Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 68011

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

Between

zone charge

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

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

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

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

6 ........... Zone 1 Residual Amount ..................................................... ........................ 2,900 .................................... ....................

Note: The Zone 1 Carry Forward Amount becomes a Between Zone Carry Forward Amount because it does not offset with Zone 2 as they

are both short positions. The Between Zone 1 Carry Forward Amount is not offset against Zone 3 because the Zone 3 Carry Forward Amount is

eliminated through its offset with Zone 2 as calculated below. Consequently, the Between Zone 1 Carry Forward Amount becomes a Residual

Charge.

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

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

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

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

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

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

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

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

15 ........... Less Offsetting ..................................................................... 18,750 ........................

16 ........... Zone 4 Residual Amount ..................................................... 11,250 ........................ .................................... ....................

Note: The Zone 4 Carry Forward Amount became a Between Zone Carry Forward Amount when the Zone 3 Carry Forward Amount was

eliminated. The Between Zone 4 Carry Forward Amount is partially offset by the Between Zone 2 Carry Forward Amount. Because there are no

other Between Zone Carry Forward Amounts to offset against the Between Zone 4 Carry Forward Amount, it becomes a Residual Charge.

Total Between

Zone

Charge.

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

Risk charge Applicable rule section Haircut

Total Haircut

Specific Market Charge ............................................................... 15c3–1(c)(2)(vi)(A)(2) ................................................................ $89,500

Sub-Zone Charge ........................................................................ 15c3–1(c)(2)(vi)(A)(3)(ii) ............................................................ 21,195

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

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

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

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

Total Haircut ......................................................................... .................................................................................................... 227,970

Total Value of Portfolio ........................................................ .................................................................................................... 54,200,000

[FR Doc. 97–33401 Filed 12–29–97; 8:45 am]

BILLING CODE 8010–01–P

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Part 240

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

RIN 3235–AH29

Net Capital Rule

AGENCY: Securities and Exchange

Commission.

ACTION: Concept release; request for

comments.

SUMMARY: The Securities and Exchange

Commission is continuing its study of

its approach to determining net capital

requirements for broker-dealers. As part

of its study, the Commission is

considering the extent to which

statistical models should be used in

setting the capital requirements for a

broker-dealer’s proprietary positions.

Accordingly, the Commission is posing

a number of questions on this subject as

well as soliciting views on other

possible alternatives for establishing net

capital requirements.

DATES: Comments must be received on

or before March 30, 1998.

ADDRESSES: Interested persons should

submit three copies of their written

data, views, and opinions to Jonathan G.

Katz, Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W.,

Washington, D.C. 20549. Comments also

may be submitted electronically at the

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

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

file number should be included on the

subject line if E-mail is used. All

submissions will be available for public

inspection and copying at the

Commission’s Public Reference Room,

450 Fifth Street, N.W., Washington, D.C.

20549. Electronically submitted

comment letters will be posted on the

Commission’s Internet web site (http://

www.sec.gov).
68012 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

1For example, in the case where a firm has a long

position of $100,000 in equity securities and a short

position of $50,000 in equity securities, that firm’s

haircut for equity securities would be:

1. Long Position: $100,000 x 15% = $15,000

2. Short Position: $50,000—$25,000 (25% of long

position) x 15% = $3,750

3. Total haircut for equity securities: $15,000 +

$3,750 = $18,750.

2Securities Exchange Act Rel. No. 32256 (May 4,

1993), 58 FR 27486 (May 10, 1993).

3The six firms in the DPG are CS First Boston,

Goldman Sachs, Morgan Stanley, Merrill Lynch,

Salomon Brothers, and Lehman Brothers.

4Framework For Voluntary Oversight, A

Framework For Voluntary Oversight Of The OTC

Derivatives Activities Of Securities Firm Affiliates

To Promote Confidence And Stability In Financial

Markets, Derivatives Policy Group (March 1995).

FOR FURTHER INFORMATION CONTACT:

Michael A. Macchiaroli, Associate

Director, at 202/942–0132; Peter R.

Geraghty, Assistant Director, at 202/

942–0177; Thomas K. McGowan,

Special Counsel, at 202/942–4886; Marc

J. Hertzberg, Attorney, at 202/942–0146;

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:

I. Introduction

As part of a comprehensive review of

the net capital rule, Rule 15c3–1 (17

CFR 240.15c3–1) (the ‘‘net capital rule’’

or the ‘‘Rule’’), the Securities and

Exchange Commission (‘‘Commission’’)

is publishing this release to solicit

comment on how the net capital rule

could be modified to incorporate

modern risk management techniques as

to a broker-dealer’s proprietary

positions and to reflect the continuing

evolution of the securities markets.

More specifically, the Commission seeks

comment on how the existing haircut

structure could be modified and

whether the net capital rule should be

amended to allow firms to use statistical

models to calculate net capital

requirements.

A. The Current Net Capital Rule

The Commission adopted the net

capital rule in substantially its current

form in 1975. The Rule requires every

broker-dealer to maintain specified

minimum levels of liquid assets, or net

capital. The Rule requires broker-dealers

to maintain sufficient liquid assets in

order to enable those firms that fall

below the minimum net capital

requirements to liquidate in an orderly

fashion. The Rule is designed to protect

the customers of a broker-dealer from

losses upon the broker-dealer’s failure.

The Rule requires different minimum

levels of capital based upon the nature

of the firm’s business and whether a

broker-dealer handles customer funds or

securities.

In calculating the capital requirement,

the Rule requires a broker-dealer to

deduct from its net worth certain

percentages, known as haircuts, of the

value of the securities and commodities

positions in the firm’s portfolio. The

applicable percentage haircut is

designed to provide protection from the

market risk, credit risk, and other risks

inherent in particular positions.

Discounting the value of a brokerdealer’s proprietary positions provides a

capital cushion in case the portfolio

value of the broker-dealer’s positions

decline.

The Rule requires a broker-dealer to

compute its haircuts by multiplying the

market value of its securities positions

by prescribed percentages. For example,

a broker-dealer’s haircut for equity

securities is equal to 15 percent of the

market value of the greater of the long

or short equity position plus 15 percent

of the market value of the lesser

position, but only to the extent this

position exceeds 25 percent of the

greater position. 1 In contrast to the

uniform haircut for equity securities, the

haircuts for several types of interest rate

sensitive securities, such as government

securities, are directly related to the

time remaining until the particular

security matures. The Rule uses a

sliding scale of haircut percentages with

these securities because changes in

interest rates will usually have a greater

impact on the price of securities with

longer remaining maturities compared

to those securities with shorter

remaining maturities. For example,

there is no haircut on government

securities with less than three months

remaining maturity, but there is a six

percent haircut on government

securities with 25 years or more

remaining maturity.

The Commission believes the Rule

has worked well over the years. The

Commission and the self-regulatory

organizations (‘‘SROs’’) have generally

been able to identify at early stages

broker-dealers that are experiencing

financial problems and to supervise selfliquidations of failing securities firms.

This early regulatory intervention has

helped to avoid customer losses and the

need for formal proceedings under the

Securities Investor Protection Act of

1970.

B. Prior Relevant Actions

Since 1993, the Commission has

undertaken a number of initiatives to

better understand how securities firms

manage market and credit risk and to

evaluate whether the firms’ risk

management techniques could be

incorporated into the net capital rule.

This section reviews four of the

Commission’s initiatives as well as

recent rules addressing capital

requirements for banks adopted 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’’).

1. 1993 Concept Release

In May 1993, the Commission began

a comprehensive review of the Rule by

issuing a concept release soliciting

comment on alternative methods for

computing haircuts on derivative

financial instruments (‘‘Concept

Release’’). 2 Although the Concept

Release’s focus was on derivative

instruments, the Commission intended

to commence a dialogue with the

securities industry regarding how the

Rule could better reflect the market and

credit risks inherent in a broker-dealer’s

proprietary securities portfolio. At that

time, the Commission envisioned a

multi-step revision of the net capital

rule that would substantially change

how broker-dealers calculate the market

and credit risk haircuts arising from

their proprietary positions.

2. Derivatives Policy Group

The Derivatives Policy Group

(‘‘DPG’’), consisting of the six U.S.

firms 3 most active in the over-thecounter (‘‘OTC’’) derivatives market,

was formed at the Commission’s request

to address the public policy issues

arising from the activities of

unregistered affiliates of registered

broker-dealers and registered futures

commission merchants. In March 1995,

after discussions with the Commission,

the DPG published its Framework for

Voluntary Oversight (‘‘Framework’’)

under which the members of the DPG

agreed to report voluntarily to the

Commission on their activities in the

OTC derivatives market. 4 The

Framework provides for the use of

proprietary statistical models to

measure capital at risk due to the firms’

OTC derivatives activities; however, the

Framework was not intended to be used

as a method for calculating minimum

capital standards for the DPG firms.

For purposes of using models to

measure capital at risk, the DPG defines

risk of loss, or ‘‘capital at risk,’’ to be

‘‘the maximum loss expected to be

exceeded with a probability of one

percent over a two-week holding
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 68013

5 Id. at 28.

6Specifically, the core risk factors include: (1)

Parallel yield curve shifts, (2) changes in steepness

of yield curves, (3) parallel yield curve shifts

combined with changes in 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.

7Securities Exchange Act Rel. No. 38248

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

8Currently, the model maintained and operated

by The Options Clearing Corporation (‘‘OCC’’) is the

only approved model. OCC’s model has been

temporarily approved until September 1, 1999.

9Under the rule amendment, the Third-Party

Source will collect the following information: (1)

the dividend streams for the underlying securities,

(2) interest rates (either the current call rate or the

Eurodollar rate for the maturity date which

approximates the expiration date of the option), (3)

days to expiration, and (4) closing underlying

security and option prices from various vendors.

10Securities Exchange Act Rel. No. 39454

(December 17, 1997).

period.’’ 5 The Framework covers several

products, including: interest rate,

currency, equity, and commodity swaps;

OTC options (including caps, floors, and

collars); and currency forwards (i.e.,

currency transactions of more than a

two-day duration, except that firms may

elect to include only currency

transactions of 14 days or more of

duration). The Framework provides that

each firm’s model must capture all

material sources of market risk that

might impact the value of the firm’s

positions, including nine specific

material sources of risk, or core risk

factors, based on interest rate shocks,

changes in equity values, and changes

in exchange rates.6

Each DPG firm agreed to calculate

capital at risk under two scenarios.

Under the first scenario, each firm

would independently determine the size

of the shocks used to calculate its

capital at risk. Under the second

scenario, each firm would calculate its

capital at risk due to certain

Commission specified, hypothetical

large shocks to the core risk factors. The

purposes of preparing a second set of

capital at risk data are to assist the

Commission in comparing volatility

among the firms’ portfolios and to

evaluate the usefulness of the firms’

models in measuring market risk during

times of unusual market stress.

The Framework does not specify

minimum correlations between

securities that are to be used in the

models. The Framework states that there

are many generally accepted methods

for estimating historical or marketimplied volatilities and correlations

and, instead of utilizing predetermined

correlation factors, the Framework

provides that hedging would be

permitted where contracts and

instruments within the category exhibit

an ‘‘appropriately high degree of

positive price correlation.’’ Thus, the

degree to which firms would recognize

positions as hedges was left to the

individual discretion of each firm. The

Framework notes, however, that

estimates of volatility and correlation

may not be accurate during times of

market stress.

The Framework also sets forth

common audit and verification

procedures of the technical and

performance characteristics of the

models. Under the Framework, the firms

are responsible for making all

computations necessary for purposes of

assessing risk in relation to capital on a

regular basis and to provide such

computations on a current basis upon

request. Under the Framework, the

inventory pricing and modelling

procedures of firms are to be reviewed

at least annually by independent

auditors or consultants. The

independent auditors or consultants

provide reports summarizing the results

of their reviews, and the firms provide

the audit reports to the Commission.

Under the Framework, the DPG firms

have enhanced reporting requirements

regarding their exposure to credit risk.

The information reported to the

Commission falls primarily into two

principal categories: credit

concentration and portfolio credit

quality. Credit concentration in the

portfolio is reported by separately

identifying the top 20 net exposures on

a counterparty-by-counterparty basis.

The credit quality of the portfolio is

reported by aggregating for each

counterparty the gross and net

replacement value and net exposure of

the firm. Credit information also is

categorized by credit rating, industry,

and geographic location.

The Framework established risk

management guidelines that provide a

comprehensive framework for the DPG

firms to implement their business

judgments as to the appropriate scope

and level of their OTC derivatives

activities. The Framework provides that

each firm’s board of directors should

adopt written guidelines addressing the

scope of permitted activities, the

acceptable levels of credit and market

risk, and the structure and

independence of the risk monitoring

and risk management processes and

related organizational checks and

balances from the firm’s trading

operations. Senior management should

also implement independent risk

measuring and risk monitoring

processes to manage risk within the

guidelines established by the board of

directors.

3. Theoretical Options Pricing Models

In February 1997, the Commission

completed an important step in its

review of the net capital rule by

amending the Rule to allow brokerdealers to use theoretical option pricing

models to determine capital charges for

listed equity, index, and currency

options, and related positions that

hedge these options.7 The amendment

permits broker-dealers to use a model

(other than a proprietary model)

maintained and operated by a thirdparty source (‘‘Third-Party Source’’) and

approved by a designated examining

authority (‘‘DEA’’).8 The Third-Party

Source is required to collect certain

information on a daily basis concerning

different options series.9 Using this

information, the Third-Party Source

measures the implied volatility for each

option series and inputs to the model

the resulting implied volatility for each

option series. For each option series, the

model calculates theoretical prices at 10

equidistant valuation points using

specified increases and decreases in the

underlying instrument.

After the model calculates the

theoretical gain or loss valuations, the

Third-Party Source provides the

valuations to broker-dealers. Brokerdealers download this information into

a spreadsheet from which the brokerdealer calculates the profit or loss for

each of its proprietary and marketmaker options positions. The greatest

loss at any one valuation point is the

haircut. This amendment to the Rule

was a milestone because it was the first

time the Commission allowed modelling

techniques for regulatory capital

purposes.

4. OTC Derivatives Dealers

Simultaneously with this release, the

Commission is proposing a new limited

regulatory regime for OTC derivatives

dealers.10 Under this regime, OTC

derivatives dealers could register with

the Commission and be subject to

specialized net capital requirements.

The Commission is considering

requiring OTC derivatives dealers

registered under this framework to

maintain tentative net capital of not less

than $100 million and net capital of not

less than $20 million. As part of this

proposal, the Commission is

contemplating giving OTC derivatives

dealers the option of taking either the

existing securities haircuts or haircuts

based on statistical models. OTC

derivatives dealers electing to use
68014 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

11The Governors of the G–10 countries

established the Basle Committee on Banking

Supervision in 1974 to provide a forum for ongoing

cooperation among member countries on banking

supervisory matters.

12The Banking Agencies defined general market

risk as changes in the market value of on-balance

sheet assets and liabilities and off-balance sheet

items resulting from broad market movements, such

as changes in the general level of interest rates,

equity prices, foreign exchange rates, and

commodity prices. Specific risk is defined by the

Banking Agencies as changes in the market value

of individual positions due to factors other than

broad market movements and includes such risks

as the credit risk of an issuer.

13Securities Exchange Act Rel. No. 39455

(December 17, 1997).

models would have to calculate

potential losses and specific capital

charges for both market and credit risk.

These OTC derivatives dealers also

would have to maintain models that

meet certain minimum qualitative and

quantitative requirements that are

substantially similar to the requirements

set forth in the U.S. Banking Agencies’

rules.

5. U.S. Banking Agencies

In August 1996, the U.S. Banking

Agencies adopted rules incorporating

into their bank capital requirements

risk-based capital standards for market

risk that cover debt and equity positions

in the trading accounts of certain banks

and bank holding companies and

foreign exchange and commodity

positions wherever held by the

institutions. The U.S. Banking Agencies’

rules were designed to implement the

Basle Committee on Banking

Supervision’s (‘‘Basle Committee’’) 11

agreement on a model based approach

to cover market risk. These rules apply

to any bank or bank holding company

whose trading activity equals ten

percent or more of its total assets, or

whose trading activity equals $1 billion

or more. The U.S. Banking Agencies’

final rules became effective January 1,

1997 and compliance will be mandatory

by January 1, 1998. Institutions that do

not meet these minimum securities

trading thresholds will not be subject to

market risk capital requirements.

The U.S. Banking Agencies’ rule

amendments require affected banks or

bank holding companies to adjust their

risk-based capital ratio to reflect market

risk by taking into account the general

market risk and specific risk of debt and

equity positions in their trading

accounts.12 These institutions also must

take into account the general market risk

associated with their foreign exchange

and commodity positions, wherever

located. The capital charge for market

risk must be calculated by using the

institution’s own internal model.

II. Alternatives to the Current Financial

Responsibility Regime

The Commission is soliciting

comment on possible alternative

methods for calculating credit and

market risk capital requirements for

broker-dealers. This release will help

the Commission evaluate different ways

the net capital rule could be modified to

accommodate changes in the securities

business since the current uniform net

capital rule was adopted in 1975, with

a particular emphasis on incorporating

modern risk management techniques. In

this regard, the Commission believes it

can modernize the Rule by either

amending the current haircut

percentages or by allowing certain

broker-dealers to use a model-based

system to calculate appropriate capital

charges for market risk. This section

discusses each of the alternative

structures and lists relevant questions.

A. Modify Current Haircut Approach

As discussed above, the Rule requires

a broker-dealer to deduct from its net

worth certain fixed percentages, or

haircuts, of the value of its securities

positions. The present prescriptive

haircut methodology has several

advantages. It requires an amount of

capital which will be sufficient as a

provision against losses, even for

unusual events. It is an objective,

although conservative, measurement of

risk in positions that can act as a tool

to compare firms against one another.

Moreover, the current methodology

enables examiners to determine readily

whether a firm is properly calculating

haircuts. The examiner can review

either the entire net capital calculation

or just material portions of the firm’s

proprietary positions.

However, there are some weaknesses

associated with determining capital

charges based on fixed percentage

haircuts. For example, the current

method of calculating net capital by

deducting fixed percentages from the

market value of securities can allow

only limited types of hedges without

becoming unreasonably complicated.

Accordingly, the net capital rule

recognizes only certain specified

hedging activities, and the Rule does not

account for historical correlations

between foreign securities and U.S.

securities or between equity securities

and debt securities. By failing to

recognize offsets from these correlations

between and within asset classes, the

fixed percentage haircut method may

cause firms with large, diverse

portfolios to reserve capital that actually

overcompensates for market risk.

To eliminate weaknesses in the

current haircut structure, the

Commission could modernize the Rule

by maintaining the current methodology

but changing the haircut percentages

and recognizing additional offsetting

positions. For example, the proposing

release issued simultaneously with this

concept release proposes amendments

to the Rule that would treat haircuts on

certain interest rate products as being

part of a single portfolio, similar to the

standard approach in the Basle

Committee’s Capital Accord.13 As

proposed, the net capital rule would

recognize hedges among government

securities, investment grade

nonconvertible debt securities (or

corporate debt securities), pass-through

mortgage backed securities, repurchase

and reverse repurchase agreements,

money market instruments, and futures

and forward contracts on these debt

instruments. As a next step, the

Commission could revise the current

haircut percentages and develop

methodology to account for more

correlations and hedges among other

types of securities.

The Commission solicits comment on

the following topics. It is not necessary,

however, that comments be limited to

the specific issues raised in this release.

Commenters are encouraged to submit

statements with respect to any aspect of

the current net capital rule that may be

useful to the Commission.

Question 1: Should the Commission retain

the current haircut approach but revise the

current percentages? If so, which haircut

percentages should be modified? How should

these percentages be modified? What should

be the objective basis for modified haircut

percentages? Please provide relevant data to

support your response.

Question 2: Do the current haircut

percentages adequately account for the

market risk, credit risk, and other risks

inherent in a particular position?

Question 3: Do the current haircut

percentages enable firms to reserve sufficient

capital for times of market stress, including

one day movements and movements over a

period of time? Please provide relevant data

to support your response.

Question 4: How can haircut percentages

be further adjusted to account for correlations

between and within asset classes? Please

provide relevant data to support your

response.

Question 5: How can the current haircut

approach be modified to improve the

treatment for specific types of securities,

including foreign securities, collateralized

mortgage obligations (‘‘CMOs’’), and overthe-counter options on interest-rate

securities? Please provide relevant data to

support your response.
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 68015

14The 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, September–October 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 value-at-risk 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).

15See Autoro Estrella et al., Options Positions:

Risk Measurement and Capital Requirements,

Federal Reserve Bank of New York Research Paper

number 9415, September 1994 (evaluating different

methods of measuring the market risk of options

and analyzing the capital treatment of the market

and credit risk of options).

Question 6: Should the Commission

include security-specific models, other than

the option pricing models, in the Rule? If so,

what forms should these models take and

what types of minimum requirements should

apply to the use of such models?

Question 7: If the Commission includes

other security-specific models in the Rule,

what types of securities should be covered by

such models (i.e., CMOs, over-the-counter

options, or treasury securities)?

B. Model Based Approach

1. Generally

A number of broker-dealers, primarily

those with large proprietary securities

portfolios, have indicated to the

Commission that they may be willing to

incur the expenses associated with

developing and using statistical models

to calculate haircuts on their securities

portfolios. Under a model based net

capital rule, in lieu of taking fixed

percentage haircuts, a broker-dealer

would use either an external or internal

model as the basis for a market risk

charge and take a separate charge, or

charges, for other types of risk, such as

credit risk and liquidity risk.

The Commission could allow firms to

calculate market risk capital charges

according to external models for specific

types of securities that are similar to the

options pricing models allowed under

Appendix A to the Rule. The benefit of

an external model is that all firms

would be utilizing the same model.

However, the Commission could have

difficulty finding a third party

(comparable to the Options Clearing

Corporation for listed options) that

would have access to all the data

necessary to facilitate external securityspecific models for securities other than

options.

With respect to internal models, the

Commission would need to prescribe

certain minimum quantitative and

qualitative standards that a firm’s model

would have to meet prior to that firm

using its internal model for regulatory

capital purposes. Currently, several

large firms use value at risk (‘‘VAR’’)

models as part of their risk management

system. These firms typically utilize

VAR modelling to analyze, control, and

report the level of market risk from their

trading activities. Generally, 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 tenday 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 more than

$150,000 during a ten-day period only

once every 100 ten-day periods.

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.14

Given the increased use and

acceptance of VAR as a risk

management tool, the Commission

believes that it warrants consideration

as a method of computing net capital

requirements for broker-dealers.

However, while VAR can be used to

manage market risk, broker-dealers that

rely solely on VAR for risk management

may not have a comprehensive risk

management program. VAR models,

unlike haircuts, do not typically account

for those risks other than market risk,

such as credit risk, liquidity risk, and

operational risk. Broker-dealers that

utilize VAR models should therefore use

additional techniques to manage those

risks.

Further, while VAR may be useful in

helping broker-dealers project possible

daily trading losses under ‘‘normal’’

market conditions, VAR may not help

firms measure the losses that fall

outside of normal conditions during

times of market stress. For example,

VAR models may not capture possible

steep market declines because these

models typically measure exposure at

the first percentile (or the fifth

percentile) and steep market declines

are, by definition, below the first

percentile. In addition, the most

common VAR approaches may pose a

problem for those portfolios that utilize

options or other products with nonlinear payoffs.15

The purpose of the Commission’s net

capital rule is to protect markets from

broker-dealer failures and to enable

those firms that fall below the minimum

net capital requirements to liquidate in

an orderly fashion without the need for

a formal proceeding or financial

assistance from the Securities Investor

Protection Corporation. The

Commission believes that market risk

charges must adequately protect a

broker-dealer during severe market

stress, whether that stress occurs on

only one day or over a period of several

days, such as the drop in equity prices

during the October 1987 market break or

the Mexican debt crisis in 1994. Because

VAR models do not typically reserve

capital for severe market declines, it

may be necessary to impose additional

safeguards to account for possible losses

or decreases in liquidity during times of

stress. This may include the use of a

multiplier or the use of stress tests that

firms could apply to their portfolios. A

multiplier could be used to account for

the other risks in a firm’s portfolio that

are not captured by VAR models, such

as operational, settlement, or legal risk.

On the other hand, stress testing could

provide a more complete picture of the

portfolio’s sensitivity to changing

market conditions and a more accurate

representation of capital needs than a

simple multiplier.

The primary advantage of

incorporating models into the net

capital rule is that a firm would be able

to recognize, to a greater extent, the

correlations and hedges in its securities

portfolio and have a comparatively

smaller capital charge for market risk.

Accordingly, if the Rule is amended to

permit models to be used to calculate

market risk in lieu of taking the haircuts

currently imposed by the rule, the

Commission solicits comment on how

the Rule may be modified to include

separate capital requirements to cover

sources of risk other than market risk.

Other issues associated with

incorporating models into the Rule are

the need for management controls

necessary to ensure that the firm is

collecting accurate and comprehensive

information on its proprietary positions
68016 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

and the effectiveness of those controls to

monitor the risk assumed by the firm.

2. Two Tiered Approach

One way that the Commission could

incorporate models into the net capital

rule would be to have different net

capital requirements based on certain

standards (‘‘Two Tiered Approach’’).

Under the Two Tiered Approach,

broker-dealers meeting certain

minimum threshold levels would be

required to use models to determine

capital compliance. For example,

broker-dealers with net capital

exceeding a certain amount and

currently using models for in-house risk

management purposes could use models

to determine their market risk capital

charge under prescribed circumstances.

Firms with less than the prescribed

level of net capital and those firms with

net capital greater than the prescribed

level but not using models for risk

management could be required to

continue to follow the current Rule’s

haircut methodology. These haircut

percentages could either be the same as

the current percentages or modified

versions.

A Two Tiered Approach potentially

has two primary benefits. First, the

Commission could structure a Two

Tiered Approach to limit the use of

models to those firms that currently use

sophisticated models such as VAR,

thereby not requiring other firms to

incur the cost of implementing such

models. Second, the Commission could

design a Two Tiered Approach that

establishes appropriate limits on which

firms can utilize models to determine

capital compliance.

A potential weakness of a Two Tiered

Approach is that it could inhibit

competition between large and small

firms because models may give large

firms more flexibility in determining

their net capital requirements. However,

this advantage could be small if smaller

firms did not have to incur the start-up

and maintenance costs associated with

models and the risk management

infrastructure to support their use.

Additionally, a Two Tiered Approach

could still allow firms with simple

portfolios to easily calculate the

applicable haircuts on their portfolios.

3. Base Approach With PreCommitment Feature

Another option for incorporating

models into the Rule could be to

combine the current haircut

methodology using fixed percentage

haircuts with a model-based approach

(the ‘‘Base Approach’’). The Base

Approach could combine the strengths

of both haircuts and models and at the

same time possibly address the

weaknesses of each. The Base Approach

would include three primary

components. First, broker-dealers could

be required to maintain a certain

minimum base level of net capital for

each of their business activities, similar

to the minimum requirements under the

current rule. For example, higher capital

levels could apply to broker-dealers that

hold customer funds and securities as

opposed to those firms that only

introduce customer accounts to clearing

firms. Second, broker-dealers could take

a fixed percentage haircut for each

security in their portfolio. This haircut

would be similar to the haircut

requirements under the current net

capital rule; however, the size of the

haircut would be lower due to the

additional charge for market risk

obtained from the third component.

The third component of the Base

Approach could consist of a capital

charge based on the firm’s model and

include a pre-commitment feature that

could require a broker-dealer to take

capital charges based on the realized

performance of its models (‘‘precommitment feature’’). The precommitment feature could have two

steps. First, at the start of a predetermined time period (i.e., one month

or one quarter), a broker-dealer could be

required to represent that its losses, as

computed by its model, would be

within certain parameters over the fixed

time period. Second, at the conclusion

of each fixed time period, the firm’s

minimum net capital level could

increase by an amount equal to the

difference between the actual portfolio

gains and losses and those projected

based on its model. These additional

capital contributions would be required

because differences between the actual

results and those projected by the model

could indicate that the firm’s models

may not be accurately assessing the risk

of the firm’s portfolio.

By incorporating haircuts and models

into the Base Approach, the inherent

strengths and weaknesses of each could

potentially offset each other.

Additionally, the Base Approach may be

a viable capital standard for firms with

diverse portfolios and those that use

more sophisticated methods of risk

management. The pre-commitment

feature would create additional

incentives for broker-dealers to manage

risk effectively. On the other hand, a

Base Approach may be too complicated

for firms to apply. In balance, however,

the Base Approach could potentially

provide firms with flexibility in

developing models and control systems,

encourage the development of accurate

forecasts, and still ensure that firms

reserve sufficient amounts of net capital.

4. Comments on the Potential Use of

Models

The Commission solicits comment on

the following specific topics, including

the appropriateness of using proprietary

models generally and the recent

initiatives of both the DPG and the U.S.

Banking Agencies.

a. Models as a means to determine

broker-dealer regulatory capital.

Question 8: Should the Commission permit

the use of models to calculate regulatory

capital for registered broker-dealers? If yes,

please explain whether the Commission

should allow firms to utilize internal models

or whether the Commission should establish

an external model approach similar to the

treatment of options under Appendix A to

the Rule.

Question 9: If the Commission permits the

use of internal models, should the models

conform to certain objective criteria, or

should they be subjective? When could the

assumptions upon which models rest be

challenged? Should internal or external

auditors periodically review and approve the

models and their applications? If so, how

much should regulators rely on auditors’

application of models? Could the selfregulatory organizations adequately surveil

and examine for net capital compliance

utilizing models?

Question 10: Should the Commission

impose limits on the types of firms that can

use models? Should there be certain

additional minimum criteria a firm must

satisfy in order to use a proprietary model?

Should firms that meet the minimum criteria

for using models have the option of using an

alternate standard approach (i.e., not using

models) to calculate regulatory capital? If so,

what should that approach be?

Question 11: Is VAR an appropriate

method of using models as the basis for

calculating capital requirements for brokerdealers? The Commission understands there

are several approaches to calculating VAR

that are currently used by firms (e.g., Monte

Carlo, variance/covariance, and historical

simulation approaches). Given the various

methods, the Commission seeks comment on

whether minimum criteria should be

established for models used for regulatory

capital purposes. If not, how can the

Commission provide for the ability to

compare levels of risks among firms or

understand the significance of levels of risk

reported by firms when determining their net

capital requirements?

Question 12: The Commission believes that

any approach that uses models for setting

regulatory capital requirements should result

in broadly consistent results for firms with

similar portfolios. Can consistent results for

similar portfolios be obtained without the

Commission requiring firms to use a standard

model? How else can consistency of capital

standards among firms with similar

portfolios be achieved?

Question 13: Some firms use different

types of statistical models to measure risk
Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules 68017

from different types of businesses, such as

fixed income securities and foreign equities.

Should the Commission permit firms to use

more than one model to calculate regulatory

capital? If yes, would the inefficiencies in

each model get accentuated or mitigated

when the results of the different models are

aggregated?

Question 14: Should the Commission allow

the use of models gradually (i.e., first allow

models for debt securities, then allow models

for equity securities and other securities)?

Question 15: What will be the costs of

implementing models? How do the costs of

implementing models compare to the current

costs of computing net capital? At what level

would it be economical for firms to try to use

models? How do the start-up costs of

implementing models compare to the

ongoing costs of managing models incurred

by firms that currently use models? How

does the availability (or anticipated future

development) of software packages and

databases impact cost estimates? Will the

costs of implementing models be a barrier to

firms not currently using models? Please

provide relevant data to support your

response.

Question 16: Will firms not currently using

models be at a competitive disadvantage to

those firms that currently use models? Please

provide relevant data to support your

response.

Question 17: If the Commission permits the

use of models, what additional reporting or

recordkeeping requirements would the

Commission need to impose on brokerdealers using models? Should firms using

models have to file additional reports with

the Commission or their DEA? Should the

Commission amend its books and records

rules to require firms using models to

maintain certain books and records that they

are currently not required to maintain? How

can the Commission ensure that it has access

to information regarding a firm’s models that

is not maintained by the broker-dealer (i.e.,

information maintained at an unregistered

entity)? What measure could the Commission

require to ensure broker-dealers would not be

able to modify the model (or data inputs) to

avoid falling out of net capital compliance?

Should the Commission require models to be

stored with third-parties subject to escrow

arrangements?

Question 18: If the Commission permits the

use of models, should firms using models be

subject to modified forms of Commission and

DEA inspections? Should the models

themselves be subject to review and approval

by the Commission or DEA?

b. Abnormal Market Conditions.

Question 19: Because the purpose of VAR

is to provide an estimate of losses over a

short period under normal conditions, is it

possible for VAR models to ensure an

adequate capital cushion during unusual

market stress or structural shifts in the

economy given the nature, size, and liquidity

of a broker-dealer’s portfolio? Given the

complexity of models, could an accurate and

rapid assessment be made of a firm’s true

financial condition? Please provide relevant

data to support your response.

Question 20: Would models be more

effective during times of severe market

fluctuations if stress testing were required?

Should the Commission specify what stress

tests should be used by the firms? Please

provide relevant data to support your

response.

Question 21: If stress testing were required,

should a firm be required to use the same

parameters when conducting stress testing on

each of its business units (i.e., apply the same

levels and stress the same movements in the

relevant securities, markets, and indexes)?

Question 22: If stress testing were required,

should a firm be required to test its models

based on a predetermined number of volatile

days of market movements (i.e., models

would have to be stress tested based on the

100 most volatile days of market movements

during the last ten years)?

Question 23: Should the results of stress

testing impact the calculation of a firm’s

capital requirements (i.e., through the use of

some type of multiplication factor)? Please

provide relevant data to support your

response.

Question 24: Does the use of a minimum

multiplier, as endorsed in the Basle Standard

and by the U.S. Banking Agencies,

adequately address risks arising from severe

market movements? Please provide relevant

data to support your response.

Question 25: Should back-testing (i.e., ex

post comparisons between model results and

actual performance) be required and, if so, to

what extent? Should back-testing results be

used to determine a multiplier for minimum

capital amounts? Could back-testing results

be used to raise minimum capital levels for

the firms?

c. Qualitative and Quantitative

Criteria for Models.

Question 26: Will setting minimum

qualitative and quantitative criteria prevent a

firm from adjusting its model to encompass

changing market conditions, the firm’s

structure, or the firm’s business lines?

Question 27: Two important components

of models are the length of time over which

market risk is to be measured and the

confidence level at which market risk is

measured. The definition of ‘‘capital at risk’’

as used in the DPG Framework is the

maximum loss expected to be exceeded with

a probability of one percent over a two-week

period. Is this definition appropriate for

regulatory capital purposes?

Question 28: What should be the minimum

criteria for models, including pricing

accuracy, correlations, netting factors, and

observation periods? Please provide relevant

data to support your response.

Question 29: Are the minimum standards

for the use of models, the separate

calculation of capital at risk due to shocks to

the core risk factors, and the audit

requirements used in the DPG Framework

appropriate? Please provide relevant data to

support your response.

Question 30: VAR models typically assume

normality and that future return distributions

and correlations will behave similar to the

way they behaved in the past. For these

reasons, the Commission needs to ensure that

VAR models can withstand steep market

declines. Other than by specifying minimum

qualitative and quantitative criteria, how can

regulators assure themselves that the

proprietary models used by the firms are

adequate for capital purposes?

Question 31: Should the Commission

require that broker-dealers utilizing models

manage these models from a risk

management division that is separate from

the firm’s business divisions?

Question 32: Should the Commission

require that broker-dealers utilizing models

use the same model for both computing net

capital and internal risk management

purposes?

Question 33: Currently, firms utilize a wide

variety of risk management techniques.

Should the Commission mandate specific

minimum risk management standards for

firms that wish to use models?

Question 34: Should the Commission

require that firms using models manage risk

on either a firm-wide, legal entity, or

business basis?

d. Additional Risks.

Question 35: Usually, VAR models do not

handle options products well because the

returns on an options portfolio are not

typically normally distributed. How should

the non-linear nature of options be

adequately addressed? For firms with

substantial options positions, is a standard

approach (similar to the Commission’s

amendments to Appendix A of the net capital

rule) more appropriate? Is the approach set

forth in the Commission’s recent

amendments to Appendix A a viable

alternative?

Question 36: Models typically measure

losses by assuming that assets can be sold at

current market prices. However, if a firm has

a portfolio which includes illiquid assets,

highly customized structured products

(including, for example, some CMOs), or

aged items, the Commission is particularly

concerned that models may underestimate

the true losses since these assets may have

to be sold at a discount. Given the

importance of liquidity risk, the Commission

solicits specific comment with respect to

how this risk should be addressed if models

are permitted for regulatory purposes.

Question 37: Is it possible to include a

credit risk analysis in a model based

methodology? Please provide relevant data to

support your response.

Question 38: As mentioned above, models

may not properly account for additional

risks, including credit risk, liquidity risk,

operational risk, settlement risk, and legal

risk. How should these additional risks be

treated? Can the Rule be modified to include

separate capital requirements to cover these

sources of risk? Please provide relevant data

to support your response.

Question 39: Is there an alternative to using

a multiplier to account for operational risk,

legal risk, and other risks that are difficult to

quantify? Is the use of insurance to cover

these risks a viable option? Please provide

relevant data to support your response.

Question 40: In order for a firm to calculate

VAR effectively, data must be aggregated

from all its departments worldwide. Also,

there is often incompatibility of trading and

back-office accounting computer systems that

operate from different regions of the world.
68018 Federal Register / Vol. 62, No. 249 / Tuesday, December 30, 1997 / Proposed Rules

1Securities Exchange Act Release No. 34616

(August 31 1994), 59 FR 46314 (September 7, 1994)

(‘‘Concept Release’’).

How can this problem of integration be

adequately addressed?

e. OTC Derivatives Dealer.

Question 41: Should the Commission

amend the Rule so that all broker-dealers are

eligible to use the methodology for

calculating market and credit risk as in

proposed Appendix F to the Rule?

Question 42: What minimum capital

requirements should the Commission require

a broker-dealer to meet to be eligible to use

proposed Appendix F? Should the criteria be

based on tentative net capital, net capital, or

both? Are the $100 million tentative net

capital and $20 million net capital

requirements appropriate?

Question 43: Assuming that the

Commission were to allow all broker-dealers

to utilize Proposed Appendix F, what

sections in Proposed Appendix F need to be

modified for all broker-dealers? Are the

market risk and credit risk sections in

Proposed Appendix F appropriate for all

broker-dealers? Are the qualitative and

quantitative requirements for VAR models in

Proposed Appendix F appropriate to VAR

models used by non-OTC derivatives dealers?

f. Two Tiered Approach.

Question 44: Is a Two Tiered Approach a

viable alternative to the current net capital

rule? If so, what standards should the

Commission utilize to determine which

broker-dealers are required to utilize

statistical models? Should the tier limits be

based on capital, amount of customer

business, level of proprietary trading, or

some other factor(s)? Should these minimum

net capital amounts be fixed dollar amounts

or be based on financial ratios such as

aggregate indebtedness or aggregate debit

items as in the current rule? Please provide

relevant data to support your response.

Question 45: Should the current haircut

percentages be maintained? If not, what

modifications should be made to the current

haircut percentages? Please provide relevant

data to support your response.

Question 46: What will be the impact on

competition among firms in different tiers? In

this regard, the Commission seeks comment

on the effects of creating a two-tiered system

from broker-dealers that do not currently use

models in their risk management system and

from broker-dealers that currently use models

for risk management purposes but either lack

sufficient capital or sufficiently diverse

securities portfolios to use models for net

capital purposes.

g. Base Approach with PreCommitment Feature.

Question 47: Is the Base Approach a viable

alternative to the current net capital rule?

Question 48: Should the Base Approach

only apply to firms that meet certain

standards? If so, what are the appropriate

standards?

Question 49: What minimum capital

requirements should the Commission

establish for certain broker-dealer activities?

Should these minimum net capital amounts

be fixed dollar amounts or based on financial

ratios such as aggregate indebtedness or

aggregate debit items as in the current rule?

Should the current minimum levels be

retained?

Question 50: What modifications should

the Commission make to the current haircut

percentages? Please provide relevant data to

support your response.

Question 51: What should be the

parameters for the pre-commitment feature?

Should firms be penalized for differences

between actual results and the results as

projected by VAR models? If so, what criteria

should be used to determine the additional

capital requirements for these differences?

III. Summary of Requests for Comment

Following receipt and review of

comments, the Commission will

determine whether rulemaking or other

action is appropriate. Commenters are

invited to discuss the broad range of

concepts and approaches described in

this release concerning the

Commission’s regulation of brokerdealers’ net capital requirements. In

addition to responding to the specific

questions presented in this release, the

Commission encourages commenters to

provide any information to supplement

the information and assumptions

contained herein regarding the current

net capital rule, VAR models, and the

other suggested alternatives. The

Commission also invites commenters to

provide views and data as to the costs

and benefits associated with the

possible changes discussed above in

comparison to the costs and benefits of

the current net capital rule. In order for

the Commission to assess the impact of

changes to the Rule, comment is

solicited, without limitation, from

investors, broker-dealers, SROs, and

other persons involved in the securities

markets.

Dated: December 17, 1997.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97–33400 Filed 12–29–97; 8:45 am]

BILLING CODE 8010–01–P

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Part 240

[Release No. 34–39457; File No. S7–33–97]

RIN 3235–AH28

Capital Requirements for Brokers or

Dealers Under the Securities Exchange

Act of 1934

AGENCY: Securities and Exchange

Commission.

ACTION: Proposed rule.

SUMMARY: The Securities and Exchange

Commission (‘‘Commission’’) is

proposing for comment amendments to

Rule 15c3–1 under the Securities

Exchange Act of 1934. The proposed

amendments would define the term

‘‘nationally recognized statistical rating

organization’’ (‘‘NRSRO’’). The

proposed definition sets forth a list of

attributes to be considered by the

Commission in designating rating

organizations as NRSROs and the

process for applying for NRSRO

designation.

DATES: Comments must be received on

or before March 2, 1998.

ADDRESSES: Persons wishing to submit

written comments should file three

copies with Jonathan G. Katz, Secretary,

Securities and Exchange Commission,

450 Fifth Street, N.W., Stop 6–9,

Washington, D.C. 20549. Comments also

may be submitted electronically at the

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

should refer to File No. S7–33–97. This

file number should be included on the

subject line if E-mail is used. All

comments received will be available for

public inspection and copying in the

Commission’s Public Reference Room,

450 Fifth Street, N.W., Washington,

D.C., 20549. Electronically submitted

comment letters will be posted on the

Commission’s Internet web site (http://

www.sec.gov).

FOR FURTHER INFORMATION CONTACT:

Michael A. Macchiaroli, Associate

Director, 202/942–0131, Peter R.

Geraghty, Assistant Director, 202/942–

0177, Louis A. Randazzo, Special

Counsel, 202/942–0191, or Michael E.

Greene, Staff Attorney, 202/942–4169,

Division of Market Regulation,

Securities and Exchange Commission,

450 Fifth Street, N.W., Washington, D.C.

20549.

SUPPLEMENTARY INFORMATION:

I. Introduction

A. The Commission’s Concept Release

In August 1994, the Commission

issued a concept release soliciting

public comment on the Commission’s

role in using the ratings of NRSROs.1 In

the Concept Release, the Commission

specifically solicited comments on: (1)

Whether it should continue to use the

NRSRO concept, and, if so, whether it

should define the term ‘‘NRSRO’’; and

(2) whether the current no-action letter

process for designating a rating

organization an NRSRO is satisfactory,

and, if not, whether the Commission

should establish an alternative

procedure. The Commission is now