[Federal Register Volume 62, Number 249 (Tuesday, December 30, 1997)]
[Proposed Rules]
[Pages 67940-67995]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33406]



[[Page 67939]]

_______________________________________________________________________

Part II





Securities and Exchange Commission





_______________________________________________________________________



17 CFR Parts 200 et al.



Brokers and Dealers Reporting Requirements; Proposed Rules

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

[[Page 67940]]



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.

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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-the-counter markets. Registration as an OTC 
derivatives dealer under the proposed rules would be an alternative to 
registration as a fully regulated broker-dealer, 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: <a href="/cdn-cgi/l/email-protection#f88a8d949dd5f29b9795959d968c8bb88b9d9bd69f978e">rule-
<span class="__cf_email__" data-cfemail="80e3efedede5eef4f3c0f3e5e3aee7eff6">[email protected]</span></a>. 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 <SUP>1</SUP> 
under the Securities Exchange Act of 1934 (``Exchange 
Act'').<SUP>2</SUP> The Commission also proposes to amend Rule 30-3 
<SUP>3</SUP> and Exchange Act Rules 8c-1, 15b1-1, 15c2-1, 15c3-1, 15c3-
3, 17a-3, 17a-4, and 17a-11,<SUP>4</SUP> and to revise Form X-17A-5 
(FOCUS report).<SUP>5</SUP>
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    \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.
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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.<SUP>6</SUP> 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.<SUP>7</SUP>
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    \6\ ``ISDA Market Survey,'' ISDA Internet web site (<a href="http://
www.isda.org">http://
www.isda.org</a>).
    \7\ See Peter A. Abken, Beyond Plain Vanilla: A Taxonomy of 
Swaps, Financial Derivatives Reader (Robert W. Kolb, ed.) (1992) at 
265.
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    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.<SUP>8</SUP> 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.<SUP>9</SUP>
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    \8\ Swaps 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.
    \9\ See, 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).
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    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,

[[Page 67941]]

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'').<SUP>10</SUP> 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 <SUP>11</SUP> 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,'' <SUP>12</SUP> they may engage in a broad range of 
securities and non-securities OTC derivatives activities consistent 
with guidance issued by their applicable bank regulators.<SUP>13</SUP>
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    \10\ 15 U.S.C. 78c(a)(10).
    \11\ See 15 U.S.C. 78o(b).
    \12\ This 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. Sec. 78c(a)(6)].
    \13\ Bank 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).
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    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.<SUP>14</SUP>
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    \14\ The 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.
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    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 broker-dealer 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 non-securities 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 broker-dealer 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. <SUP>15</SUP>
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    \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.
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    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

[[Page 67942]]

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); <SUP>16</SUP> (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) <SUP>17</SUP>
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    \16\ Transactions 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.
    \17\ The 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.
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    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 <SUP>18</SUP> 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.
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    \18\ 15 U.S.C. 78o(b).
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    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.<SUP>19</SUP> 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.
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    \19\ Part 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.
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    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

[[Page 67943]]

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 broker-dealer regulation, including 
the Commission's existing capital and margin requirements, and be 
subject to supervision by a securities self-regulatory 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.<SUP>20</SUP>
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    \20\ As 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].
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    Under the proposed rule, OTC derivatives dealers would be permitted 
to take possession of and sell counterparty collateral and invest 
short-term 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 over-capitalizing 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.<SUP>21</SUP> 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.
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    \21\ Trading 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.
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    Other permissible securities activities would include engaging in 
certain financing transactions involving repurchase and reverse 
repurchase agreements, buy/sell transactions,<SUP>22</SUP> and lending 
and borrowing transactions, as well as entering into certain 
transactions for arbitrage purposes.<SUP>23</SUP> 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.
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    \22\ A 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.
    \23\ Consistent 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.
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    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.<SUP>24</SUP> The

[[Page 67944]]

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.
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    \24\ Except 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. Sec. 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 broker-dealer'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 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.
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    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.<SUP>25</SUP> Under the 
proposed amendments to Exchange Act Rule 15b1-1,<SUP>26</SUP> 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.
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    \25\ 17 CFR 249.501.
    \26\ 17 CFR 240.15b1-1.
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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 non-securities 
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.<SUP>27</SUP> 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.<SUP>28</SUP>
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    \27\ The 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.
    \28\ Exchange 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 broker-
dealer 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 broker-dealer 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.
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    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 
broker-dealer. 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

[[Page 67945]]

dealer, subject to appropriate supervision by both firms.<SUP>29</SUP>
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    \29\ Fully 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.
---------------------------------------------------------------------------

    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 broker-dealers that extend credit for the 
purpose of purchasing or carrying securities are required to comply 
with the provisions of Regulation T.<SUP>30</SUP> The margin 
requirements for banks are contained in Regulation U.<SUP>31</SUP>
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    \30\ 12 CFR 220.1.
    \31\ 12 CFR 221.1.
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    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.<SUP>32</SUP> This means that under Regulation 
U, dealers may extend credit on securities other than margin stock, 
including securities OTC derivative instruments.
---------------------------------------------------------------------------

    \32\ 12 CFR 221.2(f).
---------------------------------------------------------------------------

    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.<SUP>33</SUP> The 
Commission solicits commenters' views regarding the proposed margin 
treatment of transactions by OTC derivatives dealers.
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    \33\ The 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.
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    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).<SUP>34</SUP> 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.
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    \34\ 15 U.S.C. 78(g)(d)(2)(C)(i).
---------------------------------------------------------------------------

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.<SUP>35</SUP> 
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.<SUP>36</SUP>
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    \35\ See Exchange Act Section 15(b)(8) [15 U.S.C. 78o(b)(8)].
    \36\ See 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)].
---------------------------------------------------------------------------

    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.

[[Page 67946]]

    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 <SUP>37</SUP> 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.
---------------------------------------------------------------------------

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

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,<SUP>38</SUP> 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.
---------------------------------------------------------------------------

    \38\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    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 
broker-dealers 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.<SUP>39</SUP> 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.
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    \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).
---------------------------------------------------------------------------

    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.<SUP>40</SUP> 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.
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    \40\ See infra Section II.E.3.b. for a discussion of proposed 
Appendix F.
---------------------------------------------------------------------------

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.<SUP>41</SUP>
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    \41\ The 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 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).
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    The current rule permits using statistical models only for limited 
types of securities.<SUP>42</SUP> The Commission

[[Page 67947]]

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 <SUP>43</SUP> 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.
---------------------------------------------------------------------------

    \42\ See 17 CFR 240.15c3-1a. The Commission recently amended 
Appendix A to permit broker-dealers 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).
    \43\ For 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.
---------------------------------------------------------------------------

    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'').<SUP>44</SUP> In December 1995, the 
Basle Committee amended its Capital Accord <SUP>45</SUP> to incorporate 
market risk capital requirements and approved the use of proprietary 
VAR models to determine bank capital requirements for market 
risk.<SUP>46</SUP> 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.
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    \44\ The 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.
    \45\ The 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.
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    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.<SUP>47</SUP> Proposed Appendix F is 
generally consistent with the U.S. Banking Agencies' rules, and 
incorporates the quantitative and qualitative conditions imposed on 
banking institutions.
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    \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.
---------------------------------------------------------------------------

    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.<SUP>48</SUP> 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.
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    \48\ Exchange Act Rel. No. 39456 (Dec. 17, 1997).
---------------------------------------------------------------------------

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.<SUP>49</SUP> 
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.
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    \49\ To 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.
---------------------------------------------------------------------------

    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 
<SUP>50</SUP> 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.<SUP>51</SUP>
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    \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.
    \51\ See infra Section II.E.3.b.iii. for a discussion of how an 
OTC derivatives dealer would determine the appropriate 
multiplication factor.
---------------------------------------------------------------------------

    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

[[Page 67948]]

incorporated into the model.<SUP>52</SUP> The firm's application would 
also include a description of the risk management controls adopted by 
the firm pursuant to proposed Rule 15c3-4.<SUP>53</SUP>
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    \52\ See infra Sections II.E.3.b.iii. through iv. for a 
description of the qualitative and quantitative requirements.
    \53\ See infra Section II.H.3. for a description of the risk 
management controls that would be required by proposed Rule 15c3-4.
---------------------------------------------------------------------------

    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.<SUP>54</SUP> 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.<SUP>55</SUP>
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    \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.
---------------------------------------------------------------------------

    ii. Credit Risk. OTC derivatives dealers electing to apply Appendix 
F would deduct from their net worth a capital charge for credit 
risk.<SUP>56</SUP> 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'') <SUP>57</SUP> 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.
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    \56\ In general, credit risk is the risk that a counterparty 
will fail to perform its obligations to an OTC derivatives dealer.
    \57\ For 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.
---------------------------------------------------------------------------

    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.<SUP>58</SUP> 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.
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    \58\ Stress 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.
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    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

[[Page 67949]]

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 broker-dealers generally use VAR models to 
measure portfolio volatility on a day-to-day basis, the Commission 
would impose certain requirements on VAR models to address regulatory 
capital-related 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-
1<SUP>59</SUP> and 15c2-1, <SUP>60</SUP> 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.
---------------------------------------------------------------------------

    \59\ 17 CFR 240.8c-1.
    \60\ 17 CFR 240.15c2-1.
---------------------------------------------------------------------------

    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,<SUP>61</SUP> 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.
---------------------------------------------------------------------------

    \61\ 17 CFR 240.15c3-3.
---------------------------------------------------------------------------

    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''),<SUP>62</SUP> including membership in the Securities 
Investor Protection Corporation (``SIPC'').<SUP>63</SUP> 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.<SUP>64</SUP> 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.<SUP>65</SUP> This

[[Page 67950]]

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.
---------------------------------------------------------------------------

    \62\ 15 U.S.C. 78aaa et seq.
    \63\ Section 2 of SIPA [15 U.S.C. 78bbb] generally incorporates 
SIPA into the Exchange Act.
    \64\ The 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).
    \65\ The 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 (collateral) involved in the OTC derivatives 
business are quite different from the ordinary brokerage business 
and customer assets contemplated by SIPA.
---------------------------------------------------------------------------

    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 
<SUP>66</SUP> and 17a-4.<SUP>67</SUP> Section 17(a)(1) of the Exchange 
Act <SUP>68</SUP> 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.<SUP>69</SUP>
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    \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.
---------------------------------------------------------------------------

    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.<SUP>70</SUP> 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.
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    \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.
---------------------------------------------------------------------------

    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 <SUP>71</SUP> 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.
---------------------------------------------------------------------------

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

    Participants in OTC derivatives markets are exposed to various 
risks, including (1) operational risk; <SUP>72</SUP> (2) market risk; 
<SUP>73</SUP> (3) credit risk; <SUP>74</SUP> (4) liquidity risk; 
<SUP>75</SUP> and (5) legal risk.<SUP>76</SUP> 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,

[[Page 67951]]

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.
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    \72\ Operational 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.
    \73\ Market 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.
    \74\ Credit risk comprises risk of loss resulting from 
counterparty default on loans, swaps, options, and during 
settlement.
    \75\ Liquidity risk includes the risk that a firm will not be 
able to unwind or hedge a position.
    \76\ Legal risk arises from possible risk of loss due to an 
unenforceable contract or an ultra vires act of a counterparty.
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    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.<SUP>77</SUP>
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    \77\ Systemic 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.
---------------------------------------------------------------------------

    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 well-developed 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 <SUP>78</SUP> requires all broker-dealers 
to file various reports with the Commission. These reports include 
periodic Financial Operational Combined Uniform Single Reports (FOCUS), 
<SUP>79</SUP> 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.
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    \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.
    \79\ Form X-17A-5 [17 CFR 249.617].
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    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''). <SUP>80</SUP> 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.
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    \80\ See Framework for Voluntary Oversight, Derivatives Policy 
Group (Mar. 1995). The firms comprising the DPG consist of the six 
U.S. broker-dealers 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 broker-
dealers 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.
---------------------------------------------------------------------------

    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

[[Page 67952]]

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 non-securities 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

[[Page 67953]]

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 
on-going 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 <SUP>81</SUP> 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.
---------------------------------------------------------------------------

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

    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 <SUP>82</SUP> 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.
---------------------------------------------------------------------------

    \82\ 15 U.S.C. 78g.
---------------------------------------------------------------------------

    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.<SUP>83</SUP>
---------------------------------------------------------------------------

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

    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

[[Page 67954]]

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, well-capitalized 
entities. The proposed definition may include potential counterparties 
that would be considered small entities for purposes of the Regulatory 
Flexibility Act (``RFA'').<SUP>84</SUP>
---------------------------------------------------------------------------

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

    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.

[[Page 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 non-securities 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. Sec. 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 non-securities 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

[[Page 67956]]

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.<SUP>85</SUP> 
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.<SUP>86</SUP> 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.
---------------------------------------------------------------------------

    \85\ 17 CFR 240.17a-3.
    \86\ The 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 brokers-dealers.
---------------------------------------------------------------------------

    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).<SUP>87</SUP> 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.<SUP>88</SUP> Finally, proposed Rule 17a-12 would require an 
OTC derivatives dealer to file annually its audited financial 
statements along with a corresponding audit report.
---------------------------------------------------------------------------

    \87\ Form X-17A-5 [17 CFR 249.617].
    \88\ See Framework for Voluntary Oversight, Derivatives Policy 
Group (Mar. 1995).
---------------------------------------------------------------------------

    The proposed rule would be integral part of the Commission's 
financial responsibility program for OTC derivatives dealers. The 
information to

[[Page 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:


Sec. 200.30-3(a)(63)  Delegation of authority to Director of Division 
of Market Regulation.

* * * * *
    (a) * * *
    (63) Pursuant to Sec. 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 Secs. 240.3b-12 through 240.3b-16 to read as follows:


Sec. 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 Sec. 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.


Sec. 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.


Sec. 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

[[Page 67958]]

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.


Sec. 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 
Sec. 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 
Sec. 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.


Sec. 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:


Sec. 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 Sec. 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 Sec. 240.15a-1 under the undesignated center heading 
``Exemption of Certain Securities From Section 15(a)'' to read as 
follows:


Sec. 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

[[Page 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:


Sec. 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 (Sec. 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 Sec. 240.15b9-2 under the underquoted center heading 
``registration of brokers and dealers'' to read as follows:


Sec. 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:


Sec. 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 Sec. 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:


Sec. 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 Sec. 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 Sec. 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 
(Sec. 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 Secs. 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 
(Sec. 240.15c3-1b). However, for an OTC derivatives dealer electing to 
use appendix F of this chapter (Sec. 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:


Sec. 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 Sec. 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 Sec. 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 Sec. 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

[[Page 67960]]

in accordance with the theoretical pricing model set forth in appendix 
A of this section (Sec. 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 long-term 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    
------------------------------------------------------------------------
                                                          Multiplication
                  Number of exceptions                        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 ten-business 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

[[Page 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 ``Sec. 240.17a-5,'' to read 
``Sec. 240.17a-5 or Sec. 240.17a-12,''.


Sec. 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 Sec. 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 Sec. 240.15c3-4 to read as follows:


Sec. 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;

[[Page 67962]]

    (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 Sec. 240.17a-3, in paragraph (a)(4)(vi) by revising the 
phrase ``Rule 17a-13 and Rule 17a-5 hereunder'' to read 
``Secs. 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:


Sec. 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 Sec. 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 Sec. 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 ``Sec. 240.17a-5(i)(xv)'' to read ``Secs. 240.17a-5(d) and 
240.17a-12(b)'';
    b. In paragraph (b)(8)(xv) by revising the phrase ``Sec. 240.17a-
5'' to read ``Secs. 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 Sec. 240.15b9-2'' after the phrase ``(15 U.S.C. 
78q(d))'' and by adding the phrase ``or its examining authority 
pursuant to Sec. 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 Sec. 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 
Sec. 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 Sec. 240.15b9-2 or'' after the phrase ``shall 
file with''.


Sec. 240.17a-4  Records to be preserved by certain exchange members, 
brokers and dealers.

* * * * *
    (b) * * *
    (10) The records required to be made pursuant to Sec. 240.15c3-4 
and the results of the periodic reviews conducted pursuant to 
Sec. 240.15c3-4(d).
* * * * *
    16. Amend Sec. 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 Sec. 240.17a-12(f)(2)'' after the phrase ``240.17a-
5(h)(2)'' and by adding the phrase ``or Sec. 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 Sec. 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 ``Sec. 240.15c3-3(i) and 
Sec. 240.17a5-5(h)(2)'' to read ``Sec. 240.15c3-3(i), Sec. 240.17a-
5(h)(2), and Sec. 240.17a-12(f)(2)''.


Sec. 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 Sec. 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 Sec. 240.15b9-2, or the Commission that 
it is, or has been, in violation of Sec. 240.15c3-1 and the broker or 
dealer has not given notice of the capital deficiency under this 
Sec. 240.17a-11, the broker or dealer, even if it does not agree that 
it is, or has been, in violation of Sec. 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 Sec. 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 
Sec. 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 
Sec. 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 Sec. 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 Sec. 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 Sec. 240.17a-12 to read as follows:


Sec. 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 (Sec. 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 Sec. 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 (Sec. 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 Sec. 240.15b9-2.
    (2) The reports provided for in this paragraph (a) shall be 
considered filed when received at the Commission's

[[Page 67963]]

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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 (Sec. 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 (Sec. 249.617 of this 
chapter), Part IIB. If the Statement of Financial Condition filed in 
accordance with instructions to Form X-17A-5 (Sec. 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 (Sec. 249.617 of this chapter), a Computation of Net Capital 
under Sec. 240.15c3-1.
    (4) A reconciliation, including appropriate explanations, of the 
Computation of Net Capital under Sec. 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 Sec. 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 Sec. 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 
Sec. 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

[[Page 67964]]

accordance with the provisions of Sec. 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 Sec. 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 
Sec. 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 Sec. 240.15b9-2 by telegraphic or 
facsimile notice within 24 hours thereafter as set forth in 
Sec. 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

[[Page 67965]]

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 Sec. 240.15b9-2 by report of material inadequacy within 24 
hours thereafter as set forth in Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 240.15b9-2 shall maintain, in the manner 
prescribed in Sec. 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 
Sec. 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 
Sec. 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 Sec. 240.15b9-2.
    (p) Filing requirements. For purposes of filing requirements as 
described in Sec. 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 Sec. 240.17a-12 
which is applicable.
    18. By adding Secs. 240.36a1-1 and 240.36a1-2 to read as follows:


Sec. 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

[[Page 67966]]

(other than an OTC derivatives dealer) in connection with transactions 
in eligible OTC derivative instruments for which an OTC derivatives 
dealer acts as counterparty.


Sec. 240.36a1-2  Exemption from SIPA for OTC derivatives dealers.

    OTC derivatives dealers, as defined in Sec. 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 ``Sec. 240.17a-
12,'' after the phrase ``240.17a-5(a), (b), and (d),''.
    21. Form X-17A-5 (referenced in Sec. 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

[[Page 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 240.17h-1T, 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


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