Document ID: SEC-2006-0970-0001
Agency: sec
Document Type: Notice
Title: Self-regulatory organizations; proposed rule changes: New York Stock Exchange LLC
Posted Date: 2006-07-31T04:00Z

[Federal Register: July 31, 2006 (Volume 71, Number 146)]
[Notices]               
[Page 43260-43263]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr31jy06-126]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54205; File No. SR-NYSE-2005-38]

 
Self-Regulatory Organizations; New York Stock Exchange, Inc. (n/
k/a New York Stock Exchange LLC); Order Approving Proposed Rule Change 
and Amendment No. 1 Thereto to Rules 104 (``Dealings by Specialists'') 
and 123E (``Specialist Combination Review Policy'') To Change the 
Exchange's Capital Requirements for Specialist Organizations

July 25, 2006.

I. Introduction

    On May 26, 2005, the New York Stock Exchange, Inc. (n/k/a New York 
Stock Exchange LLC) (the ``Exchange'' or ``NYSE'') filed with the 
Securities and Exchange Commission (``SEC'' or the ``Commission'') a 
proposed rule change to amend Rules 104 (``Dealings by Specialists'') 
and 123E (``Specialist Combination Review Policy'') in order to change 
the Exchange's capital requirements for specialist organizations 
pursuant to Section 19(b)(1) \1\ of the Securities Exchange Act of 1934 
(the

[[Page 43261]]

``Exchange Act'') \2\ and Rule 19b-4 thereunder.\3\ On November 22, 
2005, the NYSE amended the proposed rule change, replacing it in its 
entirety (``Amendment No. 1''). The proposed rule change, as amended, 
was issued by the Commission on December 16, 2005 and published for 
comment in the Federal Register on December 23, 2005 (the ``Proposing 
Release'').\4\ In the Proposing Release, the Commission requested 
public comment on the proposed rule change (the comment period ended 
January 13, 2006). The Commission received comments from two commenters 
regarding the proposed rule change.\5\ The NYSE responded directly to 
the comments made by the first commenter.\6\ The second commenter 
raised no new issues and the NYSE's responses to the first commenter 
addressed the comments made by the second commenter. This order 
approves the proposed rule change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 15 U.S.C. 78a et seq.
    \3\ 17 CFR 240.19b-4.
    \4\ See Securities Exchange Act Release No. 52969 (Dec. 16, 
2005), 70 FR 76337 (Dec. 23, 2005).
    \5\ Mr. George Rutherfurd (``Rutherfurd''), sent three separate 
letters, dated January 13, 2006, March 7, 2006 and April 12, 2006. 
Rutherfurd's subsequent letters re-iterated the arguments made in 
his first letter and did not raise any additional issues. Mr. Junius 
Peake (``Peake''), sent one letter dated April 18, 2006.
    \6\ The NYSE responded to comments by letters dated February 28, 
2006 and March 31, 2006.
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II. Description of Proposed Rule Change

    Exchange Rule 104.20 (``Regular Specialists'') presently requires a 
specialist organization to maintain sufficient financial resources to 
assume certain specified positions in each stock that it is allocated. 
Further, the rule requires specialist organizations that engage in 
certain types of business to maintain specified levels of net liquid 
assets. The rule also sets a minimum capital requirement for specialist 
organizations.
    Exchange Rule 104.21 presently requires that specialist 
organizations maintain additional amounts of net liquid assets to the 
extent the specialist organization's market share exceeds 5% of certain 
``concentration measures'' specified in the rule.
    Exchange Rule 104.22 presently requires that, when two or more 
specialist organizations combine as the result of a merger, 
consolidation, acquisition or other combination of assets, the combined 
specialist entity must maintain the aggregate net liquid assets of the 
respective specialist entities prior to their combination. The Exchange 
has indicated that this is commonly referred to as the ``marriage 
penalty.'' Similarly, Exchange Rule 123E(f)(i) requires that 
combinations of specialist organizations maintain the higher capital 
requirement of the combined unit, rather than allowing a possible 
reduction of capital.
    The Exchange has proposed to amend Rules 104 and 123E to change the 
capital requirement of specialist organizations. The Exchange stated in 
the proposal that the amendments to Rule 104 are designed to more 
accurately address market risks and volatility. The Exchange also 
indicated in the proposal that the amendments to Rules 104.22 and 
123E(f)(i) are intended to eliminate the ``marriage penalty'' capital 
requirement for specialist organization combinations.
    The Exchange proposed that NYSE Rule 104.20 (to be re-titled 
``Specialist Organizations--Minimum Capital Requirements'') be amended 
to require a specialist organization to maintain the greater of 
$1,000,000 or an amount calculated under the proposed amendment to Rule 
104.21 described below. For ETFs, the Exchange proposed amending Rule 
104.20 to clarify that a specialist organization registered solely in 
ETFs maintain the greater of $500,000 for each ETF or $1,000,000. These 
new requirements would replace the current financial requirements, 
which are based on the number of securities allocated to the specialist 
organization.
    The Exchange proposed that NYSE Rule 104.21 (to be re-titled 
``Specialist Organizations--Additional Capital Requirements'') be 
amended to require a specialist organization to meet, with its own net 
liquid assets, a minimum capital requirement determined by adding two 
separately calculated amounts. The first amount is equal to $1,000,000 
for each one tenth of one percent (.1%) of Exchange transaction dollar 
volume in the specialist organization's allocated securities, plus 
$500,000 for each Exchange Traded Fund. The second amount--an add-on to 
the first amount--is calculated either by multiplying by three the 
average haircuts on the specialist organization's proprietary positions 
over the most recent twenty days, or through the use of an Exchange-
approved value-at-risk (VaR) model, which would include a multiplier of 
between 3.0 and 4.0 depending on the accuracy of the model (i.e., the 
number of exceptions to its calculated VaR amount).
    The Exchange also proposed amending 104.21 to require that a 
specialist organization's net liquid assets used to meet the proposed 
requirements in Rules 104.20 and .21 must be dedicated exclusively to 
specialist dealer activities, and must not be used for any other 
purpose without the express written consent of the Exchange.
    The Exchange proposed that Rule 104.22 (to be re-titled 
``Definitions and Model Approval Process'') be amended to specify 
certain qualitative requirements with respect to a VaR model a 
specialist organization uses to meet the add-on requirement in the 
proposed amendment to Rule 104.21. Under the proposed amendment, the 
VaR model would need, among other things, to: (1) Be integrated into 
the specialist organization's internal risk management system; (2) be 
reviewed both periodically and annually; and (3) adequately capture 
specific risk. The proposed amendment also would require a specialist 
organization that has been granted approval by the Exchange to use a 
VaR model to continue to compute its net liquid asset requirement using 
the model, unless a change is approved upon application to the 
Exchange.
    The Exchange proposed amending Rules 104.22 and 123E(f)(i) to 
eliminate certain of the requirements that arise when specialist 
organizations combine. The Exchange stated the increased requirements 
that apply after a combination would not be appropriate or necessary 
given the proposed amendments to Rules 104.20 and .21. However, the 
proposed amendments to Rule 123E(f)(i) would provide the Exchange with 
discretion to temporarily revise the requirements after a specialist 
organization combination.
    The Exchange also proposed to eliminate Rules 104.30 (``Financing 
of Specialists''), 104.40 (``Reports on Form SPC'') and 104.50 
(``Income Records''), which relate to the specialist organization 
financing transactions. The proposed elimination of Rule 104.30 would 
recognize that net liquid asset requirements must be met by assets the 
specialist organization holds free and clear of any liens. The 
elimination of Rule 104.30 would obviate the need for Rule 104.40. 
Finally, the recordkeeping requirements of Rule 104.50 also are no 
longer necessary in light of Exchange Rule 440 (``Books and Records''), 
which incorporates, by reference, Securities and Exchange Act Rules 
17a-3 and 17a-4.
    The Exchange also proposed several minor technical amendments to 
the rules for purposes of clarity and consistency.

III. Summary of Comments and NYSE's Responses

    The Commission received comments from two commenters regarding the

[[Page 43262]]

proposed rule change.\7\ The Exchange responded directly to the 
comments made by Rutherfurd,\8\ who raised six distinct issues. Peake 
only commented on one issue, which was substantially the same as one of 
the issues raised by Rutherfurd. Consequently, the Exchange's response 
to Rutherfurd regarding that issue served to also address Peake's 
comments.
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    \7\ See supra, note 5.
    \8\ See supra, note 6.
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    As noted previously, Rutherfurd raised six issues: 1) The Exchange 
should disclose in dollar amounts the anticipated impact the proposed 
rule amendments would have on the aggregate capitalization of 
specialist organizations; 2) the specialist organizations are 
inadequately capitalized at present; 3) the Exchange's analysis, set 
forth in the Proposing Release, fails to address a severely stressed 
market, 4) the existing specialist organization combination 
requirements are appropriate; 5) the proposed amendments are premature 
in light of the expansion of specialist organization dealer activity as 
a consequence of the Exchange's new ``hybrid market'' rules; and 6) the 
proposed reduced requirements would make it easier for a specialist 
organizations to leave the specialist business. The issue raised by 
Peake was substantially the same as the issue raised by Rutherfurd 
regarding the Exchange's new ``hybrid market'' rules.

A. Material Information

    Rutherfurd stated that the Exchange failed to describe the impact 
of the proposed rules on specialist capitalization.\9\ The Exchange 
responded that specialist organizations, in the aggregate, are required 
to maintain capital of $1.8 billion dollars, but, in fact, generally 
maintain capital of approximately $2.3 billion.\10\ The Exchange stated 
that, under the proposed rules, specialist organizations would be 
required to maintain minimum capital of $1.1 billion, but that it is 
anticipated they would maintain capital in excess of the requirement.
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    \9\ See Rutherfurd's January 13, 2006, March 7, 2006 and April 
12, 2006 letters.
    \10\ See Exchange letter dated March 31, 2006.
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B. Capitalization of the Specialist System

    Rutherfurd stated that the current capital requirements for 
specialist organizations are inadequate because they do not address 
potential market stresses or extreme events and, therefore, the 
proposed reduction in requirements would be inappropriate.\11\ The 
Exchange responded that the proposed requirements establish 
comprehensive and prudent capitalization requirements that address the 
specialist system in the context of contemporary market realities, 
including realities attendant to severe market downturns.\12\ The 
Exchange stated further that the proposed capitalization levels are 
more than adequate to buttress the specialist system when considered in 
conjunction with: (1) Margining and financing arrangements currently 
available to specialist organizations; (2) the ability of specialist 
organizations to hedge risk; and (3) the access, in most instances, 
that specialist organizations have to the capital of their parent 
companies.
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    \11\ See Rutherfurd's January 13, 2006, March 7, 2006 and April 
12, 2006 letters.
    \12\ See Exchange's February 28, 2006 and March 31, 2006 
letters.
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C. VaR Models

    Rutherfurd stated that a VaR methodology is inappropriate for 
calculating the proposed capital requirement add-on because, while 
useful for day-to-day management purposes, it would not capture the 
potential impacts of severe market events.\13\ The Exchange responded 
by acknowledging the limits of VaR methodologies and noting that the 
proposed rules require, as an initial matter, that a specialist 
organization maintain capital equal to $1,000,000 for 0.1% transaction 
dollar volume.\14\ The Exchange further responded that the VaR 
calculated add-on is determined by multiplying the VaR amount by, at 
least, three times. The Exchange stated that the transaction-based 
requirement and the VaR multiplier are designed to address extreme 
market events.
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    \13\ See Rutherfurd's January 13, 2006, March 7, 2006 and April 
12, 2006 letters.
    \14\ See Exchange letter dated February 28, 2006.
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D. Specialist Organization Combination Requirements

    Rutherfurd stated that the current specialist organization 
combination requirements are appropriate because they are intended to 
maintain the aggregate capitalization of the specialist organizations 
after a merger.\15\ The Exchange responded that the current 
requirements arbitrarily raise capital requirements without regard for 
the actual risks faced by the combined entity.\16\ The Exchange 
responded further that its proposed requirements would more closely 
align the capital requirements of merged specialist organizations with 
the amount of risk they take on and the dollar value and volatility of 
their portfolios.
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    \15\ See Rutherfurd's January 13, 2006 and March 7, 2006 
letters.
    \16\ See Exchange letter dated February 28, 2006.
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E. Hybrid Market

    Both commenters expressed their belief that the proposed rules are 
premature in light of the expansion of specialist dealer activity under 
the Exchange's new ``Hybrid Market'' rules.\17\ The Exchange responded 
that any withdrawals of additional excess net liquid assets resulting 
from the proposed requirement would be gradually phased in, on a 
measured basis, over a nine-month period to allow for an orderly and 
carefully considered transition.\18\ The Exchange further responded 
that it considered the impact of other rules, policies, procedures, and 
systems on the proposed rules. In addition, the Exchange responded that 
it would, on an ongoing basis, continue to consider the impact of the 
Hybrid Market rules have on the proposed rules.
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    \17\ See Rutherfurd's January 13, 2006 and March 7, 2006 letters 
and Peake's April 18, 2006 letter. The Exchange's Hybrid Market 
rules were approved by the Commission in Exchange Act Release No. 
53539 (March 22, 2006).
    \18\ See Exchange letter dated February 28, 2006.
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F. Specialist Organization Withdrawals

    Finally, Rutherfurd stated that the proposed rules would make it 
easier for existing specialist organizations to exit the specialist 
business.\19\ The Exchange responded that it is unaware of any data to 
support this contention.\20\ Further, the Exchange responded that the 
proposed rules may attract new specialist organizations.
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    \19\ See Rutherfurd's January 13, 2006 letter.
    \20\ See Exchange letter dated February 28, 2006.
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    The Commission believes that the Exchange has responded 
sufficiently to the issues raised by the Commenters.

 IV. Discussion and Commission Findings

    After careful review of the proposed rule changes, comments and the 
Exchange responses to the comments, the Commission finds that the 
proposed rule changes, as amended, are consistent with the requirements 
of the Exchange Act and the rules and regulations thereunder applicable 
to a national securities exchange in that they are designed to 
recognize contemporary approaches to managing risk and recent 
developments involving the structure of the Exchange.\21\
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    \21\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule change's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).

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[[Page 43263]]

    In particular, the Commission believes that the proposed rule 
changes are consistent with Section 6(b)(5) of the Exchange Act,\22\ 
which requires that the rules of the exchange be designed, among other 
things, to remove impediments to and perfect the mechanisms of a free 
and open market, and, in general, to protect investors and the public 
interest. The Commission finds that amending Exchange Rules 104 and 
123E is consistent with the requirements of Section 6(b)(5) because the 
amendments are designed to more closely align net liquid asset 
requirements with a specialist organization's risks.
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    \22\ 15 U.S.C. 78f(b)(5).
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,\23\ that the proposed rule change (File No. SR-NYSE-2005-
38), as amended, be, and it hereby is, approved.
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    \23\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\24\
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    \24\ 17 CFR 200.30-3(a)(12).

Jill M. Peterson,
Assistant Secretary.
[FR Doc. E6-12183 Filed 7-28-06; 8:45 am]

BILLING CODE 8010-01-P