either the NASD or the New York

Stock Exchange. Under this alternative,

these SROs would be authorized to

inspect OTC derivatives dealers and to

enforce applicable Commission rules.

They would not, however, be permitted

to apply or enforce existing or new SRO

rules.

E. Net Capital Requirements for OTC

Derivatives Dealers

1. Reasons for Amending the Net Capital

Rule; Overview

The Commission proposes to amend

the net capital rule, Exchange Act Rule

15c3–1,38 as it would apply to OTC

derivatives dealers. In general, the net

capital rule requires every registered

broker-dealer to maintain certain

specified minimum levels of liquid

assets, or net capital, to enable those

firms that fall below the minimum net

capital requirements to liquidate in an

orderly fashion without the need for a

formal legal proceeding. The rule is

designed to protect the customers of a

broker-dealer from losses that can be

incurred upon a broker-dealer’s failure.

The rule prescribes different required

minimum levels of capital based upon

the nature of the broker-dealer’s

business and whether the firm handles

customer funds or securities.

When calculating its net capital, a

broker-dealer must reduce its capital by

certain percentage amounts, or haircuts,

based on the market value of the

securities it owns. Discounting the value

of a broker-dealer’s proprietary

securities positions provides a capital

cushion if the value of these securities

positions were to decline. Haircuts also

cover other risks faced by the firm, such

as credit and liquidity risk.

The Commission has been told that

few swaps and other types of OTC

derivative instruments are booked in

registered broker-dealers because of the

way these transactions are treated under

the net capital rule. There are two

reasons for this. First, the current net

capital rule requires a firm to subtract

most unsecured receivables from its net

worth when calculating its net capital.

For example, for an interest rate swap,

the rule requires that the current value

of the next net interest payment due

from a counterparty be deducted from

the firm’s net worth in calculating its

net capital. Also, any unrealized gains

on the swap would have to be deducted.

Second, the rule does not allow brokerdealers to take into account positions

that offset their OTC derivatives

positions to the same extent as banks or

foreign dealers using value-at-risk

(‘‘VAR’’) models.39 This treatment of

OTC derivatives transactions often

requires broker-dealers to reserve more

capital with respect to these

transactions than banks or foreign

broker-dealers have to reserve.

The Commission is addressing the

current rule’s treatment of OTC

derivatives transactions by proposing

certain amendments to the rule to

reduce the capital charges on these

types of transactions. Under proposed

Appendix F of Rule 15c3–1, OTC

derivatives dealers would be permitted

to add back to their net worth any

trading gains and unsecured receivables

arising from transactions in eligible OTC

derivative instruments with permissible

derivatives counterparties.40 Appendix

F would also allow OTC derivatives

dealers to use VAR models to compute

their capital charges on proprietary

positions instead of taking haircuts on

them as required under the current rule.

As mentioned above, the current haircut

approach allows limited offsetting

among positions in comparison to using

a VAR model to compute capital

charges. Allowing OTC derivatives

dealers to use VAR models to compute

capital charges on OTC derivative

instruments would enable these dealers

to reduce their market risk capital

charges to the extent that they may hold

offsetting positions.

2. Reasons for Allowing OTC

Derivatives Dealers To Use VAR Models

Currently, several large firms use VAR

models as part of their risk management

system. These firms use VAR modelling

to analyze, control, and report the level

of market risk from their trading

activities. In general, VAR is an estimate

of the maximum potential loss expected

over a fixed time period at a certain

probability level. For example, a firm

may use a VAR model with a ten-day

holding period and a 99 percentile

criteria to calculate that its $100 million

portfolio has a potential loss of

$150,000. In other words, the firm’s

VAR model has forecasted that with this

portfolio the firm may lose $150,000

during a ten-day period once every 100

ten-day periods (i.e., with a probability

of 1%).

In practice, VAR models aggregate

several components of price risk into a

single quantitative measure of the

potential for loss. In addition, VAR is

based on a number of underlying

mathematical assumptions and firm

specific inputs. For example, VAR

models typically assume normality and

that future return distributions and

correlations can be predicted by past

returns.41

The current rule permits using

statistical models only for limited types

of securities.42 The Commission
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67947

43For an OTC derivatives dealer that elects to

compute its market risk charges under proposed

Appendix F, the term ‘‘tentative net capital’’ would

mean the net capital of an OTC derivatives dealer

before the application of the charges for market and

credit risk as computed pursuant to proposed

Appendix F and increased by unsecured receivables

(unrealized gains) resulting from eligible OTC

derivative instruments.

44The Governors of the G–10 countries

established the Basle Committee in 1974 to provide

a forum for ongoing cooperation among member

countries on banking supervisory matters.

45The Basle Accord, or Capital Accord, is a

common measurement system and a minimum

standard for capital adequacy of international banks

in the G–10 countries.

46 In July 1995, IOSCO’s Technical Committee

issued a paper stating that further information and

analysis was required before the Technical

Committee could consider the use of internal

models by securities firms to set regulatory capital

standards for market risk. Due to the differences

between banks and securities firms, the Technical

Committee believed that more work was necessary

before allowing securities firms to use VAR models

to establish their capital requirements. The

Implications for Securities Regulators of the

Increased Use of Value At Risk Models by

Securities Firms, Technical Committee of IOSCO,

July 1995.

47 Department of the Treasury, Office of the

Comptroller of the Currency Docket No. 96–18,

Federal Reserve System, Docket No. R–0884,

Federal Deposit Insurance Corporation, RIN 3064–

AB64 (Sept. 6, 1996), 61 FR 47358.

48Exchange Act Rel. No. 39456 (Dec. 17, 1997).

49To some degree, the multiplication factor

applied to a firm’s VAR is designed to provide

capital for risks other than credit or market risk. See

infra Section II.E.3.b.iii. for a discussion of how an

OTC derivatives dealer would determine its

appropriate multiplication factor.

50 In general, market risk is the risk of adverse

price movements resulting from a change in market

prices, interest rates, volatilities, correlations, or

other market factors.

51See infra Section II.E.3.b.iii. for a discussion of

how an OTC derivatives dealer would determine

the appropriate multiplication factor.

believes, however, that a more flexible

approach for determining capital

requirements for OTC derivatives

dealers would be appropriate because of

the special nature of their business and

the additional financial responsibility

requirements that would be applicable

to these firms. The proposed rule

requires an OTC derivatives dealer to

maintain a minimum of $100 million in

tentative net capital 43 and at least $20

million in net capital. OTC derivatives

dealers would also be prohibited from

accepting or holding customer funds or

securities or generally from owing

money or securities to customers in

connection with securities activities.

OTC derivatives dealers would,

however, be allowed to hold

counterparty collateral or owe money or

securities to counterparties, but only as

a result of contractual commitments.

Finally, OTC derivatives dealers would

be required to establish risk

management controls pursuant to

proposed Rule 15c3–4.

The more flexible capital treatment

that would be available to OTC

derivatives dealers under the proposed

rules reflect international efforts to

standardize capital requirements.

During the past few years, the

Commission has actively participated in

several international undertakings to

gain further experience with the use of

VAR models to measure market and

credit risk. For example, through its

membership in the International

Organization of Securities Commissions

(‘‘IOSCO’’), the Commission has been

cooperating with the Basle Committee

on Banking Supervision (‘‘Basle

Committee’’).44 In December 1995, the

Basle Committee amended its Capital

Accord 45 to incorporate market risk

capital requirements and approved the

use of proprietary VAR models to

determine bank capital requirements for

market risk.46 The Capital Accord

recommended a number of quantitative

and qualitative conditions that should

apply to a bank’s use of models to

ensure that VAR models are prudently

used.

Rules adopted recently by the Board

of Governors of the Federal Reserve

System, the Office of the Comptroller of

the Currency, and the Federal Deposit

Insurance Corporation (collectively, the

‘‘U.S. Banking Agencies’’) were

designed to implement the Capital

Accord for U.S. banks and bank holding

companies.47 Proposed Appendix F is

generally consistent with the U.S.

Banking Agencies’ rules, and

incorporates the quantitative and

qualitative conditions imposed on

banking institutions.

In a companion release, the

Commission is considering whether it

should permit VAR models to be used

by broker-dealers other than OTC

derivatives dealers for regulatory capital

purposes.48 By allowing OTC

derivatives dealers to use VAR models

in calculating their net capital

requirement, the Commission would

have a valuable opportunity to gain

experience with the use of these models

by entities within its jurisdiction. This

experience would enable the

Commission to reassess its current rules

for determining capital charges for

market risk and determine whether

more intensive subjective examinations

would be needed to ensure compliance

with Commission regulations

concerning the use of models.

3. Discussion of Net Capital

Requirements

a. Proposed Paragraph 15c3–1(a)(5).

Under proposed paragraph (a)(5) of Rule

15c3–1, OTC derivatives dealers would

be required to maintain tentative net

capital of not less than $100 million and

net capital of not less than $20 million.

The Commission believes the minimum

of $100 million in tentative net capital

is necessary to ensure against excessive

leverage and risks other than credit or

market risk, all of which are now

factored into the current haircuts, and to

provide for a cushion of capital against

severe market disturbances.49 Proposed

paragraph (a)(5) would give OTC

derivatives dealers the option of either

taking capital charges, or haircuts,

computed in accordance with paragraph

(c)(2)(vi) of Rule 15c3–1 or taking

capital charges for market and credit

risk computed under proposed

Appendix F to Rule 15c3–1. The

Commission requests comment on

whether the $100 million tentative net

capital and $20 million net capital

requirements would be adequate to

ensure against excessive leverage and

risks other than credit or market risk.

b. Proposed Appendix F. Proposed

Appendix F would apply only to OTC

derivatives dealers that elect to be

subject to the appendix. OTC

derivatives dealers that elect to be

subject to Appendix F would be

required to calculate specific capital

charges for market and credit risk. They

would also be required to maintain VAR

models that meet certain minimum

qualitative and quantitative

requirements.

i. Market Risk. OTC derivatives

dealers electing to apply Appendix F

would deduct from their net worth a

capital charge for market risk 50 that is

computed using one of two methods.

First, OTC derivatives dealers would be

able to use the full VAR method to

calculate capital charges for market risk

exposure for transactions in eligible

OTC derivative instruments and other

proprietary positions of the OTC

derivatives dealer. Under the full VAR

method, a market risk capital charge

would be equal to the VAR of its

positions multiplied by a factor

specified in Appendix F.51

OTC derivatives dealers would be

required to obtain authorization from

the Commission before using VAR

models. An OTC derivatives dealer

planning to use the full VAR method

would send an application to the

Commission describing its VAR model,

including whether the firm has

developed its own model and how the

qualitative and quantitative aspects

described in Appendix F are
67948 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

52See infra Sections II.E.3.b.iii. through iv. for a

description of the qualitative and quantitative

requirements.

53See infra Section II.H.3. for a description of the

risk management controls that would be required by

proposed Rule 15c3–4.

54 17 CFR 240.15c3–1a. The Commission recently

amended Appendix A to include theoretical pricing

models. Exchange Act Rel. No. 38248 (Feb. 6, 1997),

62 FR 6474 (Feb. 12, 1997).

55 17 CFR 240.15c3–1a(b)(1)(B). The minimum

pricing factors in Appendix A require that a pricing

model consider:

(1) The current spot price of the underlying asset;

(2) The exercise price of the option;

(3) The remaining time until the option’s

expiration;

(4) The volatility of the underlying asset;

(5) Any cash flows associated with ownership of

the underlying asset that can reasonably be

expected to occur during the remaining life of the

option; and

(6)The current term structure of interest rates.

56 In general, credit risk is the risk that a

counterparty will fail to perform its obligations to

an OTC derivatives dealer.

57For purposes of calculating credit risk charges,

net replacement value in the account of a

counterparty would mean the aggregate value of all

receivables due from that counterparty (which

would be computed by marking the value of such

receivables to market daily), including the effect of

legally enforceable netting agreements and the

application of liquid collateral.

58Stress tests are used to evaluate changes in the

value of a firm’s portfolio under extreme market

conditions. The Commission expects stress tests to

include the core risk factors of: (1) Parallel yield

curve shifts; (2) changes in the steepness of yield

curves; (3) parallel yield curve shifts combined with

changes in the steepness of yield curves; (4)

changes in yield volatilities; (5) changes in the

value of equity indices; (6) changes in equity index

volatilities; (7) changes in the value of key

currencies (relative to the U.S. dollar); (8) changes

in foreign exchange rate volatilities; and (9) changes

in swap spreads in at least the G–7 countries plus

Switzerland. Stress tests should also be designed to

reflect the composition of the firm’s portfolio.

incorporated into the model.52 The

firm’s application would also include a

description of the risk management

controls adopted by the firm pursuant to

proposed Rule 15c3–4.53

Second, an OTC derivatives dealer

could use an alternative method of

computing the market risk capital

charge for equity instruments and OTC

options and use VAR for its other

proprietary positions. This alternative

method would also be used by a firm

that does not receive Commission

authorization to use a VAR model for

equity instruments. Under the

alternative method, an OTC derivatives

dealer would deduct from its net worth

an amount equal to the largest

theoretical loss calculated in accordance

with the theoretical pricing model set

forth in Appendix A of Rule 15c3–1.54

The OTC derivatives dealer would be

permitted to use its own theoretical

pricing model as long as it contains the

minimum pricing factors set forth in

Appendix A.55

ii. Credit Risk. OTC derivatives

dealers electing to apply Appendix F

would deduct from their net worth a

capital charge for credit risk.56 This

charge would have two parts and would

be computed on a counterparty by

counterparty basis. First, for each

counterparty, OTC derivatives dealers

would take a capital charge equal to the

net replacement value in the account of

the counterparty (‘‘net replacement

value’’) 57 multiplied by 8%, and further

multiplied by a counterparty factor. The

counterparty factor would be based on

the counterparty’s rating by at least two

nationally recognized statistical rating

organizations (‘‘NRSROs’’ or ‘‘rating

organizations’’). The counterparty

factors would range from 20% for

counterparties that are highly rated to

100% for counterparties with ratings

among the lowest rating categories. By

using the ratings of the rating

organizations as a basis, the

counterparty factors would link the size

of the credit risk capital charge to the

perceived risk that the counterparty may

default. A charge of 100% of the net

replacement value would be assessed

for counterparties that are in bankruptcy

or whose bonds are in default. The

Commission requests comment on

alternatives to relying on the ratings of

NRSROs for approximating the risk that

a counterparty may default.

The second part of the credit risk

charge would consist of a concentration

charge that would apply when the net

replacement value in the account of any

one counterparty exceeds 25% of the

OTC derivatives dealer’s tentative net

capital. In these situations, the amount

of the concentration charge would also

be based on the counterparty’s rating by

at least two rating organizations. For

counterparties that are highly rated, the

concentration charge would equal 5% of

the amount of the net replacement value

in excess of 25% of the OTC derivatives

dealer’s tentative net capital. The

concentration charge would increase in

relation to the OTC derivatives dealer’s

exposure to lower rated counterparties.

For example, the concentration charge

for counterparties with ratings among

the lowest rating categories would equal

50% of the amount of the net

replacement value in excess of 25% of

the OTC derivatives dealer’s tentative

net capital. Further, if the aggregate net

replacement values of all counterparties

exceeds 300% of the OTC derivatives

dealer’s tentative net capital, the OTC

derivatives dealer would deduct 100%

of the excess from its net worth. The

Commission requests comment on

whether the 300% threshold for

determining an overall concentration

charge would result in excessive

concentration risk charges.

If a counterparty is not rated by a

rating organization, an OTC derivatives

dealer would be permitted to use its

own ratings of the counterparty to

calculate its credit risk charge. In these

situations, however, the OTC

derivatives dealer would have to

demonstrate that its ratings criteria and

due diligence procedures, including

procedures for the initial analysis and

ongoing review of the counterparty, are

equivalent to those used by NRSROs.

iii. Qualitative Requirements for

Value-at-Risk Models. OTC derivatives

dealers that elect to apply Appendix F

would be required to have VAR models

that meet certain minimum qualitative

requirements. The Commission

proposes to establish these minimum

requirements to ensure that the VAR

models used for computing market risk

capital charges are the same as those

used to perform internal risk

management functions.

The qualitative requirements would

address four aspects of an OTC

derivatives dealer’s risk management

system. First, an OTC derivatives

dealer’s VAR model would have to be

integrated into the OTC derivatives

dealer’s daily risk management process.

Second, an OTC derivatives dealer’s

policies and procedures would have to

identify and provide for appropriate

stress tests.58 The OTC derivatives

dealer’s policies and procedures would

have to identify the procedures to

follow in response to the results of the

stress tests and backtests, and the OTC

derivatives dealer would be required to

follow these procedures. Third, an OTC

derivatives dealer’s VAR model and risk

management systems would be required

to undergo both periodic independent

reviews that would be performed by

internal audit staff, and annual reviews

that would be conducted by an

independent public accountant. Fourth,

OTC derivatives dealers would be

required to conduct backtesting.

Backtesting would be intended to

gauge the accuracy of a dealer’s model

by comparing the dealer’s projections

against actual trading results. The OTC

derivatives dealer would be required to

conduct backtesting by comparing each

of its most recent 250 business days’

actual net trading profit or loss with the

corresponding daily VAR measures. In

addition, once each quarter, the OTC

derivatives dealer would have to

identify the number of exceptions, that

is, the number of business days for

which the actual daily net trading loss,

if any, exceeds the corresponding daily

VAR measure. The number of

exceptions would determine the

multiplication factor the OTC
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67949

59 17 CFR 240.8c–1.

60 17 CFR 240.15c2–1.

61 17 CFR 240.15c3–3.

62 15 U.S.C. 78aaa et seq.

63Section 2 of SIPA [15 U.S.C. 78bbb] generally

incorporates SIPA into the Exchange Act.

64The bankruptcy code contains certain

exceptions to its automatic stay provisions that

enable a counterparty in a derivatives transaction to

exercise its rights to liquidate a position (i.e., it

preserves a counterparty’s contractual termination,

setoff, and collateral foreclosure rights) in the event

of the other counterparty’s insolvency. See, e.g., 11

U.S.C. Section 362(b)(6), (7), (17); id. at Sections

555, 556, 559, and 560. Several of these provisions,

however, may be subject to a stay order under SIPA.

See 11 U.S.C. Section 555 (contractual right to

liquidate a securities contract); id. at Section 559

(contractual right to liquidate a repurchase

agreement).

65The Commission believes that the counterparty

collateral that would be held by OTC derivatives

dealers should not be considered customer assets

for purposes of SIPA. Congress enacted SIPA in

1970 primarily to protect the retail customers of a

broker-dealer in the event of its financial difficulty.

Congress was concerned that prior to the enactment

of SIPA, public customers sometimes had

encountered difficulty in obtaining their cash

balances or securities from insolvent broker-dealers.

Congress analogized the need for SIPA to the need

which prompted establishment of the Federal

Deposit Insurance Corporation. H.R. Rep. No. 91–

1613, 91st Cong., 2d Sess. 2 (1970). The

Commission believes that the type of privately

negotiated transactions and counterparty assets

Continued

derivatives dealer would be required to

use for the following quarter, and which

would continue to apply until the next

quarter’s backtesting results are

obtained or unless the Commission

determines that a different adjustment

or other action is appropriate.

Depending on the number of exceptions,

the multiplication factors would range

from three to four. Increasing the

multiplication factor in response to the

number of backtesting exceptions

increases an OTC derivatives dealer’s

market risk charge, thus penalizing an

OTC derivatives dealer that uses a less

accurate model. Although the

multiplication factor would increase an

OTC derivative’s dealer’s market risk

charge and corresponding capital

requirement, the Commission intends

that firms work to improve the accuracy

of their models rather than set aside

additional capital for an inaccurate

model.

The multiplication factor is intended

to cover the additional risks that would

be present in an OTC derivatives

dealer’s portfolio, other than market and

credit risk. For example, an OTC

derivatives dealer would be subject to

legal, liquidity, and operational risk.

Operational risk is generally the risk of

human error or deficiencies in the firm’s

operating systems, including VAR

model. It is difficult to quantify and

develop capital charges specifically for

these risks. The Commission, however,

believes that the multiplication factor

would be an appropriate way to account

for these other risks facing OTC

derivatives dealers.

iv. Quantitative Requirements for

Value-at-Risk Models. Appendix F

would also contain minimum

quantitative requirements to address

regulatory concerns. Because brokerdealers generally use VAR models to

measure portfolio volatility on a day-today basis, the Commission would

impose certain requirements on VAR

models to address regulatory capitalrelated concerns where a longer time

horizon is appropriate. For example,

OTC derivatives dealers would be

required to calculate VAR measures

using a confidence level with a price

change equivalent to a ten-business day

movement in rates and prices, rather

than a one-day price movement that is

used in many VAR models currently

used by firms for internal risk

management purposes.

F. Use of Counterparty Collateral

1. Proposed Amendments to Exchange

Act Rules 8c–1 and 15c2–1;

Hypothecation Rules

The Commission proposes to amend

Exchange Act Rules 8c–159 and 15c2–

1, 60 which address the hypothecation of

customer securities. The hypothecation

rules generally prohibit a broker-dealer

from using its customers’ securities as

collateral to finance its own trading,

speculating, or underwriting

transactions. More specifically, the rules

state three main principles: first, that a

broker or dealer is prohibited from

commingling the securities of different

customers as collateral for a loan

without the consent of each customer;

second, that a broker or dealer cannot

commingle its customers’ securities

with its own under the same pledge;

and third, that a broker or dealer can

only pledge its customers’ securities up

to the value of monies owed to the

broker-dealer by its customers.

In privately negotiated OTC

derivatives transactions, counterparties

generally agree that assets pledged as

collateral may be used in the business

of the OTC derivatives dealer without

being segregated. For this reason, it is

not necessary to treat counterparties as

customers of OTC derivatives dealers for

purposes of Exchange Act Rules 8c–1

and 15c2–1, or to apply these rules to

counterparty assets held as collateral by

an OTC derivatives dealer. Accordingly,

Rules 8c–1 and 15c2–1 would be

amended so that an OTC derivatives

dealer would not be deemed to hold

collateral for the account of any

customer when that collateral is

received as a result of the OTC

derivatives dealer acting as counterparty

in transactions in eligible OTC

derivative instruments and the

permissible derivatives counterparty has

consented to the unrestricted use of its

collateral after receiving appropriate

disclosure.

2. Proposed Amendments to Exchange

Act Rule 15c3–3; Customer Protection

Rule

The Commission also proposes to

amend Exchange Act Rule 15c3–3,61 the

Commission’s customer protection rule.

The customer protection rule generally

prohibits a broker or dealer from using

customers’ funds and securities to

finance its business. As a result, this

rule helps to ensure that customers can

promptly obtain their funds or securities

from a broker-dealer.

As amended, Rule 15c3–3 would

clarify that the term ‘‘customer,’’ as used

in the rule, is not intended to include

a permissible derivatives counterparty

that has consented to the unrestricted

use of its collateral by an OTC

derivatives dealer after receiving

appropriate disclosure. As noted

previously, counterparties in privately

negotiated OTC derivative transactions

generally agree that assets pledged as

collateral may be used in the business

of the OTC derivatives dealer without

being segregated.

G. Proposed Rule 36a1–2; Exemption

From SIPA

Under proposed Rule 36a1–2, OTC

derivatives dealers would be exempted

from the provisions of the Securities

Investor Protection Act of 1970

(‘‘SIPA’’),62 including membership in

the Securities Investor Protection

Corporation (‘‘SIPC’’).63 Under SIPA,

broker-dealers registered under Section

15(b) become SIPC members. The

Commission is concerned that the

application of SIPA’s liquidation

provisions to an OTC derivatives dealer

in bankruptcy could undermine certain

provisions of the bankruptcy code

applicable to the dealer’s business.64

The potential application of SIPA to

OTC derivatives dealers would create

legal uncertainty about the rights of

counterparties in transactions with

registered OTC derivatives dealers in

the event of dealer insolvency.65 This
67950 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

(collateral) involved in the OTC derivatives

business are quite different from the ordinary

brokerage business and customer assets

contemplated by SIPA.

66 17 CFR 240.17a–3.

67 17 CFR 240.17a–4.

68 15 U.S.C. 78q(a)(1).

69 In general, Exchange Act Rule 17a–3 requires

broker-dealers to make records concerning the

purchases and sales of securities, receipts and

deliveries of securities, and receipts and

disbursements of cash. In addition, the rule requires

broker-dealers to make and keep ledgers reflecting

securities borrowed and securities received,

repurchase and reverse repurchase agreements, and

a record of net capital computations.

Exchange Act Rule 17a–4 specifies how long

broker-dealers must keep the records required to be

made under Rule 17a–3 and how long they must

keep other records made in the normal course of

business. Specifically, Rule 17a–4(b) requires

broker-dealers to keep trial balances, internal audit

workpapers, and net capital computations and

related workpapers for three years. Rule 17a–4(b)

also requires broker-dealers to keep all written

agreements relating to the broker-dealer’s business

for three years.

70 17 CFR 240.17a–11. Under Rule 17a–11, if a

broker-dealer’s net capital falls below the required

minimum level, the broker-dealer must provide

both the Commission and the broker-dealer’s

designated examining authority with notice of such

deficiency. A broker-dealer is also required to give

same-day notice if it fails to make and keep current

its books and records pursuant to Rules 17a–3 and

17a–4, and to submit a report within 48 hours

detailing the steps it is taking to correct the

problem. In addition, Rule 17a–11 requires a

broker-dealer to give notice when it discovers any

material inadequacy in its system of internal

controls, or is notified of this inadequacy by its

independent public accountant. In these instances,

the broker-dealer is required to submit a report

detailing steps being taken to correct the

inadequacy.

71 15 U.S.C. 78o(c)(3).

72Operational risk encompasses the risk of loss

due to the breakdown of controls within the firm

including, but not limited to, unidentified limit

excesses, unauthorized trading, fraud in trading or

in back office functions, inexperienced personnel,

and unstable and easily accessed computer systems.

73Market risk involves the risk that prices or rates

will adversely change due to economic forces. Such

risks include adverse effects of movements in

equity and interest rate markets, currency exchange

rates, and commodity prices. Market risk can also

include the risks associated with the cost of

borrowing securities, dividend risk, and correlation

risk.

74Credit risk comprises risk of loss resulting from

counterparty default on loans, swaps, options, and

during settlement.

75Liquidity risk includes the risk that a firm will

not be able to unwind or hedge a position.

76Legal risk arises from possible risk of loss due

to an unenforceable contract or an ultra vires act of

a counterparty.

uncertainty could impair the ability of

securities firms electing to register OTC

derivatives dealers to compete

effectively with banks and foreign

dealers, which are not subject to similar

legal uncertainty.

Accordingly, the Commission believes

that the purposes of SIPA would not be

promoted by its application to OTC

derivatives dealers, and may in fact

result in legal uncertainty for OTC

derivatives dealer counterparties. The

Commission therefore believes that

exempting OTC derivatives dealers from

SIPA would be necessary or appropriate

in the public interest and consistent

with the protection of investors. The

Commission requests comments on the

need, appropriateness, and form of the

proposed exemption.

H. Books and Records

1. Proposed Amendments to Exchange

Act Rules 17a–3 and 17a–4; Books and

Records to be Maintained by OTC

Derivatives Dealers

OTC derivatives dealers, like other

broker-dealers that are registered with

the Commission, would be required to

comply with the books and records

requirements of Exchange Act Rules

17a–3 66 and 17a–4.67 Section 17(a)(1) of

the Exchange Act 68 requires registered

broker-dealers to make, keep, furnish,

and disseminate records and reports

that are prescribed by the Commission

as necessary or appropriate in the public

interest, for the protection of investors,

or otherwise in furtherance of the

purposes of the Exchange Act.

Consistent with the requirements of

Section 17(a)(1), Rules 17a–3 and 17a–

4 require all broker-dealers to make and

keep certain records relating to their

business activities. These rules would

also apply to OTC derivatives dealers.69

Currently, Rule 17a–3 does not

specifically provide for maintaining

records relating to the full range of

activities that would be conducted by

OTC derivatives dealers. For this reason,

Rule 17a–3 would be amended to reflect

the activities of OTC derivatives dealers

and to require that OTC derivatives

dealers compile a register of all

transactions in eligible OTC derivative

instruments. The Commission also

proposes to make technical amendments

to Rule 17a–4 to require OTC

derivatives dealers to retain the records

required to be made pursuant to

proposed Rules 15c3–4 and 17a–12. As

discussed in more detail below, the

records required under Rule 17a–12

would be similar to those currently

required under Rule 17a–5. In part,

these records would include the OTC

derivatives dealer’s risk management

control guidelines and information

supporting data contained in the

dealer’s annual audited financial

statements. These records would have to

be retained for three years.

2. Proposed Amendments to Exchange

Act Rule 17a–11; Notification

Requirements

OTC derivatives dealers would be

subject to the provisions of Exchange

Act Rule 17a–11, which requires a

broker-dealer to report capital and other

operational problems to the Commission

and the broker-dealer’s examining

authority within specified time

periods.70 Because Rule 17a–11

provides the Commission with valuable

tools in overseeing the financial and

operational health of broker-dealers, it is

appropriate that Rule 17a–11 also apply

to OTC derivatives dealers.

Rule 17a–11 would be amended to

take into consideration the new

tentative net capital requirements that

would apply to OTC derivatives dealers.

As a result, if an OTC derivatives

dealer’s tentative net capital were to

drop below 120 percent of its required

minimum, the dealer would be required

to provide notice both to the

Commission and the examining

authority responsible for reviewing its

activities pursuant to proposed Rule

15b9–2. Notice would also be required

in the event the OTC derivatives

dealer’s tentative net capital were to

drop below its required minimum. This

notice requirement would provide the

Commission and the examining

authority with early warning of an OTC

derivatives dealer’s financial or

operational problems and allow the

Commission and the examining

authority to increase their supervision

of the dealer’s operations. It would also

give the Commission and the examining

authority time to obtain additional

information about the OTC derivatives

dealer’s financial condition and to take

corrective action, as necessary.

3. Proposed Rule 15c3–4; Internal Risk

Management Control Systems for OTC

Derivatives Dealers

Section 15(c)(3) of the Exchange Act 71

enables the Commission to adopt rules

and regulations regarding the financial

responsibility of broker-dealers that the

Commission deems necessary or

appropriate in the public interest or for

the protection of investors. Pursuant to

this authority, the Commission is

proposing Rule 15c3–4 to require OTC

derivatives dealers to establish a system

of internal controls for monitoring and

managing the risks associated with their

business activities.

Participants in OTC derivatives

markets are exposed to various risks,

including (1) operational risk; 72 (2)

market risk; 73 (3) credit risk; 74 (4)

liquidity risk; 75 and (5) legal risk.76

These risks are due, in part, to the

characteristics of OTC derivative

products and the way OTC derivative

markets have evolved in comparison to

the markets for equity securities and

listed options. For example,
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67951

77Systemic risk encompasses the risk that the

failure of one firm or within one market segment

would trigger failures in other market segments or

throughout the financial markets as a whole.

78 17 CFR 240.17a–5. Rule 17a–5 was adopted by

the Commission pursuant to authority under

Section 17 of the Exchange Act [15 U.S.C. 78q], and

particularly Section 17(e) [15 U.S.C. 78q(e)], which

requires every broker or dealer to file annually with

the Commission a certified balance sheet and

income statement, and such other information

concerning its financial condition as the

Commission may prescribe.

79Form X–17A–5 [17 CFR 249.617].

80See Framework for Voluntary Oversight,

Derivatives Policy Group (Mar. 1995). The firms

comprising the DPG consist of the six U.S. brokerdealers with the largest OTC derivatives affiliates.

This group was organized to respond to the public

policy interests of Congress, federal agencies, and

others in the OTC derivatives activities of

unregulated affiliates of SEC-registered brokerdealers and CFTC-registered futures commission

merchants. The Framework for Voluntary Oversight

specifies certain information that the members of

the DPG have voluntarily agreed to submit

regarding their OTC derivatives activities and

establishes certain internal control principles that

group members should follow.

individually negotiated OTC derivative

products generally are not very liquid.

Also, the absence at this time of a

clearing system for OTC derivative

products means that market participants

face risks associated with the financial

and legal ability of counterparties to

perform under the terms of specific

transactions. The additional exposure to

credit risk, liquidity risk, and other risks

makes it necessary for OTC derivatives

market participants to implement a risk

management control system.

During the past few years, the

importance of operational risk

management controls has been

highlighted by the multi-billion dollar

losses experienced by several large

financial firms. These losses were

caused by unauthorized and

undisclosed employee trading. In each

case, these losses went virtually

undetected by management because of

the lack of basic internal controls,

including the separation of

responsibility for recording the trades

on the firms’ books from the personnel

responsible for trading.

Risk management controls within

financial institutions promote the

stability of these firms and,

consequently, the stability of the entire

financial system. They do this by

reducing the risk of significant losses by

a firm, which also reduces the risk that

spreading losses would cause multiple

defaults and undermine markets as a

whole. Specifically, internal risk

management controls promote stability

by providing two important functions:

(1) Protecting against firm specific risk

such as operational, market, credit,

legal, and liquidity risks; and (2)

protecting the financial industry from

systemic risk.77

The specific elements of a risk

management system will vary

depending on the size and complexity

of a firm’s business operations. As a

result, the design and implementation of

a system of internal controls for a

particular firm should reflect the

circumstances of the firm. Any welldeveloped risk management system,

however, should include a risk

management strategy, policies and

procedures to accomplish that strategy,

risk measurement methodologies,

compliance monitoring and reporting,

and on-going assessment of the

effectiveness of the strategies, policies,

and procedures.

The Commission recognizes that an

individual firm must have the flexibility

to implement specific policies and

procedures unique to its circumstances.

As a result, proposed Rule 15c3–4

would establish only basic elements for

the design, implementation, and review

of an OTC derivatives dealer’s risk

management control system. These

elements are designed to ensure the

integrity of the risk management

process, to clarify that the appropriate

level of management is authorizing the

types of activity that can be conducted

and the level of risk that can be

assumed, and to ensure that the OTC

derivatives dealer reviews its activities

for consistency with risk management

guidelines.

The proposed rule would require an

OTC derivatives dealer to assess a

number of aspects about its business

environment when creating its risk

management control system. This

assessment is designed to ensure that

the system implemented is appropriate

for the individual firm. For example, an

OTC derivatives dealer would need to

consider the sophistication and

experience of relevant trading, risk

management, and internal audit

personnel, as well as the management

philosophy and culture of the firm.

Despite the need for firms to develop

controls appropriate to their specific

circumstances, the proposed rule would

also require certain elements to be

included in OTC derivatives dealers’

internal control systems. These

elements ensure that internal control

systems protect against risks that are

universal to the business of OTC

derivatives dealers. For example, the

unit at the firm responsible for

monitoring risk must be separate from

and senior to the trading units whose

activity create the risks. This is to

ensure the independence of the risk

management process. In addition,

personnel responsible for recording

transactions in the books of the OTC

derivatives dealer cannot be the same as

those responsible for executing

transactions. This is to ensure that

trading losses cannot be hidden.

Finally, the OTC derivatives dealer’s

management must periodically review

the firm’s business activities for

consistency with established risk

management guidelines. This will

ensure that personnel are operating

within the scope of permissible activity

and that the risk management system

will continue to be adequate.

4. Proposed Rule 17a–12; Reports To Be

Made by OTC Derivatives Dealers

Exchange Act Rule 17a–5 78 requires

all broker-dealers to file various reports

with the Commission. These reports

include periodic Financial Operational

Combined Uniform Single Reports

(FOCUS), 79 annual audited financial

statements, and designations of

accountant. Under proposed Rule 17a–

12, similar periodic requirements would

be put into place for OTC derivatives

dealers.

Proposed Rule 17a–12 would require

OTC derivatives dealers to file quarterly

FOCUS reports, and to include in these

filings the enhanced reporting

information and the evaluation of risk in

relation to capital provisions of the

Framework for Voluntary Oversight of

the Derivatives Policy Group (‘‘DPG’’). 80

The DPG credit and market risk

information (Schedules I–V and VI of

the proposed FOCUS report) are

intended to enable the Commission to

ascertain the nature and scope of a

firm’s OTC derivatives activity and to

monitor the firm’s risk exposure.

Proposed Rule 17a–12 would also

require the OTC derivatives dealer to

file annually its audited financial

statements along with a corresponding

audit report. Among other things, the

annual audit report would include a

statement of financial condition, a

statement of income, a statement of cash

flows, a statement of changes in owners’

equity, and a statement of changes in

subordinated liabilities. The proposed

rule establishes guidelines for the

content and form of the annual report,

accountant qualifications, the process

for designating an accountant, and audit

objectives.

Each of the reports required under

proposed Rule 17a–12 would assist the

Commission to monitor the operations
67952 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

of OTC derivatives dealers and to

enforce their compliance with the

Commission’s rules. These reports

would also enable the Commission to

review the business activities of OTC

derivatives dealers and to anticipate,

where possible, how these dealers may

be affected by significant economic

events.

5. Proposed Amendments to Form X–

17A–5

Proposed Rule 17a–12 would require

that certain conforming changes be

made to Rule 249.617 to require OTC

derivatives dealers to file the

appropriate parts of Form X–17A–5,

commonly known as the FOCUS report.

These changes would provide for

appropriate disclosure of the business

activities of OTC derivatives dealers and

the risks associated with those

activities.

Under the proposed amendments to

Form X–17A–5, the net capital

computation worksheet would be

revised to reflect the proposed net

capital requirements for OTC

derivatives dealers. Other changes

would include revising the statement of

financial condition and the statement of

income, and eliminating the customer

reserve computation and commission

income line items. OTC derivatives

dealers would also be required to

include certain information in the

quarterly FOCUS filing. This

information would include credit

concentration information, together

with a geographic breakdown and a

counterparty breakdown as described in

the DPG Framework for Voluntary

Oversight. OTC derivatives dealers

would also be required to provide,

where applicable, a detailed summary of

all long and short securities and

commodities positions, including all

OTC derivatives contracts.

By incorporating the DPG credit and

market risk information into the FOCUS

filing requirement for OTC derivatives

dealers, the Commission would be able

to ascertain the nature and scope of a

firm’s OTC derivatives activity and to

monitor the firm’s risk exposure. This

information has been valuable to the

Commission in understanding the OTC

derivatives business of those firms

already participating in the DPG

Framework for Voluntary Oversight

program.

III. General Requests for Comment

The Commission solicits comment on

its proposal to establish a limited,

optional regulatory system for OTC

derivatives dealers. In particular, the

Commission solicits comments on the

extent to which persons eligible to

become registered as OTC derivatives

dealers believe this proposed system

would address any competitive

inequalities that discourage securities

firms from conducting an OTC

derivatives business in the United

States. The Commission also solicits

comments on this proposal from

derivatives counterparties and other

interested participants in global

financial markets. In addition,

commenters are requested to express

their views on the application of the

Commission’s broker-dealer rules to

OTC derivatives dealers and whether

additional amendments or exemptions

would be needed for this class of

dealers. For purposes of the Small

Business Regulatory Enforcement

Fairness Act of 1996, the Commission is

also requesting information regarding

the potential impact of the proposed

rules on the national economy on an

annual basis. Commenters should

provide empirical data to support their

views.

IV. Costs and Benefits of the Proposed

Rules and Rule Amendments

To assist the Commission in its

evaluation of the costs and benefits that

may result from the proposed limited

regulatory system for OTC derivatives

dealers, commenters are requested to

provide analysis and data relating to the

costs and benefits associated with the

proposals. 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 rules and rule

amendments and the potential benefits

arising from participation in the

regulatory scheme.

The Commission has identified

certain costs and benefits that would be

associated with the proposed regulatory

system for OTC derivatives dealers. This

proposed system would be optional and

is designed to allow U.S. securities

firms to establish separate OTC

derivatives dealer affiliates capable of

acting as counterparties with respect to

both securities and non-securities OTC

derivative products. Capital, margin,

and other broker-dealer regulatory

requirements would be tailored to the

activities of these entities. Registration

as an OTC derivatives dealer would be

an alternative to registration as a fully

regulated broker-dealer under Section

15(b) of the Exchange Act for firms

combining a business in securities and

non-securities OTC derivative products,

and would be available only to entities

acting primarily as counterparties in

privately negotiated OTC derivatives

transactions.

It is expected that firms electing to

become registered as OTC derivatives

dealers would be able to conduct

business more efficiently and at lower

cost than under current Commission

rules. This would allow OTC derivatives

dealers to compete more effectively

against banks and foreign dealers in

OTC derivatives markets. The

Commission expects that the benefits to

OTC derivatives dealers of being able to

compete more effectively in global

derivatives markets at a lower cost

would outweigh the potential cost of

this limited regulation.

Cost savings would result in several

areas. First, firms that currently conduct

securities OTC derivatives activities

from registered broker-dealers and nonsecurities OTC derivatives activities

from separate, unregistered entities,

would be able to combine these

activities in one OTC derivatives dealer.

This combination of operations in one

entity would result in a decrease in

operational costs. There would also be

a decrease in regulatory costs. OTC

derivatives dealers that register with the

Commission would become subject to

tailored capital and other requirements

that are intended to impose lesser

regulatory burdens than are imposed on

fully regulated broker-dealers. In

addition, OTC derivatives dealers would

be exempted from the margin

requirements of Section 7 and

Regulation T, provided these dealers

comply with the margin requirements of

Regulation U. Applying Regulation U to

extensions of credit by OTC derivatives

dealers would allow them to extend

credit on the broader range of securities

OTC derivatives products that make up

their business.

The Commission preliminary believes

that the proposed rules and rule

amendments would promote both

efficiency and capital formation. The

proposed rules and rule amendments

should provide broker-dealers the

opportunity to increase operational

efficiency by reducing the need to

fractionalize their OTC derivatives

business. The Commission, however,

solicits comment on whether the

proposal would promote both efficiency

and capital formation.

The proposed limited regulatory

system for OTC derivatives dealers

would also result in benefits to

regulators and to financial markets.

First, OTC derivatives dealers that

register with the Commission would be

subject to the proposed net capital

requirements and other financial

responsibility requirements for OTC

derivatives dealers. These are intended
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67953

81 15 U.S.C. 78w(a)(2).

82 15 U.S.C. 78g.

83Exchange Act Rule 0–10 [17 CFR 240.0–10].

to ensure against excessive leverage and

the risks associated with conducting an

OTC derivatives business, and to

provide a cushion of capital against

market declines and other risks. Second,

Commission oversight authority,

including proposed reporting and notice

requirements, would enable the

Commission to monitor the financial

condition and securities activities of

OTC derivatives dealers. Third,

proposed internal risk management

control systems are intended to promote

the financial responsibility of OTC

derivatives dealers to the extent they

have elected to do business through this

type of broker-dealer. By reducing the

risk of significant losses by a single firm,

internal risk management control

systems would also reduce the risk that

the problems of one firm would spread,

causing defaults by other firms and

undermining securities markets as a

whole.

Firms electing to register as OTC

derivatives dealers would incur various

costs. As a preliminary matter, there

may be costs associated with combining

activities currently conducted in a

registered broker-dealer with activities

conducted in other unregistered entities.

These firms would incur the one-time

and on-going costs of registration as an

OTC derivatives dealer. These firms

would also have the one-time and ongoing costs of making adjustments to

risk management practices to conform

with proposed Rule 15c3–4, and of

maintaining capital required by

proposed Appendix F to the net capital

rule. In addition, these firms would

have the one-time and on-going costs of

complying with the books and records

requirements under proposed

amendments to Rules 17a–3 and 17a–4.

OTC derivatives dealers would incur

costs associated with preparing and

submitting FOCUS reports and annual

audited financial statements. This

would include the cost of contracting

with a certified public accountant to

conduct an annual audit. Moreover,

while OTC derivatives dealers would be

exempted from the more restrictive

margin requirements of Regulation T,

the dealers would have the one-time

and on-going costs associated with

complying with the margin

requirements of Regulation U, including

the costs of developing systems for

compliance and the costs associated

with subjecting currently unregulated

offshore activities to Regulation U.

V. The Effects on Competition of the

Proposed Rules and Rule Amendments

Section 23(a)(2) of the Exchange Act 81

requires the Commission, in adopting

rules under the Exchange Act, to

consider the impact any rule would

have on competition and to not adopt

any rule that would impose a burden on

competition not necessary or

appropriate in the public interest. The

Commission’s preliminary view is that

the proposed rules for OTC derivatives

dealers would not have any

anticompetitive effects. These rules are

intended to remove substantial

regulatory and economic barriers that

impede the ability of U.S. securities

firms to compete effectively in global

securities markets. In particular, by

providing OTC derivatives dealers with

relief from certain provisions of the

federal securities laws, these rules

would put U.S. securities firms on a

level footing with their bank and foreign

dealer competitors.

As discussed above, the limited

regulatory system for OTC derivatives

dealers would be optional, and would

be an alternative to regulation as a fully

regulated broker-dealer. OTC derivatives

dealers that elect to register with the

Commission in order to conduct both

securities and non-securities OTC

derivatives transactions in a single

entity would be subject to modified

capital, margin, and other regulatory

requirements. Because of the substantial

minimum capital requirements that

would be imposed on OTC derivatives

dealers, regulation as an OTC

derivatives dealer would be available

only to large, well-capitalized firms.

In general, major dealers in OTC

derivatives markets include the largest,

highest capitalized banks and securities

firms. It is possible, however, that there

may be smaller firms participating in

these markets that could not satisfy the

minimum capital requirements for OTC

derivatives dealers and, as a result, not

be able to take advantage of the

competitive benefits available under the

proposed rules. Nevertheless, these

minimum capital requirements for OTC

derivatives dealers are necessary to

ensure against excessive leverage and

the risks associated with conducting an

OTC derivatives business, and to

provide a cushion of capital against

severe market disturbances. The

Commission requests comment on the

competitive benefits to OTC derivatives

dealers that may result under the

proposed rules. The Commission also

requests comment on any

anticompetitive effects that may result

under the proposed rules.

VI. Summary of Regulatory Flexibility

Analysis

The Commission has prepared an

Initial Regulatory Flexibility Analysis

(‘‘IRFA’’) in accordance with 5 U.S.C.

603 regarding proposed rules and rule

amendments under the Exchange Act

that would tailor capital, margin, and

other broker-dealer regulatory

requirements to the activities of OTC

derivatives dealers. The following

summarizes the IRFA.

The proposed rules and rule

amendments are intended to improve

the efficiency and competitiveness of

U.S. securities firms participating in

global OTC derivatives markets. These

improvements would be realized

through a limited regulatory structure

that is intended to be deregulatory and

to impose fewer costs on firms

conducting an OTC derivatives business

than would be imposed under the

Commission’s current rules. In

particular, the application of revised

capital requirements and an exemption

from the margin provisions of Section 7

of the Exchange Act 82 are expected to

make it feasible for firms to conduct a

business involving both securities and

non-securities OTC derivative products

within the United States.

A broker-dealer (including any person

that would be an OTC derivatives

dealer) generally would be considered a

small entity if (i) it has total capital (net

worth plus subordinated liabilities) of

less than $500,000 on the date in the

prior fiscal year as of which its audited

financial statements were prepared

pursuant to Rule 17a–5(d) or, if not

required to file such statements, a

broker-dealer that had total capital (net

worth plus subordinated liabilities) of

less than $500,000 on the last day of the

preceding fiscal year (or in the time that

it has been in business, if shorter); and

(ii) it is not affiliated with any person

(other than a natural person) that is not

a small business or small organization.83

Under the proposed amendments to

Rule 15c3–1, OTC derivatives dealers

would be required to maintain at least

$100 million in tentative net capital and

at least $20 million in regulatory net

capital. Based on these minimum

capital requirements, the IRFA notes

that no OTC derivatives dealer would be

considered a small entity. Major dealers

in OTC derivatives markets tend to be

the largest, highest-capitalized banks

and securities firms. The proposed

capital requirements have been tailored
67954 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

84 5 U.S.C. 601 et seq.

to this market and are necessary to

ensure against excessive leverage and

the risks associated with conducting an

OTC derivatives business, as well as to

provide for a cushion of capital against

severe market disturbances. The

Commission is not aware of any small

entities that are active as dealers in OTC

derivatives markets. In the IRFA, the

Commission requests comment on

whether there are small entities that act

as dealers in OTC derivatives markets,

and what effect, if any, the proposed

rules and rule amendments would have

on their activities.

The Commission also requests

comment from persons acting as

counterparties in transactions with

persons eligible to become registered as

OTC derivatives dealers. Under

proposed Rule 3b–14, the term

‘‘permissible derivatives counterparty’’

would include a range of financial

institutions, corporations, and other

institutional entities with whom OTC

derivatives dealers would be permitted

to enter into OTC derivatives

transactions. Like OTC derivatives

dealers, these institutional

counterparties are frequently large, wellcapitalized entities. The proposed

definition may include potential

counterparties that would be considered

small entities for purposes of the

Regulatory Flexibility Act (‘‘RFA’’).84

The proposed definition would

include various classes of persons, such

as banks, trust companies, saving

associations, credit unions, insurance

companies, investment companies,

broker-dealers, commodity pools,

futures commission merchants, and

governmental entities, without regard to

any minimum financial requirements.

The Commission requests comment

regarding the participation of these

classes of persons in OTC derivatives

markets, whether any of them would be

considered small entities, and what

effect, if any, the proposed rules and

rule amendments would have on their

activities.

The proposed definition would also

include classes of persons, such as

corporations, partnerships, trusts, and

employee benefit plans, that would have

minimum financial requirements for

being considered a permissible

derivatives counterparty. In the case of

corporations, partnerships, trusts, and

certain other entities described in the

proposed definition, any such entity

would be required to have total assets

exceeding $10 million, have obligations

under the terms of an OTC derivatives

transaction that are guaranteed by

certain classes of persons described in

the rule, or a net worth of $1 million if

it enters into OTC derivatives

transactions in connection with the

conduct of its business. Employee

benefit plans would be required to have

total assets exceeding $5 million.

Alternatively, employee benefit plans

would satisfy the definition if its

investment decisions are made by a

bank, trust company, insurance

company, investment adviser, or

commodity trading advisor subject to

regulation by the Commodity Futures

Trading Commission.

Some of these entities, despite

minimum financial requirements, may

be considered small entities for

purposes of the RFA. The Commission

requests comment regarding the

participation of these classes of persons

in OTC derivatives markets.

Commenters should address whether

any of these potential participants in

OTC derivatives markets are likely to be

small entities, and what effect, if any,

the proposed rules and rule

amendments would have on their

activities. The Commission also requests

comment from small entities that would

not be able to satisfy the definition of

permissible derivatives counterparty

and, therefore, would not be eligible to

engage in transactions with OTC

derivatives dealers. Commenters should

indicate what effect, if any, the

proposed rules and rule amendments

would have on their activities.

As explained in the IRFA, none of the

recordkeeping, reporting, or other

compliance requirements under the

proposed rules and rule amendments

are expected to be unduly burdensome.

Under the proposed amendments to

Rule 15c3–1, the Commission would

allow OTC derivatives dealers to use

VAR models to calculate their net

capital requirements. Although many

dealers active in OTC derivatives

markets already use VAR models, OTC

derivatives dealers would be required to

bring their use of models into

compliance with the requirements of

proposed Rule 15c3–1.

OTC derivatives dealers would also be

exempted under proposed Rule 36a1–1

from the provisions of Section 7 of the

Exchange Act, provided they comply

with other federal margin requirements

applicable to non-broker-dealer lenders.

This exemption is intended to be

deregulatory and to allow OTC

derivatives dealers greater flexibility by

allowing them to extend credit on

securities other than ‘‘margin stock,’’

including securities OTC derivative

instruments. These OTC derivative

dealers, however, would be required to

implement systems for complying with

the margin requirements applicable to

their business.

Under the proposed amendments to

Rules 17a–3, 17a–4, 17a–11, proposed

Rule 17a–12, and proposed revisions to

Form X–17A–5 (FOCUS report), OTC

derivatives dealers would be required to

maintain certain records regarding their

OTC derivatives transactions, and to

provide certain information to the

Commission regarding their financial

condition and operations. Any new

requirements under these proposed

rules and rule amendments would

supplement current requirements that

apply to fully regulated broker-dealers.

Compliance with these requirements

would require modification of the

existing recordkeeping systems of

dealers that become registered as OTC

derivatives dealers.

Under proposed Rule 15c3–4, OTC

derivatives dealers would be required to

maintain internal risk management

controls. In general, dealers in OTC

derivatives markets already maintain

and follow internal risk management

controls. Under proposed Rule 15c3–4,

OTC derivatives dealers would be

required to modify their existing

controls systems to the requirements

under the rule. It is also expected that

OTC derivatives dealers that elect to

register with the Commission under the

proposed amendments to Rule 15b1–1

would maintain general policies and

procedures designed to promote

compliance with the Commission rules,

including compliance with the

restrictions on the activities of OTC

derivatives dealers described in

proposed Rule 15a–1.

As noted in the IRFA, the

Commission requests comment on the

costs of coming into compliance with

the recordkeeping, reporting, and other

requirements under the proposed rules

and rule amendments, and whether

there would be any on-going costs

associated with complying with the

rules and rule amendments.

Commenters should provide detailed

estimates of these costs. The IRFA also

notes that none of the recordkeeping,

reporting, or other compliance

requirements under the proposed rules

and rule amendments are expected to

apply to counterparties that enter into

transactions with OTC derivatives

dealers. The Commission, however,

requests comment regarding the

participation of small entities as

counterparties in OTC derivatives

markets, and what counterparty costs, if

any, may be associated with the

obligations of OTC derivatives dealers to

comply with the proposed rules and

rule amendments.
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67955

As discussed further in the IRFA, the

Commission has considered alternatives

to the proposed rules and rule

amendments that would accomplish the

stated objectives of improving the

efficiency and competitiveness of U.S.

securities firms participating in global

OTC derivatives markets, and making it

feasible for these firms to conduct a

business involving securities and nonsecurities OTC derivative products

within the United States. The proposed

rules and rule amendments accomplish

these objectives by tailoring capital,

margin, and other regulatory

requirements to the activities of OTC

derivatives dealers. The proposed

capital requirements, in particular,

provide OTC derivatives dealers with

significant alternatives for computing

risk charges. These requirements do

this, while also being intended to ensure

against excessive leverage and risk, and

to provide a cushion of capital against

severe market disturbances. Improved

competition and efficiency should

benefit participants in OTC derivatives

markets.

As noted in the IRFA, the

Commission is encouraging the

submission of written comments with

respect to any aspect of the IRFA.

Comment specifically is requested

whether any small entities would be

affected by the proposed rules and rule

amendments, the costs of compliance

with the proposed rules and rule

amendments, and suggested alternatives

that would accomplish the objectives of

the proposed rules and rule

amendments. After receipt of any

comments from interested persons and

preliminary evaluation of the possible

compliance costs and effects upon

competition, it may be appropriate to

conclude, and for the Chairman of the

Commission to certify, that the proposal

does not have a significant economic

impact on a substantial number of small

entities. Comments received will also be

considered in the preparation, if

required, of a Final Regulatory

Flexibility Analysis if the proposed

rules and rule amendments are adopted.

For purposes of the Small Business

Regulatory Enforcement Fairness Act of

1996, the Commission is also requesting

information regarding the potential

impact of the proposed rules and rule

amendments on the economy on an

annual basis. Commenters should

provide empirical data to support their

views. A copy of the IRFA may be

obtained by contacting Glenn J. Jessee,

Securities and Exchange Commission,

450 Fifth Street, N.W., Mail Stop 7–11,

Washington, D.C. 20549.

VII. Paperwork Reduction Act

Certain provisions of the proposed

rules and rule amendments contain

‘‘collection of information’’

requirements within the meaning of the

Paperwork Reduction Act of 1995 (44

U.S.C. § 3501 et seq.). The Commission

has submitted them to the Office of

Management and Budget (‘‘OMB’’) for

review in accordance with 44 U.S.C.

3507(d) and 5 CFR 1320.11. The titles

for the collections of information are: (1)

Appendix F to Rule 15c3–1, Optional

Market and Credit Risk Requirements

for OTC Derivatives Dealers; (2) Rule

15c3–4 Internal Risk Management

Control Systems for OTC Derivatives

Dealers (New Rule); (3) Rule 17a–3

Records to be Made by Certain Exchange

Members, Brokers and Dealers (OMB

Control Number 3235–0033); and (4)

Rule 17a–12 Reports to be Made by OTC

Derivatives Dealers (New Rule).

The Commission proposes to

implement a limited regulatory system

under the Exchange Act for OTC

derivatives dealers. Under the proposed

regulatory structure, OTC derivatives

dealers would be permitted to act

primarily as counterparties with respect

to certain types of securities and nonsecurities OTC derivative instruments,

and to issue and reacquire issued

securities, without being required to

comply with the full range of capital,

margin, and other regulatory

requirements applicable to other

registered broker-dealers.

The collection of information

obligations imposed by the proposed

rules and rule amendments would be

mandatory. However, it is important to

note that registration as an OTC

derivatives dealer would be voluntary.

The information collected, retained,

and/or filed pursuant to the proposed

rules and rule amendments would be

kept confidential to the extent permitted

by the Freedom of Information Act [5

U.S.C. 552 et seq.]. An agency may not

conduct or sponsor, and a person is not

required to comply with, a collection of

information unless it displays a

currently valid OMB control number.

A. Appendix F to Rule 15c3–1, Optional

Market and Credit Risk Requirements

for OTC Derivatives Dealers

Rule 15c3–1 requires broker-dealers to

maintain minimum levels of net capital

computed in accordance with the rule’s

provisions. The net capital reserves are

intended to ensure that broker-dealers

have sufficient capital to protect the

assets of customers and to meet their

responsibilities to other broker-dealers.

The Commission is proposing to add

Appendix F to the rule to provide an

alternative net capital requirement and

method for determining net capital for

OTC derivatives dealers.

Under proposed Appendix F’s

alternative method for determining net

capital requirements, an OTC

derivatives dealer would be permitted to

use a VAR model to calculate its net

capital requirements. The OTC

derivatives dealer would be required to

send notice to the Commission

describing its VAR model, including

whether the firm has developed its own

model and how the qualitative and

quantitative aspects of Appendix F of

the rule are incorporated into the model.

In addition to developing and

submitting a notice describing its

model, an OTC derivatives dealer would

be required to maintain its model

according to certain prescribed

standards. Maintenance of the model

would require an OTC derivatives

dealer to create and maintain certain

information and periodically adjust the

model. For example, the OTC

derivatives dealer would be required to

conduct backtesting by comparing each

of its most recent 250 business days’

actual net trading profit or loss with the

corresponding daily VAR measures.

Finally, the OTC derivatives dealer

would be required to submit a

description of its risk management

control system implemented pursuant to

proposed Rule 15c3–4.

Proposed Appendix F would help to

ensure that OTC derivatives dealers

would be able to meet their financial

obligations and would facilitate the

monitoring of the financial condition of

OTC derivatives dealers by the

Commission. Failure to require the

current and proposed collections of

information would undermine the safety

and soundness of OTC derivatives

dealers and the securities markets.

It is anticipated that Appendix F

would affect approximately six OTC

derivatives dealers. However, it is

possible that more than ten OTC

derivatives dealers would be affected. It

is anticipated that the six affected OTC

derivatives dealers would each spend an

average of approximately 1,000 hours

developing and submitting their VAR

model and the description of their risk

management control system to the

Commission. In addition, these OTC

derivatives dealers would spend

annually, an average of approximately

1,000 hours each maintaining the

model. Consequently, the total initial

burden is estimated to be 6,000 hours

and the total annual burden is estimated

to be 6,000 hours. The estimates of the

initial and annual burdens are based on

discussions with potential respondents.

The retention period for any
67956 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

85 17 CFR 240.17a–3.

86The Commission is authorized by Sections

17(a) [15 U.S.C. 78q(a)] and 23(a) [15 U.S.C. 78w(a)]

of the Exchange Act to promulgate rules and

regulations regarding the maintenance and

preservation of books and records of brokersdealers.

87Form X–17A–5 [17 CFR 249.617].

88See Framework for Voluntary Oversight,

Derivatives Policy Group (Mar. 1995).

recordkeeping requirement under the

rule would be three years.

B. Proposed Rule 15c3–4

Proposed Rule 15c3–4 would

establish basic elements governing the

creation, execution, and review of a

firm’s risk management control system.

These elements are designed to ensure

the integrity of the risk measurement,

monitoring, and management process,

and to clarify accountability, at the

appropriate organizational level, for

defining the permitted scope of activity

and level of risk.

The proposed rule would require an

OTC derivatives dealer to consider a

number of issues affecting its business

environment when creating its risk

management control system. For

example, an OTC derivatives dealer

would need to consider, among other

things, the sophistication and

experience of relevant trading, risk

management, and internal audit

personnel, as well as the separation of

duties among these personnel, when

designing and implementing its internal

control system’s guidelines, policies,

and procedures. This would help to

ensure that the control system that is

implemented would adequately address

the risks posed by the firm’s business

and the environment in which it is

being conducted. In addition, this

would enable an OTC derivatives dealer

to implement specific policies and

procedures unique to its circumstances.

In implementing its policies and

procedures, an OTC derivatives dealer

would be required to document and

record its system of internal risk

management controls. In particular, an

OTC derivatives dealer would be

required to document its consideration

of certain issues affecting its business

when designing its internal controls. An

OTC derivatives dealer would also be

required to prepare and maintain

written guidelines that discuss its

internal control system, including

procedures for determining the scope of

authorized activities.

The proposed rule would be an

integral part of the Commission’s

financial responsibility program for

OTC derivatives dealers. The

information to be collected under

proposed Rule 15c3–4 would be

essential to the regulation and oversight

of OTC derivatives dealers and their

compliance with the Commission’s

proposed financial responsibility

requirements. More specifically,

requiring an OTC derivatives dealer to

document the planning,

implementation, and periodic review of

its risk management controls would

ensure that all pertinent issues are

considered, that the risk management

controls are implemented properly, and

that they continue to adequately address

the risks faced by OTC derivatives

dealers.

It is anticipated that the proposed rule

would affect approximately six OTC

derivatives dealers. However, it is

possible that more than ten OTC

derivatives dealers would be affected. It

is estimated that the average amount of

time a firm would spend implementing

its risk management control system

would be 2,000 hours. On average, it is

expected that an OTC derivatives dealer

would spend approximately 200 hours

each year reviewing and updating its

risk management control system. The

total initial burden for all OTC

derivatives dealers would be 12,000

hours and the annual burden would be

1,200 hours. The estimates of the initial

and annual burdens are based on

discussions with potential respondents.

The retention period for the

recordkeeping requirement under the

rule would be three years.

C. Proposed Amendments to Rule 17a–

3.

OTC derivatives dealers, like other

broker-dealers that are registered with

the Commission, would be required to

comply with the books and records

requirements of Exchange Act Rule 17a–

3.85 In general, Rule 17a–3 requires

broker-dealers to make records

concerning the purchases and sales of

securities, receipts and deliveries of

securities, and receipts and

disbursements of cash. As part of the

limited regulatory system for OTC

derivatives dealers, the Commission

proposes to amend Rule 17a–3 to reflect

the business conducted by OTC

derivatives dealers.86 In particular, Rule

17a–3(a)(10) would be amended to

require OTC derivatives dealers to

compile a register of all transactions in

eligible OTC derivative instruments.

Currently, Rule 17a–3(a)(10) requires

broker-dealers to make a record of all

securities puts, calls, spreads, straddles,

and other options in which a member,

broker, or dealer has any direct or

indirect interest, but does not address

other types of OTC transactions.

Rule 17a–3 is an important part of the

Commission’s financial responsibility

program for broker-dealers. The

information required to be preserved

under the proposed amendment of the

rule would be used by representatives of

the Commission and the examining

authority responsible for reviewing the

activities of the OTC derivatives dealer

pursuant to proposed Rule 15b9–2 to

ensure that OTC derivatives dealers

would be in compliance with applicable

Commission rules.

It is anticipated that the proposed rule

amendment would affect approximately

six OTC derivatives dealers. However, it

is possible that more than ten OTC

derivatives dealers would be affected.

The current estimate of the time

required to comply with the existing

provisions of Rule 17a–3 is one hour per

broker-dealer per working day. It is

expected that any additional burden

under the proposed rule amendment

would be minimal because the

information that would be called for

under the proposed amendment to the

rule is information a prudent OTC

derivatives dealer would already

maintain during the ordinary course of

its business. The proposed amendment

to Rule 17a–3 would require each of the

six affected OTC derivatives dealers to

spend approximately 52 hours per year

collecting the required information.

Thus, the Commission estimates that

complying with the proposed

amendment to Rule 17a–3 would

require an additional 312 hours per year

(52 hours per year multiplied by six

affected OTC derivatives dealers). The

estimates of the initial and annual

burdens are based on discussions with

potential respondents. The retention

period for the recordkeeping

requirements under the rule would be

three years.

D. Proposed Rule 17a–12

Proposed Rule 17a–12 would

establish the basic periodic reporting

structure for OTC derivatives dealers.

The proposed rule would require OTC

derivatives dealers to file quarterly

Financial and Operational Combined

Uniform Single Reports (FOCUS).87 OTC

derivatives dealers would be required to

include in these quarterly filings the

enhanced reporting information and the

evaluation of risk in relation to capital

provisions of the DPG’s Framework for

Voluntary Oversight.88 Finally,

proposed Rule 17a–12 would require an

OTC derivatives dealer to file annually

its audited financial statements along

with a corresponding audit report.

The proposed rule would be integral

part of the Commission’s financial

responsibility program for OTC

derivatives dealers. The information to
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67957

be collected under proposed Rule 17a–

12 would be essential to the regulation

and oversight of OTC derivatives dealers

and would assist the Commission and

the examining authorities responsible

for reviewing the activities of OTC

derivatives dealers pursuant to

proposed Rule 15b9–2 to monitor and

enforce compliance with applicable

Commission rules, including rules

pertaining to financial responsibility.

These FOCUS and annual reports would

also be intended to be used to evaluate

the activities conducted by OTC

derivatives dealers and to anticipate,

where possible, how these dealers could

be affected by significant economic

events.

It is anticipated that the proposed rule

would affect approximately six OTC

derivatives dealers. However, it is

possible that more than ten OTC

derivatives dealers would be affected. It

is estimated that the average amount of

time necessary to prepare and file the

information required by the proposed

rule would be 180 hours annually per

OTC derivatives dealer. This is based

upon an estimated average of four

responses per year and an average of 20

hours spent preparing each response

with an additional 100 hours spent on

preparing the annual audit. This

estimate of the annual burden is based

on discussions with potential

respondents. The retention period for

the recordkeeping requirements under

the rule would be three years.

E. Request for Comments

Written comments are invited on: (a)

Whether the proposed collections of

information would be necessary for the

proper performance of the functions of

the agency, including whether the

information would have practical

utility; (b) the accuracy of the agency’s

estimates of the burdens of the proposed

collections of information; (c) ways to

enhance the quality, utility, and clarity

of the information to be collected; and

(d) ways to minimize the burden of the

collections of information on

respondents, including through the use

of automated collection techniques or

other forms of information technology.

Persons wishing to submit comments

on the collection of information

requirements should direct them to the

following persons: (i) Desk Officer for

the Securities and Exchange

Commission, Office of Information and

Regulatory Affairs, Office of

Management and Budget, Room 3208,

New Executive Office Building,

Washington, D.C. 20503; and (ii)

Jonathan G. Katz, Secretary, Securities

and Exchange Commission, 450 Fifth

Street, N.W., Washington, D.C. 20549

with reference to File No. S7–30–97.

OMB is required to make a decision

concerning the collections of

information between 30 and 60 days

after publication, so a comment to OMB

is best assured of having its full effect

if OMB receives it within 30 days of

publication.

VIII. Statutory Authority

The Commission is amending Title

17, Chapter II of the Code of Federal

Regulations pursuant to the Securities

Exchange Act of 1934 (15 U.S.C. 78a et

seq.) (particularly sections 3(b), 15(a),

15(b), 15(c), 17(a), 23, and 36 thereof (15

U.S.C. 78c(b), 78o(a), 78o(b), 78o(c),

78q(a), 78w, and 78mm)).

Text of Proposed Rule Amendments

List of Subjects

17 CFR Part 200

Administrative practice and

procedure, Authority delegations

(Government agencies).

17 CFR Parts 240 and 249

Broker-dealers, Reporting and

recordkeeping requirements, Securities.

PART 200—ORGANIZATION;

CONDUCT AND ETHICS; AND

INFORMATION AND REQUESTS

1. The authority citation for Part 200

continues to read in part as follows:

Authority: 15 U.S.C. 77s, 78d–1, 78d–2,

78w, 78ll(d), 79t, 77sss, 80a–37, 80b–11,

unless otherwise noted.

* * * * *

2. Section 200.30–3 is amended by

adding paragraph (a)(63) to read as

follows:

§ 200.30–3(a)(63) Delegation of authority to

Director of Division of Market Regulation.

* * * * *

(a) * * *

(63) Pursuant to § 240.15a–1(a)(1)(iii)

of this chapter, to designate by order

other securities transactions in which an

OTC derivatives dealer may engage.

* * * * *

PART 240—GENERAL RULES AND

REGULATIONS, SECURITIES

EXCHANGE ACT OF 1934

3. The general authority citation for

Part 240 is revised to read 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), 78mm, 79q, 79t, 80a–20, 80a–23,

80a–29, 80a–37, 80b–3, 80b–4 and 80b–11,

unless otherwise noted.

* * * * *

4. By adding §§ 240.3b–12 through

240.3b–16 to read as follows:

§ 240.3b–12 Definition of OTC derivatives

dealer.

The term OTC derivatives dealer

means any dealer that:

(a) Limits its securities activities to:

(1) Engaging as a counterparty in

transactions in eligible OTC derivative

instruments with permissible

derivatives counterparties;

(2) Issuing and reacquiring issued

securities, including warrants on

securities, hybrid securities, and

structured notes, through a registered

broker or dealer (other than an OTC

derivatives dealer); or

(3) Engaging in other securities

transactions which the Commission

designates by order pursuant to

§ 240.15a–1(a)(1)(iii); and

(b) In connection with the activities

described in paragraph (a) of this

section, engages in permissible risk

management, arbitrage, and trading

transactions.

§ 240.3b–13 Definition of eligible OTC

derivative instrument.

The term eligible OTC derivative

instrument means any agreement,

contract, or transaction (or class

thereof):

(a) That is not part of a fungible class

of agreements, contracts, or transactions

that are standardized as to their material

economic terms;

(b) That is based, in whole or in part,

on the value of, any interest in, any

quantitative measure of, or the

occurrence of any event relating to, one

or more securities, commodities,

currencies, interest or other rates,

indices, or other assets, or that involves

the purchase and sale of a security on

a firm basis at least one year following

the transaction date; and

(c) That is not entered into and traded

on or through an exchange, an

electronic marketplace, or similar

facility supervised or regulated by the

Commission, or any other multilateral

transaction execution facility.

§ 240.3b–14 Definition of permissible

derivatives counterparty.

The term permissible derivatives

counterparty means, and shall be

limited to, the following persons or

classes of persons:

(a) A bank or trust company (acting on

its own behalf or on behalf of another

permissible derivatives counterparty);

(b) A savings association or credit

union;

(c) An insurance company;

(d) An investment company or a

foreign person performing a similar role

or function subject as such to foreign

regulation, provided that such

investment company or foreign person
67958 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

is not formed solely for the specific

purpose of constituting a permissible

derivatives counterparty;

(e) A commodity pool formed and

operated by a person subject to

regulation under the Commodity

Exchange Act (7 U.S.C. 1 et seq.) or a

foreign person performing a similar role

or function subject as such to foreign

regulation, provided that such

commodity pool or foreign person is not

formed solely for the specific purpose of

constituting a permissible derivatives

counterparty and has total assets

exceeding $5 million;

(f) A corporation, partnership,

proprietorship, organization, trust, or

other entity not formed solely for the

specific purpose of constituting a

permissible derivatives counterparty:

(1) Which has total assets exceeding

$10 million;

(2) The obligations of which under the

terms of a transaction in eligible OTC

derivative instruments are guaranteed or

otherwise supported by a letter of credit

or keepwell, support, or other agreement

by any such entity referenced in

paragraph (f)(1) of this section or by an

entity referred to in paragraphs (a), (b),

(c), (d), (e), (f) or (h) of this section; or

(3) Which has a net worth of $1

million and enters into transactions in

eligible OTC derivative instruments in

connection with the conduct of its

business, or which has a net worth of $1

million and enters into transactions in

eligible OTC derivative instruments to

manage the risk of an asset or liability

owned or incurred in the conduct of its

business or reasonably likely to be

owned or incurred in the conduct of its

business;

(g) An employee benefit plan subject

to the Employee Retirement Income

Security Act of 1974 or a foreign person

performing a similar role or function

subject as such to foreign regulation

with total assets exceeding $5 million,

or whose investment decisions are made

by a bank, trust company, insurance

company, investment adviser, or a

commodity trading adviser subject to

regulation under the Commodity

Exchange Act;

(h) Any governmental entity

(including the United States, any state,

or any foreign government) or political

subdivision thereof, or any

multinational or supranational entity or

any instrumentality, agency, or

department of any such entity;

(i) A broker, dealer, or a foreign

person performing a similar role or

function subject as such to foreign

regulation, acting on its own behalf or

on behalf of another permissible

derivatives counterparty; provided,

however, that if such broker or dealer (or

foreign person) is a natural person or

proprietorship, the broker or dealer (or

foreign person) must also meet the

requirements of either paragraph (f) or

(k) of this section;

(j) A futures commission merchant,

floor broker, or floor trader subject to

regulation under the Commodity

Exchange Act or a foreign person

performing a similar role or function

subject as such to foreign regulation,

acting on its own behalf or on behalf of

another permissible derivatives

counterparty; provided, however, that if

such futures commission merchant,

floor broker, or floor trader (or foreign

person) is a natural person or

proprietorship, the futures commission

merchant, floor broker, or floor trader

(or foreign person) must also meet the

requirements of paragraph (f) or (k) of

this section; or

(k) Any natural person with total

assets exceeding at least $10 million.

§ 240.3b–15 Definition of permissible risk

management, arbitrage, and trading

transaction.

The term permissible risk

management, arbitrage, and trading

transaction means, when used in

connection with any transaction

engaged in by, or effected on behalf of,

an OTC derivatives dealer, a transaction

involving:

(a) The taking possession of or selling

of counterparty collateral;

(b) Cash management;

(c) Hedging an element of market or

credit risk associated with one or more

existing or anticipated transactions in

eligible OTC derivative instruments or

the issuance of securities, including

warrants on securities, hybrid securities,

or structured notes;

(d) Financing, through repurchase and

reverse repurchase transactions, buy/

sell transactions, and securities lending

and borrowing transactions, a securities

position that is acquired in connection

with a transaction listed in paragraphs

(a) through (c) of this section, or that is

designated by the Commission pursuant

to § 240.15a–1(a)(1)(iii);

(e) Arbitrage, provided that arbitrage

involving securities shall be limited to

arbitrage of a securities position that is

acquired in connection with a

transaction listed in paragraphs (a)

through (c) of this section, or that is

designated by the Commission pursuant

to § 240.15a–1(a)(1)(iii); or

(f) Securities trading relating to a

securities position that is acquired in

connection with a transaction listed in

paragraphs (a) through (c) of this

section, provided that the number of any

such transactions does not exceed 150

transactions in any calendar year, and

provided further that the OTC

derivatives dealer engaging in any such

transaction maintains and enforces

written policies and procedures

reasonably designed to achieve

compliance with the other provisions of

this section.

§ 240.3b–16 Definition of hybrid security.

The term hybrid security shall mean

a security that incorporates payment

features economically similar to

options, forwards, futures, swap

agreements, or collars involving

currencies, interest rates, commodities,

securities, or indices (or any

combination, permutation, or derivative

of such contract or underlying interest).

5. Section 240.8c–1 is amended by

revising paragraph (b)(1) to read as

follows:

§ 240.8c1 Hypothecation of customers’

securities.

* * * * *

(b) * * *

(1) The term customer shall not be

deemed to include any general or

special partner or any director or officer

of such member, broker or dealer, or any

participant, as such, in any joint, group

or syndicate account with such member,

broker or dealer or with any partner,

officer or director thereof, or a

permissible derivatives counterparty as

defined in § 240.3b–14 who has

delivered collateral pursuant to a

transaction in an eligible OTC derivative

instrument and who has consented to

the unrestricted use of its collateral by

an OTC derivatives dealer after

receiving disclosure of the unrestricted

use of the collateral;

* * * * *

6. By adding § 240.15a–1 under the

undesignated center heading

‘‘Exemption of Certain Securities From

Section 15(a)’’ to read as follows:

§ 240.15a–1 Transactions by OTC

derivatives dealers.

(a) An OTC derivatives dealer shall

not engage in any securities transaction

other than:

(1)(i) Engaging as a counterparty in

transactions in eligible OTC derivative

instruments with permissible

derivatives counterparties;

(ii) Issuing and reacquiring issued

securities, including warrants on

securities, hybrid securities, and

structured notes, through a registered

broker or dealer (other than an OTC

derivatives dealer); or

(iii) Engaging in other securities

transactions which the Commission

designates by order; and

(2) In connection with the

transactions described in paragraph
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67959

(a)(1) of this section, engaging in

permissible risk management, arbitrage,

and trading transactions.

(b) To the extent an OTC derivatives

dealer engages in any securities

transaction listed in paragraph (a) of this

section, such transaction shall be

effected through a registered broker or

dealer other than an OTC derivatives

dealer.

7. Section 240.15b1–1 is amended to

revise paragraph (a) to read as follows:

§ 240.15b1–1 Application for registration

of brokers or dealers.

(a) An application for registration of a

broker or dealer that is filed pursuant to

Section 15(b) of the Act (15 U.S.C.

78o(b)) shall be filed on Form BD

(§ 249.501 of this chapter) in accordance

with the instructions to the form. A

broker or dealer that is an OTC

derivatives dealer shall indicate where

appropriate on Form BD that the type of

business in which it is engaged is solely

that of acting as an OTC derivatives

dealer.

* * * * *

8. By adding § 240.15b9–2 under the

underquoted center heading

‘‘registration of brokers and dealers’’ to

read as follows:

§ 240.15b9–2 Exemption from SRO

membership for OTC derivatives dealers.

Any broker or dealer required by

Section 15(b)(8) of the Act (15 U.S.C.

78o(b)(8)) to become a member of a

registered national securities association

shall be exempt from such requirement,

provided that:

(a) Such broker or dealer is an OTC

derivatives dealer; and

(b) Such OTC derivatives dealer

enters into an agreement with the

examining authority designated

pursuant to Section 17(d) of the Act (15

U.S.C. 78(q)(d)) for one or more of its

affiliates that is a registered broker or

dealer by which such examining

authority agrees to conduct a review of

such OTC derivatives dealer, report to

the Commission any potential violation

of applicable Commission rules, and

evaluate the OTC derivatives dealer’s

procedures and controls designed to

prevent violations of the Commission’s

rules.

9. Section 240.15c2–1 is amended to

revise paragraph (b)(1) to read as

follows:

§ 240.15c2–1 Hypothecation of customers’

securities.

* * * * *

(b) * * *

(1) The term customer shall not be

deemed to include any general or

special partner or any director or officer

of such broker or dealer, or any

participant, as such, in any joint, group

or syndicate account with such broker

or dealer or with any partner, officer or

director thereof, or a permissible

derivatives counterparty as defined in

§ 240.3b–14 who has delivered

collateral pursuant to a transaction in an

eligible OTC derivative instrument and

who has consented to the unrestricted

use of its collateral by a OTC derivatives

dealer after receiving disclosure of the

unrestricted use of the collateral;

* * * * *

10. Section 240.15c3–1 is amended to

add a sentence following the first

sentence in the introductory text of

paragraph (a); add paragraph (a)(5);

redesignate paragraph (c)(12) as

paragraph (c)(12)(i) and add paragraph

(c)(12)(ii) and (c)(15) to read as follows:

§ 240.15c3–1 Net capital requirements for

brokers or dealers.

(a) * * * In lieu of applying

paragraphs (a)(1) and (a)(2) of this

section, every dealer meeting the

definition of an OTC derivatives dealer

pursuant to § 240.3b–12 under the

Securities Exchange Act of 1934 shall

maintain net capital pursuant to

paragraph (a)(5) of this section. * * *

* * * * *

(5) A dealer meeting the definition of

an OTC derivatives dealer pursuant to

§ 240.3b–12 may elect not to apply the

provisions of paragraph (c)(2)(vi) of this

section to its securities, money market

instruments, options, or eligible OTC

derivative instruments and in lieu

thereof apply the provisions in

appendix F of this chapter (§ 240.15c3–

1f). An OTC derivatives dealer shall at

all times maintain tentative net capital

of not less than $100 million and net

capital of not less than $20 million.

* * * * *

(c) * * *

(12)(i) * * *

(ii) The term examining authority of

an OTC derivatives dealer shall mean

for the purposes of §§ 240.15c3–1 and

240.15c3–1a through d the examining

authority responsible for conducting

reviews of the OTC derivatives dealer

pursuant to 240.15b9–2.

* * * * *

(15) The term tentative net capital

shall mean the net capital of a broker or

dealer before deducting the securities

haircuts computed pursuant to

paragraph (c)(2)(vi) of this section and

the charges on inventory computed

pursuant to appendix B of this chapter

(§ 240.15c3–1b). However, for an OTC

derivatives dealer electing to use

appendix F of this chapter (§ 240.15c3–

1f), the term ‘‘tentative net capital’’ shall

mean the OTC derivatives dealer’s net

capital before deducting the charges for

market and credit risk as computed

pursuant to appendix F and increased

by unrealized trading gains and

unsecured receivables resulting from

transactions in eligible OTC derivative

instruments with permissible

derivatives counterparties.

* * * * *

11. By adding Section 240.15c3–1f to

read as follows:

§ 240.15c3–1f Optional Market and Credit

Risk Requirements for OTC Derivatives

Dealers (appendix F to 17 CFR 240.15c3–1).

(a) A dealer meeting the definition of

an OTC derivatives dealer pursuant to

§ 240.3b–12 may elect to compute

capital charges for market and credit

risk pursuant to this appendix in place

of computing securities haircuts

pursuant to § 240.15c3–1(c)(2)(vi). A

dealer may make this election by filing

an application with the Commission

stating whether the firm has developed

its own model and describing the

qualitative and quantitative aspects of

its internal value-at-risk (‘‘VAR’’) model,

which at a minimum must adhere to the

criteria set forth in paragraph (d) of this

appendix. The dealer’s application shall

also include a description of the risk

management controls adopted pursuant

to § 240.15c3–4.

Market Risk

(b) An OTC derivatives dealer electing

to apply this appendix F shall compute

a capital requirement for market risk

using the Full Value-at-Risk Method or

the Alternative Method as follows:

(1) Full value-at-risk method. An OTC

derivatives dealer shall deduct from net

worth an amount for market risk

exposure for eligible OTC derivatives

instruments and other positions in its

proprietary or other accounts equal to

the VAR of these positions obtained

from its proprietary model, multiplied

by the appropriate multiplication factor

in paragraph (d)(1)(iv)(C) of this

appendix. The model may not be used

by the dealer for this purpose until the

use of the model by the dealer has been

authorized by the Commission.

(2) Alternative method for equities.

An OTC derivatives dealer may choose

to use the alternative method to

calculate market risk for equity

instruments, including OTC options, or

if the Commission does not approve an

OTC derivatives dealer’s use of a VAR

model for equity instruments, the OTC

derivatives dealer using this appendix

must use the alternative method. Under

the alternative method, the deduction

for market risk must be an amount equal

to the largest theoretical loss calculated
67960 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

in accordance with the theoretical

pricing model set forth in appendix A

of this section (§ 240.15c3–1a). The OTC

derivatives dealer may use its own

theoretical pricing model as long as it

contains the minimum pricing factors

set forth in appendix A.

Credit Risk

(c) The capital requirement for credit

risk arising from its transactions in

eligible OTC derivatives instruments

shall be:

(1) The net replacement value in the

account of the counterparty (including

the effect of legally enforceable netting

agreements and the application of liquid

collateral) multiplied by 8% multiplied

by the counterparty factor. The

counterparty factors are:

(i) 20% for entities with ratings for

senior unsecured long-term debt or

commercial paper in the two highest

rating categories by at least two

nationally recognized statistical rating

organizations (‘‘NRSROs’’);

(ii) 50% for entities with ratings for

senior unsecured long-term debt in the

third and fourth highest ratings

categories by at least two NRSROs; and

(iii) 100% for entities with ratings for

senior unsecured long-term debt below

the four highest rating categories.

(2) The net replacement value in the

account of the counterparty (including

the effect of legally enforceable netting

agreements and the application of liquid

collateral) with senior unsecured longterm debt in default.

(3) A concentration charge calculated

as follows:

(i) Where the net replacement value in

the account of any one counterparty

exceeds 25% of the OTC derivatives

dealer’s tentative net capital, it must

deduct from net worth:

(A) For counterparties with ratings for

senior unsecured long-term debt or

commercial paper in the two highest

rating categories by at least two

NRSROs, 5% of the amount of the net

replacement value in excess of 25% of

the OTC derivatives dealer’s tentative

net capital;

(B) For counterparties with ratings for

senior unsecured long-term debt in the

third and fourth highest rating

categories by at least two NRSROs, 20%

of the amount of the net replacement

value in excess of 25% of the OTC

derivatives dealer’s tentative net capital;

and

(C) For counterparties with ratings for

senior unsecured long-term debt below

the four highest rating categories, 50%

of the amount of the net replacement

value in excess of 25% of the OTC

derivatives dealer’s tentative net capital;

and

(ii) Where the aggregate of the net

replacement values of all counterparties

exceeds 300% of an OTC derivatives

dealer’s tentative net capital, it must

deduct from net worth 100% of the

amount of such excess.

(4) Counterparties that are not rated

by an NRSRO may be rated by the OTC

derivatives dealer upon demonstrating

to the Commission that the OTC

derivatives dealer uses ratings criteria

equivalent to those used by NRSROs

and that such ratings are current.

VAR Models

(d) An OTC derivatives dealer’s VAR

model must meet the following

qualitative and quantitative

requirements:

(1) Qualitative requirements. An OTC

derivatives dealer electing to apply this

appendix F must have a VAR model that

meets the following minimum

qualitative requirements:

(i) The OTC derivatives dealer’s VAR

model must be integrated into the firm’s

daily risk management process;

(ii) The OTC derivatives dealer must

conduct appropriate stress tests of the

VAR model, and develop procedures to

follow in response to the results of such

tests;

(iii) The OTC derivatives dealer must

conduct periodic reviews (which may

be performed by internal audit staff) of

its VAR model. The OTC derivatives

dealer’s VAR model also must be subject

to annual reviews conducted by

independent public accountants;

(iv) The OTC derivatives dealer must

conduct backtesting of the VAR model

pursuant to the following procedures:

(A) Beginning one year after an OTC

derivatives dealer starts to comply with

this appendix, an OTC derivatives

dealer must conduct backtesting by

comparing each of its most recent 250

business days’ actual net trading profit

or loss with the corresponding daily

VAR measures generated for

determining market risk capital charges

and calibrated to a one-day holding

period and a 99 percent, one-tailed

confidence level;

(B) Once each quarter, the OTC

derivatives dealer must identify the

number of exceptions, that is, the

number of business days for which the

actual daily net trading loss, if any,

exceeded the corresponding daily VAR

measure; and

(C) An OTC derivatives dealer must

use the multiplication factor indicated

in Table 1 of this appendix in

determining its capital charge for market

risk until it obtains the next quarter’s

backtesting results, unless the

Commission determines that a different

adjustment or other action is

appropriate.

TABLE 1.—MULTIPLICATION FACTOR

BASED ON RESULTS OF BACKTESTING

Number of exceptions

Multiplication

factor

4 or fewer ...................................... 3.00

5 .................................................... 3.40

6 .................................................... 3.50

7 .................................................... 3.65

8 .................................................... 3.75

9 .................................................... 3.85

10 or more .................................... 4.00

(2) Quantitative requirements. An

OTC derivatives dealer electing to apply

this Appendix F must have a VAR

model that meets the following

quantitative requirements:

(i) The VAR measures must be

calculated on a daily basis using a 99

percent, one-tailed confidence level

with a price change equivalent to a tenbusiness day movement in rates and

prices;

(ii) The effective historical

observation period for VAR measures

must be at least one year, and the

weighted average time lag of the

individual observations cannot be less

than six months. Historical data sets

must be updated at least every three

months and reassessed whenever

market prices or volatilities are subject

to large changes;

(iii) The VAR measures must include

the risks arising from the non-linear

price characteristics of options positions

and the sensitivity of the market value

of the positions to changes in the

volatility of the underlying rates or

prices. An OTC derivatives dealer must

measure the volatility of options

positions by different maturities;

(iv) The VAR measures may

incorporate empirical correlations

within and across risk categories,

provided that the OTC derivatives

dealer’s process for measuring

correlations is sound. In the event that

the VAR measures do not incorporate

empirical correlations across risk

categories, then the OTC derivatives

dealer must add the separate VAR

measures for the four major risk

categories in paragraph (d)(2)(v) of this

appendix to determine its aggregate

VAR measure; and

(v) The OTC derivatives dealer’s VAR

model must use risk factors sufficient to

measure the market risk inherent in all

covered positions. The risk factors must

address interest rate risk, equity price

risk, foreign exchange rate risk, and

commodity price risk. For material

exposures in the major currencies and
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67961

markets, modelling techniques must

capture spread risk and must

incorporate enough segments of the

yield curve to capture differences in

volatility and less than perfect

correlation of rates along the yield

curve. An OTC derivatives dealer must

provide the Commission with evidence

that the OTC derivatives dealer’s VAR

model takes account of specific risk in

positions.

12. Section 240.15c3–3 is amended to

revise paragraph (a)(1), and in paragraph

(h) to revise the phrase ‘‘§ 240.17a–5,’’

to read ‘‘§ 240.17a–5 or § 240.17a–12,’’.

§ 240.15c3–3 Customer protection—

reserves and custody of securities.

(a) * * *

(1) The term customer shall mean any

person from whom or on whose behalf

a broker or dealer has received or

acquired or holds funds or securities for

the account of that person. The term

shall not include a broker or dealer, a

municipal securities dealer, or a

government securities broker or

government securities dealer. The term

shall not include general partners or

directors or principal officers of the

broker or dealer or any other person to

the extent that person has a claim for

property or funds which by contract,

agreement or understanding, or by

operation of law, is part of the capital

of the broker or dealer or is

subordinated to the claims of creditors

of the broker or dealer. The term shall

not include a permissible derivatives

counterparty as defined in § 240.3b–14

who has delivered collateral pursuant to

a transaction in an eligible OTC

derivative instrument and who has

consented to the unrestricted use of its

collateral by an OTC derivatives dealer

after receiving disclosure of the

unrestricted use of the collateral. The

term customer shall, however, include

another broker or dealer to the extent

that broker or dealer maintains an

omnibus account for the account of

customers with the broker or dealer in

compliance with Regulation T (12 CFR

part 220).

* * * * *

13. By adding § 240.15c3–4 to read as

follows:

§ 240.15c3–4 Internal risk management

control systems for OTC derivatives

dealers.

(a) An OTC derivatives dealer shall

establish and document a system of

internal risk management controls to

assist it to manage the risks associated

with its business activities.

(b) An OTC derivatives dealer shall

consider the following when adopting

its internal control system guidelines,

policies, and procedures:

(1) The ownership and governance

structure of the OTC derivatives dealer;

(2) The composition of the governing

body of the OTC derivatives dealer;

(3) The management philosophy and

culture of the OTC derivatives dealer;

(4) The scope and nature of

established risk management guidelines;

(5) The scope and nature of the

permissible OTC derivatives activities;

(6) The sophistication and experience

of relevant trading, risk management,

and internal audit personnel;

(7) The sophistication and

functionality of information and

reporting systems; and

(8) The scope and frequency of

monitoring, reporting, and auditing

activities.

(c) An OTC derivatives dealer’s

internal risk management control

system shall include the following

elements:

(1) A risk control unit that reports

directly to senior management and is

independent from business trading

units;

(2) Separation of duties between

personnel responsible for entering into

a transaction and those responsible for

recording the transaction in the books

and records of the OTC derivatives

dealer;

(3) Periodic reviews (which may be

performed by internal audit staff) and

annual reviews (which must be

conducted by independent public

accountants) of the OTC derivatives

dealer’s risk management systems;

(4) Definitions of risk, risk

monitoring, and risk management; and

(5) Written guidelines, approved by

the OTC derivatives dealer’s governing

body, that include and discuss the

following:

(i) The OTC derivatives dealer’s

consideration of the elements in

paragraph (b) of this section;

(ii) The scope, and the procedures for

determining the scope of authorized

activities or any nonquantitative

limitation on the scope of authorized

activities;

(iii) Any quantitative guidelines for

managing the OTC derivatives dealer’s

overall risk exposure;

(iv) The type, scope, and frequency of

reporting by management on risk

exposures;

(v) The procedures for and the timing

of the governing body’s periodic review

of the risk monitoring and risk

management written guidelines,

systems, and processes;

(vi) The process for monitoring risk

independent of the business or trading

units whose activities create the risks

being monitored;

(vii) The performance of risk

management function by persons

independent from or senior to the

business or trading units whose

activities create the risks;

(viii) The authority and resources of

the groups or persons performing the

risk monitoring and risk management

functions;

(ix) The procedures governing the

action management should take when

internal risk management guidelines

have been exceeded;

(x) The procedures to monitor and

address the risk that an OTC derivative

transaction contract will be

unenforceable;

(xi) The procedures requiring the

documentation of the principal terms of

OTC derivatives transactions and other

relevant information regarding such

transactions; and

(xii) The procedures authorizing

specified employees to commit the OTC

derivatives dealer to particular types of

transactions.

(d) Management must periodically

review, in accordance with written

procedures, the OTC derivatives dealer’s

business activities for consistency with

risk management guidelines.

Management must review the following:

(1) Whether risks arising from the

OTC derivatives dealer’s OTC

derivatives activities are consistent with

prescribed guidelines;

(2) Whether risk exposure guidelines

for each business unit are appropriate

for the business unit;

(3) Whether the data necessary to

conduct the risk monitoring and risk

management function as well as the

valuation process over the OTC

derivatives dealer’s portfolio of products

is accessible on a timely basis and

information systems are available to

capture, monitor, analyze, and report

relevant data;

(4) Whether procedures are in place to

enable management to take action when

internal risk management guidelines

have been exceeded;

(5) Whether procedures are in place to

monitor and address the risk that an

OTC derivative transaction contract will

be unenforceable;

(6) Whether procedures are in place to

identify and address any deficiencies in

the operating systems and to contain the

extent of losses arising from

unidentified deficiencies;

(7) Whether procedures are in place to

authorize specified employees to

commit the OTC derivatives dealer to

particular types of transactions, to

specify any quantitative limits on such

authority, and to provide for the

oversight of their exercise of such

authority;
67962 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

(8) Whether procedures are in place to

provide for adequate documentation of

the principal terms of OTC derivatives

transactions and other relevant

information regarding such transactions;

(9) Whether personnel resources with

appropriate expertise are committed to

implementing the risk monitoring and

risk management systems and processes;

and

(10) Whether a mechanism is in place

for periodic internal and external review

of the risk monitoring and risk

management functions.

14. Amend § 240.17a–3, in paragraph

(a)(4)(vi) by revising the phrase ‘‘Rule

17a–13 and Rule 17a–5 hereunder’’ to

read ‘‘§§ 240.17a–13, 240.17a–5, and

240.17a–12’’, and by adding a sentence

to the end of paragraph (a)(10) to read

as follows:

§ 240.17a–3 Records to be made by certain

exchange members, brokers and dealers.

(a) * * *

(10) * * * An OTC derivatives dealer

shall also keep a record of all eligible

OTC derivative instruments as defined

in § 240.3b–13 in which such OTC

derivatives dealer has any direct or

indirect interest or which such dealer

has written or guaranteed, containing, at

least, an identification of the security or

other instrument and the number of

units involved.

* * * * *

15. Amend § 240.17a–4 as follows:

a. In paragraph (b)(8) introductory text

by revising the phrase ‘‘Part IIA’’ to read

‘‘Part IIA or Part IIB’’ and by revising the

phrase ‘‘§ 240.17a–5(i)(xv)’’ to read

‘‘§§ 240.17a–5(d) and 240.17a–12(b)’’;

b. In paragraph (b)(8)(xv) by revising

the phrase ‘‘§ 240.17a–5’’ to read

‘‘§§ 240.17a–5 and 240.17a–12’’;

c. By adding paragraph (b)(10) to read

as follows:

d. In paragraph (f)(2)(i) by adding the

phrase ‘‘or its examining authority

pursuant to § 240.15b9–2’’ after the

phrase ‘‘(15 U.S.C. 78q(d))’’ and by

adding the phrase ‘‘or its examining

authority pursuant to § 240.15b9–2’’

after the phrase ‘‘designated examining

authority’’;

e. In paragraph (f)(2)(ii)(D) by adding

the phrase ‘‘, the examining authority

pursuant to § 240.15b9–2’’ after the

phrase ‘‘by the Commission’’;

f. In paragraphs (f)(3)(i), (f)(3)(iv)(A),

(f)(3)(v)(A), and (f)(3)(vi) by adding the

phrase ‘‘, its examining authority

pursuant to § 240.15b9–2,’’ after the

phrase ‘‘of the Commission’’; and

g. In paragraph (f)(3)(vii) by adding

the phrase ‘‘its examining authority

pursuant to § 240.15b9–2 or’’ after the

phrase ‘‘shall file with’’.

§ 240.17a–4 Records to be preserved by

certain exchange members, brokers and

dealers.

* * * * *

(b) * * *

(10) The records required to be made

pursuant to § 240.15c3–4 and the results

of the periodic reviews conducted

pursuant to § 240.15c3–4(d).

* * * * *

16. Amend § 240.17a–11 by revising

paragraph (b) and paragraph (c)(3) to

read as follows; in paragraph (e)

introductory text by adding the phrase

‘‘or § 240.17a–12(f)(2)’’ after the phrase

‘‘240.17a–5(h)(2)’’ and by adding the

phrase ‘‘or § 240.17a–12(e)(2)’’ after the

phrase ‘‘240.17a–5(g)’’; by revising

paragraph (f) to read as follows; in

paragraph (g) by adding the phrase ‘‘the

examining authority responsible for

conducting reviews of an OTC

derivatives dealer pursuant to

§ 240.15b9–2,’’ after the phrase ‘‘the

designated examining authority of

which such broker or dealer is a

member,’’; and in paragraph (h) by

revising the phrase ‘‘§ 240.15c3–3(i) and

§ 240.17a5–5(h)(2)’’ to read ‘‘§ 240.15c3–

3(i), § 240.17a–5(h)(2), and § 240.17a–

12(f)(2)’’.

§ 240.17a–11 Notification provisions for

brokers and dealers.

* * * * *

(b)(1) Every broker or dealer whose

net capital declines below the minimum

amount required pursuant to

§ 240.15c3–1 shall give notice of such

deficiency that same day in accordance

with paragraph (g) of this section. The

notice shall specify the broker’s or

dealer’s net capital requirement and its

current amount of net capital. If a broker

or dealer is informed by its designated

examining authority, its examining

authority pursuant to § 240.15b9–2, or

the Commission that it is, or has been,

in violation of § 240.15c3–1 and the

broker or dealer has not given notice of

the capital deficiency under this

§ 240.17a–11, the broker or dealer, even

if it does not agree that it is, or has been,

in violation of § 240.15c3–1, shall give

notice of the claimed deficiency, which

notice may specify the broker’s or

dealer’s reasons for its disagreement.

(2) In addition to the requirements of

paragraph (b)(1) of this section, an OTC

derivatives dealer shall also provide

notice if its tentative net capital falls

below the minimum amount required

pursuant to § 240.15c3–1. The notice

shall specify the OTC derivatives

dealer’s net capital requirement,

tentative net capital requirement, its

current amount of net capital, and

tentative net capital.

(c) * * *

(3) If a computation made by a broker

or dealer pursuant to § 240.15c3–1

shows that its total net capital is less

than 120 percent of the broker’s or

dealer’s required minimum net capital.

If a computation made by an OTC

derivatives dealer pursuant to

§ 240.15c3–1 shows that its total

tentative net capital is less than 120

percent of the dealer’s required

minimum tentative net capital.

* * * * *

(f) Every national securities exchange,

national securities association, or

examining authority responsible for

conducting reviews of an OTC

derivatives dealer pursuant to

§ 240.15b9–2 that learns that a member

broker or dealer or an OTC derivatives

dealer has failed to send notice or

transmit a report required by paragraphs

(b), (c), (d), or (e) of this section, even

after being advised by the securities

exchange, national securities

association, or examining authority

responsible for conducting reviews of an

OTC derivatives dealer pursuant to

§ 240.15b9–2 to send notice or transmit

a report, shall immediately give notice

of such failure in accordance with

paragraph (g) of this section.

* * * * *

17. By adding § 240.17a–12 to read as

follows:

§ 240.17a–12 Reports to be made by

certain OTC derivatives dealers.

(a) Filing of quarterly reports. (1) This

paragraph (a) shall apply to every OTC

derivatives dealer registered pursuant to

Section 15 of the Act (15 U.S.C. 78o).

(i) Every OTC derivatives dealer shall

file Part IIB of Form X–17A–5 (§ 249.617

of this chapter) within 17 business days

after the end of each calendar quarter

and within 17 business days after the

date selected for the annual audit of

financial statements where said date is

other than the end of the calendar

quarter.

(ii) Upon receiving from the

Commission or the examining authority

responsible for performing reviews of

the OTC derivatives dealer pursuant to

§ 240.15b9–2 written notice that

additional reporting is required, an OTC

derivatives dealer shall file monthly, or

at such times as shall be specified, Part

IIB of Form X–17A–5 (§ 249.617 of this

chapter) and such other financial or

operational information as shall be

required by the Commission or the

examining authority responsible for

performing reviews of the OTC

derivatives dealer pursuant to

§ 240.15b9–2.

(2) The reports provided for in this

paragraph (a) shall be considered filed

when received at the Commission’s
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principal office in Washington, D.C.,

and at the principal office of the

examining authority responsible for

performing reviews of the OTC

derivatives dealer pursuant to

§ 240.15b9–2. All reports filed pursuant

to this paragraph (a) shall be deemed to

be confidential.

(3) Upon written application by an

OTC derivatives dealer to the examining

authority responsible for performing

reviews of the OTC derivatives dealer

pursuant to § 240.15b9–2, the examining

authority may extend the time for filing

the information required by this

paragraph (a). The examining authority

for the OTC derivatives dealer shall

maintain, in the manner prescribed in

§ 240.17a–1, a record of each extension

granted.

(b) Annual filing of audited financial

statements. (1)(i) Every OTC derivatives

dealer registered pursuant to Section 15

of the Act (15 U.S.C. 78o) shall file

annually, on a calendar or fiscal year

basis, a report which shall be audited by

an independent public accountant.

Reports pursuant to this paragraph (b)

shall be as of the same fixed or

determinable date each year, unless a

change is approved in writing by the

examining authority responsible for

performing reviews of the OTC

derivatives dealer pursuant to

§ 240.15b9–2. A copy of such written

approval shall be sent to the

Commission’s principal office in

Washington, D.C.

(ii) An OTC derivatives dealer

succeeding to and continuing the

business of another OTC derivatives

dealer need not file a report under this

paragraph (b) as of a date in the fiscal

or calendar year in which the

succession occurs if the predecessor

OTC derivatives dealer has filed a report

in compliance with this paragraph (b) as

of a date in such fiscal or calendar year.

(2) The annual audited report shall

contain a Statement of Financial

Condition (in a format and on a basis

which is consistent with the total

reported on the Statement of Financial

Condition contained in Form X–17A–5

(§ 249.617 of this chapter), Part IIB, a

Statement of Income, a Statement of

Cash Flows, a Statement of Changes in

Stockholders’ or Partners’ or Sole

Proprietor’s Equity, and Statement of

Changes in Liabilities Subordinated to

Claims of General Creditors. Such

statements shall be in a format which is

consistent with such statements as

contained in Form X–17A–5 (§ 249.617

of this chapter), Part IIB. If the

Statement of Financial Condition filed

in accordance with instructions to Form

X–17A–5 (§ 249.617 of this chapter),

Part IIB, is not consolidated, a summary

of financial data for subsidiaries not

consolidated in the Part IIB Statement of

Financial Condition as filed by the OTC

derivatives dealer shall be included in

the notes to the consolidated statement

of financial condition reported on by the

independent public accountant. The

summary financial data shall include

the assets, liabilities, and net worth or

stockholders’ equity of the

unconsolidated subsidiaries.

(3) Supporting schedules shall

include, from Part IIB of Form X–17A–

5 (§ 249.617 of this chapter), a

Computation of Net Capital under

§ 240.15c3–1.

(4) A reconciliation, including

appropriate explanations, of the

Computation of Net Capital under

§ 240.15c3–1 contained in the audit

report with the broker’s or dealer’s

corresponding unaudited most recent

Part IIB filing shall be filed with the

report when material differences exist. If

no material differences exist, a

statement so indicating shall be filed.

(5) The annual audit report shall be

filed not more than sixty (60) days after

the date of the financial statements.

(6) Two copies of the annual audit

report shall be filed at the Commission’s

principal office in Washington, D.C.,

and the principal office of the

examining authority responsible for

performing reviews of the OTC

derivatives dealer pursuant to

§ 240.15b9–2.

(c) Nature and form of reports. The

financial statements filed pursuant to

paragraph (b) of this section shall be

prepared and filed in accordance with

the following requirements:

(1) An audit shall be conducted by a

public accountant who shall be in fact

independent as defined in paragraph (f)

of this section, and it shall give an

opinion covering the statements filed

pursuant to paragraph (b) of this section.

(2) Attached to the report shall be an

oath or affirmation that, to the best

knowledge and belief of the person

making such oath or affirmation the

financial statements and schedules are

true and correct and neither the OTC

derivatives dealer, nor any partner,

officer, or director, as the case may be,

has any significant interest in any

counterparty or in any account

classified solely as that of a

counterparty. The oath or affirmation

shall be made before a person duly

authorized to administer such oaths or

affirmations. If the OTC derivatives

dealer is a sole proprietorship, the oath

or affirmation shall be made by the

proprietor; if a partnership, by a general

partner; or if a corporation, by a duly

authorized officer.

(3) All of the statements filed

pursuant to paragraph (b) of this section

shall be confidential except that they

shall be available for use by any official

or employee of the United States or by

any other person to whom the

Commission authorizes disclosure of

such information as being in the public

interest.

(d) Qualification of accountants. The

Commission will not recognize any

person as a certified public accountant

who is not duly registered and in good

standing as such under the laws of his

place of residence or principal office.

The Commission will not recognize any

person as a public accountant who is

not in good standing and entitled to

practice as such under the laws of his

place of residence or principal office.

(e) Designation of accountant. (1)

Every OTC derivatives dealer shall file

no later than December 10 of each year

a statement with the Commission’s

principal office in Washington, D.C.,

and the principal office of the

examining authority responsible for

performing reviews of the OTC

derivatives dealer pursuant to

§ 240.15b9–2. Such statement shall

indicate the existence of an agreement

dated no later than December 1, with an

independent public accountant covering

a contractual commitment to conduct

the OTC derivatives dealer’s annual

audit during the following calendar

year.

(2) The agreement may be of a

continuing nature, providing for

successive yearly audits, in which case

no further filing is required. If the

agreement is for a single audit, or if the

continuing agreement previously filed

has been terminated or amended, a new

statement must be filed by the required

date.

(3) The statement shall be headed

‘‘Notice pursuant to § 240.17a–12(e)’’

and shall contain the following

information:

(i) Name, address, telephone number

and registration number of the OTC

derivatives dealer;

(ii) Name, address and telephone

number of the accounting firm; and

(iii) The audit date of the OTC

derivatives dealer for the year covered

by the agreement.

(4) Notwithstanding the date of filing

specified in paragraph (e)(1) of this

section, every OTC derivatives dealer

shall file the notice provided for in

paragraph (e) of this section within 30

days following the effective date of

registration as an OTC derivatives

dealer.

(f) Independence of accountant. An

accountant shall be independent in
67964 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

accordance with the provisions of

§ 210.2–01(b) and (c) of this chapter.

(g) Replacement of accountant. (1) An

OTC derivatives dealer shall file a

notice that must be received by the

Commission’s principal office in

Washington, D.C., and the principal

office of the examining authority

responsible for performing reviews of

the OTC derivatives dealer pursuant to

§ 240.15b9–2 not more than 15 business

days after:

(i) The OTC derivatives dealer has

notified the accountant whose opinion

covered the most recent financial

statements filed under paragraph (b) of

this section that the accountant’s

services will not be utilized in future

engagements; or

(ii) The OTC derivatives dealer has

notified an accountant who was engaged

to give an opinion covering the financial

statements to be filed under paragraph

(b) of this section that the engagement

has been terminated; or

(iii) An accountant has notified the

OTC derivatives dealer that it would not

continue under an engagement or give

an opinion covering the financial

statements to be filed under paragraph

(b) of this section; or

(iv) A new accountant has been

engaged to give an opinion covering the

financial statements to be filed under

paragraph (b) of this section without any

notice of termination having been given

to or by the previously engaged

accountant.

(2) Such notice shall state the date of

notification of the termination of the

engagement or engagement of the new

accountant as applicable and the details

of any problems existing during the 24

months (or the period of the

engagement, if less) preceding such

termination or new engagement relating

to any matter of accounting principles

or practices, financial statement

disclosure, auditing scope or procedure,

or compliance with applicable rules of

the Commission, which problems, if not

resolved to the satisfaction of the former

accountant, would have caused the

former accountant to make reference to

them in connection with the report on

the subject matter of the problems. The

problems required to be reported in

response to the preceding sentence

include both those resolved to the

former accountant’s satisfaction and

those not resolved to the former

accountant’s satisfaction. Problems

contemplated by this section are those

which occur at the decision making

level—i.e., between principal financial

officers of the OTC derivatives dealer

and personnel of the accounting firm

responsible for rendering its report. The

notice shall also state whether the

accountant’s report on the financial

statements for any of the past two years

contained an adverse opinion or a

disclaimer of opinion or was qualified

as to uncertainties, audit scope, or

accounting principles, and describe the

nature of each such adverse opinion,

disclaimer of opinion, or qualification.

The OTC derivatives dealer shall also

request the former accountant to furnish

the OTC derivatives dealer with a letter

addressed to the Commission stating

whether the former accountant agrees

with the statements contained in the

notice of the OTC derivatives dealer

and, if not, stating the respects in which

the former accountant does not agree.

The OTC derivatives dealer shall file

three copies of the notice and the

accountant’s letter, one copy of which

shall be manually signed by the sole

proprietor, or a general partner or a duly

authorized corporate officer, as

appropriate, and by the accountant,

respectively.

(h) Audit objectives. (1) The audit

shall be made in accordance with

generally accepted auditing standards

and shall include a review of the

accounting system, the internal

accounting control, internal

management controls, and procedures

for safeguarding securities including

appropriate tests thereof for the period

since the prior examination date. The

audit shall include all procedures

necessary under the circumstances to

enable the independent public

accountant to express an opinion on the

statement of financial condition, results

of operations, cash flows, and the

Computation of Net Capital under

§ 240.15c3–1. The scope of the audit

and review of the accounting system,

the internal accounting controls,

internal management controls, and

procedures for safeguarding securities

shall be sufficient to provide reasonable

assurance that any material

inadequacies existing at the date of the

examination in the following are

detected:

(i) The accounting system;

(ii) The internal accounting controls;

and

(iii) Procedures for safeguarding

securities.

(2) A material inadequacy in the

accounting system, internal accounting

controls, procedures for safeguarding

securities, and practices and procedures

referred to in paragraph (h) of this

section which is expected to be reported

under these audit objectives includes

any condition which has contributed

substantially to or, if appropriate

corrective action is not taken, could

reasonably be expected to:

(i) Inhibit an OTC derivatives dealer

from promptly completing securities

transactions or promptly discharging its

responsibilities to counterparties, other

brokers and dealers or creditors;

(ii) Result in material financial loss;

(iii) Result in material misstatements

of the OTC derivatives dealer’s financial

statements;

(iv) Result in violations of the

Commission’s recordkeeping or

financial responsibility rules to an

extent that could reasonably be

expected to result in the conditions

described in paragraphs (h)(2)(i), (ii), or

(iii) of this section; or

(v) Result in any matter that would be

deemed a reportable condition under

U.S. Generally Accepted Auditing

Standards.

(i) Extent and timing of audit

procedures. (1) The extent and timing of

audit procedures are matters for the

independent public accountant to

determine on the basis of its review and

evaluation of existing internal controls

and other audit procedures performed

in accordance with generally accepted

auditing standards and the audit

objectives set forth in paragraph (h) of

this section. In determining the extent of

testing, consideration shall be given to

the materiality of an area and the

possible effect on the financial

statements and schedules of a material

misstatement in a related account. The

performance of auditing procedures

involves the proper synchronization of

their application and thus comprehends

the need to consider simultaneous

performance of procedures in certain

areas such as, for example, securities

counts, transfer verification, and

customer and broker confirmation in

connection with verification of

securities positions.

(2) If, during the course of the audit

or interim work, the independent public

accountant determines that any material

inadequacies exist in the accounting

system, internal accounting control,

procedures for safeguarding securities,

or as otherwise defined in paragraph

(h)(2) of this section, then the

independent public accountant shall

call it to the attention of the chief

financial officer of the OTC derivatives

dealer, who shall have a responsibility

to inform the Commission and the

examining authority responsible for

performing reviews of the dealer

pursuant to § 240.15b9–2 by telegraphic

or facsimile notice within 24 hours

thereafter as set forth in § 240.17a–11(e)

and (g). The OTC derivatives dealer

shall also furnish the accountant with a

copy of said notice to the Commission

by telegram or facsimile within said 24

hour period. If the accountant fails to
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receive such notice from the OTC

derivatives dealer within said 24 hour

period, or if the accountant disagrees

with the statements contained in the

notice of the OTC derivatives dealer, the

accountant shall have a responsibility to

inform the Commission and the

examining authority responsible for

performing reviews of the OTC

derivatives dealer pursuant to

§ 240.15b9–2 by report of material

inadequacy within 24 hours thereafter

as set forth in § 240.17a–11(g). Such

report from the accountant shall, if the

OTC derivatives dealer failed to file a

notice, describe any material

inadequacies found to exist. If the OTC

derivatives dealer filed a notice, the

accountant shall file a report detailing

the aspects, if any, of the OTC

derivatives dealer’s notice with which

the accountant does not agree.

(j) Accountant’s reports, general

provisions.—(1) Technical

requirements. The accountant’s report

shall be dated; be signed manually;

indicate the city and state where issued;

and identify without detailed

enumeration the financial statements

and schedules covered by the report.

(2) Representations as to the audit.

The accountant’s report shall state

whether the audit was made in

accordance with generally accepted

auditing standards; state whether the

accountant reviewed the procedures

followed for safeguarding securities; and

designate any auditing procedures

deemed necessary by the accountant

under the circumstances of the

particular case which have been

omitted, and the reason for their

omission. Nothing in this section shall

be construed to imply authority for the

omission of any procedure which

independent accountants would

ordinarily employ in the course of an

audit made for the purpose of

expressing the opinions required under

this section.

(3) Opinion to be expressed. The

accountant’s report shall state clearly

the opinion of the accountant:

(i) In respect of the financial

statements and schedules covered by

the report and the accounting principles

and practices reflected therein; and

(ii) As to the consistency of the

application of the accounting principles,

or as to any changes in such principles

which have a material effect on the

financial statements.

(4) Exceptions. Any matters to which

the accountant takes exception shall be

clearly identified, the exception thereto

specifically and clearly stated, and, to

the extent practicable, the effect of each

such exception on the related financial

statements given.

(5) Definitions. For the purpose of this

section, the terms audit (or

examination), accountant’s report, and

certified shall have the meanings given

in § 210.1–02 of this chapter.

(k) Accountant’s report on material

inadequacies. The OTC derivatives

dealer shall file concurrently with the

annual audit report a supplemental

report by the accountant describing any

material inadequacies found to exist or

found to have existed since the date of

the previous audit. The supplemental

report shall indicate any corrective

action taken or proposed by the OTC

derivatives dealer in regard thereto. If

the audit did not disclose any material

inadequacies, the supplemental report

shall so state.

(l) Accountant’s report on

management controls. The OTC

derivatives dealer shall file concurrently

with the annual audit report a

supplemental report by the accountant

indicating the independent public

accountant’s opinion on the OTC

derivatives dealer’s compliance with its

internal risk management control

objectives. The procedures are to be

performed and the report is to be

prepared in accordance with U.S.

Generally Accepted Auditing Standards.

(m) Accountant’s report on inventory

pricing and modeling. (1) The OTC

derivatives dealer shall file concurrently

with the annual audit report a

supplemental report by the accountant

indicating the results of the accountant’s

review of the broker’s or dealer’s

inventory pricing and modelling

procedures. This review shall be

conducted in accordance with

procedures agreed to by the OTC

derivatives dealer and by the

independent public accountant

conducting the review.

(2) The agreed-upon procedures are to

be performed and the report is to be

prepared in accordance with the U.S.

Generally Accepted Auditing Standards.

(3) Every OTC derivatives dealer shall

file prior to the commencement of the

initial review, the procedures to be

performed pursuant to paragraph (m)(1)

of this section with the Commission’s

principal office in Washington, D.C.,

and the principal office of the

examining authority responsible for

reviewing the OTC derivatives dealer

pursuant to § 240.15b9–2. Prior to the

commencement of each subsequent

review, every OTC derivatives dealer

shall file with the Commission’s

principal office in Washington, D.C.,

and with the examining authority

responsible for reviewing the OTC

derivatives dealer pursuant to

§ 240.15b9–2 notice of changes in the

agreed-upon procedures.

(n) Extensions and exemptions. (1) An

examining authority responsible for

performing reviews of an OTC

derivatives dealer pursuant to

§ 240.15b9–2 may extend the period

under paragraph (b) of this section for

filing annual audit reports. The

examining authority responsible for

performing reviews of the OTC

derivatives dealer pursuant to

§ 240.15b9–2 shall maintain, in the

manner prescribed in § 240.17a–1, a

record of each extension granted.

(2) On written request of the

examining authority responsible for

performing reviews of the OTC

derivatives dealer pursuant to

§ 240.15b9–2, on written request of the

OTC derivatives dealer, or on its own

motion, the Commission may grant an

extension of time or an exemption from

any of the requirements of this section

either unconditionally or on specified

terms and conditions.

(o) Notification of change of fiscal

year. (1) In the event any OTC

derivatives dealer finds it necessary to

change its fiscal year, it must file, with

the Commission’s principal office in

Washington, D.C., and the principal

office of the examining authority

responsible for performing reviews of

the OTC derivatives dealer pursuant to

§ 240.15b9–2, a notice of such change.

(2) Such notice shall contain a

detailed explanation of the reasons for

the change. Any change in the filing

period for the audit report must be

approved by the examining authority

responsible for reviewing the OTC

derivatives dealer pursuant to

§ 240.15b9–2.

(p) Filing requirements. For purposes

of filing requirements as described in

§ 240.17a–12, such filing shall be

deemed to have been accomplished

upon receipt at the Commission’s

principal office in Washington, D.C.,

with duplicate originals simultaneously

filed at the locations prescribed in the

particular paragraph of § 240.17a–12

which is applicable.

18. By adding §§ 240.36a1–1 and

240.36a1–2 to read as follows:

§ 240.36a1–1 Exemption from Section 7 for

OTC derivative dealers.

(a) Except as provided in paragraph

(b) of this section, transactions by an

OTC derivatives dealer shall be exempt

from the provisions of Section 7 of the

Act (15 U.S.C. 78g), provided that the

OTC derivatives dealer complies with

other federal margin requirements

applicable to non-broker-dealer lenders.

(b) The exemption provided under

paragraph (a) of this section shall not

apply to extensions of credit made

directly by a registered broker or dealer
67966 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

(other than an OTC derivatives dealer)

in connection with transactions in

eligible OTC derivative instruments for

which an OTC derivatives dealer acts as

counterparty.

§ 240.36a1–2 Exemption from SIPA for

OTC derivatives dealers.

OTC derivatives dealers, as defined in

§ 240.3b–12, shall be exempted from the

provisions of the Securities Investor

Protection Act of 1970 (15 U.S.C. 78aaa

et seq.).

PART 249—FORMS, SECURITIES

EXCHANGE ACT OF 1934

19. The authority citation for Part 249

continues to read in part as follows:

Authority: 15 U.S.C. 78a, et seq., unless

otherwise noted;

* * * * *

20. Section 249.617 is amended by

adding the phrase ‘‘§ 240.17a–12,’’ after

the phrase ‘‘240.17a–5(a), (b), and (d),’’.

21. Form X–17A–5 (referenced in

§ 249.617) is amended by adding section

IIB to read as follows:

Note: Form X–17A–5 does not, and the

amendments will not, appear in the Code of

Federal Regulations. Part IIB of Form X–17A–

5 is attached as Appendix A to this

document.

Dated: December 17, 1997.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

Appendix A

[Note: the text of Appendix A does not

appear in the Code of Federal Regulations.]

General Instructions

The FOCUS Report (Form X–17A–5IIB)

constitutes the basic financial and

operational report required of OTC

derivatives dealers. Much of the information

required by the FOCUS report is the same or

similar to the information required to be

reported by broker-dealers required to file

Form X–17A–5 Part II. Consequently, for

those items that appear on both forms, the

instructions for X–17A–5 Part II are to be

followed when completing form X–17A–5

Part IIB. The following instructions apply to

new information requests and to items

appearing on both forms that have been

altered to better reflect an OTC derivatives

dealer’s unique business.

Computation of Net Capital and Required Net

Capital

(Under 15c3–1 Appendix F)

Tentative Net Capital

For purposes of paragraph (a)(5), the term

‘‘tentative net capital’’ means the net capital

of an OTC derivatives dealer before the

application of either the securities haircuts in

paragraph (c)(2)(vi) of Rule 15c3–1 or the

charges for market and credit risk as

computed pursuant to proposed Appendix F

and increased by unsecured receivables

(unrealized gains) resulting from eligible

OTC derivative instruments.

Market Risk Exposure

The capital requirement for an OTC

derivatives dealer electing to apply Appendix

F of Rule 240.15c3–1 is computed as follows:

(1) Full Value-at-Risk Method. An OTC

derivatives dealer shall deduct from net

worth an amount for market risk exposure for

eligible OTC derivatives transactions and

other positions in its proprietary or other

accounts equal to the value at risk (‘‘VAR’’)

of these positions obtained from its

proprietary model, multiplied by the

appropriate multiplication factor. See

paragraph (d)(1)(v)(C) of Appendix F for

more information on the multiplication

factor. The proprietary model used to

calculate the capital requirement for market

risk must be approved by the Commission

prior to its use.

(2) Alternative Method for Equities. An

OTC derivatives dealer may choose to use the

alternative method to calculate market risk

for equity instruments, including OTC

options, or if the Commission does not

approve an OTC derivatives dealer’s use of

VAR models for equity instruments, the OTC

derivatives dealer must use the alternative

method. Under the alternative method, the

deduction for market risk will be an amount

equal to the largest theoretical loss calculated

in accordance with the theoretical pricing

model set forth in Appendix A of Rule

240.15c3–1. The OTC derivatives dealer may

use its own theoretical pricing model as long

as it contains the minimum pricing factors

set forth in Appendix A.

Credit Risk Exposure

The capital requirement for credit risk

arising from an OTC derivatives dealer’s

eligible OTC derivatives transactions consists

of a counterparty charge and a concentration

charge. The counterparty charge is computed

as follows:

(1) the net replacement value for each

counterparty (less the value of any liquid

collateral) multiplied by 8% multiplied by

the counterparty factor. The counterparty

factors are 20% for entities with ratings for

senior unsecured long term debt or

commercial paper in the two highest rating

categories by at least two nationally

recognized statistical rating organization

(‘‘NRSROs’’); 50% for entities with ratings for

senior unsecured long term debt in the third

and fourth highest ratings categories by at

least two NRSROs; and 100% for entities

with ratings for senior unsecured long term

debt below the four highest rating categories.

(2) The net replacement value for each

counterparty with senior unsecured long

term debt in default (less any liquid

collateral).

The concentration charge is computed as

follows: where the net replacement value in

the account of any one counterparty exceeds

25% of the OTC derivatives dealer’s tentative

net capital, deduct the following amounts.

For counterparties with ratings for senior

unsecured long term debt or commercial

paper in the two highest rating categories by

at least two NRSROs, 5% of the amount of

the net replacement value in excess of 25%

of the OTC derivatives dealer’s tentative net

capital. For counterparties with ratings for

senior unsecured long term debt in the third

and fourth highest rating categories by at

least two NRSROs, 20% of the amount of the

net replacement value in excess of 25% of

the OTC derivatives dealer’s tentative net

capital. For counterparties with ratings for

senior unsecured long term debt below the

four highest rating categories, 50% of the

amount of the net replacement value in

excess of 25% of the OTC derivatives dealer’s

tentative net capital. Finally, where the

aggregate of the net replacement value of all

counterparties exceeds 300% of an OTC

derivative dealer’s tentative net capital, it

would deduct from net worth 100% of the

amount of such excess.

Computation of Net Capital and Required Net

Capital (alternative)

Tentative Net Capital

For purposes of paragraph (a)(5), the term

‘‘tentative net capital’’ means the net capital

of an OTC derivatives dealer before the

application of either the securities haircuts in

paragraph (c)(2)(vi) of Rule 15c3–1 or the

charges for market and credit risk as

computed pursuant to proposed Appendix F

and increased by unsecured receivables

(unrealized gains) resulting from eligible

OTC derivative instruments.

Credit Risk Exposure

The capital requirement for credit risk

arising from an OTC derivatives dealer’s

eligible OTC derivatives transactions consists

of a counterparty charge and a concentration

charge. The counterparty charge is computed

as follows:

(1) the net replacement value for each

counterparty (less the value of any liquid

collateral) multiplied by 8% multiplied by

the counterparty factor. The counterparty

factors are 20% for entities with ratings for

senior unsecured long term debt or

commercial paper in the two highest rating

categories by at least two nationally

recognized statistical rating organization

(‘‘NRSROs’’); 50% for entities with ratings for

senior unsecured long term debt in the third

and fourth highest ratings categories by at

least two NRSROs; and 100% for entities

with ratings for senior unsecured long term

debt below the four highest rating categories.

(2) The net replacement value for each

counterparty with senior unsecured long

term debt in default (less any liquid

collateral).

The concentration charge is computed as

follows: where the net deficit in the account

of any one counterparty exceeds 50% of the

OTC derivatives dealer’s tentative net capital,

deduct it from net worth. For counterparties

with ratings for senior unsecured long term

debt or commercial paper in the two highest

rating categories by at least two NRSROs, 5%

of the amount of the net deficit in excess of

25% of the OTC derivatives dealer’s tentative

net capital. For counterparties with ratings

for senior unsecured long term debt in the

third and fourth highest rating categories by

at least two NRSROs, 20% of the amount of

the net deficit in excess of 25% of the OTC

derivatives dealer’s tentative net capital. For

counterparties with ratings for senior
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 67967

unsecured long term debt below the four

highest rating categories, 50% of the amount

of the net deficit in excess of 25% of the OTC

derivatives dealer’s tentative net capital.

Finally, where the aggregate of the net

deficits of all counterparties exceeds 300% of

an OTC derivative dealer’s tentative net

capital, it would deduct from net worth

100% of the amount of such excess.

Aggregate Securities and OTC Derivatives

Positions

Provide the following information for each

affiliated broker-dealer as of the end of each

quarter. Indicate the name of each affiliated

broker-dealer in a separate column or

complete a separate schedule for each

affiliated broker-dealer. In the event a

separate listing of a position, financial

instrument or otherwise is required pursuant

to any of the provisions of Section 240.17h1T, the dealer should indicate as such in the

appropriate section of this schedule. Where

appropriate, indicate long and short positions

separately.

BILLING CODE 8010–01–P
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[FR Doc. 97–33406 Filed 12–29–97; 8:45 am]

BILLING CODE 8010–01–C