[Federal Register Volume 61, Number 129 (Wednesday, July 3, 1996)]
[Notices]
[Pages 34912-34915]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-16922]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37368; File No. SR-GSCC-96-01]


Self-Regulatory Organizations; Government Securities Clearing 
Corporation; Order Approving a Proposed Rule Change Relating to the 
Enhancement of Risk Management Processes

June 25, 1996.
    On January 5, 1996, the Government Securities Clearing Corporation 
(``GSCC'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change (File No. SR-GSCC-96-01) 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'').\1\ Notice of the proposal was published in the Federal 
Register on March 13, 1995.\2\ No comment letters were received. For 
the reasons discussed below, the Commission is granting approval of the 
proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1) (1988).
    \2\ Securities Exchange Act Release No. 36933 (March 6, 1996), 
61 FR 10045.
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I. Description

    As part of GSCC's continuous process of reviewing its risk 
management mechanism, GSCC has made various enhancements and revisions 
to that mechanism. The design of the risk management process for GSCC's 
newly implemented netting service for repurchase agreements (``repos'') 
and recommendations made by Commission staff during their inspection of 
GSCC last year provided the impetus for certain of the enhancements and 
revisions. Each of the changes to GSCC's risk management process is 
described in detail below.

A. Change in the Clearing Fund Formula

1. Funds Adjustment Component
    There are three components to a netting member's clearing fund 
deposit requirement: (1) the funds adjustment component, (2) the 
receive/deliver settlement component, and (3) the repo volatility 
component. The sum of the three components is a member's total clearing 
fund deposit requirement. The first component of the clearing fund, the 
funds adjustment component, addresses the potential risk that a member 
might not pay a funds-only settlement amount due to GSCC.\3\
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    \3\ Historically, this component has represented about ten 
percent of the total clearing fund requirement.
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    Prior to this amendment, the funds adjustment component was 125% of 
the average of a member's ten largest funds-only settlement amounts 
measured on an absolute basis during the most recent seventy-five 
business days.\4\ Under the proposed rule change, the funds adjustment 
component is now 100% of the average of the member's twenty largest 
funds-only settlement amounts during the most recent seventy-five 
business days.\5\ However, GSCC retains the right to reinstitute at its 
discretion

[[Page 34913]]

all or a part of the twenty-five percent cushion for a temporary 
period. For example, GSCC might reinstitute this cushion during 
volatile market conditions.
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    \4\ Prior to the implementation of GSCC's netting service for 
repos, GSCC's rules required computation of the average of a 
member's absolute funds amounts over the prior twenty business days. 
Securities Exchange Act Release No. 36491 (November 17, 1995), 60 FR 
61577 (order approving proposed rule change).
    \5\ This change has been made to both paragraphs (b) and (d) of 
Rule 4, Section 2 of GSCC's rules. Paragraph (b) applies to bank 
netting members, Category 1 dealer netting members, Category 1 
futures commission merchant netting members, Category 2 inter-dealer 
broker netting members, government securities issuer netting 
members, insurance company netting members, and registered 
investment company netting members. Paragraph (d) applies to 
Category 2 dealer netting members and Category 2 futures commission 
merchant netting members.
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2. Receive/Deliver Settlement Component
    The second component of the clearing fund requirement is the 
receive/deliver settlement component, which is based on the size and 
nature of a member's net settlement positions. The receive/deliver 
component for GSCC netting members other than Category 2 dealer or 
Category 2 future commission merchant members \6\ is the largest of the 
following four calculations based on a member's gross margin:\7\
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    \6\ GSCC's method of calculating the receive/deliver/settlement 
component for Category 2 dealer and Category 2 futures commission 
merchant members is set forth below.
    \7\ Gross margin is the product of GSCC's margin factors 
multiplied by the dollar value of a member's current outstanding net 
settlement position. GSCC's margin factors are designed to estimate 
daily security price movements, are expressed as percentages, and 
are determined by historical daily price volatility. See Section 4 
below for a discussion of GSCC's margin factors.
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    (1) Post-Offset Margin Amount (``POMA''): The POMA essentially is a 
member's total gross margin taking into account allowable offset 
percentages.\8\
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    \8\ Margin amounts on receive (long) and deliver (short) 
positions are allowed to offset each other. The extent to which an 
offset is allowed is determined by product and the degree of 
similarity in time remaining to maturity.
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    (2) Average POMA: Prior to this amendment, the average POMA 
typically was based on a member's ten highest POMA amounts occurring in 
the most recent seventy-five business days, including the current day's 
POMA amount. Under the proposed rule change, GSCC will now use an 
average of the twenty largest POMA amounts during the most recent 
seventy-five business days.
    (3) Adjusted POMA: The adjusted POMA is calculated the same way as 
the POMA with the exception of excluding all trades that are scheduled 
to settle on the current day.\9\
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    \9\ This is done based on the assumption that those trades will 
settle on the current day; thus, calculating POMA in this manner 
will more accurately reflect GSCC's settlement exposure during the 
current day.
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    (4) Liquidation Amount: This is a floor amount which previously 
equalled fifty percent of the total gross margin on all long and short 
positions without offsets. The proposed rule change lowers this amount 
to twenty-five percent.
    The proposed rule change also deletes sections (2)(g)(i) and 
(2)(g)(ii) of Rule 4 regarding alternative formulas for the receive/
deliver settlement component of the required clearing fund deposit. 
GSCC rarely used the alternative calculation under subsection (g)(i), 
which disregards when-issued trades that have been issued. Subsection 
(g)(ii) has been made obsolete by the changes approved in GSCC's filing 
pertaining to its repo netting service.\10\
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    \10\ Supra note 4.
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    With respect to Category 2 dealer or Category 2 futures commission 
merchant members, the receive/deliver settlement component was the 
largest of (1) the member's total gross margin without offsets, (2) the 
member's total gross margin without offsets and excluding positions due 
to settle that day, or (3) the average of the member's largest ten 
gross margin amounts over the most recent seventy-five business days. 
GSCC has revised the third calculation to use the average of the 
largest twenty gross margin amounts over the most recent seventy-five 
business days.
3. Repo Volatility Component
    The third component of the clearing fund requirement is the repo 
volatility component. This component was recently added to GSCC's 
clearing fund formula to cover securities' settlement exposure posed by 
repo activity. The repo volatility component was the greater of (1) the 
product of the repo volatility factor and the market value of the 
member's repo transactions taking into account allowable offset 
percentages (``repo offset amount'') or (2) the average of a member's 
ten highest repo offset amounts over the most recent seventy-five 
business days. GSCC has revised the second element of this calculation 
to take the average of a member's twenty highest repo offset amounts 
over the most recent seventy-five business days.

B. Providing GSCC With Discretion, Within Parameters, To Lower Margin 
Factors

    GSCC's Membership and Standards Committee (``Committee'') reviews 
on an ongoing basis the appropriateness of its margin factors \11\ by 
examining third-party price volatility data and GSCC's own short-term 
and long-term data covering ninety-five and ninety-nine percent of all 
price movements. However, prior to this amendment, GSCC was not allowed 
to lower any of its margin factors without first obtaining Commission 
approval through a formal rule filing process.
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    \11\ As defined in GSCC's rules, margin factors and Category 2 
margin factors are percentage, which GSCC publishes from time to 
time, representing variations weighted by maturity and product type. 
These margin factors are used in GSCC Rule 4, Section 2 to calculate 
the receive/deliver settlement component of the required fund 
deposit for GSCC's members described above in Section 2.
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    GSCC has revised its rules to permit the Committee to lower a 
margin factor subject to a predefined limitation if the Committee 
determines it appropriate based on its review of historical price 
volatility data and if the GSCC Board of Directors approves such a 
lower margin factor. With respect to GSCC netting members other than 
Category 2 dealer members and futures commission merchant members, the 
predefined limitation permits GSCC to reduce a margin factor to a level 
that is no lower than the higher of (1) the price volatility for that 
remaining maturity category taking into account ninety-five percent of 
all movements during the last calendar quarter or (2) the price 
volatility for that remaining maturity category taking into account 
ninety-five percent of all movements during the last calendar year. 
With respect to the margin factors for Category 2 dealer members and 
futures commission merchant members, the limitation provides that GSCC 
can reduce a margin factor to a level that is no lower than the higher 
of (1) the price volatility for that remaining maturity category taking 
into account ninety-nine percent of all movements during the last 
calendar quarter or (2) the price volatility for that remaining 
maturity category taking into account ninety-nine percent of all 
movements during the last calendar year.

C. Revision of Certain Margin Factors for Zero-Coupon Government 
Securities Other Than Treasury Bills (``Zeros'')

    As noted above, GSCC's margin factors are based on an assessment of 
historical daily price volatility data. Zeros require different margin 
factors than other Treasury securities because zeros generally are 
subject to greater price volatility than are other Treasury securities 
with the same maturity.\12\ The applicable margin percentages for zeros 
range from percentages that are the same as those for other Treasury 
securities with respect to shorter-term maturities to percentages that 
are two-and-a-half times the percentages applicable to other Treasury 
securities with respect to long-term maturities.\13\
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    \12\ GSCC's margin factor schedule for zeros is contained in 
GSCC's filing. A copy of the filing is available for copying and 
inspection in the Commission's Public Reference Room.
    \13\ These differences initially were based on the differences 
in the amount of haircut factors between zeros and other Treasury 
securities found in the United States Treasury Department's liquid 
capital requirements for government securities brokers and dealers.

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[[Page 34914]]

    Prior to this filing, the margin factors for zeros in several 
categories were well above the price volatility that GSCC's internal 
data show for such categories under any measure. GSCC has lowered the 
applicable margin factor for zeros in the seven to ten years remaining 
maturity category from 1.870 percent to 1.50 percent. GSCC has lowered 
the applicable margin factor for the ten to fifteen years remaining 
maturity category from 2.813 percent to 1.813 percent. GSCC has lowered 
the applicable margin factor for the fifteen years and higher remaining 
maturity category from 3.625 percent to 2.625 percent.

D. Introduction of a Tiered Surveillance Status Mechanism

    GSCC is placing members that pose a heightened level of potential 
risk to GSCC in various classes of surveillance status instead of in 
one surveillance status.\14\ GSCC's rules required that a member be 
placed on surveillance status if one or more of a number of 
circumstances is present. These circumstances include, but are not 
limited to, a significant reorganization or change in control or 
management of the member. In addition, GSCC could place a member on 
surveillance status if one or more of a number of factors, such as a 
member experiencing a condition that could materially affect its 
financial or operational capability so as to potentially increase 
GSCC's exposure to loss or liability, was present.
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    \14\ At the conclusion of their recent inspection of GSCC, 
Commission staff suggested that, in line with what many other 
clearing agencies have in place, GSCC should establish different 
classes of surveillance for its members.
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    The proposed rule change establishes three surveillance categories. 
A member will be placed on Class 1 surveillance status if one or more 
of a number of factors pertaining to its financial condition is 
present,\15\ if it has been placed on surveillance status by another 
self-regulatory organization, or if it has been upgraded from Class 2 
surveillance status within the past three calendar months. Class 1 
surveillance status will result in GSCC more thoroughly monitoring a 
member's financial condition and activities and will provide GSCC with 
discretion to require a member to make more frequent financial 
disclosures, including interim and/or pro forma reports.
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    \15\ The financial condition factors that will result in Class 1 
surveillance status include but are not limited to (1) a member 
incurring recent significant net losses, (2) a member's required 
fund deposit obligation representing a significant portion of its 
net worth or net capital, and (3) a member experiencing any 
condition that could materially affect its financial or operational 
capacity.
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    GSCC will place a netting member on Class 2 surveillance status if 
one or more of a number of factors is present. These factors include 
but are not limited to (1) any element of a member's capital position 
falls below the minimum requirements, (2) a member has been upgraded 
from Class 3 surveillance status within the last three calendar months, 
(3) a member temporarily experiences an inability to meet its 
securities settlement obligations to GSCC in a timely fashion, and (4) 
a member's designated examining authority or appropriate regulatory 
agency has a pending action against or investigation of the member that 
could call into question the member's ability to meet its obligations 
to GSCC. In addition to the consequences resulting from placement on 
Class 1 surveillance status, a member placed on Class 2 surveillance 
status will be required to maintain a required fund deposit in excess 
of the amount ordinarily required, as permitted under GSCC's rules.
    A GSCC netting member will be placed on Class 3 surveillance status 
if GSCC is considering taking action under GSCC Rule 18 (Ceasing to Act 
for a Member) or GSCC Rule 20 (Insolvency of a Member).\16\ A GSCC 
netting member on Class 3 surveillance status will be placed on a final 
notification list. A netting member will remain on such final 
notification list until the condition(s) that resulted in its 
assignment to Class 3 surveillance status have improved to an extent 
that GSCC deems appropriate to support reassignment of the member to 
Class 2 surveillance status.
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    \16\ Under Rule 18 (Ceasing to Act for a Member), GSCC may cease 
to act for a member upon notice to such member for such reasons as: 
(1) the member has failed to perform its obligations to GSCC or 
materially violated any GSCC rule, procedure, or agreement, (2) the 
member has failed to pay GSCC any payment required, (3) the member 
no longer meets its admissions or continuance standards, or (4) the 
member has been responsible for fraudulent or dishonest conduct. 
Under Rule 20 (Insolvency of a Member), GSCC will cease to act for a 
member if such member meets one of several tests of insolvency 
(e.g., such member files a petition seeking relief under the 
Bankruptcy Code).
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E. Simplification of the Clearing Fund Deficiency Call Mechanism

    GSCC's rules permit GSCC to make clearing fund deficiency calls on 
a same day basis under the following four circumstances: (1) a member's 
current day's required clearing fund deposit exceeds by twenty-five 
percent the value of its clearing fund collateral, (2) a member's 
current day's required clearing fund deposit level exceeds by more than 
$250,000 the value of its clearing fund collateral, (3) a member is on 
surveillance status and its required clearing fund deposit as of the 
current day exceeds the value of its clearing fund collateral, or (4) a 
member's ``clearing fund funds-only settlement amount,'' which excludes 
clearance difference, invoice amount, and other miscellaneous amounts, 
for the current day exceeds by more than twenty-five percent its 
average daily clearing fund funds-only settlement amount over the most 
recent twenty business days.\17\
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    \17\ The clearance difference is the dollar difference between 
GSCC's system price for a settlement obligation and the actual value 
at which the settlement obligation was settled. The invoice amount 
means all fees that a member owes GSCC.
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    The fourth circumstance, a twenty-five percent jump in the member's 
clearing fund funds-only settlement amount, has rarely been used and is 
now eliminated.\18\ A clearing fund deficiency call that is based on a 
member being on surveillance status can now be invoked only if a member 
is on Class 2 or Class 3 surveillance status. Finally, because GSCC has 
the authority to make clearing fund deficiency calls on a same day 
basis, GSCC's rule permitting GSCC automatically to make a clearing 
fund deficiency call at the beginning of each month has been deleted.
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    \18\ At the conclusion of their recent inspection of GSCC, 
Commission staff suggested that GSCC should either monitor the 
funds-only deficiency call requirements or file with the Commission 
a proposed rule change eliminating it.
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F. Elimination of the Noon Deadline for Satisfaction of Clearing Fund 
Deficiency Calls

    By 9:00 a.m., GSCC issues by telephone calls followed by telefax 
notices calls for additional clearing fund deposits by 9:00 a.m. The 
exact time that each telephone call is made is recorded. Prior to this 
filing, a member had until the later of two hours after the receipt of 
a clearing fund deficiency call or noon to satisfy the call.
    GSCC's long term goal is to develop an automated mechanism pursuant 
to which it will be in receipt of clearing fund collateral by the time 
that the securities Fedwire opens in the morning, which is currently at 
8:30 a.m. As an interim step toward achieving this goal, GSCC is 
eliminating the noon alternative deadline for satisfaction of clearing 
fund deficiency call and is requiring a member to satisfy a deficiency 
call within two hours after it is received. The practical effect of 
this change is that, in the ordinary course, a member will have to 
satisfy a deficiency call by approximately 11:00 a.m.

[[Page 34915]]

However, a clearing fund deficiency call does not need to be satisfied 
before 10:00 a.m. regardless of when the call actually is made.

II. Discussion

    Section 17A(b)(3)(F) \19\ of the Act 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 or 
for which it is responsible. The Commission believes GSCC's proposed 
rule change is consistent with the requirements of Section 17A(b)(3)(F) 
because the proposal, by enhancing and revising GSCC's risk management 
mechanism, should help ensure that the mechanism accurately reflects 
GSCC's risk and provides CSCC appropriate risk protection while 
increasing members' liquidity and minimizing the operational burdens on 
GSCC netting members.
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    \19\ 15 U.S.C. Sec. 78q-1(b)(3)(F) (1988).
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    Specifically, based upon its assessment of historical data, GSCC 
has found that certain components of its clearing fund formula are 
overly conservative. Therefore, GSCC is revising the Average POMA 
calculation of the receive/deliver component, the funds adjustment 
component, and the repo volatility component of its clearing fund 
formula to utilize the twenty largest, rather than the ten largest, 
POMA amounts, funds-only settlement amounts, and repo offset amounts 
during the most recent seventy-five business days. GSCC also is 
modifying the funds adjustment component of its clearing fund formula 
to eliminate the twenty-five percent cushion in the component's 
calculation. Because GSCC will retain the right to reinstitute at its 
discretion all or part of the twenty-five percent cushion for a 
temporary period, GSCC will be able to react quickly to changing market 
conditions. GSCC also is lowering the liquidation amount of the 
receive/deliver component of its clearing fund requirement from fifty 
percent to twenty-five percent of the total gross margin on all long 
and short positions without offsets. GSCC believes that, based on 
historical performance, the twenty-five percent floor should provide 
sufficient protection to GSCC from the risk that its margin offsets 
will not reflect actual market conditions during a liquidation period 
while enabling members that engage in activity on a fully hedged basis 
to receive the benefits afforded by being fully hedged. Because these 
modifications are based upon GSCC's assessment of historical data, the 
changes should ensure appropriate risk protection for GSCC, while 
providing members with increased liquidity.
    GSCC also is revising its rules to permit its Membership and 
Standards Committee to lower a margin factor subject to a predefined 
limitation if the Committee determines it appropriate based on its 
review of historical price volatility and if GSCC's Board of Directors 
approves such a lower margin factor. The Committee reviews the 
appropriateness of its margin factors on an ongoing basis. Thus, the 
proposed rule change should provide GSCC with the flexibility to lower 
margin factors more readily for the benefit of its members without 
compromising GSCC's risk protection. The limitation on the Committee's 
ability to lower margins (95% of all movements during the last quarter 
or year) should ensure that GSCC will always have a sufficient level of 
protection. GSCC also is lowering certain margin factors for zeros to 
reflect more accurately GSCC's needs based upon GSCC's data at the 
ninety-nine percent level over the past two years. Accordingly, members 
will not be subject to margin requirements that exceed GSCC's current 
needs.
    In addition, GSCC is introducing a tiered surveillance status 
mechanism. The new surveillance mechanism should enable GSCC to monitor 
more effectively the potential risk posed by its members and to react 
more swiftly to changes in a member's condition. Finally, as a step 
toward GSCC's goal to develop an automated mechanism by which GSCC will 
receive clearing fund collateral by the time that the securities 
Fedwire opens, GSCC is eliminating the noon alternative deadline for 
satisfaction of a clearing fund deficiency call and to require a member 
to satisfy a deficiency call within two hours after it is received. By 
increasing the efficiency of GSCC risk management processes, the tiered 
surveillance mechanism and the modifications to GSCC's clearing fund 
deficiency call rules should help GSCC fulfill its obligation to 
safeguard securities and funds which are in its custody or control or 
for which it is responsible.

III. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
in particular 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-GSCC-96-01) be and hereby is 
approved.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12)(1995).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-16922 Filed 7-2-96; 8:45 am]
BILLING CODE 8010-01-M