[Federal Register Volume 61, Number 97 (Friday, May 17, 1996)]
[Notices]
[Pages 24993-24995]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-12471]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37202; File No. SR-NSCC-95-17]


Self-Regulatory Organizations; National Securities Clearing 
Corporation; Order Temporarily Approving a Proposed Rule Change to 
Establish Additional Procedures for Placing Settling Members on Class A 
Surveillance and Collecting Clearing Fund and Other Collateral Deposits 
From Settling Members

May 10, 1996.
    On December 20, 1995, the National Securities Clearing Corporation 
(``NSCC'') filed with the Securities and Exchange Commission 
(``Commission'') a proposed rule change (File No. SR-NSCC-95-17) 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') to establish additional procedures for placing settling 
members on Class A Surveillance and collecting clearing fund and other 
collateral deposits from settling members.\1\ Notice of the proposal 
was published in the Federal Register on March 12, 1996.\2\ No comment 
letter were received. For the reasons discussed below, the Commission 
is temporarily approving the proposed rule change through May 31, 1997.
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    \1\ 15 U.S.C. 78s(b)(1) (1988).
    \2\ Securities Exchange Act Release No. 36930 (March 6, 1996), 
61 FR 10051.
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I. Description of the Proposal

    NSCC's Board of Directors has determined that under certain 
circumstances settling members who clear securities transactions for 
over-the-counter (``OTC'') market makers or who themselves engage in 
OTC market making can have their financial viability materially 
impacted by such business.\3\ Furthermore, if these settling members 
dominate one side of the market in their street-side trading positions, 
either directly by participating in OTC market making or indirectly by 
clearing transactions for OTC market makers, NSCC believes that the 
risk of default by the settling member increases.\4\ In turn, this 
could potentially increase NSCC's exposure because NSCC is obligated to 
complete defaulting settling members' unsettled trades once NSCC's 
trade guarantee attaches.
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    \3\ When a market maker, either alone or acting in concert with 
other market makers, takes net street-side trading positions (i.e., 
non-retail trading with other broker-dealers) that constitute a 
disproportionately large percentage of the total net street-side 
buys or net street-side sells in any issue (i.e., the market maker 
dominates one side of the market in the issue), the risk of default 
by that market maker can increase.
    \4\ However, to the extent that market makers' net street-side 
trading positions in dominated issues result from legitimate 
customer orders, the potential adverse impact on the financial 
viability of a settling member and the potential for increased 
exposure to NSCC could be mitigated. So long as the customer orders 
are legitimate, the risks associated with such positions are borne 
among the individual accounts of the market maker's customers and 
not concentrated solely in the proprietary accounts of the market 
maker.
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    The problem is magnified if one or more additional risk factors are 
present. These additional risk factors can include, without limitation:
    (1) Concentrated short selling in dominated issues;
    (2) Undue concentration of securities held in inventory by market 
maker(s) for dominated issues;
    (3) Dominated issues also being IPOs less than six months past 
initial issuance particularly when the current value of the issue is 
significantly different from its initial sales price or there is undue 
concentration of inventory in the managing underwriter(s); and
    (4) Clearing positions of market makers in dominated issues away 
from their primary clearing brokers.
    Rule 15, Section 3 of NSCC's rules currently provides that any 
settling member \5\ shall furnish to NSCC such adequate assurances of 
its financial responsibility and operational capability as NSCC may at 
any time or from time to time deem necessary or advisable in order to 
protect NSCC. Section 4 of Rule 15 states that such adequate assurances 
may include, but are not be limited to, increased clearing fund 
deposits of settling members. Furthermore, Section III.B.1.o. of 
Addendum B to NSCC's rules sets forth the guidelines for determining 
when NSCC may place a broker-dealer settling member on Class A 
surveillance status.\6\ Pursuant to these guidelines, NSCC may place a 
broker-dealer settling member on Class A surveillance if there is any 
condition which could materially impact the operational or financial 
viability of the settling member which increases or potentially may 
increase exposure to NSCC.
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    \5\ NSCC Rule 1 defines a ``settling member'' to include any 
NSCC member, non-clearing member and, except where a contrary intent 
is expressed in NSCC's rules, a special representative.
    \6\ Class A Surveillance permits NSCC, among other things, to 
increase a settling members clearing fund requirement by an amount 
equal to (i) up to 5% of the settling member's CNS long fail 
positions, plus (ii) up to 5% of the settling member's short fail 
positions, plus (iii) 2.5% or at NSCC's discretion up to 5% of the 
settling member's average non-CNS and non-mutual fund services 
debits, plus (iv) 2.5% of the settling member's average non-CNS and 
non-mutual fund services credits. NSCC Rules and Procedures, 
Addendum B, IV(C).
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    In order for NSCC to reduce its potential exposure from the OTC 
market making activity described above, NSCC is adding Addendum O to 
its rules and procedures. Addendum O will permit NSCC to place settling 
members on Class A surveillance if they clear for or are themselves OTC 
market makers and (i) they do not have sufficient capital or access to 
capital to support either potential increases in market making activity 
in dominated OTC issues or (ii) there is the presence of the additional 
risk factors described above. At its discretion, NSCC may elect not to 
place settling members on Class A surveillance if it has obtained 
sufficient assurances that a high degree of mitigating circumstances 
exist.\7\
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    \7\ However, the mere fact that a market maker has a large 
customer base may not necessarily constitute the necessary 
mitigating circumstances especially if the customers are retail and/
or the market maker has a history of customer complaints or other 
adverse regulatory or disciplinary actions. Refer also to note 4.
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    Furthermore, NSCC is adopting an interim collateralization policy 
which will allow NSCC in its discretion to

[[Page 24994]]

require settling members placed on Class A surveillance that clear for 
or are themselves OTC market makers to meet the following special 
collateralization requirements:
    (1) To the extent that the sum of the absolute dollar values of any 
such settling members' net unsettled trading positions in all 
securities dominated \8\ by a market maker exceeds such market maker's 
excess net capital, NSCC can require the settling member to deposit 
with NSCC at such times and in such manner as NSCC may designate, 
including an immediate deposit of same-day funds the amount by which 
the value of the net unsettled trading positions exceed the market 
maker's excess net capital.\9\ In determining the size of net unsettled 
trading positions, NSCC may take into account offsetting pending (i.e., 
non-fail) institutional delivery (``ID'') transactions that have been 
confirmed and when NSCC deems appropriate, affirmed,\10\ through the ID 
system of a clearing agency registered under Section 17A of the Act 
(``registered clearing agency'').\11\ In addition, if a market maker's 
net unsettled trading positions in dominated issues are cleared by one 
or more other settling members, including any settling member on Class 
A surveillance, NSCC will have the discretion for purposes of 
calculating the special collateral deposit of treating those positions 
as if they were all cleared by a settling member on Class A 
surveillance.
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    \8\ Domination will be determined according to criteria 
specified by NSCC from time to time.
    \9\ The term ``same-day funds'' refers to payment in funds that 
are immediately available and generally are transferred by 
electronic means.
    \10\ In determining net unsettled trading positions, NSCC in its 
discretion under certain circumstances may elect to take into 
account offsetting pending confirmed ID transactions only if such 
transactions also have been affirmed. Moreover, NSCC may decline to 
consider any ID transaction if it has reason to believe that the 
institutional counterparty may not or cannot settle such 
transaction.
    \11\ 15 U.S.C. 78q-1 (1988).
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    (2) To the extent that the unsettled positions referred to in 
paragraph (1) above are short (i.e., net sells), NSCC in its discretion 
may collect more than 100 percent of the amount by which the sum of the 
absolute dollar values of the net unsettled trading positions of any 
such settling member in all the securities dominated by a market maker 
exceeds the market maker's excess net capital.\12\ In lieu of cash 
collateral, NSCC may require or accept a book-entry delivery of 
securities to NSCC sufficient to cover such short position.
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    \12\ For example, if a clearing member's excess net capital is 
$100,000 and the value of its OTC market making activities is 
$125,000, the rule change permits NSCC to require the clearing 
member to deposit an additional $25,000. However, if the clearing 
member's OTC market making activity includes short positions, the 
rule change will permit NSCC to collect more than $25,000.
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    (3) NSCC will reserve the right at all times to accept alternative 
arrangements for its protection in any of the above situations. NSCC 
may require special collateral deposits with respect to trading 
positions in issues dominated by a market maker even when the value of 
those positions do not exceed the market maker's excess net capital. 
NSCC also may choose to forego collecting such special collateral even 
when the value of those positions exceed the market maker's excess net 
capital but do not exceed some higher threshold.\13\ NSCC will make 
these determinations based on the specific situation and depending 
upon, among other things, the presence or absence of additional risk 
factors or mitigating circumstances.
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    \13\ From time to time, NSCC will determine in its discretion 
what such higher threshold shall be.
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    The special collateralization requirements described above are 
interim measures for settling members on Class A surveillance which 
will be in effect until NSCC has gained enough experience in 
surveillance of OTC market maker trading activities to impose permanent 
special collateralization requirements. Additionally, if there is 
concentrated short selling in dominated issues, NSCC will maintain its 
right to collect special collateral deposits from the settling members 
clearing the short sales without regard to their surveillance status. 
Special collateral collected from any settling member pursuant to the 
above procedures will be in addition to the settling member's clearing 
fund deposit computed in accordance with the formulae set forth in NSCC 
Procedure XV or in accordance with the alternative method set forth 
below.
    Because NSCC believes that its settling members on Class A 
surveillance present a higher than normal risk of default and 
insolvency, NSCC is proposing that such settling members' clearing fund 
deposits be based on the close-out risk presented by their unsettled 
positions in NSCC's systems. Therefore, pursuant to Rule 15 as 
expressed under Addendum O, NSCC will have the discretion to compute 
the continuous net settlement (``CNS'') component of the clearing fund 
requirement for any settling member on Class A surveillance in 
accordance with the following alternative method rather than the 
formulae to calculate clearing fund set forth in NSCC Procedure XV.\14\
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    \14\ NSCC Procedure XV contains the formulae usually employed to 
calculated clearing members' clearing fund requirements.
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    (1) NSCC may calculate on a daily or periodic basis the volatility 
of any such settling member's net unsettled trading positions in CNS 
eligible issues (``net CNS trading positions''). Such positions shall 
be determined after taking into account offsetting pending (i.e., non-
fail) ID transactions that have been confirmed and, when NSCC deems 
appropriate, affirmed \15\ through the ID system of a registered 
clearing agency. Such calculation will be made in accordance with the 
Capital Asset Pricing Model or any other generally accepted portfolio 
volatility model, including without limitation, any margining formula 
employed by any other registered clearing agency provided, however, 
that not less than two standard deviations' volatility shall be 
calculated under any model chosen. Such calculation will be made 
utilizing such assumptions and based on such historical data as NSCC 
deems reasonable and shall cover such range of historical volatility as 
NSCC from time to time deems appropriate. If such volatility is 
calculated on a periodic basis, it may be expressed as a percentage of 
the sum of the absolute values of the firm's net CNS trading positions. 
Any such calculations, whether expressed as a dollar value or 
percentage, may be rounded as NSCC deems appropriate.
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    \15\ Supra note 10.
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    (2) NSCC shall have the discretion to exclude from the above 
calculations net CNS trading positions in classes of securities whose 
volatility is (i) less amenable to statistical analysis such as OTC 
bulletin board or pink sheet issues or issues trading below a 
designated dollar threshold (e.g., five dollars) or (ii) amenable to 
generally accepted statistical analysis only in a complex manner (e.g., 
municipal or corporate bonds). The amount of clearing fund required 
with respect to net CNS trading positions in such issues shall be 
determined by multiplying the absolute value of such positions by a 
percentage designated by NSCC, which percentage may vary depending on 
such factors as NSCC deems relevant.
    (3) The amounts calculated in accordance with the immediately 
preceding two numbered paragraphs will be substituted for the amount 
calculated in accordance with paragraph (1)(c) of Sections A.I.(a), 
A.II.(a) and A.II.(b) of NSCC's Procedure XV.\16\ In addition, NSCC may 
in its discretion reduce or eliminate the amount calculated in 
accordance with paragraph (1)(a) of Procedure XV.
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    \16\ Supra note 14.

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[[Page 24995]]

    (4) NSCC in its discretion also may calculate the total clearing 
fund requirement of any settling member on a daily basis instead of a 
twenty-day rolling average basis and may collect deficiencies at such 
times and in such manner as specified by NSCC from time to time, 
including immediate collection of same-day funds.
    Nothing in the foregoing rule change will limit NSCC's discretion 
with respect to placing settling members on Class A surveillance or 
requiring settling members to furnish adequate assurance of financial 
responsibility or operational capability as set forth in NSCC's rules 
and procedures.

II. Discussion

    Section 17A(b)(3)(F) of the Act \17\ requires that the rules of a 
clearing agency be designed to assure the safeguarding of securities 
and funds which are in the custody or control of the clearing agency 
and generally to protect investors and the public interest. The 
Commission believes the proposed rule change is consistent with NSCC's 
obligations under the Act because it will allow NSCC to take particular 
action to protect itself, its members, and investors in situations 
where settling members pose an increased risk because of their 
involvement in OTC market making.
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    \17\ 15 U.S.C. Sec. 78q-1(b)(3)(F) (1988).
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    Under the proposal, NSCC will have the authority with respect to 
settling members who participate in OTC market making activities or 
clear for correspondents that engage in such activity (1) to place such 
members on Class A surveillance, (2) to require such members to post 
additional collateral with NSCC, and (3) to calculate an alternative 
clearing fund requirement for such members when additional risk factors 
are present. Collectively, the higher level of surveillance, the 
additional level of collateralization, and the alternative clearing 
fund requirements should help to ameliorate NSCC's exposure which in 
turn should assist NSCC in fulfilling its obligations under the Act to 
safeguard securities and funds for which it has control of, is 
responsible for and, generally, to protect investors and the public 
interest.
    The Commission is temporarily approving the proposed rule change 
through May 31, 1997, so that NSCC can gain additional experience in 
the surveillance of OTC market makers and the risks posed by clearing 
such activity. NSCC also will be able to gain experience with the 
additional collateralization requirements and alternative clearing 
formula requirements for settling members subject to Class A 
surveillance prior to permanent imposition of these requirements. 
Temporary approval also will afford both the Commission and NSCC an 
opportunity to observe whether the additional collateralization and 
alternative clearing fund requirements adequately protect NSCC, its 
members, and investors from the expected risks of participating in and 
clearing OTC market maker activity and whether adjustments to the 
procedures are necessary. Prior to filing a proposed rule change 
seeking permanent approval of the procedures set forth in this 
temporary approval order, NSCC shall present to the Commission a more 
detailed report of its findings regarding the adequacy of the controls 
and discussing any changes to be made to the procedures. During the 
temporary approval period, NSCC will from time to time apprise the 
Commission on the operation of the additional collateralization 
requirements to enable the Commission to monitor the implementation of 
such requirements.

III. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposal is consistent with the requirements of the Act and in 
particular with the requirements of Section 17A of the Act and the 
rules and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-NSCC-95-17) be, and hereby 
is, approved on a temporary basis through May 31, 1997.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\18\
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    \18\ 17 CFR 200.30-3(a)(12) (1995).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-12471 Filed 5-16-96; 8:45 am]
BILLING CODE 8010-01-M