U.S. COMMODITY FUTURES TRADING COMMISSION

Three Lafayette Centre 

1155 21st Street, NW, Washington, DC 20581 

Telephone: (202) 418-5430 

Facsimile: (202) 418-5536

 

Division of Clearing and 

Intermediary Oversight

CFTC letter No. 05-21 

November 30, 2005 

No-Action 

Division of Clearing and Intermediary Oversight 

 

Re: “No-Action” Position for Alternative Capital Deductions Approved by Securities 

and Exchange Commission Order effective December 1, 2005 

Dear : 

 This is in response to your letter dated November 28, 2005 to the Division of Clearing 

and Intermediary Oversight (“the Division”) of the Commodity Futures Trading Commission 

(“the Commission”), by which you have advised that the U.S. Securities and Exchange 

Commission (“SEC”) has approved, by written order, an application that was submitted by 

“X”, or “the Firm”, in accordance with Appendix E of SEC Rule 15c3-1(§240.15c3-1e).1 The 

terms of the SEC order authorize the Firm to calculate its net capital using the market risk 

standards of Appendix E to compute a deduction for market risk on some or all of the Firm’s 

proprietary trading assets, instead of the provisions of paragraphs (c)(2)(vi) and (c)(2)(vii) of 

Rule 15c3-1, and using the credit risk standards of Appendix E to compute a deduction for 

credit risk on certain credit exposures arising from transactions in derivatives instruments, 

instead of the provision of paragraph (c)(2)(iv) of Rule 15c3-1.2

 The order was issued 

pursuant to §240.15c3-1(a)(7), by which the SEC may authorize brokers or dealers who meet 

specified requirements to compute alternative capital deductions that incorporate 

measurements from value-at-risk (“VaR”) and other mathematical models that are used 

internally by the broker or dealer.3

 For purposes of its net capital calculations under SEC 

regulations, “X” will begin using its SEC-approved alternative capital deductions as of 

December 1, 2005. 

 “X” is also a registered futures commission merchant (“FCM”). On behalf of the 

Firm, you have requested confirmation that if “X” uses its SEC-approved alternative market 

risk and credit risk capital deductions for purposes of determining the Firm’s adjusted net 

 

1

 The SEC regulations referenced herein may be found at Title 17 C.F.R. Ch. II (2005). 

2

 A copy of the order, dated “Y”, is available for public viewing on the SEC’s website, at “Z”. 

3

 The deduction for market risk under §240.15c3-1e is an amount equal to the sum of several components, 

including specified multiples of the VaR of those positions for which VaR models have been approved by the 

SEC. The required computations for the deductions for market risk and credit risk under Appendix E are 

specified in full at §240.15c3-1e(b) and (c). 
2

capital under Commission Rule 1.17, including when preparing and filing with the 

Commission its required capital computations under Commission Rule 1.10, the Division will 

not recommend that the Commission commence an enforcement action against “X” for failure 

to comply with applicable Commission regulations.4 

 A. Applicable regulations 

 

 Commission Rule 1.17(a) requires each FCM to maintain a minimum amount of 

adjusted net capital, which is defined as the FCM’s net capital less deductions (or “haircuts”) 

specified in Rule 1.17(c)(5) and (8). For purposes of these deductions, the Commission has 

incorporated by reference specific percentage haircuts that are set forth in SEC regulations 

§§240.15c3-1(c)(2)(vi) and (vii).5

 Also, Commission Rule 1.17(c)(2)(ii), which is similar to 

§240.15c3-1(c)(2)(iv), requires unsecured receivables arising from an FCM’s transactions in 

OTC derivatives to be excluded from assets for purposes of determining the firm’s regulatory 

capital. Neither of these Commission rules references the alternative capital deductions in 

§240.15c3-1e, which the SEC added through rule amendments that were adopted last year.6 

 Pursuant to Commission Rule 1.10, each FCM must file with the Commission 

monthly financial statements on Form 1-FR-FCM, which includes a computation of the 

FCM’s adjusted net capital as determined in accordance with Rule 1.17(c). Those FCMs that 

are also registered with the SEC as securities brokers or dealers are permitted by Commission 

Rule 1.10(h) to file their Financial and Operational Combined Uniform Single Report 

(“FOCUS Report”) in lieu of the Form 1-FR-FCM, provided that the FOCUS report includes 

all information which is required to be furnished on and submitted with a Form 1–FR-FCM. 

 B. Request for relief 

 

 A broker or dealer receiving approval under §240.15c3-1(a)(7) to compute the 

alternative market risk and derivatives-related credit risk capital deductions must satisfy 

certain conditions specified in the SEC’s regulations, including enhanced reporting, 

notification, and minimum capital requirements. In this regard, §240.15c3-1(a)(7) requires 

the broker or dealer to: (1) maintain tentative net capital of no less than $1 billion;7

 (2) 

provide same day notice to the SEC if its tentative net capital is less than $5 billion; and (3) 

maintain net capital of no less than $500 million. Also, the broker or dealer’s VaR models 

 

4

 The Commission regulations referenced herein may be found at Title 17 C.F.R. Ch. 1 (2005). 

5

 Commission Rule 1.17(c)(5)(v) provides that the haircuts for an FCM’s proprietary securities are “the 

percentages specified in Rule 240.15c3–1(c)(2)(vi) of the Securities and Exchange Commission (17 CFR 

240.15c3–1(c)(2)(vi)) (“securities haircuts”) and 100 percent of the value of “nonmarketable securities” as 

specified in Rule 240.15c3–1(c)(2)(vii) of the Securities and Exchange Commission (17 CFR 240.15c3–

1(c)(2)(vii)).” 

6

 The SEC adopted rule amendments implementing the alternative market risk and credit risk capital deductions 

in June of 2004, with an effective date of August 20, 2004. See 69 FR 34428 (June 21, 2004). 

 

7

 The term tentative net capital is defined at §240.15c3-1(c)(15). 
3

must meet the qualitative and quantitative requirements specified in §240.15c3-1e, and the 

broker or dealer also must maintain an internal risk management control system that satisfies 

the requirements set forth in §240.15c3-4. In addition, the broker-dealer’s ultimate holding 

company must, as a necessary prerequisite for SEC approval of the firm’s alternative capital 

deductions, provide a written undertaking to the SEC to comply with reporting, notice and 

other requirements set forth in SEC rules.8

 The ultimate holding company and its affiliate 

group will therefore be deemed a consolidated supervised entity (“CSE”) under the SEC rules. 

 

 Staff from the Division has discussed with you pertinent portions of the application 

information that the Firm filed with the SEC as required under §240.15c3-1e. “X” has also 

agreed to provide such additional information as Commission staff may determine is 

necessary for review of the Firm’s alternative capital charges. In support of its request for noaction relief, the Firm has represented the following in its letter to the Division: 

1. The Firm will provide immediate written notice, addressed by fax to the Division 

Director, upon the occurrence of any of the following in respect of the Firm: 

(a) the SEC notifies the Firm that the SEC has approved the Firm's request, if any, to 

amend its application to compute capital deductions under §240.15c3-1e; 

 (b) the SEC notifies the Firm that it is revoking, in whole or in part, its approval of the 

Firm's capital deductions under §240.15c3-1e; 

 (c) the Firm notifies the SEC that it intends to cease, after 45 days from such notice, to 

compute deductions for market risk and credit risk under §240.15c3-1e; 

 (d) the Firm is notified by the SEC that it has changed the effective date of the above 

described notice, so that the 45 day period is made either shorter or longer; or 

 (e) the Firm notifies the SEC that its tentative net capital falls below $5 billion. 

 2. At the same time that they are filed with the SEC, the Firm will provide copies to 

the Division Director of its monthly, quarterly, and annual filings with the SEC under 

§240.17a-5(a)(5) and (k). 

 3. At the time the Firm provides to the SEC any formal notification concerning 

planned withdrawals of excess net capital from the Firm, copies of such documents will also 

be provided to the Division. 

 Based upon these representations, the Division has determined that granting the 

requested relief would not be contrary to the public interest. If the Firm files financial reports 

 

8

 SEC regulation §240.15c3-1e incorporates by reference another rule, §240.15c3-1g, that the SEC adopted at the 

same time. The purpose of §240.15c3-1g is to set forth the requirements applicable to the ultimate holding 

company for a broker or dealer that calculates its haircuts in accordance with §240.15c3-1e. 
4

that include computations of adjusted net capital using the market risk and credit risk capital 

deductions approved under the SEC order described above, the Division will not recommend 

that the Commission commence an enforcement action against “X” for failure to comply with 

applicable provisions, as outlined above, of Rules 1.10 and 1.17. 

 The “no-action” position taken herein is based upon the representations that have been 

made to the Division. Any different, changed, or omitted facts or conditions might require the 

Division to reach a different conclusion. You must notify the Division immediately in the 

event that there is any change from the facts as presented to us. 

 The Commission recently published for public comment proposed amendments to 

Rule 1.17 that would authorize certain FCMs to use mathematical models to compute market 

risk and credit risk capital charges in lieu of the standard deductions.9

 If the Commission 

subsequently amends Rule 1.17 to authorize FCMs to use mathematical models to compute 

market risk and credit risk capital charges in lieu of the standard charges set forth in Rules 

1.17(c), this letter will be deemed withdrawn on the effective date of such amendments, and 

Lehman will be required to comply with the provisions of the amended Commission rules. 

This letter represents the position of the Division only and does not necessarily 

represent the views of the Commission or any other division or office of the Commission. If 

you have any questions concerning this correspondence, please contact Thomas Smith, Chief 

Accountant, or Thelma Diaz or Jennifer C.P. Bauer, attorneys on my staff, at (202) 418-5430. 

 Very truly yours, 

 

 Ananda Radhakrishnan 

 Director 

cc: [redacted] 

 

9

 70 FR 58985 (Oct. 11, 2005).