Document ID: SEC-2016-2312-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Fixed Income Clearing Corp.
Posted Date: 2016-12-28T05:00Z

[Federal Register Volume 81, Number 249 (Wednesday, December 28, 2016)]
[Notices]
[Pages 95669-95676]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-31312]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-79643; File No. SR-FICC-2016-801]

Self-Regulatory Organizations; Fixed Income Clearing Corporation; 
Notice of Filing of an Advance Notice To Implement a Change to the 
Methodology Used in the MBSD VaR Model

December 21, 2016.
    Pursuant to Section 806(e)(1) of Title VIII of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act entitled the Payment, 
Clearing, and Settlement Supervision Act of 2010 (``Clearing 
Supervision Act'' or ``Payment, Clearing and Settlement Supervision 
Act'') \1\ and Rule 19b-4(n)(1)(i) under the Securities Exchange Act of 
1934 (``Act''),\2\ notice is hereby given that on November 23, 2016, 
the Fixed Income Clearing Corporation (``FICC'') filed with the 
Securities and Exchange Commission (``Commission'') the advance notice 
as described in Items I, II and III below, which Items have been 
prepared primarily by FICC (``Advance Notice'').\3\ The Commission is 
publishing this notice to solicit comments on the Advance Notice from 
interested persons.
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    \1\ 12 U.S.C. 5465(e)(1).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ FICC also filed a proposed rule change with the Commission 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
and Rule 19b-4 thereunder, seeking approval of changes to its rules 
necessary to implement the proposal. 15 U.S.C. 78s(b)(1) and 17 CFR 
240.19b-4. See File No. SR-FICC-2016-007.
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I. Clearing Agency's Statement of the Terms of Substance of the Advance 
Notice

    The proposed change would change the methodology that FICC uses in 
the Mortgage-Backed Securities Division's (``MBSD'') value-at-risk 
(``VaR'') model from one that employs a full revaluation approach to 
one that would employ a sensitivity approach, as described in greater 
detail below.\4\
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    \4\ Capitalized terms used herein and not defined shall have the 
meaning assigned to such terms in the MBSD Clearing Rules (``MBSD 
Rules'') available at www.dtcc.com/legal/rules-and-procedures.aspx.
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    The proposed change would also amend the MBSD Rules to (1) revise 
the definition of VaR Charge to reference an alternative volatility 
calculation (referred to herein as the Margin Proxy (as defined in Item 
II(B) below)), which would be employed in the event that the requisite 
data used to employ the sensitivity approach is unavailable for an 
extended period of time, (2) revise the definition of VaR Charge to 
include a minimum amount (the ``VaR Floor'') that FICC would employ as 
an alternative to the amount calculated by the proposed VaR model for 
portfolios where the VaR Floor would be greater than the model-based 
charge amount, (3) eliminate two components from the Required Fund 
Deposit calculation that would no longer be necessary following 
implementation of the proposed VaR model, and (4) change the margining 
approach that FICC may employ for certain securities with inadequate 
historical pricing data from one that calculates charges using a 
historic index volatility model to one that would employ a simple 
haircut method, as described in greater detail below.
    The proposed sensitivity approach and Margin Proxy methodologies 
would be reflected in the Methodology and Model Operations Document--
MBSD Quantitative Risk Model (the ``QRM Methodology''). FICC is 
requesting confidential treatment of this document and has filed it 
separately with the Secretary of the Commission.\5\
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    \5\ See 17 CFR 240.24b-2.
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II. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Advance Notice

    In its filing with the Commission, the clearing agency included 
statements concerning the purpose of and basis for the Advance Notice 
and discussed any comments it received on the Advance Notice. The text 
of these statements may be examined at the places specified in Item IV 
below. The clearing agency has prepared summaries, set forth in 
sections A and B below, of the most significant aspects of such 
statements.

(A) Clearing Agency's Statement on Comments on the Advance Notice 
Received From Members, Participants or Others

    Written comments relating to the proposed change have not been 
solicited or received. FICC will notify the Commission of any written 
comments received by FICC

(B) Advance Notice Filed Pursuant to Section 806(e) of the Payment, 
Clearing and Settlement Supervision Act

Description of the Change
    FICC is proposing to change the methodology that is currently used 
in MBSD's VaR model from one that employs a full revaluation approach 
to one that would employ a sensitivity approach. In connection with 
this change, FICC is also proposing to (1) amend the definition of VaR 
Charge to reference that an alternative volatility calculation 
(referred to herein as the Margin Proxy (as defined in section B 
below)) would be employed in the event that the requisite data used to 
employ the sensitivity approach is unavailable for an extended period 
of time, (2) revise the definition of VaR Charge to include a VaR Floor 
that FICC would employ as an alternative to the amount calculated by 
the proposed VaR model for portfolios where the VaR Floor would be 
greater than the model-based charge amount, (3) eliminate two 
components from the Required Fund Deposit calculation that would no 
longer be necessary following implementation of the proposed VaR model, 
and (4) change the margining approach that FICC may employ for certain 
securities with inadequate historical pricing data from one that 
calculates charges using a historic index volatility model to one that 
would employ a simple haircut method. These changes are described in 
more detail below.

A. The Required Fund Deposit and Clearing Fund Calculation Overview

    A key tool that FICC uses to manage market risk is the daily 
calculation and collection of Required Fund Deposits from Clearing 
Members. The Required Fund Deposit serves as each Clearing Member's 
margin. The aggregate of all Clearing Members' Required Fund Deposits 
constitutes the Clearing Fund of MBSD, which FICC would access should a 
defaulting Clearing Member's own Required Fund Deposit be insufficient 
to satisfy losses to FICC

[[Page 95670]]

caused by the liquidation of that Clearing Member's portfolio.
    The objective of a Clearing Member's Required Fund Deposit is to 
mitigate potential losses to FICC associated with liquidation of such 
Member's portfolio in the event that FICC ceases to act for such Member 
(hereinafter referred to as a ``default''). Pursuant to the MBSD Rules, 
each Clearing Member's Required Fund Deposit amount currently consists 
of the following components: the VaR Charge, the Coverage Charge, the 
Deterministic Risk Component, the margin requirement differential 
(``MRD'') and, to the extent appropriate, a special charge.\6\ Of these 
components, the VaR Charge comprises the largest portion of a Clearing 
Member's Required Fund Deposit amount.
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    \6\ MBSD Rule 4 Section 2.
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    The VaR Charge is calculated using a risk-based margin methodology 
that is intended to capture the market price risk associated with the 
securities in a Clearing Member's portfolio. The methodology uses 
historical market moves to project the potential gains or losses that 
could occur in connection with the liquidation of a defaulting Clearing 
Member's portfolio. The methodology assumes that a portfolio would take 
three days to hedge or liquidate in normal market conditions. The 
projected liquidation gains or losses are used to determine the amount 
of the VaR Charge, which is calculated to cover projected liquidation 
losses at a 99 percent confidence level.\7\
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    \7\ Unregistered Investment Pool Clearing Members are subject to 
a VaR Charge with a minimum targeted confidence level assumption of 
99.5 percent.
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    FICC employs daily backtesting to determine the adequacy of each 
Clearing Member's Required Fund Deposit. The backtesting compares the 
Required Fund Deposit for each Clearing Member with actual price 
changes in the Clearing Member's portfolio. The portfolio values are 
calculated by using the actual positions in such Member's portfolio on 
a given day and the observed security price changes over the following 
three days. These backtesting results are reviewed as part of FICC's 
VaR model performance monitoring and assessment of the adequacy of each 
Clearing Member's Required Fund Deposit.
    FICC currently calculates the VaR Charge using a methodology 
referred to as the ``full revaluation'' approach. The full revaluation 
approach employs a historical simulation method to fully reprice each 
security in a Clearing Member's portfolio using valuation algorithms 
with prevailing and historical market data. VaR provides an estimate of 
the possible losses for a given portfolio based on a given confidence 
level over a particular time horizon. The VaR Charge is calibrated at a 
99 percent confidence level based on a 1-year look-back period assuming 
a three-day liquidation/hedge period. If FICC determines that a 
security's price history is incomplete and the market price risk cannot 
be calculated by the VaR model, then FICC applies an index volatility 
model until such security's trading history and pricing reflects market 
risk factors that can be appropriately calibrated from the security's 
historical data.\8\
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    \8\ MBSD Rule 4 Section 2(c).
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B. Proposed Change To Replace the Methodology Used in the Existing VaR 
Charge Calculation

    During the volatile market period that occurred during the second 
and third quarters of 2013, FICC's full revaluation approach did not 
respond effectively to the levels of market volatility at that time, 
and the VaR Charge amounts that were calculated using the profit and 
loss scenarios generated by FICC's full revaluation model did not 
achieve a 99 percent confidence level. Thus, the VaR Charge and the 
Required Fund Deposit yielded backtesting deficiencies beyond FICC's 
risk tolerance, which prompted FICC to employ a supplemental risk 
charge to ensure that each Clearing Member's VaR Charge would achieve a 
minimum 99 percent confidence level. This supplemental charge, referred 
to as the margin proxy (the ``Margin Proxy''), ensured that each 
Clearing Member's VaR Charge was adequate and, at the minimum, mirrored 
historical price moves.\9\ Shortly thereafter, the annual model 
validation exercise revealed that FICC's prepayment model,\10\ which is 
a component of the full revaluation approach, had failed to perform as 
expected due to shifting market dynamics that were not accurately 
captured by the model.
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    \9\ The Margin Proxy is currently employed to provide 
supplemental coverage to the VaR Charge, however, under this 
proposed change, the Margin Proxy would only be employed as an 
alternative volatility calculation in the event that the requisite 
data used to employ the sensitivity approach is unavailable for an 
extended period of time.
    \10\ Cash flow uncertainty as a result of unscheduled payments 
of principal (prepayments) is a key investment characteristic of 
most mortgage-backed securities. The existing VaR model uses a full 
revaluation approach that fully reprices each instrument under each 
historically simulated scenario. One component of this pricing model 
is FICC's prepayment model. This model was implemented during the 
first quarter of 2013 and it is described in AN-FICC-2012-09. 
Securities Exchange Act Release No. 34-68498 (December 20, 2012) 77 
FR 76311 (December 27, 2012) (AN-FICC-2012-09).
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    In connection with the above, FICC performed a review of the 
existing model deficiencies, examined the root causes of such 
deficiencies and considered options that would remediate the observed 
model weaknesses. As a result of this review, FICC is proposing to 
change MBSD's methodology for calculating the VaR Charge by: (1) 
Replacing the full revaluation approach with the sensitivity 
approach,\11\ (2) employing the Margin Proxy as an alternative 
volatility calculation in the event that the requisite data used to 
employ the sensitivity approach is unavailable for an extended period 
of time and (3) establishing a VaR Floor as the VaR Charge to address a 
circumstance where the proposed VaR model yields a VaR Charge amount 
that is lower than 5 basis points of the market value of a Clearing 
Member's gross unsettled positions.\12\
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    \11\ Two key choices in designing a VaR model are (1) the 
approach used to generate simulation scenarios (e.g., historical 
simulation or Monte Carlo) and (2) the approach used to value the 
portfolio change under the simulated scenarios (e.g., full 
revaluation approach or sensitivity approach).
    \12\ Assuming the market value of gross unsettled positions of 
$500,000,000, the VaR Floor calculation would be .0005 multiplied by 
$500,000,000 = $250,000. If the VaR model charge is less than 
$250,000, then the VaR Floor calculation of $250,000 would be set as 
the VaR Charge.
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    The current full revaluation method uses valuation algorithms, one 
component of which is FICC's prepayment model, to fully reprice each 
security in a Clearing Member's portfolio over a range of historically 
simulated scenarios. While there are benefits to this method, some of 
its deficiencies are that it requires significant historical market 
data inputs, calibration of various model parameters and extensive 
quantitative support for price simulations. FICC believes that the 
proposed sensitivity approach would address these deficiencies because 
it would leverage external vendor expertise in supplying the market 
risk attributes, which would then be incorporated by FICC into its 
model to calculate the VaR Charge. FICC would source security-level 
risk sensitivity data and relevant historical risk factor time series 
data from an external vendor for all Eligible Securities.\13\ The

[[Page 95671]]

sensitivity data is generated by the vendor based on its econometric, 
risk and pricing models. Because the quality of this data is an 
important component of calculating the VaR Charge, FICC would conduct 
independent data checks to verify the accuracy and consistency of the 
data feed received from the vendor. With respect to the historical risk 
factor time series data, FICC has evaluated the historical price moves 
and determined which risk factors primarily explain those price 
changes, a practice commonly referred to as risk attribution. The 
following risk factors have been incorporated into MBSD's proposed VaR 
methodology: key rate, convexity, spread, volatility, mortgage basis 
and time.\14\
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    \13\ Specified pool trades are mapped to the corresponding 
positions in to-be-announced securities (``TBAs''). For options on 
TBAs, it should be noted that FICC's guarantee for options is 
limited to the intrinsic value of option positions (that is, when 
the underlying price of the TBA position is above the call price, 
the option is considered in-the-money and FICC's guarantee reflects 
this portion of the option's positive value) at the time of a 
Clearing Member's insolvency. As such, the value change of an option 
position would be simulated as the change in intrinsic values over 
the period of risk.
    \14\ These risk factors are defined as follows:
     Key rate measures the sensitivity of a price change to 
changes in interest rates;
     convexity measures the degree of curvature in the 
price/yield relationship of key interest rates;
     spread is the yield spread that is added to a benchmark 
yield curve to discount a TBA's cash flows to match its market 
price, which takes into account a credit premium and the option-like 
feature of mortgage-backed-securities due to prepayment;
     volatility reflects the implied volatility observed 
from the swaption market to estimate fluctuations in interest rates, 
which impact the prepayment assumptions;
     mortgage basis captures the basis risk between the 
prevailing mortgage rate and a blended Treasury rate, which impacts 
borrowers' refinance incentives and the model prepayment 
assumptions; and
     time risk factor accounts for the time value change (or 
carry adjustment) over the assumed liquidation period.
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    FICC's proposal to use third-party risk factor data requires that 
FICC take steps to mitigate potential model risk. FICC has reviewed a 
description of the vendor's calculation methodology and the manner in 
which the market data is used to calibrate the vendor's models. FICC 
understands and is comfortable with the vendor's controls, governance 
process and data quality standards. Additionally, FICC would conduct an 
independent review of the vendor's release of a new version of the 
model. As described in the QRM Methodology, to the extent that the 
vendor changes its model and methodologies that produce the risk 
factors and risk sensitivities, the effect of these changes to FICC's 
proposed sensitivity approach would be reviewed by FICC. Future changes 
to the QRM Methodology would be subject to a proposed rule change 
pursuant to the Act Rule 19b-4 (``Rule 19b-4'').\15\ Modifications to 
the proposed VaR model may be subject to a proposed rule change 
pursuant to Rule 19b-4 \16\ and/or an advance notice filing pursuant to 
the Clearing Supervision Act,\17\ and Rule 19b-4(n)(1)(i) under the 
Act.\18\
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    \15\ See 17 CFR 240.19b-4.
    \16\ Id.
    \17\ See 12 U.S.C. 5465(e)(1).
    \18\ See 17 CFR 240.19b-4(n)(1)(i).
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    Under the proposed approach, a Clearing Member's portfolio risk 
sensitivities would be calculated by FICC as the aggregate of the 
security level risk sensitivities weighted by the corresponding 
position market values. The portfolio risk sensitivities and the vendor 
supplied historical risk factor time series data would then be used by 
FICC's risk model to calculate the VaR Charge for each Clearing Member. 
More specifically, FICC would look at the historical changes of the 
chosen risk factors during the look-back period in order to generate 
risk scenarios to arrive at the market value changes for a given 
portfolio. A statistical probability distribution would be formed from 
the portfolio's market value changes.
    The proposed sensitivity approach differs from the current full 
revaluation method mainly in how the market value changes are 
calculated. The full revaluation method accounts for changes in 
properties of mortgage-backed securities that change over time by 
incorporating certain historical data \19\ to calibrate the model that 
generates a simulated interest rate curve. This data is used to create 
a distribution of returns per TBA. The proposed sensitivity approach, 
by comparison, would simulate the market value changes of a Clearing 
Member's portfolio under a given market scenario as the sum of the 
portfolio risk factor exposure multiplied by the corresponding risk 
factor movements.
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    \19\ Such historical data may include TBA prices, 3-day 
movements of interest, option-adjusted spreads, current interest 
term structure and swaption volatilities.
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    The sensitivity approach would provide three key benefits. First, 
the sensitivity approach incorporates both historical data and current 
risk factor sensitivities while the full revaluation approach is 
calibrated with only historical data. The proposed sensitivity approach 
integrates both observed risk factor changes and current market 
conditions to more effectively respond to current market price moves 
that may not be reflected in the historical price moves. This is 
evidenced in FICC's independent validation of the proposed model and 
the backtesting results. The risk factor data is sourced from an 
industry-leading vendor risk model with trading quality accuracy. As 
part of the assessment of the proposed VaR model, the independent 
validation of the proposed model indicated that the proposed 
sensitivity approach would address deficiencies observed in the 
existing model by leveraging external vendor expertise, which FICC does 
not need to develop in-house, in supplying the market risk attributes 
that would then be incorporated by FICC into its model to calculate the 
VaR Charge. FICC has also performed backtesting to validate the 
performance of the proposed model and determine the impact on the VaR 
Charge. Based on FICC's review of the backtesting results and the 
impact study, the sensitivity approach provides better coverage on 
volatile days and a material improvement in margin coverage, while not 
significantly increasing the overall Clearing Fund. Results of the 
analysis indicate that the proposed sensitivity approach would be more 
responsive to changing market dynamics and that it would not negatively 
impact FICC or its Clearing Members.
    The second benefit of the proposed sensitivity approach is that it 
would provide more transparency to Clearing Members. Since Clearing 
Members typically use risk factor analysis for their own risk and 
financial reporting such Members would have comparable data and 
analysis to assess the variation in their VaR Charge based on changes 
in the market value of their portfolios. Thus, Clearing Members would 
be able to simulate the VaR Charge to a closer degree than under the 
existing VaR model.
    The third benefit of the proposed sensitivity approach is that it 
provides FICC with the ability to increase the look-back period used to 
generate the risk scenarios from 1 year to 10 years plus, to the extent 
applicable, an additional stressed period.\20\ The extended look-back 
period would be used to ensure that the historical simulation is 
inclusive of stressed market periods.
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    \20\ Under the proposed model, the 10-year look-back period 
would include the 2008/2009 financial crisis scenario. To the extent 
that an equally or more stressed market period does not occur when 
the 2008/2009 financial crisis period is phased out from the 10-year 
look-back period (e.g., from September 2018 onward), FICC would 
continue to include the 2008/2009 financial crisis scenario in its 
historical scenarios. However, if an equally or more stressed market 
period emerges in the future, FICC may choose not to augment its 10-
year historical scenarios with those from the 2008/2009 financial 
crisis.
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    FICC would have the ability to include an additional period of 
historically observed stressed market conditions to a 10-year look-back 
period if FICC observes that (1) the results of the model performance 
monitoring are not within FICC's 99th percentile confidence level or 
(2) the 10-year look-back period does not contain sufficient

[[Page 95672]]

stressed market conditions. While FICC could extend the 1-year look-
back period in the existing full revaluation approach to a 10-year 
look-back period, the performance of the model could deteriorate if 
current market conditions are materially different than indicated in 
the historical data. Additionally, since the full revaluation method 
requires FICC to maintain in-house complex pricing models and mortgage 
prepayment models, enhancing these models to extend the look-back 
period to include 10-years of historical data involves significant 
model development. The sensitivity approach, on the other hand, would 
incorporate a longer look-back period of 10 years, which would allow 
the proposed model to capture periods of historical volatility.
    On an annual basis, FICC would assess whether an additional 
stressed period should be included. This assessment would include a 
review of (1) the largest moves in the dominating market risk factor of 
the proposed VaR model, (2) the impact analyses resulting from the 
removal and/or addition of a stressed period and (3) the backtesting 
results of the proposed look-back period. As described in the QRM 
Methodology, approval by FICC's Model Risk Governance Committee 
(``MRGC'') and, to the extent necessary, the Management Risk Committee 
(``MRC'') would be required to determine when to apply an additional 
period of stressed market conditions to the look-back period and the 
appropriate historical stressed period to utilize if it is not within 
the current 10-year period.
    Finally, FICC does not believe that its engagement of the vendor 
would present a conflict of interest to FICC because the vendor is not 
an existing Clearing Member nor are any of the vendor's affiliates 
existing Clearing Members. To the extent that the vendor or any of its 
affiliates submit an application to become a Clearing Member, FICC will 
negotiate an appropriate information barrier with the applicant in an 
effort to prevent a conflict of interest from arising. An affiliate of 
the vendor currently provides an existing service to FICC, however, 
this arrangement does not present a conflict of interest because the 
existing agreement between FICC and the vendor, and the existing 
agreement between FICC and the vendor's affiliate each contain 
provisions which limit the sharing of confidential information.

C. Proposed Change To Establish a VaR Floor

    FICC is proposing to amend the definition of VaR Charge to include 
a VaR Floor. The VaR Floor would be employed as an alternative to the 
amount calculated by the proposed model for portfolios where the VaR 
Floor would be greater than the model-based charge amount. FICC's 
proposal to establish a VaR Floor seeks to address the risk that the 
proposed VaR model may calculate too low a VaR Charge for certain 
portfolios where the VaR model applies substantial risk offsets among 
long and short positions in different classes of mortgage-backed 
securities that have a high degree of historical price correlation. 
Because this high degree of historical price correlation may not apply 
in future changing market conditions,\21\ FICC believes that it is 
prudent to apply a VaR Floor that is based upon the market value of the 
gross unsettled positions in the Clearing Member's portfolio in order 
to protect FICC against such risk in the event that FICC is required to 
liquidate a large mortgage-backed securities portfolio in stressed 
market conditions.
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    \21\ For example, and without limitation, certain classes of 
mortgage-backed securities may have highly correlated historical 
price returns despite having different coupons. However, if future 
mortgage market conditions were to generate substantially greater 
prepayment activity for some but not all such classes, these 
historical correlations could break down, leading to model-generated 
offsets that would not adequately capture a portfolio's risk.
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D. Vendor Data Disruption

    As noted above, FICC intends to source certain sensitivity data and 
risk factor data from a vendor. FICC's Quantitative Risk Management, 
Vendor Risk Management, and Information Technology teams have conducted 
due diligence of the vendor in order to evaluate its control framework 
for managing key risks. FICC's due diligence included an assessment of 
the vendor's technology risk, business continuity, regulatory 
compliance, and privacy controls. FICC has existing policy and 
procedures for data management that includes market data and analytical 
data provided by vendors. These policies and procedures do not have to 
be amended in connection with this proposed rules change. FICC also has 
tools in place to assess the quality of the data that it receives from 
vendors.
    Rule 1001(c)(1) of Regulation Systems Compliance and Integrity 
(``SCI'') requires FICC to establish, maintain, and enforce reasonably 
designed written policies and procedures that include the criteria for 
identifying responsible SCI personnel, the designation and 
documentation of responsible SCI personnel, and escalation procedures 
to quickly inform responsible SCI personnel of potential SCI 
events.\22\ Further, pursuant to Rule 1002 of Regulation SCI, each 
responsible SCI personnel is responsible for determining when there is 
a reasonable basis to conclude that a SCI event has occurred, which 
will trigger certain obligations of an SCI entity with respect to such 
SCI events.\23\ FICC has existing policies and procedures which reflect 
established criteria that must be used by responsible SCI personnel to 
determine whether a disruption to, or significant downgrade of, the 
normal operation of FICC's risk management system has occurred as 
defined under Regulation SCI. These policies and procedures do not have 
to be amended in connection with this proposed rule change. In the 
event that the vendor fails to provide the requisite sensitivity data 
and risk factor data, the responsible SCI personnel would determine 
whether a SCI event has occurred and FICC would fulfill its obligations 
with respect to the SCI event.
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    \22\ See 17 CFR 242.1001(c)(1).
    \23\ See 17 CFR 242.1002.
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    In connection with FICC's proposal to source data for the proposed 
sensitivity approach, FICC is also proposing procedures that would 
govern in the event that the vendor fails to provide sensitivity data 
and risk factor data. If the vendor fails to provide any data or a 
significant portion of the data timely, FICC would use the most 
recently available data on the first day that such data disruption 
occurs. If it is determined that the vendor will resume providing data 
within five (5) business days, management would determine whether the 
VaR Charge should continue to be calculated by using the most recently 
available data along with an extended look-back period or whether the 
Margin Proxy should be invoked, subject to the approval of DTCC's Group 
Chief Risk Officer or his/her designee. If it is determined that the 
data disruption will extend beyond five (5) business days, the Margin 
Proxy would be applied, subject to the approval of the MRC followed by 
notification to FICC's Board Risk Committee.
    The Margin Proxy would be calculated as follows: (i) Risk factors 
would be calculated using historical market prices of benchmark TBA 
securities and (ii) each Clearing Member's portfolio exposure would be 
calculated on a net position across all products and for each 
securitization program (i.e., Federal National Mortgage Association 
(``Fannie Mae'') and Federal Home Loan Mortgage Corporation (``Freddie 
Mac'') conventional 30-year

[[Page 95673]]

mortgage-backed securities, Government National Mortgage Association 
(``Ginnie Mae'') 30-year mortgage-backed securities, Fannie Mae and 
Freddie Mac conventional 15-year mortgage-backed securities, and Ginnie 
Mae 15-year mortgage-backed securities). The Margin Proxy would be used 
to calculate the VaR Charge by multiplying the risk factor for the 
Fannie Mae and Freddie Mac conventional 30-year mortgage-backed 
securities (``base risk factor''), which is the dominant and most 
liquid portion of the products cleared by FICC, by the absolute value 
of the Clearing Member's net position across all products, plus the sum 
of each risk factor spread to the base risk factor multiplied by the 
absolute value of its corresponding position.\24\
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    \24\ To illustrate the Margin Proxy calculation, consider an 
example where a Clearing Member has a portfolio with a net long 
position across all products of $2 billion, and the base risk factor 
is 0.015. Further assume the Clearing Member has a net short 
position of $30 million in Fannie Mae and Freddie Mac conventional 
15-year mortgage-backed securities, and the corresponding risk 
factor spread to the base risk factor is 0.006; a net short position 
of $500 million in Ginnie Mae 30-year mortgage-backed securities, 
and the corresponding risk factor spread is 0.005; and a net long 
position of $120 million in Ginnie Mae 15-year mortgage-backed 
securities, and the corresponding risk factor spread is 0.007. In 
order to generate the Margin Proxy calculation, FICC would multiply 
the base risk factor by the absolute value of the Clearing Member's 
net position across all products, plus the sum of each risk factor 
spread of the subsequent products multiplied by absolute value of 
the position for the respective product (i.e., ([base risk 
factor]*ABS[portfolio net position]) + ([CONV15 spread risk factor] 
* ABS[CONV15 net position]) + ([GNMA30 spread risk factor] * 
ABS[GNMA30 net position]) + ([GNMA15 Spread Risk Factor] * 
ABS[GNMA15 Net Position])). The resulting Margin Proxy amount would 
be $33.52 million.
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    FICC would calculate the Margin Proxy on a daily basis and the 
Margin Proxy method would be subject to monthly performance review by 
the MRGC. FICC would monitor the performance of the calculation on a 
monthly basis to ensure that it could be used in the circumstance 
described above. Specifically, FICC would monitor each Clearing 
Member's Required Fund Deposit and the aggregate Clearing Fund 
requirements versus the requirements calculated by Margin Proxy. FICC 
would also backtest the Margin Proxy results versus the three-day 
profit and loss based on actual market price moves. If FICC observes 
material differences between the Margin Proxy calculations and the 
aggregate Clearing Fund requirement calculated using the proposed VaR 
model, or if the Margin Proxy's backtesting results do not meet FICC's 
99 percent confidence level, management may recommend remedial actions 
to the MRGC, and to the extent necessary the MRC, such as increasing 
the look-back period and/or applying an appropriate historical stressed 
period to the Margin Proxy calibration.

E. Proposed Change To Replace the Historic Index Volatility Model With 
a Haircut Method To Measure the Risk Exposure of Securities That Lack 
Historical Data

    Occasionally, portfolios contain classes of securities that reflect 
market price changes not consistently related to historical risk 
factors. The value of these securities is often uncertain because the 
securities' market volume varies widely, thus the price histories are 
limited. Since the volume and price information for such securities is 
not robust, a historical simulation approach would not generate VaR 
Charge amounts that adequately reflect the risk profile of such 
securities. Currently, MBSD Rule 4 provides that FICC may use a 
historic index volatility model to calculate the VaR component of the 
Required Fund Deposit for these classes of securities. FICC is 
proposing to amend Rule 4 to replace the historic index volatility 
model with a haircut method.
    FICC believes that the haircut method would better capture the risk 
profile of these securities because the lack of adequate historical 
data makes it difficult to map such securities to a historic index 
volatility model. FICC is proposing to calculate the component of the 
Required Fund Deposit applicable to these securities by applying a 
fixed haircut level to the gross market value of the positions. FICC 
has selected an initial haircut of 1 percent based on its analysis of a 
five-year historical study of three-day returns during a period that 
such securities were traded. This percentage would be reviewed annually 
or more frequently if market conditions warrant and updated, if 
necessary, to ensure sufficient coverage.
    Currently, the classes of securities that lack adequate historical 
data include balloon Fannie Mae 7-year securities, balloon Freddie Mac 
5-year securities and balloon Freddie Mac 7-year securities. FICC has 
no exposure to these security classes as of the filing date of this 
proposed change and has had negligible exposure over the last several 
years. However, prudent risk management dictates that FICC maintain 
appropriate rules to cover potential future exposures.

F. Proposed Change To Eliminate the Coverage Charge Component and the 
Margin Requirement Differential Component

    FICC is also proposing to eliminate the Coverage Charge and MRD 
components from MBSD's Required Fund Deposit calculation. Both 
components are based on historical portfolio activity, which may not be 
indicative of a Clearing Member's current risk profile, but were 
determined by FICC to be appropriate to address potential shortfalls in 
margin charges under the existing VaR model.
    As part of the development and assessment of the sensitivity 
approach for MBSD's proposed VaR model, FICC obtained an independent 
validation of the proposed model by an external party, backtested the 
model's performance and analyzed the impact of the margin changes. 
Results of the analysis indicated that the proposed sensitivity 
approach would be more responsive to changing market dynamics and a 
Clearing Member's portfolio composition coverage than the existing 
model. The model validation and backtesting analysis also demonstrated 
that the proposed sensitivity model would provide sufficient margin 
coverage on a standalone basis. Because testing and validation of 
MBSD's proposed VaR model show a material improvement in margin 
coverage, FICC believes that the Coverage Charge and MRD components are 
no longer necessary.

G. Description of the Proposed Changes to the Text of the MBSD Rules

    The proposed changes to the MBSD Rules are as follows:
     Delete the term ``Coverage Charge'' from Rule 1 because 
FICC is proposing to eliminate this component from the Clearing Fund 
calculation.
     Delete the references to the Coverage Charge and the MRD 
in Rule 4 Section 2(c) because FICC is proposing to eliminate these 
components from the Clearing Fund calculation.
     Amend the term ``VaR Charge'' to reflect that (x) an 
alternative volatility calculation would be employed in the event that 
the requisite data used to employ the sensitivity approach is 
unavailable for an extended period of time and (y) the VaR Floor would 
be utilized as the VaR Charge if the proposed VaR methodology yields an 
amount that is lower than 5 basis points of the market value of a 
Clearing Member's gross unsettled positions.
     Replace the reference to the ``historic index volatility 
model'' with ``haircut method'' in Rule 4 Section 2 to reflect the 
method that would be used for classes of securities where the 
volatility is less amendable to statistical analysis.

H. Description of the QRM Methodology

    The QRM Methodology document provides the methodology by which

[[Page 95674]]

FICC would calculate the VaR Charge with the proposed sensitivity 
approach as well as other components of the Required Fund Deposit 
calculation. The document specifies (i) the model inputs, parameters, 
assumptions and qualitative adjustments, (ii) the calculation used to 
generate Required Fund Deposit amounts, (iii) additional calculations 
used for benchmarking and monitoring purposes, (iv) theoretical 
analysis, (v) the process by which the VaR methodology was developed as 
well as its application and limitations, (vi) internal business 
requirements associated with the implementation and ongoing monitoring 
of the VaR methodology, (vii) the model change management process and 
governance framework (which includes the escalation process for adding 
a stressed period to the VaR calculation), and (viii) the Margin Proxy 
calculation.
Anticipated Effect on and Management of Risks
    FICC believes that the proposed change, which consists of proposals 
to (1) implement the sensitivity approach in order to correct the 
existing deficiencies in the existing VaR methodology, (2) establish 
the Margin Proxy as a back-up to the sensitivity approach, (3) 
establish a VaR Floor as the minimum VaR Charge, (4) apply a haircut to 
securities that have market price changes that are not consistently 
related to historical risk factors and (5) remove the Coverage Charge 
component and the MRD component from the Required Fund Deposit 
calculation, would enable FICC to better limit its exposure to Clearing 
Members arising out of the activity in their portfolios.
    FICC's proposal to change the existing VaR methodology from one 
that employs a full revaluation approach to one that employs a 
sensitivity approach would affect FICC's management of risk because it 
would help to address the deficiencies observed in the current model by 
leveraging external vendor expertise in supplying the market risk 
attributes that would then be incorporated by FICC into its model to 
calculate the VaR Charge. The proposed methodology would enhance FICC's 
risk management capabilities because it would enable sensitivity 
analysis of key model parameters and assumptions. The sensitivity 
approach would allow FICC to attribute market price moves to various 
risk factors (such as key rates, option adjusted spread, and mortgage 
basis) that would enable FICC to view and respond more effectively to 
market volatility.
    As noted above, the proposed sensitivity approach would leverage 
external vendor expertise in supplying the market risk attributes. FICC 
would manage the risks associated with a potential data disruption by 
using the most recently available data on the first day that a data 
disruption occurs. If it is determined that the vendor will resume 
providing data within five (5) business days, management would 
determine whether the VaR Charge should continue to be calculated by 
using the most recently available data along with an extended look-back 
period or whether the Margin Proxy should be invoked subject to the 
approval of DTCC's Group Chief Risk Officer or his/her designee. If it 
is determined that the data disruption will extend beyond five (5) 
business days, the Margin Proxy would be applied, subject to the 
approval of the MRC followed by notification to FICC's Board Risk 
Committee.
    FICC's proposal to implement the Margin Proxy as a back-up 
methodology to the sensitivity approach would affect FICC's management 
of risk because the Margin Proxy would help ensure that FICC could 
continue to calculate each Clearing Member's VaR Charge in the event 
that FICC experiences a data disruption that is expected to last beyond 
five (5) business days.
    FICC's proposal to implement the VaR Floor would affect FICC's 
management of risk because it addresses the risk that the proposed VaR 
model may calculate too low a VaR Charge for certain portfolios where 
the VaR model applies substantial risk offsets among long and short 
positions in different classes of mortgage-backed securities that have 
a high degree of historical price correlation. Because this high degree 
of historical price correlation may not apply in future changing market 
conditions, FICC would manage this risk by applying a VaR Floor that 
would be based upon the market value of the gross unsettled positions 
in the Clearing Member's portfolio. This would protect FICC in the 
event that it is required to liquidate a large mortgage-backed 
securities portfolio in stressed market conditions.
    FICC's proposal to implement a simple haircut method for securities 
with inadequate historical pricing data would affect FICC's management 
of risk because the proposed change would better capture the risk 
profile of these securities thus helping to ensure that sufficient 
margin would be calculated for portfolios that contain these 
securities. FICC would continue to manage the market risk of clearing 
these securities by conducting analysis on the type of securities that 
cannot be processed by the proposed VaR model and engaging in periodic 
reviews of the haircut used for calculating margin for these types of 
securities.
    FICC's proposal to remove the Coverage Charge and MRD components 
would affect FICC's management of risk because the proposed changes 
would remove unnecessary components from the Clearing Fund calculation. 
As described above, both components are based on historical portfolio 
activity, which may not be indicative of a Clearing Member's current 
risk profile. As part of FICC's development of the sensitivity VaR 
model, FICC pursued a validation of the proposed model by an external 
party, performed back testing to validate model performance, and 
conducted analysis to determine the impact of the changes to the 
Clearing Members. Results of the analysis indicate that the proposed 
sensitivity approach would be more responsive to changing market 
dynamics and provide better coverage than the existing model. Given the 
improvement in model coverage, FICC believes that the Coverage Charge 
and MRD components would no longer be necessary.
    FICC has also managed the effect of the overall proposal by 
conducting extensive outreach with Clearing Members regarding the 
proposed changes, educating such Members on reasons for these proposed 
changes, and explaining the related risk management improvements. FICC 
has invited all Clearing Members to customer forums in an effort to 
provide transparency regarding the changes and the expected macro 
impact across the membership, and has provided each Clearing Member 
with an individual impact study. In addition, FICC's Enterprise Risk 
Management team and Relationship Management team have been available to 
answer all questions. Such communication gives Clearing Members the 
opportunity to manage any impact to their own risk profile.
Consistency With the Clearing Supervision Act
    The proposed changes, which have been described in detail above, 
consist of proposals to (1) implement the sensitivity approach in order 
to correct the existing deficiencies in the existing VaR methodology, 
(2) establish the Margin Proxy as a back-up to the sensitivity 
approach, (3) establish a VaR Floor as the minimum VaR Charge, (4) 
apply a haircut to securities that have market price changes that are 
not consistently related to historical risk factors and (5) remove the 
Coverage Charge component and the MRD component from the Required Fund 
Deposit calculation, would be consistent

[[Page 95675]]

with Section 805(b) of the Clearing Supervision Act.\25\ The objectives 
and principles of Section 805(b) include, among other things, the 
promotion of robust risk management.\26\ FICC believes the proposed 
changes would promote this objective because they would give MBSD the 
ability to better cover its exposure to Clearing Members arising out of 
the activity of such Members' portfolios.
---------------------------------------------------------------------------

    \25\ See 12 U.S.C. 5464(b).
    \26\ Id.
---------------------------------------------------------------------------

    FICC believes that the proposed changes are also consistent with 
Rules 17Ad-22(b)(1) and (b)(2) under the Act.\27\ Rule 17Ad-22(b)(1) 
requires a registered clearing agency that performs central 
counterparty services to establish, implement, maintain and enforce 
written policies and procedures reasonably designed to measure its 
credit exposures to its participants at least once a day and limit its 
exposures to potential losses from defaults by its participants under 
normal market conditions so that the operations of the clearing agency 
would not be disrupted and non-defaulting participants would not be 
exposed to losses that they cannot anticipate or control.\28\ Taken 
together, the proposed changes referenced in the previous paragraph 
would continue FICC's practice of measuring its credit exposures at 
least once a day and would collectively enhance the risk-based 
margining framework whose objective would be to calculate each Clearing 
Member's Required Fund Deposit such that in the event of a Clearing 
Member's default, its own Required Fund Deposit would be sufficient to 
mitigate potential losses to FICC associated with the liquidation of 
such defaulted Clearing Member's portfolio.
---------------------------------------------------------------------------

    \27\ See 17 CFR 240.17Ad-22(b)(1) and (b)(2).
    \28\ See 17 CFR 240.17Ad-22(b)(1).
---------------------------------------------------------------------------

    Rule 17Ad-22(b)(2) under the Act requires a registered clearing 
agency that performs central counterparty services to establish, 
implement, maintain and enforce written policies and procedures 
reasonably designed to use margin requirements to limit its credit 
exposures to participants under normal market conditions and use risk-
based models and parameters to set margin requirements and review such 
margin requirements and the related risk-based models and parameters at 
least monthly.\29\ The proposed changes referenced above in the second 
paragraph of this section would collectively constitute a risk-based 
model and parameters that would establish margin requirements for 
Clearing Members. This risk-based model and parameters would use margin 
requirements to limit FICC's credit exposure to its Clearing Members by 
enabling FICC to identify the risk posed by a Clearing Member's 
unsettled portfolio and to quickly adjust and collect additional 
deposits as needed to cover those risks. In order to mitigate 
counterparty exposure to each Clearing Member, under the proposed 
changes, FICC would calculate the VaR of the unsettled obligations of 
each Member to a 99 percent confidence interval with a three-day 
liquidation hedge/horizon, as the basis for its Clearing Fund 
requirement. Because the proposed changes are designed to calculate 
each Clearing Member's Required Fund Deposit at a 99 percent confidence 
level, FICC believes each Clearing Member's Required Fund Deposit would 
cover its own losses in the event that such Member defaults under 
normal market conditions.
---------------------------------------------------------------------------

    \29\ See 17 CFR 240.17Ad-22(b)(2).
---------------------------------------------------------------------------

    FICC believes that the proposed changes are consistent with Rules 
17Ad-22(e)(4) and (e)(6) of the Act, which were recently adopted by the 
Commission.\30\ Rule 17Ad-22(e)(4) will require FICC to establish, 
implement, maintain and enforce written policies and procedures 
reasonably designed to effectively identify, measure, monitor, and 
manage its credit exposures to participants and those exposures arising 
from its payment, clearing, and settlement processes.\31\ The proposed 
changes referenced above in the second paragraph of this section would 
enhance FICC's ability to identify, measure, monitor and manage its 
credit exposures to Clearing Members and those exposures arising from 
its payment, clearing, and settlement processes. Therefore, FICC 
believes the proposed changes are consistent with the requirements of 
Rule 17Ad-22(e)(4), promulgated under the Act, cited above.
---------------------------------------------------------------------------

    \30\ The Commission adopted amendments to Rule 17Ad-22, 
including the addition of new section 17Ad-22(e), on September 28, 
2016. See Securities Exchange Act Release No. 78961 (September 28, 
2016), 81 FR 70786 (October 13, 2016) (S7-03-14). The amendments to 
Rule 17ad-22 become effective on December 12, 2016. Id. FICC is a 
``covered clearing agency'' as defined in Rule 17Ad-22(a)(5) and 
must comply with new section (e) of Rule 17Ad-22 by April 11, 2017. 
Id.
    \31\ See Exchange Act Release No. 78961 (September 28, 2016), 81 
FR 70786 (October 13, 2016) (S7-03-14).
---------------------------------------------------------------------------

    Rule 17Ad-22(e)(6) will require FICC to establish, implement, 
maintain and enforce written policies and procedures reasonably 
designed to cover its credit exposures to its participants by 
establishing a risk-based margin system that is monitored by management 
on an ongoing basis and regularly reviewed, tested, and verified.\32\ 
FICC's proposal to (1) implement the sensitivity approach in order to 
correct the existing deficiencies in the existing VaR methodology, (2) 
establish the Margin Proxy as a back-up to the sensitivity approach, 
(3) establish a VaR Floor as the minimum VaR Charge, and (4) apply a 
haircut to securities that have market price changes that are not 
consistently related to historical risk factors would help FICC to 
cover its credit exposures to Clearing Members because these proposed 
changes establish a risk-based margin system that would be monitored by 
FICC management on an ongoing basis and regularly reviewed, tested, and 
verified. Therefore, FICC believes that the proposed changes are 
consistent with the requirements of Rule 17Ad-22(e)(6), promulgated 
under the Act, cited above.
---------------------------------------------------------------------------

    \32\ Id.
---------------------------------------------------------------------------

III. Date of Effectiveness of the Advance Notice and Timing for 
Commission Action

    The proposed change may be implemented if the Commission does not 
object to the proposed change within 60 days of the later of (i) the 
date that the proposed change was filed with the Commission or (ii) the 
date that any additional information requested by the Commission is 
received. The clearing agency shall not implement the proposed change 
if the Commission has any objection to the proposed change.
    The Commission may extend the period for review by an additional 60 
days if the proposed change raises novel or complex issues, subject to 
the Commission providing the clearing agency with prompt written notice 
of the extension. A proposed change may be implemented in less than 60 
days from the date the Advance Notice is filed, or the date further 
information requested by the Commission is received, if the Commission 
notifies the clearing agency in writing that it does not object to the 
proposed change and authorizes the clearing agency to implement the 
proposed change on an earlier date, subject to any conditions imposed 
by the Commission.
    The clearing agency shall post notice on its Web site of proposed 
changes that are implemented.
    The proposal shall not take effect until all regulatory actions 
required with respect to the proposal are completed.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing.

[[Page 95676]]

Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number SR-FICC-2016-801 on the subject line.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.

All submissions should refer to File Number SR-FICC-2016-801. This file 
number should be included on the subject line if email is used. To help 
the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the Advance Notice that are filed 
with the Commission, and all written communications relating to the 
Advance Notice between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for Web site viewing and printing in 
the Commission's Public Reference Room, 100 F Street NE., Washington, 
DC 20549 on official business days between the hours of 10:00 a.m. and 
3:00 p.m. Copies of the filing also will be available for inspection 
and copying at the principal office of FICC and on FICC's Web site 
(http://dtcc.com/legal/sec-rule-filings.aspx).
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-FICC-2016-801 
and should be submitted on or before January 12, 2017.

    By the Commission.
Eduardo A. Aleman,
Assistant Secretary.
[FR Doc. 2016-31312 Filed 12-27-16; 8:45 am]
 BILLING CODE 8011-01-P