[Federal Register Volume 79, Number 5 (Wednesday, January 8, 2014)]
[Rules and Regulations]
[Pages 1522-1550]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-31426]
[[Page 1521]]
Vol. 79
Wednesday,
No. 5
January 8, 2014
Part III
Securities and Exchange Commission
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17 CFR Parts 240 and 249
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Removal of Certain References to Credit Ratings Under the Securities
Exchange Act of 1934; Final Rule
Federal Register / Vol. 79 , No. 5 / Wednesday, January 8, 2014 /
Rules and Regulations
[[Page 1522]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 249
[Release No. 34-71194; File No. S7-15-11]
RIN 3235-AL14
Removal of Certain References to Credit Ratings Under the
Securities Exchange Act of 1934
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (the ``Commission'') is
adopting amendments that remove references to credit ratings in certain
rules and one form under the Securities Exchange Act of 1934 (the
``Exchange Act'') relating to broker-dealer financial responsibility
and confirmations of securities transactions. This action implements a
provision of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (the ``Dodd-Frank Act'').
DATES: The amendments will become effective on July 7, 2014.
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at (202) 551-5525; Thomas K. McGowan, Deputy Associate
Director, at (202) 551-5521; Randall W. Roy, Assistant Director, at
(202) 551-5522; Mark M. Attar, Branch Chief, at (202) 551-5889; Carrie
A. O'Brien, Special Counsel, at (202) 551-5640; and Rachel B. Yura,
Attorney, at (202) 551-5729, Office of Financial Responsibility (Net
Capital, Customer Protection, and Books and Records Requirements); and
Joseph M. Furey, Assistant Chief Counsel; and Brice D. Prince, Special
Counsel, Office of the Chief Counsel, at (202) 551-5550 (Confirmations
of Securities Transactions); Division of Trading and Markets,
Securities and Exchange Commission, 100 F Street NE., Washington, DC
20549-7010.
SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to
Rules 10b-10,\1\ 15c3-1,\2\ 15c3-1a,\3\ 15c3-1e,\4\ 15c3-1f,\5\ 15c3-
3,\6\ and 17a-4 \7\ under the Exchange Act and corresponding amendments
to the General Instructions to Form X-17A-5, Part IIB.\8\
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\1\ 17 CFR 240.10b-10.
\2\ 17 CFR 240.15c3-1.
\3\ 17 CFR 240.15c3-1a.
\4\ 17 CFR 240.15c3-1e.
\5\ 17 CFR 240.15c3-1f.
\6\ 17 CFR 240.15c3-3.
\7\ 17 CFR 240.17a-4.
\8\ See the General Instructions to Form X-17A-5, Part IIB
(referenced in 17 CFR 249.617).
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I. Introduction
On July 21, 2010, the President signed the Dodd-Frank Act into
law.\9\ This legislation was enacted to, among other things, promote
the financial stability of the United States by improving
accountability and transparency in the financial system.\10\ Section
939A of the Dodd-Frank Act requires each Federal agency, including the
Commission, to review any regulation issued by such agency that
requires the use of an assessment of the creditworthiness of a security
or money market instrument and any references to or requirements in
such regulations regarding credit ratings.\11\ The section further
provides that each such agency shall ``modify any such regulations
identified by the review . . . to remove any reference to or
requirement of reliance on credit ratings, and to substitute in such
regulations such standard of creditworthiness as each respective agency
shall determine as appropriate for such regulations.'' \12\
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\9\ See Public Law 111-203, 124 Stat. 1376 (2010).
\10\ Id. at Preamble.
\11\ Public Law 111-203 Sec. 939A(a)(1)-(2). In July 2011, the
Commission published a report on the staff's review of Commission
regulations that relied on credit ratings. See Commission Staff,
Report on Review of Reliance on Credit Ratings: As Required by
Section 939A(c) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (July 2011). Section 939A of the Dodd-Frank Act
applies to all federal agencies.
\12\ See Public Law 111-203 Sec. 939A(b).
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II. Discussion
A. Background
Prior to and after enactment of the Dodd-Frank Act, the Commission
has taken a number of steps toward removing references to credit
ratings from its regulations under the federal securities laws.\13\
These steps include a 2011 proposal to remove references to credit
ratings of nationally recognized statistical rating organizations
(``NRSROs'') from certain rules under the Exchange Act relating to
broker-dealer financial responsibility (Rule 15c3-1, Rule 15c3-3, and
Form X-17A-5, Part IIB), confirmations of securities transactions (Rule
10b-10), and distributions of securities (Rules 101 and 102 of
Regulation M).\14\ Today the Commission is adopting amendments to
remove references to credit ratings in the broker-dealer financial
responsibility and confirmations of transactions rules. In doing so,
the Commission considered its prior actions in this area. Regarding its
proposal to remove credit ratings from its rules under Regulation M
applicable to distributions of securities, the Commission is currently
reviewing comments and considering alternatives and intends to address
this proposal separately.\15\ In taking these actions, the Commission
has carefully considered the eleven comment letters it received in
response to the proposing release,\16\
[[Page 1523]]
five of which discussed the proposed amendments to the broker-dealer
financial responsibility rules,\17\ and four of which discussed the
proposed amendments to the confirmations of transactions rule.\18\
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\13\ See, e.g., Nationally Recognized Statistical Rating
Organizations, Exchange Act Release No. 34616 (Aug. 31, 1994), 59 FR
46314 (Sep. 7, 1994) (soliciting comment on, among other things,
whether references to NRSRO credit ratings should be eliminated from
Commission rules); Rating Agencies and the Use of Credit Ratings
under the Federal Securities Laws, Exchange Act Release No. 47972
(June 4, 2003), 68 FR 35258 (June 12, 2003) (soliciting comment on
whether to eliminate the use of NRSRO credit ratings, and, if so,
what alternative benchmarks could be used to meet the Commission's
regulatory objectives); References to Ratings of Nationally
Recognized Statistical Rating Organizations, Exchange Act Release
No. 58070 (July 1, 2008), 73 FR 40088 (July 11, 2008) (proposing
amendments to remove references to credit ratings from Commission
rules under the Securities Act of 1933 (``Securities Act''),
Exchange Act, and Investment Company Act of 1940 (``Investment
Company Act'')); References to Ratings of Nationally Recognized
Statistical Rating Organizations, Exchange Act Release No. 60789
(Oct. 5, 2009), 74 FR 52358 (Oct. 9, 2009) (adopting amendments to
remove references to credit ratings in certain Commission rules);
References to Ratings of Nationally Recognized Statistical Rating
Organizations, Exchange Act Release No. 60790 (Oct. 5, 2009), 74 FR
52374 (Oct. 9, 2009) (re-opening comment on proposals to remove
references to credit ratings in certain Commission rules); Security
Ratings, Securities Act Release No. 9186 (Feb. 9, 2011), 76 FR 8961
(Feb. 16, 2011) (proposing amendments to remove references to credit
ratings in certain Commission rules); References to Credit Ratings
in Certain Investment Company Act Rules and Forms, Securities Act
Release No. 9193 (Mar. 3, 2011), 76 FR 12896 (Mar. 9, 2011)
(proposing amendments to remove references to credit ratings in
certain Commission rules); Security Ratings, Securities Act Release
No. 9245 (July 27, 2011), 76 FR 46603 (Aug. 3, 2011) (adopting
amendments to remove references to credit ratings in certain
Commission rules).
\14\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, Exchange Act Release No. 64352
(Apr. 27, 2011), 76 FR 26550 (May 6, 2011). The Commission also
proposed amendments in 2011 to remove references to credit ratings
in rules under the Securities Act and the Investment Company Act.
See References to Credit Ratings in Certain Investment Company Act
Rules and Forms, 76 FR 12896; Security Ratings, 76 FR 8961.
\15\ Regulation M is a set of anti-manipulation rules designed
to preserve the integrity of the securities market by prohibiting
activities that could artificially influence the market for an
offered security. See 17 CFR 242.100-105. The rules include an
exception for nonconvertible debt securities, nonconvertible
preferred securities, and asset-backed securities that are rated by
at least one NRSRO in one of its generic rating categories that
signifies investment grade. See 17 CFR 242.101(c)(2); 17 CFR
242.102(d)(2).
\16\ Comment letter of Chris Barnard (June 6, 2011) (``Barnard
Letter''); comment letter of Creative Investment Research, Inc.
(July 4, 2011) (``Creative Investment Letter''); comment letter of
Rothwell Consulting LLC (July 5, 2011) (``Rothwell Consulting
Letter''); comment letter of Davis Polk & Wardwell LLP (July 5,
2011) (``Davis Polk Letter''); comment letter of Bond Dealers of
America (July 5, 2011) (``Bond Dealers Letter''); comment letter of
the Securities Industry and Financial Markets Association (July 5,
2011) (``SIFMA Letter''); comment letter of Better Markets, Inc.
(July 5, 2011) (``Better Markets Letter''); comment letter of
Sullivan & Cromwell LLP (July 5, 2011) (``Sullivan & Cromwell
Letter''); comment letter of the Securitization Group, Securities
Industry and Financial Markets Association (Sep. 23, 2011) (``SIFMA
Securitization Letter''); comment letter of the CFA Institute (Dec.
20, 2011) (``CFA Institute Letter''); and comment letter of the
Honorable Sean P. Duffy, U.S. House of Representatives (Oct. 4,
2013) (``Duffy Letter''). These comment letters are available at
http://www.sec.gov/comments/s7-15-11/s71511.shtml. Comments are also
available for Web site viewing and printing in the Commission's
Public Reference Room, 100 F Street NE., Washington, DC (File No.
S7-15-11).
\17\ See Barnard Letter; Better Markets Letter; Bond Dealers
Letter; CFA Institute Letter; SIFMA Letter.
\18\ See Better Markets Letter; CFA Institute Letter; SIFMA
Letter; Sullivan & Cromwell Letter. In addition, one letter
discussed the proposed amendments to Regulation M and one letter
discussed reference removal under section 939A generally. See
Rothwell Consulting Letter (Regulation M); Duffy Letter (section
939A generally).
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A number of other federal agencies have also taken action to
implement section 939A of the Dodd-Frank Act, including regulations
proposed or adopted by the Commodity Futures Trading Commission,\19\
the Office of the Comptroller of the Currency,\20\ the National Credit
Union Administration,\21\ the Federal Housing Finance Agency,\22\ the
Department of Labor,\23\ and jointly by the Office of the Comptroller
of the Currency and the Federal Reserve Board.\24\ The actions taken by
these other regulators were considered in adopting today's amendments.
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\19\ See Investment of Customer Funds and Funds Held in an
Account for Foreign Futures and Foreign Options Transactions, 76 FR
78776 (Dec. 19, 2011) (final rule); Removing Any Reference to or
Reliance on Credit Ratings in Commission Regulations; Proposing
Alternatives to the Use of Credit Ratings, 76 FR 44262 (July 25,
2011) (final rule).
\20\ See Alternatives to the Use of External Credit Ratings in
the Regulations of the OCC, 77 FR 35253 (June 13, 2012) (final
rule).
\21\ See Alternatives to the Use of Credit Ratings, 77 FR 74103
(Dec. 13, 2012) (final rule).
\22\ See Removal of References to Credit Ratings in Certain
Regulations Governing the Federal Home Loan Banks, 78 FR 30784 (May
23, 2013) (proposed rule).
\23\ See Proposed Amendments to Class Prohibited Transaction
Exemptions to Remove Credit Ratings Pursuant to the Dodd-Frank Wall
Street Reform and Consumer Protection Act, 78 FR 37572 (June 21,
2013) (proposed rule).
\24\ See Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-Weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule, 78 FR 62018 (Oct. 11, 2013) (interim final rule with request
for comment).
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The following discussion summarizes the Commission's proposals with
respect to the broker-dealer financial responsibility and confirmations
of transaction rules, the comments received by the Commission in
response to each of the proposals, and the amendments the Commission is
adopting today.\25\
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\25\ In a separate release, the Commission is adopting final
amendments to remove references to credit ratings in Rule 5b-3 and
Forms N-1A, N-2, and N-3 under the Investment Company Act.
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B. Amendments
1. The Broker-Dealer Financial Responsibility Rules
a. The Net Capital Rule
i. Proposal
In 1975, the Commission adopted the term nationally recognized
statistical rating organization as part of amendments to the broker-
dealer net capital rule (``Rule 15c3-1'').\26\ The Commission's initial
regulatory use of the term was intended to provide a method for
determining net capital charges on different grades of debt securities
under Rule 15c3-1.\27\ Rule 15c3-1 prescribes a net liquid assets test
that is designed to require a broker-dealer to maintain sufficient
liquid assets to meet all obligations to customers and counterparties
and have adequate additional resources to wind-down its business in an
orderly manner without the need for a formal proceeding if the firm
fails financially.\28\ Among other things, Rule 15c3-1 requires broker-
dealers to maintain specified minimum levels of net liquid assets, or
net capital.\29\ In particular, it requires that a broker-dealer
perform two calculations: (1) a computation of the minimum amount of
net capital the broker-dealer must maintain; \30\ and (2) a computation
of the amount of net capital the broker-dealer is maintaining.\31\ The
minimum net capital requirement is the greater of a fixed-dollar amount
specified in the rule or an amount determined by applying one of two
financial ratios.\32\
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\26\ See Adoption of Uniform Net Capital Rule and an Alternative
Net Capital Requirement for Certain Brokers and Dealers, Exchange
Act Release No. 11497 (June 26, 1975), 40 FR 29795 (July 16, 1975);
17 CFR 240.15c3-1.
\27\ See 17 CFR 240.15c3-1.
\28\ See Net Capital Rule, Exchange Act Release No. 38248 (Feb.
6, 1997), 62 FR 6474 (Feb. 12, 1997).
\29\ See 17 CFR 240.15c3-1.
\30\ See 17 CFR 240.15c3-1(a).
\31\ See 17 CFR 240.15c3-1(c)(2). The computation of net capital
is based on the definition of net capital in paragraph (c)(2) of
Rule 15c3-1. Id.
\32\ See 17 CFR 240.15c3-1(a).
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In computing net capital, a broker-dealer must, among other things,
make certain adjustments to net worth, including deducting illiquid
assets, taking other net capital charges, and adding qualifying
subordinated loans.\33\ The amount remaining after these adjustments is
defined as tentative net capital.\34\ The final step in computing net
capital is to take prescribed percentage deductions (``haircuts'') from
the mark-to-market value of proprietary positions (e.g., securities,
money market instruments, and commodities) that are included in the
broker-dealer's tentative net capital.\35\ The haircuts are designed to
account for the market risk inherent in these positions and create a
buffer of liquidity to protect against other risks associated with the
securities business.\36\
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\33\ See 17 CFR 240.15c3-1(c)(2)(i) through (xiii).
\34\ See 17 CFR 240.15c3-1(c)(15).
\35\ See 17 CFR 240.15c3-1(c)(2)(vi).
\36\ See, e.g., Uniform Net Capital Rule, Exchange Act Release
No. 13635 (June 16, 1977), 42 FR 31778 (June 23, 1977) (``[Haircuts]
are intended to enable net capital computations to reflect the
market risk inherent in the positioning of the particular types of
securities enumerated in [the rule.]''); Net Capital Rule, Exchange
Act Release No. 22532 (Oct. 15, 1985), 50 FR 42961 (Oct. 23, 1985)
(``These percentage deductions, or `haircuts', take into account
elements of market and credit risk that the broker-dealer is exposed
to when holding a particular position.''); Net Capital Rule,
Exchange Act Release No. 39455 (Dec. 17, 1997), 62 FR 67996 (Dec.
30, 1997) (``Reducing the value of securities owned by broker-
dealers for net capital purposes provides a capital cushion against
adverse market movements and other risks faced by the firms,
including liquidity and operational risks.'') (footnote omitted).
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Rule 15c3-1 prescribes differing haircut amounts for a variety of
classes of securities.\37\ The rule also contains catchall provisions
to account for securities that are not included in the specified
classes of securities.\38\ Generally, the catchall provisions impose
higher deductions (15% or 40% of the mark-to-market value of the
positions) than the haircuts applicable to the specifically identified
classes of securities.\39\ Further, if a security does not have a ready
market, it is subject to a 100% deduction from net worth.\40\
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\37\ See 17 CFR 240.15c3-1(c)(2)(vi)(A) through (H).
\38\ See 17 CFR 240.15c3-1(c)(2)(vi)(J) through (K).
\39\ Compare 17 CFR 240.15c3-1(c)(2)(vi)(A) through (H), with 17
CFR 240.15c3-1(c)(2)(vi)(J) through (K).
\40\ See 17 CFR 240.15c3-1(c)(2)(vii). The term ready market is
defined in Rule 15c3-1 as ``a market in which there exists
independent bona fide offers to buy and sell so that a price
reasonably related to the last sales price or current bona fide
competitive bid and offer quotations can be determined for a
particular security almost instantaneously and where payment will be
received in settlement of a sale at such price within a relatively
short time conforming to trade custom.'' 17 CFR 240.15c3-1(c)(11).
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[[Page 1524]]
Prior to today's amendments, commercial paper, nonconvertible debt,
and preferred stock rated in higher rating categories by at least two
NRSROs were included in the classes of securities that had lower
haircuts than securities subject to the catchall provisions.\41\
Specifically, to qualify for this treatment, among other things,
commercial paper needed to be rated in one of the three highest rating
categories by at least two NRSROs,\42\ nonconvertible debt needed to be
rated in one of the four highest rating categories by at least two
NRSROs,\43\ and preferred stock needed to be rated in one of the four
highest rating categories by at least two NRSROs.\44\ Broker-dealers
were not required to take as large a haircut for commercial paper,
nonconvertible debt, and preferred stock meeting these rating
conditions because the securities were considered to be less volatile
in price than securities that were rated in lower rating categories or
were unrated.
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\41\ See 17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H).
Generally, the haircut requirements in Rule 15c3-1 prior to today's
amendments were based on the practice of many NRSROs having at least
eight categories of ratings for debt securities, with the top four
ratings commonly referred to in the industry as investment grade.
\42\ See 17 CFR 240.15c3-1(c)(2)(vi)(E). The amount of the
haircut ranged from 0% to \1/2\ of 1% depending on the time to
maturity of the commercial paper. Id. Additional conditions to
qualify for this treatment were that the commercial paper had a
maturity at date of issuance not exceeding nine months exclusive of
days of grace, or any renewal thereof, the maturity of which was
likewise limited, and a fixed rate of interest or been sold at a
discount. Id.
\43\ See 17 CFR 240.15c3-1(c)(2)(vi)(F). The amount of the
haircut ranged from 2% to 9% depending on the time to maturity of
the nonconvertible debt security. Id. Additional conditions to
qualify for this treatment were that the nonconvertible debt
security had a fixed rate of interest, a fixed maturity, and did not
trade flat and was not in default as to principal or interest. Id.
\44\ See 17 CFR 240.15c3-1(c)(2)(vi)(H). The amount of the
haircut was 10%. Id. Additional conditions to qualify for this
treatment were that the preferred stock ranked prior to all other
classes of stock of the same issuer and was not in arrears as to
dividends. Id.
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The Commission proposed to remove references to credit ratings in
the provisions of Rule 15c3-1 establishing lower haircuts for higher
rated commercial paper, nonconvertible debt, and preferred stock and to
substitute an alternative standard of creditworthiness as a condition
for qualifying for the lower haircut treatment.\45\ The proposed
amendments retained the non-credit rating conditions for these classes
of securities to apply lower haircuts. Under the proposal, a broker-
dealer would have been permitted to apply the lower haircuts for
commercial paper (i.e., between zero and \1/2\ of 1%), nonconvertible
debt (i.e., between 2% and 9%), and preferred stock (i.e., 10%) if the
position had only a minimal amount of credit risk as determined by the
broker-dealer pursuant to written policies and procedures the broker-
dealer established, maintained, and enforced to assess
creditworthiness.\46\ Consequently, to use these lower haircuts for
commercial paper, nonconvertible debt, and preferred stock, a broker-
dealer would have been required to establish, maintain, and enforce
written policies and procedures designed to assess the credit risks
applicable to the position and, based on this process, would have had
to determine that the investment had only a minimal amount of credit
risk.\47\ A broker-dealer would have been required to take a larger
deduction, normally the 15% ``catchall'' haircut, on its proprietary
positions in commercial paper, nonconvertible debt, and preferred stock
if the firm did not have procedures to assess the creditworthiness of
the class of security or money market instrument or determined its
position was not of minimal credit risk.\48\ Moreover, if an issuance
of commercial paper, nonconvertible debt, or preferred stock did not
trade in a ready market, the broker-dealer would continue to apply a
100% haircut--meaning that the broker-dealer could not include the
value of the security in its net capital.\49\
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\45\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, 76 FR at 26552-26554.
\46\ Id. at 26552.
\47\ Id.
\48\ Id.
\49\ Id.
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In the proposing release, the Commission identified the following
factors a broker-dealer could consider, to the extent appropriate, when
assessing credit risk for purposes of determining whether an issuance
of commercial paper, nonconvertible debt, or preferred stock was of
minimal credit risk: (1) Credit spreads; (2) securities-related
research; (3) internal or external credit risk assessments; (4) default
statistics; (5) inclusion in an index; (6) priorities and enhancements;
(7) price, yield and/or volume; and (8) asset class-specific
factors.\50\ The Commission stated that the list of factors was not
intended to be exhaustive nor mutually exclusive and that the range and
type of specific factors considered would vary depending on the
particular securities that were reviewed.\51\
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\50\ Id. at 26552-26553.
\51\ Removal of Certain References to Credit Ratings under the
Securities Exchange Act of 1934, 76 FR at 26553.
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In addition, each broker-dealer would have been required to
preserve for a period of not less than three years (the first two years
in an easily accessible place) the written policies and procedures that
the broker-dealer established, maintained, and enforced for assessing
credit risk for commercial paper, nonconvertible debt, and preferred
stock.\52\ Broker-dealers would have been subject to this requirement
in the broker-dealer record retention rule (Rule 17a-4), which the
Commission proposed to amend in conjunction with the rulemaking.\53\
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\52\ Id. at 26553.
\53\ Id.; see also 17 CFR 240.17a-4.
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ii. Comments
Five commenters responded to the Commission's request for comment
on the amendments to Rule 15c3-1.\54\ One additional commenter--writing
about section 939A generally--supported the goals of section 939A to
provide incentive for more information and diligence for investors and
to increase competition in the credit rating agency industry but also
cautioned that implementation of section 939A could be confusing to
smaller banks and investors.\55\ Two commenters raised concerns
generally about replacing credit ratings with a more subjective
standard of creditworthiness.\56\ Three other commenters suggested
modifications to the Commission's list of factors that a broker-dealer
could consider when assessing creditworthiness under the proposed
minimal amount of credit risk standard.\57\ Commenters also generally
supported the Commission's proposal that broker-dealers document and
retain their policies and procedures for assessing a position's
creditworthiness to determine whether it is of minimal credit risk.\58\
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\54\ See Barnard Letter; Better Markets Letter; Bond Dealers
Letter; CFA Institute Letter; SIFMA Letter; see also Removal of
Certain References to Credit Ratings under the Securities Exchange
Act of 1934, 76 FR at 26554.
\55\ See Duffy Letter, at 1.
\56\ See Bond Dealers Letter, at 2-3; SIFMA Letter, at 11.
\57\ See Barnard Letter, at 1-2; Better Markets Letter, at 6-7;
CFA Institute Letter, at 4.
\58\ See Barnard Letter, at 2; Better Markets Letter, at 6-8.
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Among commenters raising concerns about the Commission replacing
credit ratings with a more subjective approach for determining
haircuts, one commenter stated that the proposal contains an inherent
conflict of interest, is complicated, and would disproportionately
burden smaller
[[Page 1525]]
firms.\59\ This commenter also stated that the Commission's proposal
could result in inconsistent net capital treatment across broker-
dealers absent a mandatory list of factors or an objective standard
that a broker-dealer could apply when determining net capital
haircuts--``[f]or example, one firm may determine a security qualifies
for a 9% haircut, while another might determine the haircut for the
same security is 15%.'' \60\ This commenter also has concerns that a
subjective approach would reduce liquidity, increase volatility, and
could increase costs for issuers of securities.\61\
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\59\ Bond Dealers Letter, at 2. This commenter argued that the
proposed amendments disadvantage smaller broker-dealers that lack
the necessary internal resources to determine creditworthiness and,
as a result, will be unable to apply reduced haircuts.
\60\ Id.
\61\ Id.
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The second commenter expressed concern that Commission and self-
regulatory organization (``SRO'') examiners would ``second guess'' a
broker-dealer's policies and procedures and analysis under the new
standard and that examiners should, instead, focus on the
reasonableness of the policies and procedures.\62\ This commenter also
requested that examiners avoid duplicating the work of other regulators
who have already considered the adequacy of a broker-dealer's policies
and procedures for assessing the creditworthiness of securities
positions.\63\
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\62\ SIFMA Letter, at 19.
\63\ Id. at 20-21.
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Regarding the Commission's proposed list of factors that broker-
dealers could consider when assessing creditworthiness under the
minimal amount of credit risk standard, one commenter recommended that
the Commission require broker-dealers to consider certain mandatory
factors and suggested they be codified in the final rule.\64\ In
contrast, another commenter did not believe that factors should be
codified in the rule.\65\ Another stated that a broker-dealer's
assessment of a security's creditworthiness should be based on ``hard''
factors, such as credit spreads and default statistics, rather than
``soft'' factors, such as securities-related research.\66\
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\64\ Better Markets Letter, at 5-6.
\65\ SIFMA Letter, at 20.
\66\ Barnard Letter, at 2.
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One commenter requested that ``term to maturity'' and
``concentration of credit risk'' be included as factors that a broker-
dealer could consider in assessing whether a position is of minimal
credit risk.\67\ Another suggested that a broker-dealer's policies and
procedures for assessing creditworthiness under the proposed standard
be permitted to take into account the ``size of the [broker-dealer's]
position and the purpose for which the position [was] acquired or held
by the broker-dealer.'' \68\ This commenter also stated that a broker-
dealer's obligation to monitor credit determinations should be based on
factors such as the volatility of business conditions within the
relevant industry and the frequency with which the securities
trade.\69\
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\67\ CFA Institute Letter, at 4.
\68\ SIFMA Letter, at 10-11.
\69\ Id. at 21.
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One commenter suggested that a broker-dealer be allowed to rely on
a parent's or an affiliate's credit determination.\70\ Another stated
that, to promote regulatory and market transparency, a broker-dealer
that develops internal credit ratings should be required to compare its
ratings to an external benchmark, such as NRSRO ratings, market data,
or other credit information sources.\71\ Another stated, however, that
a broker-dealer should be prohibited from considering internally or
externally developed credit ratings as part of its credit risk
assessment process and that permitting such use would conflict with
section 939A of the Dodd-Frank Act.\72\
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\70\ Id.
\71\ CFA Institute Letter, at 4.
\72\ Better Markets Letter, at 7.
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Commenters generally supported the Commission's proposal that
broker-dealers document their policies and procedures for determining
creditworthiness under the minimal amount of credit risk standard.\73\
One commenter suggested that such documentation be maintained
indefinitely.\74\ Another stated that the Commission should require a
broker-dealer to maintain a record for each assessment of
creditworthiness under the standard.\75\ Another stated that the
Commission should only require the retention of records for
determinations of credit risk when a broker-dealer is engaged in
``sophisticated credit analysis.'' \76\ This commenter stated that a
broker-dealer should not be required to document its credit analysis
with respect to a position if the analysis was based on a small number
of objective factors and could be easily reconstructed by the broker-
dealer.\77\
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\73\ One commenter stated that broker-dealers would otherwise
make self-interested determinations at the expense of customers.
Better Markets Letter, at 6-8. Another commenter stated that these
policies and procedures should be preserved for three years and
updated to reflect significant changes. Barnard Letter, at 2. This
commenter further argued that broker-dealers that create and enforce
procedures to determine creditworthiness be granted the lesser
haircut. Id.
\74\ Barnard Letter, at 2.
\75\ Better Markets Letter, at 7-8.
\76\ SIFMA Letter, at 22.
\77\ Id.
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iii. Final Rule
The Commission is amending Rule 15c3-1 to remove references to
NRSRO credit ratings in the provisions establishing lower haircuts for
commercial paper, nonconvertible debt, and preferred stock. The
Commission is adopting amendments to these provisions with
modifications from the proposal, discussed below, to address issues
raised by commenters.
Under the final amendments and consistent with the proposal, when a
broker-dealer applies haircuts for commercial paper, nonconvertible
debt, and preferred stock that have a ready market for purposes of its
net capital computation, it will have the option of: (1) Using the
firm's own written policies and procedures to determine whether the
security has only a minimal amount credit risk and, if so, applying the
appropriate lower haircut if it meets the other conditions prescribed
in Rule 15c3-1; or (2) applying the greater deduction applicable to the
position, such as the 15% haircut under the catchall provision in
paragraph (c)(2)(vi)(J) of Rule 15c3-1.\78\ Commercial paper,
nonconvertible debt, and preferred stock without a ready market would
continue to be subject to a 100% haircut.\79\
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\78\ See paragraphs (c)(2)(vi)(E), (c)(2)(vi)(F), (c)(2)(vi)(H),
and (c)(2)(vi)(I) of Rule 15c3-1, as amended.
\79\ See 17 CFR 240.15c3-1(c)(2)(vii).
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Unlike the objective approach of using NRSRO credit ratings, the
minimal amount of credit risk standard is a subjective approach because
it allows broker-dealers in the first instance to determine through
their credit assessments whether a lower haircut is applicable to a
given position. Further, whereas the rule prior to today's amendments
required that commercial paper, nonconvertible debt, and preferred
stock be given high credit ratings by an NRSRO before a reduced haircut
is permitted, the minimal amount of credit risk standard provides
flexibility to broker-dealers by allowing them to rely on a variety of
factors, both objective and subjective, in assessing the credit and
liquidity risks associated with their proprietary commercial paper,
nonconvertible debt, and preferred stock positions. However, the
Commission does not intend for the new standard to result in a more
liberal requirement that broadens the scope of
[[Page 1526]]
the rule by allowing more positions to qualify for the lower
haircuts.\80\ The Commission notes that credit ratings and market data
(such as credit spreads and yields) can serve as useful benchmarks for
evaluating whether a broker-dealer's policies and procedures, as
applied to the minimal amount of credit risk standard, are increasing
the types of commercial paper, nonconvertible debt, and preferred stock
positions to which it applies the lower haircuts as compared to the
eliminated NRSRO credit rating standard.
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\80\ As noted above, to qualify for the lower haircuts under the
NRSRO credit rating standard being replaced today, commercial paper
needed to be rated in one of the three highest rating categories by
at least two NRSROs, nonconvertible debt needed to be rated in one
of the four highest rating categories by at least two NRSROs, and
preferred stock needed to be rated in one of the four highest rating
categories by at least two NRSROs. For an example of one NRSRO's
definitions of its four highest credit rating categories, see
Standard & Poor's Ratings Definitions for long-term issuances
available at http://img.en25.com/Web/StandardandPoors/Ratings_Definitions.pdf. Information about the credit rating categories of
all the NRSROs can be obtained through the Forms NRSRO they file
with the Commission and make publicly available. Links to these
forms are available at http://www.sec.gov/about/offices/ocr.shtml.
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The Commission is amending paragraph (c)(2)(vi)(E) of Rule 15c3-1
(relating to commercial paper haircuts), paragraphs (c)(2)(vi)(F)(1)
and (c)(2)(vi)(F)(2) of Rule 15c3-1 (relating to nonconvertible debt
haircuts), and paragraph (c)(2)(vi)(H) of Rule 15c3-1 (relating to
preferred stock haircuts) by replacing references to NRSRO credit
ratings with the alternative minimal amount of credit risk
standard.\81\ Consistent with the proposal, the final rule provides
that a broker-dealer may apply the lower haircuts applicable to
commercial paper (i.e., between 0% and \1/2\ of 1%), nonconvertible
debt (i.e., between 2% and 9%), and preferred stock (i.e., 10%) if the
security has only a minimal amount of credit risk.\82\
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\81\ See paragraphs (c)(2)(vi)(E), (c)(2)(vi)(F), and
(c)(2)(vi)(H) of Rule 15c3-1, as amended.
\82\ Id.
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The Commission has made several modifications to its proposed rule
text. First, the Commission has re-structured the rule by adding new
paragraph (c)(2)(vi)(I) to specify requirements for the policies and
procedures a broker-dealer must establish, document, maintain, and
enforce for purposes of assessing whether a position has only a minimal
amount credit risk under paragraphs (c)(2)(vi)(E), (c)(2)(vi)(F)(1),
(c)(2)(vi)(F)(2), and (c)(2)(vi)(H).\83\ Under the proposal, each of
the paragraphs (i.e., paragraphs (c)(2)(vi)(E), (c)(2)(vi)(F)(1),
(c)(2)(vi)(F)(2), and (c)(2)(vi)(H)) separately provided that a broker-
dealer must determine whether a position has only a minimal amount of
credit risk pursuant to ``written policies and procedures the broker-
dealer establishes, maintains, and enforces to assess
creditworthiness.'' \84\ Consistent with the proposal, each paragraph
still requires that the security or money market instrument have only a
minimal amount of credit risk before the lower haircut may be applied;
however the reference to policies and procedures in each paragraph has
been removed. Instead, new paragraph (c)(2)(vi)(I) of Rule 15c3-1
requires the broker-dealer to establish, document, maintain, and
enforce policies and procedures to assess and monitor the
creditworthiness of each security or money market instrument that are
reasonably designed for the purpose of determining whether the position
has only a minimal amount of credit risk.\85\ Securities or money
market instruments assessed to have only a minimal amount of credit
risk also must meet the other non-credit rating conditions prescribed
in Rule 15c3-1 in order to apply the lower haircuts under paragraphs
(c)(2)(vi)(E), (c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2), or
(c)(2)(vi)(H).\86\
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\83\ See paragraph (c)(2)(vi)(I) of Rule 15c3-1, as amended.
\84\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, 76 FR at 26576.
\85\ See paragraph (c)(2)(vi)(I) of Rule 15c3-1, as amended.
\86\ Paragraph (c)(2)(vi)(E) of Rule 15c3-1, as amended, retains
the non-credit rating conditions that the commercial paper must have
a maturity at date of issuance not exceeding nine months exclusive
of days of grace, or any renewal thereof, the maturity of which is
likewise limited, and a fixed rate of interest, or be sold at a
discount. See 17 CFR 240.15c3-1(c)(2)(vi)(E). Paragraph
(c)(2)(vi)(F) of Rule 15c3-1, as amended, retains the non-credit
rating conditions that the nonconvertible debt security must have a
fixed rate of interest, a fixed maturity, and not be traded flat or
in default as to principal or interest. See 17 CFR 240.15c3-
1(c)(2)(vi)(F). Paragraph (c)(2)(vi)(H) of Rule 15c3-1, as amended,
retains the non-credit rating conditions that the preferred stock
must rank prior to all other classes of stock of the same issuer and
not be in arrears as to dividends. See 17 CFR 240.15c3-
1(c)(2)(vi)(H). See also 17 CFR 240.15c3-1(c)(2)(vii) (establishing
a 100% deduction for securities for which there is no ready market).
---------------------------------------------------------------------------
Under the final rule, new paragraph (c)(2)(vi)(I) of Rule 15c3-1
provides that in order to apply a deduction under paragraphs
(c)(2)(vi)(E), (c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2), or (c)(2)(vi)(H),
the broker-dealer must assess the creditworthiness of the security or
money market instrument pursuant to policies and procedures for
assessing and monitoring creditworthiness that the broker-dealer
establishes, documents, maintains, and enforces.\87\ The Commission
added the word ``monitoring'' to clarify that, after the initial
determination by a broker-dealer, a position must continue to have only
a minimal amount of credit risk in order to remain qualified for the
lower haircut and that monitoring must be done in accordance with the
firm's policies and procedures. Under Rule 15c3-1, a broker-dealer must
at ``all times'' have and maintain an amount of net capital that is at
least equal to the minimum amount of net capital required by the
rule.\88\ Consequently, the broker-dealer must monitor its securities
and money market instrument positions in order to ensure that it is
applying the appropriate haircuts to those positions. For example,
under the NRSRO credit rating standard being eliminated today, a
broker-dealer needed to monitor whether the positions it held continued
to have the required credit ratings to apply the lower haircuts because
credit rating agencies may adjust (e.g., downgrade) their credit
ratings. The same is true under the new minimal credit risk standard
because the creditworthiness of a security or money market instrument
can change over time and, consequently, a position that has only a
minimal amount of credit risk at one point in time may not retain that
status.
---------------------------------------------------------------------------
\87\ See paragraph (c)(2)(vi)(I) of Rule 15c3-1, as amended.
\88\ See 17 CFR 240.15c3-1(a).
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In the proposing release, the Commission requested comment on how
often a broker-dealer should be required to update its assessments.\89\
The Commission received one comment in response to this request.\90\
The commenter stated that the frequency of review ``should be a
function of a number of factors, including, e.g., the size and purpose
of the broker-dealer's position in the fixed-income security, the
volatility of business conditions within the relevant industry, the
amount of fixed-income securities issued, and the frequency with which
the securities trade.'' \91\ The Commission generally agrees with the
commenter that the frequency of review should depend on a variety
factors such as those identified by the commenter. However, as
discussed above, the requirement for a broker-dealer to maintain its
required minimum amount of net capital is moment-to-moment.
Consequently, a broker-dealer's policies and procedures for assessing
whether an issuance of commercial paper, nonconvertible debt, or
preferred stock
[[Page 1527]]
has only a minimal amount of credit risk must include a process that is
designed to ensure that its credit determinations are current, and
address the frequency with which the broker-dealer reviews and
reassesses its credit determinations. For example, a broker-dealer's
policies and procedures could require more frequent reassessments in
the case of securities or money market instruments that are close to
the line between having only a minimal amount of credit risk and having
a greater level of credit risk or that are subject to macroeconomic
conditions or issuer specific events that could have an impact on
credit risk. In addition, a higher haircut must be taken when a
security or money market instrument no longer has only a minimal amount
of credit risk. The Commission expects that a broker-dealer's process
for monitoring its credit determinations will be customized to the size
and activities of the firm to ensure that it maintains the required
amount of net capital at ``all times.'' \92\
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\89\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, 76 FR at 26554.
\90\ See SIFMA Letter.
\91\ Id. at 21.
\92\ See 17 CFR 240.15c3-1(a).
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The Commission also modified the proposed rule text relating to
policies and procedures by including in new paragraph (c)(2)(vi)(I) of
Rule 15c3-1 the qualifier that the policies and procedures must be
``reasonably designed'' for the purpose of assessing
creditworthiness.\93\ As noted above, one commenter raised a concern
that Commission and SRO examiners would ``second guess'' broker-dealer
credit assessments and stated that the regulatory focus on compliance
with the rule should be on the ``reasonableness'' of a firm's policies
and procedures for assessing creditworthiness.\94\ The Commission
agrees that the starting point for reviewing whether a firm is in
compliance with the amendments should be to evaluate the reasonableness
of the firm's policies and procedures in light of the firm's
circumstances (e.g., the size of the broker-dealer and the types and
sizes of the positions typically held by the broker-dealer). In this
regard, the policies and procedures must specify with sufficient detail
the steps the broker-dealer will take in performing a credit assessment
so that Commission and SRO examiners can evaluate them.
---------------------------------------------------------------------------
\93\ See paragraph (c)(2)(vi)(I) of Rule 15c3-1, as amended.
\94\ SIFMA Letter, at 19.
---------------------------------------------------------------------------
However, the Commission also modified the final rule to add new
text that provides that policies and procedures that are reasonably
designed ``should result in assessments of creditworthiness that
typically are consistent with market data.'' \95\ In particular, this
standard for evaluating the reasonableness of a broker-dealer's
policies and procedures will require examiners to compare market data
(e.g., external factors such as credit spreads or yields) with the
broker-dealer's determinations that a security or money market
instrument has only a minimal amount of credit risk. This provision is
designed to address concerns raised by commenters that the proposed
minimal amount of credit risk standard was too subjective.\96\
Commenters raised concerns about requiring the use of a subjective
standard because, among other things, it presents an inherent conflict
of interest, is complicated, could reduce liquidity, and could result
in uncertainty on the part of market participants.\97\ Requiring a
broker-dealer's policies and procedures to produce credit risk
determinations that typically are consistent with market data should
mitigate concerns about potential consequences of the subjectivity
inherent in the final rule. Furthermore, as explained throughout this
release, a broker-dealer can make its credit risk determination
pursuant to policies and procedures that specify the use of a small
number of objective factors and, if a broker-dealer avails itself of
this option, it should help the broker-dealer create a less-complicated
methodology that aligns with market data, therefore easing the concerns
of commenters.
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\95\ See paragraph (c)(2)(vi)(I) of Rule 15c3-1, as amended.
\96\ Bond Dealers Letter, at 2-3; SIFMA Letter, at 3.
\97\ Bond Dealers Letter, at 2; SIFMA Letter, at 3.
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Notwithstanding the reasonableness of a broker-dealer's policies
and procedures, examiners may still question a broker-dealer's credit
risk determination, and are particularly likely to question a
determination related to large concentrated positions or that is not
consistent with market data. In addition, if a broker-dealer
incorrectly determines pursuant to paragraph (c)(2)(vi)(I) of Rule
15c3-1 that a security has only a minimal amount of credit risk, the
broker-dealer could be in violation of Rule 15c3-1 to the extent the
appropriate larger haircut would put the broker-dealer below the
required minimum amount of net capital.\98\ Thus, a broker-dealer would
need to be able to support each credit determination it makes in the
context of a Commission or SRO examination. If the broker-dealer's
determination that a position has only a minimal amount of credit risk
is not consistent with market data, that result would not necessarily
be dispositive that the position is not entitled to the lower haircut.
However, the broker-dealer would have a high burden to demonstrate to
examiners that the position has only a minimal amount of credit risk.
---------------------------------------------------------------------------
\98\ Calculating a haircut incorrectly also could cause the
broker-dealer to file incorrect reports with the Commission under
Rule 17a-5. See 17 CFR 240.17a-5 (requiring broker-dealers to
periodically file financial reports that, among other things,
contain computations of net capital).
---------------------------------------------------------------------------
When assessing whether a security or money market instrument has
only a minimal amount of credit risk for purposes of Rule 15c3-1, a
broker-dealer could consider pursuant to the policies and procedures it
establishes, documents, maintains, and enforces the following factors,
to the extent appropriate:
Credit spreads (i.e., whether it is possible to
demonstrate that a position in commercial paper, nonconvertible debt,
and preferred stock has only a minimal amount of credit risk based on
the spread between the security's yield and the yield on Treasury or
other securities, or based on the spreads of credit default swaps that
reference the security or money market instrument);
Securities-related research (i.e., whether providers of
research about securities or money market instruments believe the
issuer of the security or money market instrument will be able to meet
its financial commitments, generally, or specifically, with respect to
securities or money market instruments held by the broker-dealer);
Internal or external credit risk assessments (i.e.,
whether credit assessments developed internally by the broker-dealer or
externally by a credit rating agency, irrespective of its status as an
NRSRO, express a view as to the credit risk associated with a
particular security or money market instrument of the issuer thereof);
Default statistics (i.e., whether providers of credit
information relating to securities or money market instruments express
a view that specific securities or money market instruments (or their
issuers) have a probability of default consistent with other securities
or money market instruments that have only a minimal amount of credit
risk);
Inclusion in an index (i.e., whether a security, money
market instrument, or the issuer of a security or money market
instrument, is included as a component of a recognized index of
instruments that have only a minimal amount of credit risk);
Enhancements and priorities (i.e., the extent to which a
security or money market instrument is covered by credit enhancements,
such as overcollateralization and reserve accounts, or has priority
under
[[Page 1528]]
applicable bankruptcy or creditors' rights provisions);
Price, yield and/or volume (i.e., whether the price and
yield of a security or money market instrument or a credit default swap
that references the security or money market instrument are consistent
with other securities or money market instruments that the broker-
dealer has determined have only a minimal amount of credit risk and
whether the price resulted from active trading); and
Asset class-specific factors (e.g., in the case of
structured finance products, the quality of the underlying assets).
The Commission does not intend this list of factors to be
exhaustive or mutually exclusive. For example, other factors may be
appropriate for assessing creditworthiness and, in particular, whether
a position has only a minimal amount of credit risk.
As noted above, several commenters identified additional factors
that they believe would be appropriate for purposes of assessing
whether a security or money market instrument has only a minimal amount
of credit risk and one commenter suggested making certain factors
mandatory.\99\ Some of these factors, such as the term to maturity of
the security or money market instrument, are already factored into Rule
15c3-1 and therefore do not need to be specifically added to the
list.\100\ The Commission does not believe other factors should be
added because the list is not meant to be exhaustive and broker-dealers
should tailor their policies and procedures for assessing credit risk
to their particular circumstances and specify in their policies and
procedures those factors they deem appropriate, which may include
factors that are not on the list above.\101\ In addition, the
Commission recognizes that a broker-dealer's policies and procedures
may specify the use of different factors, different sets of factors, or
different combinations of factors depending on the characteristics of
the security or money market instrument being assessed, the amount of
time the broker-dealer intends to hold the position, and the size of
the position, among other things. Further, the Commission does not
expect that in order for a broker-dealer's policies and procedures to
be ``reasonably designed'' that they must specify the use of every
factor, or any particular factor, on the list. Certain factors, such as
credit spreads, may not be applicable for bonds that are thinly traded.
Thus, mandating that factor, or any other factor, would not necessarily
help a broker-dealer make a creditworthiness determination. Instead,
each broker-dealer should analyze its unique situation when designing
its policies and procedures, including, for example, its size, the
amount of proprietary trading by the broker-dealer in commercial paper,
nonconvertible debt, and preferred stock, and the size and
characteristics of the positions the firm typically holds, among other
things.
---------------------------------------------------------------------------
\99\ Better Markets Letter, at 6 (suggesting that the list ``be
more comprehensive'' and include factors such as the nature of the
issuer, the terms of the security, and the financial and regulatory
context in which the issuer is operating); Id. at 3 (``the use of
credit spreads and/or inclusion of an index should be the objective
standard used to determine creditworthiness of these securities'');
CFA Institute Letter, at 4 (suggesting the addition of ``term to
maturity'' and ``concentration of credit risk'' as factors on the
list).
\100\ See, e.g., 17 CFR 15c3-1(c)(2)(vi)(F)(1) (nonconvertible
debt securities must have a ``fixed maturity date,'' among other
factors, in order to qualify for a reduced haircut).
\101\ One commenter agreed with the Commission. SIFMA Letter, at
20.
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Under the amendments, a broker-dealer must apply a higher
deduction, such as the 15% ``catchall'' haircut, on a proprietary
position in commercial paper, nonconvertible debt, and preferred stock
if the firm determines the security has more than a minimal amount of
credit risk or the firm opts not to have policies and procedures to
assess the creditworthiness of the class of security or money market
instrument.\102\ Moreover, if the commercial paper, nonconvertible
debt, or preferred stock held by the broker-dealer does not trade in a
ready market, the broker-dealer must apply a 100% haircut irrespective
of the firm's credit risk determination.\103\
---------------------------------------------------------------------------
\102\ See paragraph (c)(2)(vi)(I) of Rule 15c3-1, as amended; 17
CFR 240.15c3-1(c)(2)(vi)(J). If a broker-dealer chooses to apply the
net capital deduction under paragraph (c)(2)(vi)(J) of Rule 15c3-1
instead of making an assessment of the creditworthiness of each
security, the broker-dealer will not be required to have policies
and procedures to assess a security's creditworthiness for purposes
of applying the haircuts prescribed in paragraphs (c)(2)(vi)(E),
(c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2), or (c)(2)(vi)(H) of Rule 15c3-1.
\103\ See 17 CFR 240.15c3-1(c)(2)(vii). As noted above, the term
ready market is defined in Rule 15c3-1 as ``a market in which there
exists independent bona fide offers to buy and sell so that a price
reasonably related to the last sales price or current bona fide
competitive bid and offer quotations can be determined for a
particular security almost instantaneously and where payment will be
received in settlement of a sale at such price within a relatively
short time conforming to trade custom.'' 17 CFR 240.15c3-1(c)(11).
---------------------------------------------------------------------------
Under today's amendments, and consistent with the proposed
amendments, a broker-dealer must preserve for a period of not less than
three years, the first two years in an easily accessible place, the
policies and procedures that the broker-dealer establishes, documents,
maintains, and enforces for assessing and monitoring the credit risk of
commercial paper, nonconvertible debt, and preferred stock. This
requirement is codified in new paragraph (b)(13) of Rule 17a-4.\104\
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\104\ See paragraph (b)(13) of Rule 17a-4, as amended.
---------------------------------------------------------------------------
The amendments do not require a broker-dealer to maintain a record
of each of its credit risk determinations for purposes of Rule 15c3-
1.\105\ However, a broker-dealer would need to be able to support each
of its credit risk determinations both for internal risk management
purposes and in the context of a Commission or SRO examination. A
broker-dealer should maintain documentation of its credit risk
determinations for this purpose. Alternatively, a firm that maintains
or can access the data, information, and inputs used to make a credit
risk determination could be in a position to replicate the original
credit risk determination using the same process, information, and
inputs employed to make the original determination.\106\ For example,
if a broker-dealer uses market data to assess creditworthiness, it
should be able to access information showing the data as of the date
the credit risk determination was made.\107\ A broker-dealer that uses
a model with multiple inputs should be able to replicate the model
output upon request or maintain a record of the model output as of the
date of the original credit risk determination.
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\105\ Paragraph (b)(5) of Rule 17a-4 provides, in pertinent
part, that a broker-dealer shall preserve for a period of not less
than three years (the first two years in an easily accessible place)
all trial balances and computations of aggregate indebtedness and
net capital (and working papers in connection therewith). See 17 CFR
240.17a-4(b)(5). Working papers relating to credit risk
determinations made for the purposes of computing net capital under
Rule 15c3-1 will need to be preserved under this provision of Rule
17a-4. Id.
\106\ See SIFMA Letter, at 22.
\107\ Although not required by today's amendments, a broker-
dealer could choose to keep a record of the market data it used to
make the creditworthiness determination.
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The Commission recognizes that requiring a broker-dealer to make
and maintain a record of each credit risk determination, as suggested
by one commenter,\108\ may help facilitate examinations of broker-
dealers, but the Commission believes at this time that requiring
broker-dealers to maintain a record of every credit risk determination
could be burdensome in light of the benefits expected to be obtained.
For example, a broker-dealer may make multiple determinations while
assessing and monitoring the creditworthiness of a particular security.
If the broker-dealer reaches the same result time after time
[[Page 1529]]
showing that the security in question has only a minimal amount of
credit risk, the benefits of keeping every determination for three
years, when the broker-dealer has the ability to replicate the relevant
determination for an examiner, could create costs that provide little
benefits, given the examiner will have access to the replicated credit
risk determinations. Furthermore, if market data and other external
factors (e.g., external credit assessments and analysis), strongly
support the broker-dealer's assessment that a security has only a
minimal amount of credit risk, retaining a record of the credit risk
determination may not provide any incremental benefit to examiners. A
broker-dealer that can replicate through application of its policies
and procedures its original analysis to explain the basis of a credit
risk determination should be in a position to demonstrate to examiners
whether it is following its policies and procedures, and whether those
policies and procedures are reasonably designed and effective in
producing credit assessments that typically are consistent with market
data.
---------------------------------------------------------------------------
\108\ See Better Markets Letter, at 7-8.
---------------------------------------------------------------------------
The Commission is cognizant of the potential conflict of interest
inherent in a requirement that relies to some extent on the subjective
judgment of the broker-dealer to determine whether a lower haircut
should apply to a commercial paper, nonconvertible debt, or preferred
stock position, as noted by some commenters.\109\ For example, a
broker-dealer may want to hold securities with higher yields to earn
more interest but at the same time apply lower haircuts to the
positions to increase its net capital. This could bias the broker-
dealer's credit assessment towards finding the security has only a
minimal amount of credit risk. As an initial matter, if a broker-dealer
incorrectly determines a position has only a minimal amount of credit
risk and applies a lower haircut, it could lead to the firm failing to
maintain the minimum amount of required net capital in violation of the
rule. As discussed above, the final rule provides that policies and
procedures that are reasonably designed should result in assessments of
creditworthiness that typically are consistent with market data.\110\
This provides objective benchmarks (i.e., market data) to use to
evaluate the broker-dealer's policies and procedures. If a broker-
dealer has policies and procedures in place that are reasonably
designed under the rule, and those policies and procedures are
followed, the potential for bias to be a part of the assessment process
should be mitigated. The Commission also expects that this potential
conflict of interest will be mitigated by the Commission and SRO
examination process, during which Commission and SRO examiners will
review the reasonableness of broker-dealers' policies and procedures,
the assessments that result from those policies and procedures, and the
firms' adherence to the policies and procedures.\111\
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\109\ Better Markets Letter, at 5-6; Bond Dealers Letter, at 2;
CFA Institute Letter, at 4.
\110\ See paragraph (c)(2)(vi)(I) of Rule 15c3-1, as amended.
\111\ As noted above, broker-dealers that do not keep detailed
records of their credit risk determinations can replicate those
determinations for Commission and SRO examiners to demonstrate that
they followed their policies and procedures for assessing and
monitoring creditworthiness.
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The Commission also is aware of the likelihood that broker-dealers
may reach different conclusions when assessing whether a particular
position has only a minimal amount of credit risk,\112\ or may reach
conclusions that are contrary to market data. The Commission expects
that Commission and SRO staff will examine for these types of
differences and raise questions when a broker-dealer consistently
determines that positions have only a minimal amount of credit risk
notwithstanding the fact that external benchmarks (e.g., market data)
in the factors listed above indicate otherwise. A determination that a
position has only a minimal amount of credit risk that is contrary to
some market data points and factors would not necessarily mean that the
broker-dealer has failed to comply with the rule, but the broker-dealer
would have a higher hurdle to overcome to demonstrate that its credit
risk determination is correct. The Commission also notes that if a
broker-dealer determines that a security or money market instrument has
only a minimal amount of credit risk when the position actually does
not meet that standard, and applies a lower haircut, the broker-
dealer's net capital may be less than its minimum net capital
requirement in which case the broker-dealer would be in violation of
the rule.\113\
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\112\ Bond Dealers Letter, at 3; SIFMA Letter, at 20.
\113\ As noted above, applying an incorrect haircut also could
cause the broker-dealer to file incorrect reports with the
Commission under Rule 17a-5. See 17 CFR 240.17a-5 (requiring broker-
dealers to periodically file financial reports that, among other
things, contain computations of net capital).
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The Commission understands, as noted by commenters, that the amount
of resources broker-dealers can allocate toward making assessments of
creditworthiness for purposes of Rule 15c3-1 will differ across broker-
dealers and expects that this difference will be reflected in the
policies and procedures for assessing creditworthiness established by
the firms.\114\ For example, a small broker-dealer may not have the
resources to support a credit risk department comprised of analysts
that perform internal credit assessments. In this case, the firm may
establish a process for assessing creditworthiness that relies more on
external factors, such as credit spreads, default statistics, and
credit analysis. A broker-dealer with a large portfolio of debt
securities may instead use an internal approach for assessing
creditworthiness, which takes into consideration a multitude of
factors, such as default probabilities, expected and unexpected losses,
time effects, default correlations, and loss distributions, among other
things. The Commission also anticipates that some broker-dealers,
particularly those that hold few positions, may elect not to devote
resources toward performing credit risk analysis and maintaining
policies and procedures, and instead will apply a greater haircut to
their proprietary positions in commercial paper, nonconvertible debt,
and preferred stock, as permitted by the rule.
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\114\ See Bond Dealers Letter, at 3; SIFMA Letter, at 18.
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Finally, as discussed above, a broker-dealer (rather than its
parent or an affiliate) must establish, document, maintain, and enforce
the policies and procedures for assessing whether a position has only a
minimal amount of credit risk.\115\ This does not mean that a broker-
dealer cannot incorporate into its own policies and procedures the
credit policies and procedures used by its parent or an affiliate.
However, the broker-dealer must establish, document, maintain, and
enforce its own policies and procedures and apply them itself in making
creditworthiness determinations. It may not simply rely on
determinations made by its parent or an affiliate.
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\115\ See SIFMA Letter, at 21.
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b. Appendix A to Rule 15c3-1
i. Proposal
Appendix A to Rule 15c3-1 permits broker-dealers to employ a
standardized theoretical option pricing model to determine a potential
loss for a portfolio of listed options positions and related positions
to compute a single haircut for the group of positions.\116\ Under
Appendix A, a broker-dealer groups the options and related positions in
a portfolio and stresses the current market
[[Page 1530]]
price for each position at various equidistant points along a range of
positive and negative potential future market movements, using an
approved theoretical option pricing model that satisfies certain
conditions specified in the rule.\117\ Positions that have more
potential price volatility must be stressed across a wider range of
positive and negative potential future market movements than positions
with lower price volatility.\118\ For example, a broker-dealer other
than a non-clearing option specialist or market maker must employ a
range of potential future market movements for major market foreign
currencies of () 6%, whereas the range for all other
foreign currencies is () 20%.\119\ Thus, major market
foreign currency options receive more favorable treatment than options
on all other currencies when using theoretical option pricing models to
compute net capital deductions.\120\
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\116\ See 17 CFR 240.15c3-1a(b)(1). Broker-dealers also may
elect a strategy-based methodology. See 17 CFR 240.15c3-1a(b)(2).
\117\ See 17 CFR 240.15c3-1a(b)(1). Presently, there is only one
theoretical options pricing model that has been approved for this
purpose.
\118\ See 17 CFR 240.15c3-1a(b)(1)(iii).
\119\ See 17 CFR 240.15c3-1a(b)(1)(iii)(B) through (C). A
broker-dealer that is a non-clearing option specialist or market
maker must employ a range of potential future market movements for
major market foreign currencies of () 4% (i.e., less
than the () 6% required of other broker-dealers). 17 CFR
240.15c3-1a(b)(1)(iv)(A).
\120\ See 17 CFR 240.15c3-1a(b)(1)(iii)(B) through (C) and
(b)(1)(iv)(A).
---------------------------------------------------------------------------
Prior to today's amendments, the rule defined the term major market
foreign currency to mean ``the currency of a sovereign nation whose
short term debt is rated in one of the two highest categories by at
least two nationally recognized statistical rating organizations and
for which there is a substantial inter-bank forward currency market.''
\121\ Further, the rule provided that ``the European Currency Unit
(ECU) shall be deemed a major market foreign currency.'' \122\
---------------------------------------------------------------------------
\121\ Removal of Certain References to Credit Ratings under the
Securities Exchange Act of 1934, 76 FR at 26554-26555.
\122\ Id.
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With respect to the definition of major market foreign currency,
the Commission proposed to remove the phrase ``whose short-term debt is
rated in one of the two highest categories by at least two nationally
recognized statistical rating organizations.'' \123\ The proposed
change would modify the definition to include foreign currencies only
``for which there is a substantial inter-bank forward currency
market.'' \124\ The Commission also proposed to eliminate the specific
reference in the rule to the European Currency Unit (``ECU''), which
was the only currency explicitly identified in the rule as a major
market foreign currency for the purposes of Appendix A.\125\ As the
Commission stated in the proposing release, because of the
establishment of the euro as the official currency of the euro-zone, a
specific reference to the ECU was no longer needed.\126\ The Commission
also stated that a specific reference to the euro was not necessary, as
it is a foreign currency with a substantial inter-bank forward currency
market.\127\
---------------------------------------------------------------------------
\123\ Id.
\124\ Id.
\125\ Id.
\126\ Id.
\127\ Id.
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ii. Comments
The Commission received two comment letters in response to its
request for comment.\128\ One commenter supported the proposed
definition of the term major market foreign currency, stating that
``the proposed definition is sufficient to allow broker-dealers to
determine what currencies are `major market foreign currencies.' ''
\129\ Both commenters stated that the Commission should create a list
of major market foreign currencies and update it periodically to
clarify the new definition in Appendix A.\130\ One commenter suggested
that if the Commission chooses not to create a list of major market
foreign currencies, it should propose an alternative measure of
creditworthiness and define the term as one where the currency is
issued by a nation whose sovereign debt presents ``minimal credit
risk.'' \131\
---------------------------------------------------------------------------
\128\ See Better Markets Letter; CFA Institute Letter; see also
Removal of Certain References to Credit Ratings under the Securities
Exchange Act of 1934, 76 FR at 26555.
\129\ See CFA Institute Letter, at 4 (``[T]he existence of a
substantial inter-bank forward currency market indicates market
interest and the existence of market oversight and thus provides a
strong indication of market sentiment about the quality of
currencies within that definition.'').
\130\ Better Markets Letter, at 9; CFA Institute Letter, at 5.
\131\ See Better Markets Letter, at 9.
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iii. Final Rule
For the reasons described below, the Commission is adopting the
amendments to Appendix A as proposed.\132\ Specifically, the Commission
is removing from the definition of major market foreign currency the
phrase ``whose short-term debt is rated in one of the two highest
categories by at least two nationally recognized statistical rating
organizations.'' \133\ The change modifies the definition to include
foreign currencies only ``for which there is a substantial inter-bank
forward currency market.'' \134\ Also, the Commission is eliminating
the specific reference in the rule to the ECU, which was identified, by
rule, as the only major market foreign currency for the purposes of
Appendix A.\135\ As the Commission noted in the proposing release,
specific reference to the ECU is no longer needed because the euro has
been established as the official currency of the euro-zone.\136\
Further, the specific reference to the euro is not necessary as it is a
foreign currency with a substantial inter-bank forward currency market,
consistent with the rule as amended.
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\132\ See paragraph (b)(1)(i)(C) of Rule 15c3-1a, as amended.
\133\ Id.
\134\ Id.
\135\ Id.
\136\ Removal of Certain References to Credit Ratings under the
Securities Exchange Act of 1934, 76 FR at 26555.
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In order to retain a degree of flexibility, the Commission is not
codifying in the rule a list of currencies that meet the definition of
major market foreign currency though some commenters requested such a
list. However, broker-dealers may treat a foreign currency as a major
market foreign currency for the purposes of Appendix A if the currency
is a major foreign currency for purposes of applying a 6% (rather than
20%) haircut under Rule 15c3-1. Currently, under a staff
interpretation, broker-dealers are subject to a 6% (rather than 20%)
unhedged currency risk exposure haircut on foreign currency balances
and positions in the euro, the British pound, the Swiss franc, the
Canadian dollar, and the Japanese yen.\137\ The Commission believes the
staff interpretation identifies currencies that all meet the definition
of major market foreign currency for the purposes of Appendix A as they
all have a substantial inter-bank forward currency market.
Consequently, broker-dealers may treat these currencies as major market
foreign currencies under Appendix A. By treating these currencies as
major market foreign currencies, the haircuts applicable to foreign
currencies under Rule 15c3-1 are more closely aligned with the haircuts
applicable to options on the same foreign currencies under
[[Page 1531]]
Appendix A.\138\ Given this interpretation identifying certain foreign
currencies that meet the definition of major market foreign currency,
the Commission believes it has addressed the concern raised by one
commenter that, in the absence of a list, the Commission should define
the term as one where the currency is issued by a nation whose
sovereign debt presents minimal credit risk.\139\
---------------------------------------------------------------------------
\137\ See FINRA Interpretations of Financial and Operational
Rules, Rule 15c3-1(c)(2)(vi)/08, available at http://www.finra.org/web/groups/industry/@ip/@reg/@rules/documents/interpretationsfor/p037763.pdf, p. 406 (publishing the staff's interpretation). A 20%
haircut applies to unhedged currency risk exposure on all other
foreign currency balances and positions. Id. These interpretations
are provided to FINRA from the Commission staff in the Division of
Trading and Markets. Broker-dealers can also seek assurance as to
whether another foreign currency meets the definition of major
market foreign currency by, for example, requesting guidance from
the staff.
\138\ Treating the option consistently with the instrument
underlying the option is supported by Appendix A. For example, under
Appendix A, the range of potential future market movements that must
be employed for a portfolio of equity positions with a ready market
is () 15%. See 17 CFR 240.15c3-1a(b)(1)(iii)(A). Under
Rule 15c3-1, the haircut that must be applied to an equity security
with a ready market is 15%. See 17 CFR 240.15c3-1(c)(2)(vi)(J).
\139\ See Better Markets Letter, at 9.
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c. Appendix E to Rule 15c3-1
i. Proposal
Certain broker-dealers (``ANC broker-dealers'') are approved by the
Commission to use internal value-at-risk (``VaR'') models to determine
market risk charges for proprietary securities and derivatives
positions and to take a credit risk charge in lieu of a 100% charge for
unsecured receivables related to OTC derivatives transactions.\140\
Specifically, under Appendix E to Rule 15c3-1, ANC broker-dealers are
permitted to add back to net worth uncollateralized receivables from
counterparties arising from OTC derivatives transactions (i.e., they
can add back the amount of the uncollateralized current exposure).\141\
Instead of the 100% deduction that applies to most unsecured
receivables under Rule 15c3-1, ANC broker-dealers are permitted to take
a credit risk charge based on the uncollateralized credit exposure to
the counterparty.\142\ In most cases, the credit risk charge is
significantly less than a 100% deduction, since it is a percentage of
the amount of the receivable that otherwise would be deducted in full.
ANC broker-dealers are permitted to use this approach because they are
required to implement processes for analyzing credit risk to OTC
derivative counterparties and to develop mathematical models for
estimating credit exposures arising from OTC derivatives transactions.
---------------------------------------------------------------------------
\140\ See 17 CFR 240.15c3-1(a)(7); 17 CFR 240.15c3-1e. As part
of the application to use internal models, an entity seeking to
become an ANC broker-dealer must identify the types of positions it
intends to include in its model calculation. See 17 CFR 240.15c3-
1e(a)(1)(iii). After approval, an ANC broker-dealer must obtain
Commission approval to make a material change to the model,
including a change to the types of positions included in the model.
See 17 CFR 240.15c3-1e(a)(8). An ANC broker-dealer must maintain
minimum tentative net capital of at least $1 billion and minimum net
capital of at least $500 million. See 17 CFR 240.15c3-1(a)(7)(i).
The Commission has proposed raising these requirements to $5 billion
and $1 billion, respectively. See Capital, Margin, and Segregation
Requirements for Security-Based Swap Dealers and Major Security-
Based Swap Participants and Capital Requirements for Broker-Dealers,
Exchange Act Release No. 68071 (Oct. 18, 2012), 77 FR 70213 (Nov.
23, 2012).
\141\ See 17 CFR 240.15c3-1e(c).
\142\ See 17 CFR 240.15c3-1e(c); 17 CFR 240.15c3-1(a)(7). The
Commission has proposed narrowing this treatment of OTC derivatives
exposures so that it would apply only to uncollateralized
receivables from commercial end users arising from security-based
swaps (i.e., uncollateralized receivables from other types of
counterparties would be subject to the 100% deduction from net
worth). See Capital, Margin, and Segregation Requirements for
Security-Based Swap Dealers and Major Security-Based Swap
Participants and Capital Requirements for Broker-Dealers, 77 FR at
70240-70244.
---------------------------------------------------------------------------
Under Appendix E, the credit risk charge is the sum of three
calculated amounts: (1) A counterparty exposure charge; (2) a
concentration charge if the current exposure to a single counterparty
exceeds certain thresholds; and (3) a portfolio concentration charge if
aggregate current exposure to all counterparties exceeds certain
thresholds.\143\ The first component of the credit risk charge is the
counterparty exposure charge.\144\ The exposure charge for a given
counterparty (other than a counterparty that is insolvent, in a
bankruptcy proceeding, or in default of an obligation on its senior
debt) is the credit equivalent amount of the ANC broker-dealer's
exposure to the counterparty multiplied by an applicable credit risk
weight factor and then multiplied by 8%.\145\ The credit equivalent
amount is the sum of the ANC broker-dealer's: (1) Maximum potential
exposure (``MPE'') to the counterparty multiplied by a back-testing
determined factor; and (2) current exposure to the counterparty.\146\
The MPE amount is a charge to address potential future exposure and is
calculated using the ANC broker-dealer's VaR model as applied to the
counterparty's positions after giving effect to a netting agreement
with the counterparty, taking into account collateral received from the
counterparty, and taking into account the current replacement value of
the counterparty's positions.\147\ The current exposure amount is the
current replacement value of the counterparty's positions after giving
effect to a netting agreement with the counterparty and taking into
account collateral received from the counterparty.\148\ The
counterparty exposure charge is the sum of the MPE and current exposure
amounts multiplied by an applicable credit risk weight factor and then
multiplied by 8%.\149\ Appendix E to Rule 15c3-1 prescribes three
standardized credit risk weight factors (20%, 50%, and 150%) for
transactions with counterparties and, as an alternative, permits an ANC
broker-dealer with Commission approval to use internal methodologies to
determine appropriate credit risk weights to apply to
counterparties.\150\ A higher percentage credit risk weight factor
results in a larger counterparty exposure charge amount. Prior to
today's amendments, ANC broker-dealers were permitted to use NRSRO
credit ratings or internally derived credit ratings to determine the
appropriate risk weight factor.
---------------------------------------------------------------------------
\143\ 17 CFR 240.15c3-1e(c).
\144\ 17 CFR 240.15c3-1e(c)(1).
\145\ See 17 CFR 240.15c3-1e(c)(1)(ii).
\146\ See 17 CFR 240.15c3-1e(c)(4)(i). The amount of the factor
is based on back-testing exceptions.
\147\ See 17 CFR 240.15c3-1e(c)(4)(ii).
\148\ See 17 CFR 240.15c3-1e(c)(4)(iii).
\149\ See 17 CFR 240.15c3-1e(c)(1)(ii).
\150\ See 17 CFR 240.15c3-1e(c)(4)(vi).
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The Commission proposed removing paragraphs (c)(4)(vi)(A) through
(c)(4)(vi)(D) of Appendix E, which specify the appropriate risk weight
factor of counterparties based on NRSRO credit ratings.\151\
Consequently, under the proposal, an ANC broker-dealer would need to
determine credit risk charges using internal credit ratings or to take
a 100% capital charge with respect to the exposure to the
counterparty.\152\ By removing the option to use NRSRO credit ratings,
a broker-dealer that applies to use the approach set forth in Appendix
E would need to describe how it will determine the applicable
counterparty credit risk charge based on internal credit ratings as
part of its initial application to the Commission.\153\
---------------------------------------------------------------------------
\151\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, 76 FR at 26555-26556.
\152\ Id.
\153\ Id. at 26555.
---------------------------------------------------------------------------
ii. Comments
The Commission received two comments in response to its request for
comment.\154\ One commenter supported the proposed removal of NRSRO
credit ratings as an option but raised two concerns.\155\ The commenter
stated first that an internal model may not take into account
concentration of risk with a specific counterparty, and second that ANC
firms will apply low risk weights
[[Page 1532]]
to all but the most illiquid instruments.\156\
---------------------------------------------------------------------------
\154\ Better Markets Letter; CFA Institute Letter; see also
Removal of Certain References to Credit Ratings under the Securities
Exchange Act of 1934, 76 FR at 26555-26556.
\155\ CFA Institute Letter, at 5-6.
\156\ Id.
---------------------------------------------------------------------------
Another commenter suggested that the factors listed in the
proposing release with respect to determining creditworthiness under
Rule 15c3-1 should become part of Appendix E.\157\ This commenter
further argued that the factors each broker-dealer needed to use to
make the determination should be explicitly stated in the rule.\158\
---------------------------------------------------------------------------
\157\ Better Markets Letter, at 10.
\158\ Id.
---------------------------------------------------------------------------
iii. Final Rule
The Commission is adopting the amendments to Appendix E to Rule
15c3-1 as proposed.\159\ The amendments remove paragraphs (c)(4)(vi)(A)
through (c)(4)(vi)(D) of Appendix E to Rule 15c3-1, which specify the
appropriate risk weight factor based on NRSRO credit ratings.\160\ By
removing the provisions utilizing NRSRO credit ratings, the final rule
requires an ANC broker-dealer to determine the appropriate risk weight
factor using internal credit ratings or to take a 100% capital charge
with respect to the exposure to the counterparty.\161\
---------------------------------------------------------------------------
\159\ See paragraph (c)(4)(vi) of Rule 15c3-1e, as amended.
\160\ Id.
\161\ Id.
---------------------------------------------------------------------------
All ANC broker-dealers calculate credit risk charges using internal
credit ratings (rather than using NRSRO credit ratings approach) or
take a 100% capital charge with respect to the exposure to the
counterparty risk.\162\ Consequently, removing the option to use NRSRO
credit ratings will not have an immediate effect on these broker-
dealers. A broker-dealer that applies to become an ANC broker-dealer
will need to describe how it will determine internal credit ratings for
the purpose of determining the applicable credit charges for
counterparty risk in its application to the Commission.
---------------------------------------------------------------------------
\162\ Currently, there are six ANC broker-dealers: Barclays
Capital Inc.; Citigroup Global Markets, Inc.; Goldman Sachs & Co.;
J.P. Morgan Chase Securities LLC; Merrill Lynch Pierce Fenner &
Smith Incorporated; and Morgan Stanley & Co. Incorporated.
---------------------------------------------------------------------------
In taking this action, the Commission has considered the views of
commenters \163\ and determined that whether a model adequately
considers risks associated with a counterparty or a specific instrument
is a concern that should be addressed during the initial review of the
ANC broker-dealer's model, as well as during the monitoring and
examination of the firm.\164\ The amendments also do not incorporate
the minimal amount of credit risk standard from Rule 15c3-1 into
Appendix E, as suggested by one commenter.\165\ This standard is
replacing a binary NRSRO credit rating standard under which the
application of a lower or higher haircut amount depends on whether the
commercial paper is rated in the top three rating categories and the
nonconvertible debt and preferred stock is rated in the top four rating
categories. Consequently, a given instrument either meets the
requirement to apply a lower haircut amount or is subject to the higher
amount. The NRSRO credit rating standard in Appendix E to Rule 15c3-1
is not binary in that there are three different credit risk weights
(20%, 50%, and 150%) that are determined by three different levels of
credit rating: The two highest rating categories; the third and fourth
highest rating categories; and below the fourth highest rating. Thus,
the minimal amount of credit risk standard would not be a suitable
replacement for the NRSRO credit ratings standard because the minimal
amount of credit risk standard, as drafted for Rule 15c3-1, would apply
only to the second gradation (the third and fourth highest rating
categories).\166\
---------------------------------------------------------------------------
\163\ CFA Institute Letter, at 5; Better Markets Letter, at 10.
\164\ See, e.g., 17 CFR 15c3-1e(a)(1)(iv).
\165\ Better Markets Letter, at 10.
\166\ See 15 CFR 15c3-1e(c)(4)(vi)(B).
---------------------------------------------------------------------------
In addition, as stated throughout this release, the Commission has
determined not to mandate that a broker-dealer use any specific factor
in its credit analysis. Consequently, the Commission does not believe
it would be appropriate to codify the list of factors in the rule as
suggested by one commenter.
d. Appendix F to Rule 15c3-1 and Form X-17A-5, Part IIB
i. Proposal
Similar to ANC broker-dealers, a type of limited purpose broker-
dealer that deals solely in OTC derivatives (an ``OTC derivatives
dealer'') is permitted, with Commission approval, to calculate net
capital using internal models as the basis for taking market risk and
credit risk charges in lieu of the standardized haircuts for classes of
positions for which they have been approved to use VaR models.\167\
Specifically, under Appendix F to Rule 15c3-1, OTC derivatives dealers
are permitted to add back to net worth uncollateralized receivables
from counterparties arising from OTC derivatives transactions (i.e.,
they can add back the amount of the uncollateralized current exposure).
Instead of the 100% deduction that applies to most unsecured
receivables under Rule 15c3-1, OTC derivatives dealers are permitted to
take a credit risk charge based on counterparty factors and
concentration charges.\168\ In most cases, the counterparty factors and
concentration charges are significantly less than a 100% deduction,
since the charges are a percentage of the amount of the receivable that
otherwise would be deducted in full. OTC derivatives dealers are
permitted to use this approach because they are required to implement
processes for analyzing credit risk to OTC derivative counterparties
and to develop mathematical models for estimating credit exposures
arising from OTC derivative transactions.
---------------------------------------------------------------------------
\167\ See 17 CFR 240.15c3-1(a)(5); 17 CFR 240.15c3-1f. As part
of the application to use internal models, an entity seeking to
become an OTC derivatives dealer must identify the types of
positions it intends to include in its model calculation. See 17 CFR
240.15c3-1f(a)(1)(ii). After approval, an OTC derivatives dealer
must obtain Commission approval to make a material change to the
model, including a change to the types of positions included in the
model. See 17 CFR 240.15c3-f(a)(3). OTC derivatives dealers are
exempt from certain broker-dealer requirements, including membership
in an SRO (17 CFR 240.15b9-2), broker-dealer margin rules (17 CFR
240.36a1-1), and application of the Securities Investor Protection
Act of 1970 (17 CFR 240.36a1-2). OTC derivatives dealers are subject
to special requirements, including limitations on the scope of their
securities activities (17 CFR 240.15a-1), specified internal risk
management control systems (17 CFR 240.15c3-4), recordkeeping
obligations (17 CFR 240.17a-3(a)(10)), and reporting
responsibilities (17 CFR 240.17a-12). They are also subject to
alternative net capital treatment (17 CFR 240.15c3-1(a)(5)). See 17
CFR 240.15a-1, Preliminary Note. The minimum net capital
requirements for an OTC derivatives dealer are tentative net capital
of at least $100 million and net capital of at least $20 million.
See 17 CFR 240.15c3-1(a)(5) and (c)(15).
\168\ See 17 CFR 240.15c3-1f(d); 17 CFR 240.15c3-1(a)(5).
---------------------------------------------------------------------------
Under Appendix F to Rule 15c3-1, OTC derivatives dealers are
required to deduct from their net capital credit risk charges that take
counterparty risk into consideration.\169\ This charge has two parts
and is computed on a counterparty-by-counterparty basis. First, for
each counterparty with an investment or speculative grade rating, an
OTC derivatives dealer must take a net capital charge equal to the net
replacement value in the account of the counterparty (``net replacement
value'') multiplied by 8%, and further multiplied by a counterparty
factor.\170\ As part of this deduction, the OTC derivatives dealer must
apply a counterparty risk weight factor of either 20%, 50%, or
100%.\171\ Prior to today's amendments, the counterparty risk weight
factor (i.e., 20%, 50%, or 100%) was determined using either NRSRO
[[Page 1533]]
credit ratings or the firm's internal credit ratings.\172\
---------------------------------------------------------------------------
\169\ See 17 CFR 240.15c3-1f(d).
\170\ See 17 CFR 240.15c3-1f(d)(2).
\171\ See 17 CFR 240.15c3-1f(d)(2)(i) through (iii).
\172\ See 17 CFR 240.15c3-1f(d)(2) and (4).
---------------------------------------------------------------------------
The second part of the credit risk charge consists of a
concentration charge that applies when the net replacement value in the
account of any one counterparty exceeds 25% of the OTC derivatives
dealer's tentative net capital.\173\ The concentration charge increases
in relation to the OTC derivatives dealer's exposure to lower rated
counterparties.\174\ Prior to today's amendments, this concentration
charge was also determined using either NRSRO credit ratings or the
firm's internal credit ratings. Currently, OTC derivatives dealers do
not use NRSRO credit ratings to determine their counterparty factors
and concentration charges.
---------------------------------------------------------------------------
\173\ See 17 CFR 240.15c3-1f(d)(3).
\174\ For counterparties that are highly rated, the
concentration charge equals 5% of the amount of the net replacement
value in excess of 25% of the OTC derivatives dealer's tentative net
capital. 17 CFR 240.15c3-1f(d)(3)(i). The concentration charge for
counterparties with ratings among the lowest rating categories would
equal 50% of the amount of the net replacement value in excess of
25% of the OTC derivatives dealer's tentative net capital. 17 CFR
240.15c3-1f(d)(3)(iii).
---------------------------------------------------------------------------
The Commission proposed to amend paragraphs (d)(2), (d)(3)(i),
(d)(3)(ii), (d)(3)(iii), and (d)(4) of Appendix F to Rule 15c3-1, which
permit the use of NRSRO ratings (as an alternative to internal credit
ratings) to determine an OTC derivatives dealer's counterparty factors
and concentration charges. Because the proposal would eliminate the
option to use NRSRO credit ratings, a broker-dealer that applies to
become an OTC derivatives dealer and operate under Appendix F will
need, as part of its initial application, to request Commission
approval to use internal credit ratings (as the option to use NRSRO
credit ratings is being eliminated). The OTC derivatives dealer would
need to describe how it will determine the applicable counterparty
factors and concentration charges as part of its initial application to
the Commission.
As part of its proposal, the Commission also proposed conforming
amendments to the General Instructions to Form X-17A-5, Part IIB. This
form constitutes the basic financial and operational report OTC
derivatives dealers are required to file with the Commission. Under the
heading ``Computation of Net Capital and Required Net Capital,'' the
Commission proposed making conforming changes to the section ``Credit
risk exposure.'' This section instructs an OTC derivatives dealer on
how to compute the counterparty credit risk charges for purposes of the
dealer's net capital computation. The proposed amendments to the
instructions would eliminate references to NRSRO credit ratings for
purposes of determining these charges.
ii. Comments
The Commission received two comments in response to its request for
comment.\175\ One commenter suggested that the Commission require OTC
derivatives dealers to use counterparty factors similar to those
proposed under Appendix E discussed above (e.g., 20%, 50% or 150% risk
weights based on internal credit ratings to determine capital
deductions) and argued against requiring OTC derivatives dealers to
reapply to the Commission to use internal credit ratings.\176\ This
commenter also expressed concern that an OTC derivatives dealer's
internal model may not take into account concentration of risk with a
specific counterparty.\177\
---------------------------------------------------------------------------
\175\ CFA Institute Letter; Better Markets Letter; see also
Removal of Certain References to Credit Ratings under the Securities
Exchange Act of 1934, 76 FR at 26556.
\176\ CFA Institute Letter, at 6.
\177\ Id.
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The second commenter suggested that the Commission ``supply an
appropriate alternative standard of creditworthiness that derivatives
dealers must apply'' such as ``an explicit set of factors that will
appropriately gauge the credit risk associated with counterparties in
derivatives transactions.'' \178\
---------------------------------------------------------------------------
\178\ Better Markets Letter, at 10, n.15.
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iii. Final Rule
The Commission is adopting the amendments to Appendix F to Rule
15c3-1 as proposed.\179\ Specifically, the amendments remove the use of
NRSRO credit ratings from paragraphs (d)(2), (d)(3)(i), (d)(3)(ii),
(d)(3)(iii), and (d)(4) of Appendix F to Rule 15c3-1, which, prior to
today's amendments, permitted the use of NRSRO ratings when determining
counterparty credit risk and concentration charges.\180\ Because the
amendments remove the option to use NRSRO credit ratings, a broker-
dealer that applies to become an OTC derivatives dealer will need, as
part of its initial application, to request Commission approval to use
internal credit ratings (as the option to use NRSRO credit ratings is
being eliminated). The applicant will need to describe how it will use
internal credit ratings to determine the applicable credit risk charges
for counterparty risk in its application to the Commission. The current
OTC derivatives dealers will not need to seek new approval from the
Commission.\181\
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\179\ See paragraph (d) of Rule 15c3-1f, as amended.
\180\ See paragraphs (d)(2), (d)(3)(i), (d)(3)(ii), (d)(3)(iii),
and (d)(4) of Rule 15c3-1f, as amended.
\181\ Currently, four firms are operating pursuant to Appendix F
to Rule 15c3-1. These firms are: Credit Suisse Capital LLC; Goldman
Sachs Financial Markets, L.P.; Merrill Lynch Financial Markets,
Inc.; and Natixis Derivatives Inc. Natixis Derivatives, Inc. filed a
Form BDW on October 17, 2013.
---------------------------------------------------------------------------
The Commission also is adopting the conforming amendments to the
General Instructions to Form X-17A-5, Part IIB as proposed.
Consistent with the discussion above relating to Appendix E to Rule
15c3-1, the Commission has determined that whether a model adequately
considers concentration risk with a specific counterparty is a concern
that is best addressed during the initial review of, or an amendment
to, an OTC derivatives dealer's model as well as during the monitoring
and examination of the OTC derivatives dealer.\182\ Further, as stated
above, the current OTC derivatives dealers do not use NRSRO ratings to
compute the credit risk and concentration charges under Appendix F.
Thus, the amendments will not impact these firms.
---------------------------------------------------------------------------
\182\ See, e.g., 17 CFR 15c3-1f(a)(1)(ii); see also CFA
Institute Letter, at 6.
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The Commission is not adopting an alternative standard in the rule,
such as the minimal amount of credit risk standard. As discussed above,
the minimal amount of credit risk standard is replacing a binary NRSRO
credit rating standard under which the application of a lower or higher
haircut amount depends on whether the commercial paper is rated in the
top three rating categories and the nonconvertible debt and preferred
stock is rated in the top four rating categories. Consequently, a given
instrument either meets the requirement to apply a lower haircut amount
or is subject to the higher amount. The NRSRO credit rating standard in
Appendix F to Rule 15c3-1 is not binary in that there are three ranges
of credit ratings to determine the applicable risk weight factors and
concentration charges: The two highest rating categories; the third and
fourth highest rating categories; and below the fourth highest rating
category. Thus, the minimal amount of credit risk standard would not be
a suitable replacement for the credit risk charges required under
Appendix F to Rule 15c3-1 because the minimal amount of credit risk
standard, as drafted for Rule 15c3-1, would apply only to the second
[[Page 1534]]
range (the third and fourth highest rating categories).\183\
---------------------------------------------------------------------------
\183\ See 17 CFR 240.15c3-1f(d)(2)(ii); 17 CFR 240.15c3-
1f(d)(3)(ii).
---------------------------------------------------------------------------
In addition, as stated throughout this release, the Commission has
determined not to mandate that a broker-dealer use any specific factor
in its credit analysis; instead, each firm will need to tailor its
procedures for determining credit risk to the broker-dealer's business
model.\184\
---------------------------------------------------------------------------
\184\ Better Markets Letter, at 10, n.15.
---------------------------------------------------------------------------
e. Appendix G to Rule 15c3-1
Appendix G to Rule 15c3-1 provides that broker-dealers may use the
ANC computation only if their ultimate holding companies agree to
provide the Commission with additional information about the financial
condition of the holding company and its affiliates.\185\ Appendix G is
intended to provide the Commission with certain information to assess
the financial and operational health of the ultimate holding company
and its potential impact on the risk exposure of the broker-
dealer.\186\ Paragraph (a) of Appendix G sets forth a methodology for
computing allowable capital and allowances for market and credit risk
at the consolidated holding company level. One aspect of calculating
credit risk in Appendix G provided that those firms must use credit
ratings in accordance with the applicable provisions of Appendix E.
Since those provisions in Appendix E are being deleted, the Commission
proposed deleting the corresponding references to those provisions in
Appendix G.\187\ Specifically, the Commission proposed to delete
references in paragraph (a)(3)(i)(F) of Appendix G that correspond to
the provisions of Appendix E that the Commission is deleting as
described above.\188\
---------------------------------------------------------------------------
\185\ 17 CFR 240.15c3-1g.
\186\ Id. Currently, each broker-dealer that uses the ANC
computation has an ultimate holding company that has a principal
regulator.
\187\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, 76 FR at 26556-26557.
\188\ Id.
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The Commission received no comments addressing these changes.\189\
The Commission is amending Appendix G to Rule 15c3-1 as proposed.\190\
Accordingly, the Commission is adopting a conforming amendment to
Appendix G that deletes references in paragraph (a)(3)(i)(F) of
Appendix G that correspond to the provisions of Appendix E that the
Commission is deleting as described above.\191\
---------------------------------------------------------------------------
\189\ Id. at 26557.
\190\ See paragraph (a)(3)(i)(F) of Rule 15c3-1g, as amended.
\191\ Id.
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f. Exhibit A to Rule 15c3-3
Rule 15c3-3 (the ``Customer Protection Rule'') under the Exchange
Act is designed to protect customer funds and securities held by
broker-dealers.\192\ To meet this objective, Rule 15c3-3 requires a
broker-dealer that maintains custody of customer securities and cash (a
``carrying broker-dealer'') to take two primary steps to safeguard
these assets. The steps are designed to protect customers by
segregating their securities and cash from the broker-dealer's
proprietary business activities. If the broker-dealer fails
financially, the securities and cash should be readily available to be
returned to the customers. In addition, if the failed broker-dealer is
liquidated in a formal proceeding under the Securities Investor
Protection Act of 1970, the securities and cash should be isolated and
readily identifiable as customer property and, consequently, available
to be distributed to customers ahead of other creditors.\193\
---------------------------------------------------------------------------
\192\ 17 CFR 240.15c3-3.
\193\ See 15 U.S.C. 78aaa et seq.
---------------------------------------------------------------------------
The first step to safeguard customer assets under Rule 15c3-3
requires a carrying broker-dealer to maintain possession or control of
all fully paid and excess margin securities of its customers.\194\
Physical possession or control means the broker-dealer must hold these
securities in one of several locations specified in Rule 15c3-3 and
free of liens or any other interest that could be exercised by a third
party to secure an obligation of the broker-dealer.\195\ Permissible
locations include a bank, as defined in section 3(a)(6) of the Exchange
Act, and a clearing agency.\196\ A broker-dealer must make a daily
determination of the amount of fully paid and excess margin securities
it holds for customers and compare it to the amount actually held in
the permissible locations in order to comply with this aspect of the
rule.\197\
---------------------------------------------------------------------------
\194\ 17 CFR 240.15c3-3(b)(1).
\195\ 17 CFR 240.15c3-3(c).
\196\ 17 CFR 240.15c3-3(c).
\197\ 17 CFR 240.15c3-3(d).
---------------------------------------------------------------------------
The second step covers customer funds and requires that a carrying
broker-dealer must maintain a reserve of cash or qualified securities
in one or more accounts at a bank that is at least equal in value to
the net cash owed to customers and the amount of cash obtained from the
use of customer securities.\198\ The account must be titled ``Special
Account for the Exclusive Benefit of Customers of the Broker-Dealer''
(``customer reserve account'').\199\ The amount of cash and/or
qualified securities that must be kept in the customer reserve account
is computed pursuant to a formula set forth in Exhibit A to Rule 15c3-
3.\200\ Under the Exhibit A formula, the broker-dealer adds customer
credit items (e.g., cash in customer securities accounts) and then
subtracts from that amount customer debit items (e.g., margin
loans).\201\ If credit items exceed debit items, the net amount must be
on deposit in the customer reserve account in the form of cash and/or
qualified securities.\202\ If the debits exceed credits, no deposit is
necessary. Funds deposited in a customer reserve account cannot be
withdrawn until the broker-dealer completes another computation that
shows that the broker-dealer has on deposit more funds than the reserve
formula requires.
---------------------------------------------------------------------------
\198\ 17 CFR 240.15c3-3(e).
\199\ 17 CFR 240.15c3-3(e)(1).
\200\ 17 CFR 240.15c3-3a.
\201\ 17 CFR 240.15c3-3a.
\202\ 17 CFR 240.15c3-3(e).
---------------------------------------------------------------------------
Under Note G to Exhibit A, a carrying broker-dealer may include
margin collateral for transactions in security futures products as a
debit in its reserve formula computation if that margin collateral is
required and on deposit at a clearing agency or derivatives clearing
organization that meets at least one of four conditions: (1) The
clearing agency or derivatives clearing organization maintains the
highest investment-grade rating from an NRSRO; (2) the clearing agency
or derivatives clearing organization maintains security deposits from
clearing members in connection with regulated options or futures
transactions and assessment power over member firms that equal a
combined total of at least $2 billion, at least $500 million of which
must be in the form of security deposits; (3) the clearing agency or
derivatives clearing organization maintains at least $3 billion in
margin deposits; or (4) the clearing agency or derivatives clearing
organization obtains an exemption from the Commission.
Margin collateral that is posted for customer positions in security
futures products constitutes an unsecured receivable from the clearing
agency or derivatives clearing organization. Therefore, requiring a
clearing agency or a derivatives clearing organization to meet certain
minimum creditworthiness criteria before margin collateral deposited
with that entity may be included as a debit in a broker-dealer's
customer reserve formula is consistent with the customer protection
function of Rule 15c3-3 because the debit offsets any credits when
computing the customer reserve deposit requirement.
[[Page 1535]]
Accordingly, this requirement is intended to provide reasonable
assurance that customer margin collateral deposited with a clearing
agency or derivatives clearing organization related to security futures
products will be available to be returned to the broker-dealer and,
therefore, can serve as an appropriate offset to customer credits in
the reserve formula.
The Commission proposed to remove the first criterion described
above (i.e., the highest investment-grade rating from an NRSRO).\203\
The criteria are disjunctive and, therefore, a clearing agency or
derivatives clearing organization needs to satisfy only one criterion
to permit a broker-dealer to treat posted customer margin collateral as
a reserve formula debit. In the proposing release, the Commission
stated that the proposed amendment would not lessen the protections for
customer funds and securities.\204\ While one potential criterion would
be removed, currently, only the Options Clearing Corporation (``OCC'')
clears and accepts margin on security futures products. The OCC
qualifies under two of the other criteria in Note G.\205\ If at a later
date another clearing entity accepts margin on security futures
products, and it did not meet one of the remaining criteria, a broker-
dealer may request an exemption for that clearing entity under Note G
to Appendix A to Rule 15c3-3.\206\ Thus, the proposed amendment does
not disqualify any current clearing entities, nor require a broker-
dealer to obtain new clearing memberships to comply with Rule 15c3-3.
---------------------------------------------------------------------------
\203\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, 76 FR at 26557.
\204\ Id.
\205\ At the end of 2012, OCC maintained $78.8 billion in margin
deposits, well in excess of the $3 billion threshold set forth in
paragraph (b)(1)(iii) of Note G. The OCC also maintained $2.7
billion in clearing member deposits, well in excess of the $500
million threshold set forth in paragraph (b)(1)(ii) of Note G. See
OCC, 2012 Annual Report (2012) (Notes 3 and 4 to the Financial
Statements).
\206\ The Commission may, in its sole discretion, grant such an
exemption subject to such conditions as are appropriate under the
circumstances if the Commission determines that such conditional or
unconditional exemption is necessary or appropriate in the public
interest and is consistent with the protection of investors. See 17
CFR 240.15c3-3a(b)(1)(iv), Note G.
---------------------------------------------------------------------------
The Commission received no comments on the proposed amendment to
Rule 15c3-3. The Commission is adopting the amendment to Note G to
Exhibit A to Rule 15c3-3 as proposed by removing paragraph (b)(1)(i).
2. Rule 10b-10
a. Proposal
Rule 10b-10 under the Exchange Act, the Commission's customer
confirmation rule, generally requires broker-dealers effecting
transactions for customers in securities, other than U.S. savings bonds
or municipal securities, to provide those customers with a written
notification, at or before completion of the securities transaction,
disclosing certain information about the terms of the transaction.\207\
This required disclosure includes, among other things, the date, time,
identity, and number of securities bought or sold; the capacity in
which the broker-dealer acted (e.g., as agent or principal); yields on
debt securities; and, under special circumstances, the amount of
compensation the broker-dealer will receive from the customer and any
other parties.\208\ By requiring these disclosures, the rule serves a
basic customer protection function by conveying information that: (1)
Allows customers to verify the terms of their transactions; (2) alerts
customers to potential conflicts of interest; (3) acts as a safeguard
against fraud; and (4) allows customers a means of evaluating the costs
of their transactions and the quality of the broker-dealer's execution.
---------------------------------------------------------------------------
\207\ See 17 CFR 240.10b-10.
\208\ Id.
---------------------------------------------------------------------------
The Commission proposed to delete paragraph (a)(8) from Rule 10b-
10.\209\ Paragraph (a)(8), which the Commission adopted in 1994,
requires a broker-dealer to inform the customer in the confirmation if
a debt security, other than a government security, is unrated by an
NRSRO.\210\ As explained when it was added to Rule 10b-10 in 1994,
paragraph (a)(8) was intended to alert customers to the potential need
to obtain more information about a security from a broker-dealer; it
was not intended to suggest that an unrated security is inherently
riskier than a rated security.\211\
---------------------------------------------------------------------------
\209\ See Removal of Certain References to Credit Ratings under
the Securities Exchange Act of 1934, 76 FR at 26563-26564 & n.80.
Consistent with this proposed change, the Commission also proposed
to re-designate paragraph (a)(9) of the rule, under which a broker-
dealer that is not a member of the Securities Investor Protection
Corporation generally must disclose that fact, as paragraph (a)(8).
Id. at 26564 n.89, 26576.
\210\ See 17 CFR 240.10b-10(a)(8); Confirmation of Transactions,
Exchange Act Release No. 34962 (Nov. 10, 1994), 59 FR 59612, 59617
(Nov. 17, 1994), corrected, Securities Exchange Act Release No.
34962A (Nov. 18, 1994), 59 FR 60555 (Nov. 25, 1994).
\211\ Id. (stating, ``In most cases, this disclosure should
verify information that was disclosed to the investor prior to the
transaction. If the customer was not previously informed of the
security's unrated status, then confirmation disclosure may prompt a
dialogue between the customer and the broker-dealer,'' and noting
that the disclosure was ``not intended to suggest that an unrated
security is inherently riskier than a rated security.'').
---------------------------------------------------------------------------
The Commission had previously proposed, and re-proposed, the
deletion of paragraph (a)(8) from Rule 10b-10.\212\ These previous
proposals, however, were prompted by concerns regarding the undue
reliance on NRSRO ratings and confusion about the significance of those
ratings. Because paragraph (a)(8) of Rule 10b-10 does not refer to
NRSRO ratings as a means of determining creditworthiness, it arguably
does not come strictly within section 939A. Nevertheless, to the extent
that the provision may focus investor attention on ratings issued by
NRSROs, as distinct from other items of information, the Commission
believed deleting it would be consistent with the intent of the Dodd-
Frank Act.
b. Comments
---------------------------------------------------------------------------
\212\ See References to Ratings of Nationally Recognized
Statistical Rating Organizations, 74 FR 52374; References to Ratings
of Nationally Recognized Statistical Rating Organizations, 73 FR
40088.
---------------------------------------------------------------------------
The Commission received four comments regarding the proposed
removal of paragraph (a)(8) from Rule 10b-10. One commenter was
supportive of the deletion, without providing any additional
comment.\213\ Another commenter recommended that in place of the
deletion, the proposed rules should require Rule 10b-10 confirmations
to include information that would ensure that investors understand the
potential need to learn more about the debt securities that they have
acquired from their broker-dealers.\214\ The commenter recommended
requiring broker-dealers to inform investors that debt securities vary
in terms of their creditworthiness; that investors should understand
the credit quality of the specific debt securities acquired through
their broker-dealer; and that credit quality can affect not only the
value of the debt securities, but also their liquidity and price
stability.\215\ In contrast, a third commenter believed that the
removal of paragraph (a)(8) serves no useful purpose, stating: ``We do
not see how requiring disclosure of the absence of a credit rating in
any way encourages greater reliance on credit ratings.'' \216\ The
commenter further recommended that if paragraph (a)(8) were deleted,
the Commission should not replace it with
[[Page 1536]]
any further required disclosures.\217\ A fourth commenter recommended
that paragraph (a)(8) of Rule 10b-10 should be retained.\218\ The
commenter stated that, given that the types of securities that are
unrated by NRSROs typically include small offerings, the required
broker-dealer disclosures may no longer signal to investors any need to
investigate the quality of the securities being purchased.\219\ The
commenter added that the required notification that certain securities
are unrated serves to encourage investors to evaluate the securities in
which they are investing without undermining the overall intent to
eliminate reliance upon ratings bestowed by NRSROs.\220\
---------------------------------------------------------------------------
\213\ See SIFMA Letter, n.3 (``SIFMA endorses the Commission's
proposed changes to Rules 15c3-3 and Rule 10b-10.'').
\214\ See Better Markets Letter.
\215\ Id.
\216\ See Sullivan & Cromwell Letter.
\217\ Id.
\218\ See CFA Institute Letter.
\219\ Id.
\220\ Id.
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c. Final Rule
After careful consideration of the received comments, the
Commission has decided to delete paragraph (a)(8) from Rule 10b-10, as
proposed. The Commission acknowledges that, to some extent, the
paragraph may have served the purpose for which it was added to the
rule in 1994 by prompting investors to investigate or question a
broker-dealer about the quality of certain securities. Based on the
comments received in response to the proposing release, however, the
Commission believes it is likely that the paragraph's disclosure
requirement has to a greater extent added to investors' undue reliance
on credit ratings, and that the deletion of the paragraph is consistent
with the intent of section 939A of the Dodd-Frank Act to reduce
reliance on NRSRO credit ratings. In addition, requiring broker-dealers
to use customer confirmations as a means of providing investors with
general information related to credit risk and debt securities as
suggested by commenters would not further paragraph (a)(8)'s purpose of
flagging unrated securities for more careful investor scrutiny. The
paragraph was added to the rule to require disclosure of information
suggesting that investors may want to obtain more information about
certain unrated securities, not to ``require that confirmations alert
customers to the importance of understanding the credit quality of a
debt security and the impact of credit quality on the value, resale,
and price of such securities.'' \221\ The purpose of Rule 10b-10 is not
to educate investors about the characteristics of different kinds of
securities in general, but rather, in the context of particular
transactions, convey information allowing investors to verify the terms
of their transactions, alert investors to potential conflicts of
interest with their broker-dealers, deter and prevent deceptive and
fraudulent acts and practices, and assist customers in evaluating the
costs and quality of services proved by broker-dealers in connection
with the execution of their securities transactions.\222\
---------------------------------------------------------------------------
\221\ See Better Markets Letter, at 4.
\222\ See Confirmation of Transactions, at 59 FR 59613;
Securities Confirmations, Exchange Act Release No. 15219 (Oct. 4,
1978), 43 FR 47495, 47496 (Oct. 16, 1978).
---------------------------------------------------------------------------
The Commission further notes, as it did in the proposing release,
that after the deletion of paragraph (a)(8), broker-dealers will not be
prohibited from continuing to provide the information currently
required by paragraph (a)(8) on a voluntary basis.\223\ If broker-
dealers believe that continuing to provide such information on
confirmations would, for example, give investors an incentive to carry
out additional research on their debt securities, the broker-dealers
may continue to provide this disclosure at their discretion.\224\ Also,
in particular circumstances they may believe that a reasonable investor
likely would consider a security's lack of a credit rating significant.
---------------------------------------------------------------------------
\223\ See Removal of Certain References to Credit Ratings Under
the Securities Exchange Act of 1934, 76 FR at 26564. The Commission
understands that, as a practical matter, broker-dealers will likely
not reprogram their systems solely to remove the information even
though the legal obligation to include it has been eliminated.
Rather, it is anticipated that firms may choose to make the change
at a later date as part of a larger reprogramming initiative.
\224\ Based on a limited review of customer confirmations, the
Commission understands that some broker-dealers currently disclose
NRSRO ratings for rated securities even though this information is
not required by paragraph (a)(8).
---------------------------------------------------------------------------
After consideration of the comments received, the Commission is
removing paragraph (a)(8) and believes that it is unnecessary to
replace the paragraph with any other disclosure requirement. Although
the Commission recognizes the potential benefit of requiring broker-
dealers to remind investors of the varying creditworthiness of debt
securities, the Commission believes that such a requirement would be
unnecessary given the other security-specific disclosures currently
required by Rule 10b-10.\225\ Also, general information about credit
risk and other risks associated with corporate bonds is widely
available to investors.\226\
---------------------------------------------------------------------------
\225\ See information broker-dealers must disclose as specified
in paragraphs (a)(1) through (a)(7) of Rule 10b-10, as amended.
\226\ See, e.g., SEC's Office of Investor Education and
Advocacy's Investor Bulletin, What Are Corporate Bonds? (June 2013),
available at http://www.sec.gov/investor/alerts/ib_corporatebonds.pdf.
---------------------------------------------------------------------------
III. Paperwork Reduction Act
Certain provisions of the amendments to the rules and form contain
``collection of information requirements'' within the meaning of the
Paperwork Reduction Act of 1995 (``PRA'').\227\ The Commission
solicited comment on the estimated burden associated with the
collection of information requirements in the proposed amendments. The
Commission submitted the proposed collection of information
requirements to the Office of Management and Budget (``OMB'') for
review in accordance with 44 U.S.C. 3507 and 5 CFR 1320.11. The titles
of the affected information collections are Rule 15c3-1 (OMB Control
Number 3235-0200), Rule 15c3-3 (OMB Control Number 3235-0078), Rule
17a-4 (OMB Control Number 3235-0279), Rule 10b-10 (OMB Control Number
3235-0444), and the General Instructions to Form X-17A-5, Part IIB (OMB
Control Number 3235-0498). An agency may not conduct or sponsor, and a
person is not required to respond to, a collection of information
requirement unless it displays a currently valid OMB control number.
---------------------------------------------------------------------------
\227\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
As discussed above, the Commission received eleven comment letters
on the proposed amendments. Some of the comments in these letters
relate indirectly to the PRA and are addressed below. The estimates
contained in this section do not include any other possible costs or
economic effects beyond the costs required for PRA purposes.\228\
---------------------------------------------------------------------------
\228\ See discussion below in Section IV.D.
---------------------------------------------------------------------------
A. Summary of Collection of Information
As discussed above, the Commission is adopting amendments to Rule
15c3-1, Appendices A, E, F, and G to Rule 15c3-1, Exhibit A to Rule
15c3-3, Rule 17a-4, the General Instructions to Form X-17A-5, Part IIB,
and Rule 10b-10. These amendments are consistent with section 939A of
the Dodd-Frank Act.
The amendments to Rule 15c3-1, and Rule 17a-4 establish a new
standard of creditworthiness that will allow broker-dealers to
establish their own policies and procedures to determine whether a
security has only a minimal amount of credit risk. If a broker-dealer
chooses to establish these policies and procedures, it would create a
new ``collection of information'' burden for those broker-dealers, as
explained below. The amendments to Appendices A, E, F, and G to Rule
15c3-1 and the General Instructions to Form X-17A-5, Part IIB remove
provisions permitting reliance
[[Page 1537]]
on NRSRO ratings to calculate haircuts and credit risk charges related
to counterparties. In addition, the amendments to the Customer
Protection Rule remove one method for verifying the status of a
registered clearing agency or derivatives clearing organization under
Note G to Exhibit A. Broker-dealers have to use a new method for
verifying the status of a registered clearing agency or derivatives
clearing organization may have to comply with a new ``collection of
information'' within the meaning of the PRA.
The Commission does not believe that the amendment to Rule 10b-10,
which eliminates a requirement that broker-dealers inform customers in
transaction confirmations for debt securities (other than government
securities) if a security is unrated by an NRSRO, would change the
existing paperwork burden for Rule 10b-10.
B. Proposed Use of Information
The written policies and procedures required by the amendments to
Rule 15c3-1, and the retention of these policies and procedures
required by the amendment to Rule 17a-4, will assist Commission and SRO
examination staff in evaluating whether the broker-dealer has a
reasonable basis for determining if a security has only a minimal
amount of credit risk. It also will assist examination staff and the
broker-dealer in evaluating whether the broker-dealer has followed
those policies and procedures when acquiring positions in commercial
paper, nonconvertible debt, and preferred stock. In addition, written
policies and procedures will provide a broker-dealer's personnel with
consistent guidance on how to determine if a security has a minimal
amount of credit risk for the purposes of complying with Rule 15c3-1.
The amendment to Rule 10b-10 will eliminate a requirement for
transaction confirmations for debt securities (other than government
securities) to inform customers if a security is unrated by an NRSRO.
This amendment will alter neither the general requirement that broker-
dealers generate transaction confirmations and send those confirmations
to customers, nor the potential use of information contained in
confirmations by the Commission, SROs, and other securities regulatory
authorities in the course of examinations, investigations and
enforcement proceedings.
C. Respondents
The Commission estimates that the collections of information would
apply to the number of respondents as indicated in the following
table.\229\
---------------------------------------------------------------------------
\229\ See also section IV.B., infra.
------------------------------------------------------------------------
Number of
Rules broker-dealers
------------------------------------------------------------------------
Amendments to Rule 15c3-1 (not including appendices) and 434
Rule 17a-4.............................................
Amendments to Appendices A, E, F, and G to Rule 15c3-1.. 115
Amendments to Exhibit A to Rule 15c3-3.................. 72
Amendments to the General Instructions to Form X-17A-5, 4
Part IIB...............................................
Amendments to Rule 10b-10............................... 502
------------------------------------------------------------------------
D. Total Initial and Annual Reporting and Recordkeeping Burden
1. Rule 15c3-1 Appendices A, E, F, and G to Rule 15c3-1, Rule 17a-4,
and the General Instructions to Form X-17A-5, Part IIB
The amendments to Rule 15c3-1 and Rule 17a-4 modify broker-dealers'
existing practices to impose additional voluntary recordkeeping
burdens. The amendments to Rule 15c3-1 replace NRSRO ratings-based
criteria for evaluating creditworthiness with an option for a broker-
dealer to apply a new standard based on the broker-dealer's own
evaluation of creditworthiness. A broker-dealer that chooses not to
make such an evaluation could instead take the higher haircuts as
specified in Rule 15c3-1. A broker-dealer that chooses to evaluate the
creditworthiness of securities will have to establish, document,
maintain, and enforce policies and procedures that are reasonably
designed to determine whether a security has a minimal amount of credit
risk. Broker-dealers will be required to develop (if they have not
already) criteria for assessing creditworthiness and apply those
criteria to commercial paper, nonconvertible debt, and preferred stock
included in their net capital calculations.
The Commission requested comment on the PRA burden associated with
its proposed amendments to Rule 15c3-1 and Rule 17a-4. Two commenters
discussed costs, although the comments did not explicitly address the
PRA.\230\ One commenter stated that ``[a] significant number of large
broker-dealers have sophisticated internal credit review functions''
but those broker-dealers may not ``have access to internally generated
analyses of all or nearly all issuers and securities.'' \231\ Both
commenters were concerned that the costs imposed by the proposed
amendments could be considerable, particularly for small and medium-
sized broker-dealers.\232\ One commenter noted, however, that ``the
burden on small and medium-sized broker-dealers would be significantly
reduced if the proposed amendment were to be interpreted . . . to
permit policies and procedures that base the credit risk analysis
solely on a small number of objectively determinable factors.'' \233\
The amended rule allows a broker-dealer to establish policies and
procedures customized to its size and business activities.\234\ For
example, a smaller broker-dealer may decide to establish procedures
that use a small number of objective factors or that default to the
higher haircuts with respect to certain types of securities or money
market instruments in lieu of establishing policies and procedures to
address them. Both of these options should minimize the compliance
burden on the broker-dealer. Furthermore, the Commission believes that
many of the firms that hold commercial paper, nonconvertible debt
securities, and preferred stock (or combinations thereof) have
established policies and procedures for assessing creditworthiness;
broker-dealers that have not established such policies and procedures
do not typically hold large portfolios of these types of
positions.\235\ In addition, the broker-dealer should be able to use
its policies and procedures to replicate its credit determinations and
is not required to create and maintain records of those
[[Page 1538]]
determinations. Nonetheless, the Commission believes that those broker-
dealers that already have policies and procedures in place for
evaluating the overall risk and liquidity levels of proprietary
securities for the purposes of Rule 15c3-1 may incur additional burdens
as a result of the amendments. In particular, the policies and
procedures may need to be modified to address the particular
requirements of the amendments.
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\230\ Bond Dealers Letter; SIFMA Letter.
\231\ SIFMA Letter, at 11, 18.
\232\ Bond Dealers Letter, at 2; SIFMA Letter, at 18.
\233\ SIFMA Letter, at 18.
\234\ See section II.B.1.a.iii., supra.
\235\ SIFMA Letter, at 18 (``A number of broker-dealers have
access to credit analysis functions that could be applied to
generate internal credit analysis of debt instruments.'').
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According to data collected by the Commission, of the approximately
4,462 broker-dealers registered with the Commission as of year-end
2012, approximately 434 broker-dealers maintained proprietary positions
in debt securities and took haircuts on these securities pursuant to
paragraphs (c)(2)(vi)(E), (c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2) and
(c)(2)(vi)(H) of Rule 15c3-1.\236\ The Commission estimated in the
proposing release that, on average, broker-dealers would spend 25 hours
developing policies and procedures or revising their current policies
and procedures for evaluating creditworthiness for purposes of the
amendments to Rule 15c3-1.\237\ The Commission received no comments on
this estimate. The Commission believes that this estimate is still
valid, resulting in an aggregate initial burden of 10,850 hours.\238\
This estimate is based on the Commission's belief that many of these
broker-dealers already have their own criteria in place for evaluating
creditworthiness and, therefore, most broker-dealers will only be
revising their current policies and procedures. If a broker-dealer does
not have policies and procedures in place (e.g., a small broker-dealer
holding only a few debt securities) but determines to establish them
rather than taking the larger haircut, the Commission believes that
such a firm will likely establish less complex policies and procedures
using a small number of objective factors.\239\
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\236\ The number of 434 broker-dealers was obtained by reviewing
broker-dealer Financial and Operational Combined Single (or
``FOCUS'') Reports for 2012 year-end and then calculating how many
firms reported holding proprietary debt positions. For FOCUS Part II
filers, the balances examined were ``Bankers Acceptances'' and
``Corporate Debt.'' For FOCUS CSE filers, the balances examined
were: ``Money Market Instruments,'' ``Private Label Mortgage Backed
Securities,'' ``Other Asset Backed Securities,'' and ``Corporate
Debt.'' For Part IIA filers, the balance examined was ``Debt
Securities.'' Broker-dealers that hold preferred stock also may hold
positions in debt securities. However, because preferred stock is
not a separate line item on the FOCUS Report, broker-dealers that
hold only preferred stock and no other debt securities are not
included in this estimate.
\237\ Removal of Certain References to Credit Ratings under the
Securities Exchange Act of 1934, 76 FR at 26568.
\238\ 434 broker-dealers x 25 hours = 10,850 hours. It should be
noted that this hour burden is less than the hour burden in the
proposing release. This decrease is a result of the number of
broker-dealers that reported holding proprietary debt positions on
the FOCUS Report. The number decreased from 480 at 2009 year end to
434 at 2012 year end.
\239\ See SIFMA Letter, at 18 (``the burden on small and medium-
sized broker-dealers would be significantly reduced if the proposed
amendment were to be interpreted . . . to permit policies and
procedures that base the credit risk analysis solely on a small
number of objectively determinable factors . . .'').
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The Commission also estimated in the proposing release that, on
average, each broker-dealer will spend an additional 10 hours a year
reviewing and adjusting its own standards for evaluating
creditworthiness for purposes of the amendments to Rule 15c3-1.\240\
The Commission received no comments on this estimate and believes it is
still valid. As a result, the Commission estimates that a broker-dealer
will spend approximately twenty-five hours initially and ten hours on
an annual basis on its policies and procedures. Thus, the industry, as
a whole, is estimated to spend approximately 10,850 hours initially and
4,340 hours \241\ annually reviewing and adjusting its standards for
evaluating creditworthiness for purposes of the amendments to Rule
15c3-1.\242\
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\240\ Removal of Certain References to Credit Ratings under the
Securities Exchange Act of 1934, 76 FR at 26568. Although the
Commission has added language to the rule to clarify that a broker-
dealer's policies and procedures must be reasonably designed to
monitor its creditworthiness determination, the duty to monitor was
required under the proposed rule and was reflected in the
corresponding burden estimate. See section II.B.1.a.iii, supra.
\241\ 434 broker-dealers x 10 hours = 4,340 hours.
\242\ The Commission estimated in the proposing release that
firms would use a controller to review these standards, both
initially and on an annual basis. The Commission received no
comments on this estimate. Thus, the Commission believes the per-
firm costs of the controller to be approximately $10,475 initially
and $4,190 on an annual basis, for an aggregate industry cost of
$4,546,150 initially and $1,818,460 on an annual basis. For purposes
of this analysis, the Commission is using salary data from the
Securities Industry and Financial Markets Association (``SIFMA'')
Report on Management and Professional Earnings in the Securities
Industry 2012, which provides base salary and bonus information for
middle management and professional positions within the securities
industry, as modified by Commission staff to account for an 1800-
hour work-year and multiplied by 5.35 to account for bonuses, firm
size, employee benefits and overhead. Hereinafter, references to
data derived from the report as modified in the manner described
above will be cited as SIFMA Report on Management and Professional
Earnings in the Securities Industry 2012. The Commission believes
that the reviews required by the proposed amendments would be
performed by the controller at an average rate $419 per hour. $419 x
25 = $10,475 x 434 = $4,546,150; $419 x 10 = $4,190 x 434 =
$1,818,460.
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The Commission received no comments on the estimated burdens
associated with the record retention requirements arising from the
proposed amendments to Rule 17a-4. The Commission continues to believe
that the requirement to retain the policies and procedures for three
years pursuant to Rule 17a-4 would result in de minimis incremental
costs beyond those already incurred under Rule 17a-4. The three-year
preservation requirement in Rule 17a-4 will only be applicable once a
broker-dealer changes its policies and procedures as the operative
policies and procedures must be documented and maintained under the
amendments to Rule 15c3-1. In addition, all broker-dealers are
currently required to comply with the three-year preservation period in
Rule 17a-4 for other records and should have procedures in place to
satisfy such preservation requirements.
The amendments to the appendices to Rule 15c3-1 include amendments
to certain recordkeeping and disclosure requirements that are subject
to the PRA. The amendment to Appendix A to Rule 15c3-1 removes the
NRSRO reference from the definition of the term major market foreign
currency. However, the Commission does not intend to change which
currencies would meet the definition of major market foreign currency
because they will still have to have a substantial inter-bank foreign
currency market. In the proposing release the Commission stated that
there would be a recordkeeping burden if a broker-dealer wanted to
request that a currency be deemed to meet the definition of major
market foreign currency, by submitting such a request to the
Commission. After further review, and based on staff experience with
paragraph (c)(2)(vi) of Rule 15c3-1, the Commission believes that
broker-dealers will rarely formally request in writing that a currency
be added to the list. Thus, the Commission does not believe there is a
burden associated with this amendment.\243\
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\243\ In the proposing release, the Commission estimated that
submitting a request that a new currency met the definition of
``major market foreign currency'' would take 10 hours for a total
burden to the industry of 1,580 hours. See Removal of Certain
References to Credit Ratings under the Securities Exchange Act of
1934, 76 FR at 26568.
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The amendments to Appendices E and F to Rule 15c3-1 and conforming
amendments to Appendix G would remove the provisions permitting
reliance on NRSRO ratings for the purposes of determining counterparty
risk. As a result of these deletions, an entity that wishes to use the
approach set forth in these appendices to determine counterparty risks
would need, as part of its initial application to use the alternative
approach or in an amendment, to request Commission
[[Page 1539]]
approval to determine credit charges based on internal credit ratings
and make and keep current a record of the basis for the credit risk
weight applied to each counterparty.
The Commission does not believe that the removal of the option
permitting reliance on NRSRO ratings would affect the small number of
entities that currently elect to compute their net capital deductions
pursuant to the alternative methods set forth in Appendices E or F.
Although the collections of information obligations imposed by the
amendments are mandatory, applying for approval to use the alternative
capital calculation is voluntary.\244\ To date, a total of six entities
are using the methods set forth in Appendix E, while four are using the
methods set forth in Appendix F. All of the approved firms already use
internal credit ratings to calculate market and credit risks under the
alternative net capital calculation methods set forth in the appendices
or are taking a 100% charge for counterparty risk. No firms are using
NRSRO ratings to measure counterparty risk.\245\ For each entity that
already employs its own models to calculate market and credit risk and
keeps current a record of the basis for the credit risk weight of each
counterparty, the amendments would not alter the paperwork burden
currently imposed by Appendices E and F. Firms that have Commission-
approved models to calculate market and credit risk, but have chosen
not to seek Commission approval to calculate counterparty risk during
their initial applications, can file an amendment to their applications
to calculate counterparty risk. Based on the staff's review of how
firms approved to use Appendices E and F are calculating counterparty
risk, the staff believes that of the firms that do not have models
approved to calculate counterparty risk, none would use NRSRO ratings
to calculate counterparty risk even if it remained an option. Instead,
these firms would continue to take a 100% charge for counterparty risk
or would amend their application if charges related to counterparty
risk increased to the point that the 100% charge was no longer
economically practical. Any PRA burdens from these amended applications
are included in the PRA burden associated with Appendix E or Appendix
F. Thus, the Commission does not believe there are any additional
burdens associated with this rulemaking.
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\244\ See, e.g., Alternative Net Capital Requirements for
Broker-Dealers That Are Part of Consolidated Supervised Entities,
Exchange Act Release No. 34-49830 (June 8, 2004), 69 FR 34428 at
34456 (June 21, 2004).
\245\ In the proposing release, the Commission stated that all
firms have models approved to calculate counterparty risk. Although
the Commission received no comments on this estimate, upon further
review the staff has determined that although no firm is using NRSRO
ratings to calculate counterparty risk, not all firms have models
approved to calculate counterparty risk (i.e., some firms take the
100% charge).
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The staff estimates that three additional firms may apply for
permission to use Appendix E and one additional firm may apply to use
Appendix F. However, the Commission believes, and commenters did not
contest, that there should be no additional paperwork burden on these
firms based on the amendments. Any firm that applies to use Appendices
E or F to Rule 15c3-1 must submit its internal models to the Commission
for approval as part of that process. These models will calculate
market risk and credit risk, including the counterparty charge, which
is not a change from the previous approval process for a firm that is
applying to use Appendix E or Appendix F. Thus, the Commission does not
believe the amendments to Appendices E and F will alter the existing
paperwork burden estimates for these collections.
The instructions to Form X-17A-5, Part IIB currently include a
summary of the credit risk calculation in paragraph (d) of Rule 15c3-
1f. Paragraph (d) of Rule 15c3-1f is amended to remove that part of the
credit risk calculation that is summarized in Form X-17A-5, Part IIB.
Accordingly, the Commission is adopting a conforming amendment to the
form that would remove the summary of the credit risk calculation. The
Commission received no comments on its estimate in the proposing
release that there would be no change in the burden for the collection
of information related to the instructions to Form X-17A-5, Part IIB in
the proposing release. The summary in the instructions provides
additional information for the benefit of the filer and is not related
to the information reported on the forms. Accordingly, the Commission
does not believe the amendment would result in a substantive revision
to these collections of information.
2. Exhibit A to Rule 15c3-3
The amendment to Note G to Exhibit A to Rule 15c3-3 imposes
additional recordkeeping burdens on certain broker-dealers that are
mandatory. Note G allows a broker-dealer to include, as a debit in its
customer reserve formula, the amount of customer margin related to
customer positions in security futures products posted to a registered
clearing or derivatives clearing organization that meets certain
minimum standards that are indicia of long-term financial strength.
Prior to this amendment, clearing organizations that maintained the
highest investment grade rating from an NRSRO qualified under Note
G.\246\ The amendment removes this NRSRO criterion such that firms
including the debit in their reserve formula calculations must rely on
one of the remaining three non-NRSRO criterions, or seek an exemption
from the Commission. Broker-dealers are expected to ensure that any
clearing or derivatives clearing organization it posts margin to meets
one of the criterions under Note G, which results in the creation and
maintenance of records of those assessments. The Commission requested
comment on all aspects of the burdens associated with Note G to Exhibit
A to Rule 15c3-3 and received no comments. The Commission estimates
that approximately 72 firms would be required to comply with the
provisions of Note G as amended.\247\ In the final release that added
Note G to Exhibit A to Rule 15c3-3,\248\ the Commission estimated that
firms would each spend approximately 0.25 hours to verify that the
clearing or derivatives clearing organizations they post customer
margin to satisfy the conditions of Note G. In the proposing release
for these rule amendments, the Commission again estimated that firms
would spend approximately 0.25 hours to verify that a clearing or
derivatives clearing organization satisfies the conditions of Note G.
The Commission
[[Page 1540]]
received no comments on this estimate and believes it is still valid.
The Commission therefore estimates that broker-dealers that trade in
single stock futures will spend a total of approximately 18 hours per
year, initially and on an ongoing basis, to verify the status of a
registered clearing or derivatives clearing organization imposed by
this amendment.\249\
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\246\ A broker-dealer may also include customer margin related
to customers' positions in security futures products posted to a
registered clearing or derivatives clearing organization: (1) That
maintains security deposits from clearing members in connection with
regulated options or futures transactions and assessment power over
member firms that equal a combined total of at least $2 billion, at
least $500 million of which must be in the form of security
deposits; (2) that maintains at least $3 billion in margin deposits;
or (3) which does not meet any of the other criteria but which the
Commission has agreed, upon a written request from the broker-
dealer, that the broker-dealer may utilize. 17 CFR 240.15c3-3a, Note
G, (b)(1)(ii)-(iv).
\247\ The number 72 comes from reviewing the members of the OCC
listed in the member directory on the OCC's Web site, available at
http://www.optionsclearing.com/membership/member-information/. Of
the list of 228 members, the Commission looked only at those who
trade in single stock futures. Of the list of members that trade in
single stock futures, the Commission deleted any members who had the
exact same firm name but different firm numbers. This methodology is
consistent with the methodology used in the proposing release.
Removal of Certain References to Credit Ratings Under the Securities
Exchange Act of 1934, 76 FR at 26570 n.115. The Commission received
no comments on this estimate.
\248\ See Reserve Requirements for Margin Related to Security
Futures Products, Exchange Act Release No. 34-50295 (Aug. 31, 2004),
69 FR 54182, 54188 (Sep. 7, 2004).
\249\ 72 broker-dealers x .25 hours = 18 hours.
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The Commission estimated in the proposing release that firms would
spend one hour changing their methods of determining whether a clearing
or derivatives clearing organization meets the remaining four
requirements of Note G. The Commission received no comments on this
estimate and believes it is still accurate. The result is an aggregate,
one-time initial burden of 72 hours.\250\
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\250\ 72 broker-dealers x 1 hour = 72 hours. The Commission
notes that this hour burden is less than the hour burden in the
proposing release. This decrease is a result of the number of OCC
member firms that trade in single stock futures decreasing from 90
to 72. The Commission estimated in the proposing release that firms
will use a senior operations manager to review these standards. The
Commission received no comments on this estimate and believes that
it is still accurate. The Commission therefore estimates that the
one-time costs of a senior operations manager to be $341 per hour,
resulting in an aggregate, one-time cost to the industry of $24,552.
72 broker-dealers x $341/hour x 1 hour = $24,552. SIFMA Report on
Management and Professional Earnings in the Securities Industry
2012.
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3. Rule 10b-10
In the proposing release, the Commission stated that the proposed
amendment to Rule 10b-10 was not expected to result in any significant
change to the cost of providing confirmations to customers in
connection with those transactions covered by paragraph (a)(8) of the
rule.\251\ The Commission did not receive any comments that addressed
the Rule 10b-10 amendment's potential effects on the burden associated
with generating and sending confirmations. The Commission continues to
believe that broker-dealers need not incur any new costs if they choose
not to input information that a debt security is unrated into their
existing confirmation systems. Accordingly, the Commission continues to
believe that the Rule 10b-10 amendment will not result in any
significant change to the recordkeeping or reporting burdens of
generating and sending confirmations, and retains this conclusion as
originally proposed.
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\251\ See Removal of Certain References to Credit Ratings Under
the Securities Exchange Act of 1934, 76 FR at 26575.
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IV. Economic Analysis
A. Overview
The Commission is sensitive to the costs and benefits of its rules.
When engaging in rulemaking that requires the Commission to consider or
determine whether an action is necessary or appropriate in the public
interest, section 3(f) of the Exchange Act requires that the Commission
consider, in addition to the protection of investors, whether the
action will promote efficiency, competition, and capital
formation.\252\ In addition, section 23(a)(2) of the Exchange Act
requires that the Commission consider the effects on competition of any
rules the Commission adopts under the Exchange Act, and prohibits the
Commission from adopting any rule that would impose a burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.\253\
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\252\ 15 U.S.C. 78c(f).
\253\ 15 U.S.C. 78w(a)(2).
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In the proposing release, the Commission solicited comment on the
costs and benefits of the proposed amendments, including whether
estimates of the costs and benefits were accurate and
comprehensive.\254\ The Commission further encouraged commenters to
provide specific data and analysis in support of their views.\255\ The
Commission also requested comment on whether the proposed amendments
would place a burden on competition, and promote efficiency,
competition, and capital formation.\256\
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\254\ An economic analysis was included in the proposing
release. See Removal of Certain References to Credit Ratings Under
the Securities Exchange Act of 1934, 76 FR at 26571-26574.
\255\ See Removal of Certain References to Credit Ratings Under
the Securities Exchange Act of 1934, 76 FR at 26574.
\256\ Id.
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The Commission received two comment letters addressing the
Commission's estimates of the costs associated with the proposed
amendments.\257\ Generally, these commenters expressed concerns that
the potential costs associated with the proposed rules could be
considerable.\258\ While commenters stated that the costs may be high,
they did not provide quantified estimates of the costs--this reflects
the fact that many of the costs and benefits of today's amendments are
difficult to quantify with any degree of certainty, especially as
practices at broker-dealers are expected to evolve and appropriately
adapt to market developments. Moreover, this difficulty is aggravated
by the fact that limited public data exists that is related to a
broker-dealer's net capital calculation that could assist in
quantifying certain costs. Consequently, the Commission has relied on
qualitative assessments of the likely costs and benefits in its
analysis. As discussed throughout this release, the Commission has
modified the amendments being adopted today in a way that it believes
will help to minimize costs to broker-dealers. A number of costs and
benefits that are related to the rules being adopted today are
discussed below.
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\257\ See SIFMA Letter; Bond Dealers Letter.
\258\ See Bond Dealers Letter, at 2 (``the cost to comply may be
prohibitively high for the smaller or middle-market broker-
dealers''); SIFMA Letter, at 18 (``we believe the cost and
complexity of developing a credit evaluation infrastructure covering
many issuers and securities may be beyond the means of many broker-
dealers'').
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As discussed above, the amendments to Rule 15c3-1, Appendices A, E,
F, and G to Rule 15c3-1, Exhibit A to Rule 15c3-3, Rule 17a-4, the
General Instructions to Form X-17A-5, Part IIB, and Rule 10b-10
implement section 939A of the Dodd-Frank Act by eliminating the
reference to and requirement for the use of NRSRO ratings in these
rules. The Commission recognizes that there are additional costs
associated with adopting the amendments that are separate from the
costs associated with the hour and cost burdens discussed in the PRA.
The discussion below focuses on the Commission's reasons for adopting
these amendments, the affected parties, the impact on efficiency,
competition, and capital formation, and the costs and benefits of the
amendments as compared to the baseline, described below, and to
alternative courses of action.
B. Economic Baseline
The regulatory changes adopted today amend requirements that apply
to broker-dealers registered with the Commission. However, security
issuers, NRSROs, non-NRSRO credit rating agencies, and other providers
of credit risk analysis as well as a broker-dealer's customers and
counterparties could all be affected by the amendments. The discussion
below characterizes the economic baseline against which the costs and
benefits, as well as the impact on efficiency, competition, and capital
formation, of today's amendments are measured. It includes the
approximate numbers of broker-dealers that would be directly affected
by today's amendments and a description of the relevant features of the
economic and regulatory environment in which the various impacted
parties operate. The economic baseline being used for this analysis is
the economic and regulatory framework
[[Page 1541]]
in existence just prior to the adoption of today's amendments.
The regulations that are affected by today's amendments include
Rule 15c3-1, which provided prior to today's amendments, among other
things, that a broker-dealer could apply a lesser capital charge (e.g.,
less than the 15% catchall charge) for commercial paper, nonconvertible
debt, and preferred stock if the instrument is rated in the higher
rating categories by two NRSROs; the Appendices to Rule 15c3-1, which
rely on credit ratings for calculating haircuts or credit risk charges
related to counterparties; Exhibit A to Rule 15c3-3, which uses NRSRO
ratings to determine whether a broker-dealer can include customer
margin for transactions in securities futures products as a debit in
its reserve formula; and Rule 10b-10, which requires disclosing in
customer confirmations of securities transactions if non-government
debt securities have not been rated by an NRSRO. The rule amendments
would help to reduce any perceived Commission endorsement of NRSROs and
NRSRO ratings and reduce reliance on credit ratings. The relevant rule
amendments are described in detail below.
The broker-dealers registered with the Commission vary
significantly in terms of their size, business activities, and the
complexity of their operations. For example, carrying broker-dealers
hold customer securities and funds.\259\ Clearing broker-dealers clear
transactions as members of securities exchanges, the Depository Trust &
Clearing Corporation, and the OCC.\260\ Many clearing broker-dealers
are carrying broker-dealers, but some clearing broker-dealers clear
only their own transactions and do not hold customer securities and
cash.
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\259\ Rule 15c3-1 specifies that a broker-dealer shall be deemed
to carry customer or broker-dealer accounts ``if, in connection with
its activities as a broker or dealer, it receives checks, drafts, or
other evidences of indebtedness made payable to itself or persons
other than the requisite registered broker or dealer carrying the
account of a customer, escrow agent, issuer, underwriter, sponsor,
or other distributor of securities'' or ``if it does not promptly
forward or promptly deliver all of the securities of customers or of
other brokers or dealers received by the firm in connection with its
activities as a broker or dealer.'' 17 CFR 240.15c3-1(a)(2)(i); see
also the description of Rule 15c3-1 in section II.B.1.a.i., supra.
Further, Rule 15c3-3, defines the term securities carried for the
account of a customer to mean ``securities received by or on behalf
of a broker or dealer for the account of any customer and securities
carried long by a broker or dealer for the account of any
customer,'' as well as securities sold to, or bought for, a customer
by a broker-dealer. 17 CFR 240.15c3-3(a)(2); see also the
description of the Customer Protection Rule in section II.B.1.f.,
supra.
\260\ See Definitions of Terms and Exemptions Relating to the
``Broker'' Exceptions for Banks and Exemptions for Banks Under
Section 3(a)(5) of the Securities Exchange Act of 1934, Exchange Act
Release No. 34-56501 (Sep. 24, 2007), 72 FR 56514 (Oct. 3, 2007), at
n.269.
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A broker-dealer that claims an exemption from Rule 15c3-3 is
generally referred to as ``non-carrying broker-dealer.'' Non-carrying
broker-dealers include ``introducing brokers.'' \261\ These non-
carrying broker-dealers typically accept customer orders and introduce
their customers to a carrying broker-dealer that will hold the
customers' securities and cash along with the securities and cash of
customers of other introducing broker-dealers and those of direct
customers of the carrying broker-dealer. The carrying broker-dealer
generally receives and executes orders of the introducing broker-
dealer's customers.\262\ Carrying broker-dealers generally also prepare
trade confirmations, settle trades, and organize book entries of the
securities.\263\ Introducing broker-dealers also may use carrying
broker-dealers to clear the firm's proprietary trades and carry the
firm's securities. Another group of non-carrying broker-dealers effects
transactions in securities such as mutual funds on a subscription-way
basis.\264\ Generally, customers purchase the securities by providing
the funds directly to the issuer. Finally, some non-carrying broker-
dealers act as finders by referring prospective purchasers of
securities to issuers.\265\
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\261\ See Net Capital Rule, Exchange Act Release No. 34-31511
(Nov. 24, 1992), 57 FR 56973 (Dec. 2, 1992) (describing the role of
introducing broker-dealers).
\262\ Id.
\263\ See, e.g., FINRA Rule 4311 (Carrying Agreements). This
FINRA rule governs the requirements applicable to FINRA members when
entering into agreements for the carrying of any customer accounts
in which securities transactions can be effected. Historically, the
purpose of this rule has been to require that certain functions and
responsibilities are clearly allocated to either the introducing or
carrying firm, consistent with the requirements of the SRO's and
Commission's financial responsibility rules and other rules and
regulations, as applicable. See also Notice of Filing of Amendment
No. 1 and Order Granting Accelerated Approval of a Proposed Rule
Change Adopting, as Modified by Amendment No. 1, Rules Governing
Guarantees, Carrying Agreements, Security Counts and Supervision of
General Ledger Accounts in the Consolidated FINRA Rulebook, Exchange
Act Release 34-63999 (Mar. 7, 2011), 76 FR 12380 (Mar. 7, 2011).
\264\ See Books and Records Requirements for Brokers and Dealers
Under the Securities Exchange Act of 1934, Exchange Act Release No.
34-44992 (Oct. 26, 2001), 66 FR 55818 (Nov. 2, 2001) (``[T]he
Commission recognizes that for some types of transactions, such as
purchases of mutual funds or variable annuities, the customer may
simply fill out an application or a subscription agreement that the
broker-dealer then forwards directly to the issuer.'').
\265\ See American Bar Association, Report and Recommendations
of the Task Force on Private Placement Broker-Dealers, 23-24 (2005);
see also Net Capital Rule, 57 FR 56973.
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The broker-dealer industry is the primary industry affected by the
rule amendments, although the amendments impose different requirements
on different types of broker-dealers. For example, only those broker-
dealers that hold proprietary positions in commercial paper,
nonconvertible debt, and preferred stock will be affected by the
amendments to Rules 15c3-1 and 17a-4, only those broker-dealers that
trade in foreign currency options will be affected by the amendments to
Appendix A to Rule 15c3-1, and only those broker-dealers that clear and
carry positions in security futures products for customers will be
affected by the amendment to Exhibit A to Rule 15c3-3. The amendments
to Appendices E and F to Rule 15c3-1 and the conforming amendments to
Appendix G to Rule 15c3-1 and the General Instructions to Form X-17A-5,
Part IIB will affect only ANC broker-dealers and OTC derivatives
dealers. The amendment to Rule 10b-10 eliminates a disclosure
requirement for broker-dealers that currently produce transaction
confirmations for debt securities other than government securities.
To establish a baseline for competition among broker-dealers, the
Commission looks at the status of the broker-dealer industry detailed
below. In terms of size, the following tables illustrate the variance
among broker-dealers with respect to total capital. The information in
the tables is based on FOCUS Report data for calendar year 2012.
Broker-Dealer Capital at Calendar Year-End 2012
[$ Millions]
------------------------------------------------------------------------
Number of Sum of total
Capital firms capital
------------------------------------------------------------------------
Less than $500,000...................... 2,347 $345
[[Page 1542]]
Greater than or equal to 500,000 and 1,273 2,207
less than 5 million....................
Greater than or equal to 5 million and 569 9,712
less than 50 million...................
Greater than or equal to 50 million and 83 5,632
less than 100 million..................
Greater than or equal to 100 million and 121 25,465
less than 500 million..................
Greater than or equal to 500 million and 27 19,688
less than 1 billion....................
Greater than or equal to 1 billion and 26 56,034
less than 5 billion....................
Greater than or equal to 5 billion and 7 47,922
less than 10 billion...................
Greater than or equal to 10 billion..... 9 185,022
-------------------------------
Total............................... 4,462 352,028
------------------------------------------------------------------------
According to FOCUS Report data, as of December 31, 2012, there were
approximately 4,462 broker-dealers registered with the Commission. Nine
broker-dealers account for more than half of all capital held by
broker-dealers. Of the 4,462 registered broker-dealers, 434 firms
reported holding proprietary debt positions on their FOCUS
Reports.\266\ The Commission has also estimated that there are 101
broker-dealers that trade foreign currency options and are, therefore,
subject to Appendix A to Rule 15c3-1.\267\ Furthermore, there are six
ANC broker-dealers (i.e., firms that operate under Appendix E to Rule
15c3-1) and four OTC derivatives dealers (i.e., firms that operate
under Appendix F to Rule 15c3-1). In addition, the staff estimates
that, for reasons unrelated to the rule amendments being adopted today,
an additional three firms will apply to operate as ANC broker-dealers
and one additional firm will apply to operate as an OTC derivatives
dealer. The Commission also has estimated that there are 72 firms
subject to Note G to Exhibit A to Rule 15c3-3.\268\
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\266\ See section III.C., supra.
\267\ To arrive at this number, the Commission reviewed the
members of the OCC listed in the member directory on the OCC's Web
site available at http://www.optionsclearing.com/membership/member-information/. Of the list of 228 members, the Commission looked only
at those that trade in index options because members approved to
trade index options are also approved to trade such foreign currency
options. Of the list of members that trade in index options, the
Commission deleted any members that had the exact same firm name but
different firm numbers. The Commission received no comments on its
estimate of the number of broker-dealers that would be affected by
the amendment to Appendix A to Rule 15c3-1 in the proposing release.
See also Removal of Certain References to Credit Ratings under the
Securities Exchange Act of 1934, 76 FR at 26568.
\268\ See section III.C., supra.
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The Commission also believes other parties could be affected by
today's amendments. Under the economic baseline, issuers of securities
who obtain favorable ratings from two or more NRSROs enjoy the benefit
of greater access to the capital markets because such securities are--
holding other things constant--more attractive to broker-dealers who
can take lower haircuts on such securities for the purposes of
compliance with Rule 15c3-1. While the Commission does not intend the
amendments to Rule 15c3-1 to alter the scope of securities and money
market instruments that qualify for the lower haircuts, eliminating
preferential regulatory treatment of NRSRO-rated securities could
affect security issuers by altering the portfolio preferences of
broker-dealers if, for example, broker-dealers establish policies and
procedures for assessing creditworthiness that produce more
conservative results than the NRSRO credit rating standard. These
conservative results could cause broker-dealers to avoid holding
positions that they would have held under the NRSRO credit rating
standard. Alternatively, if the policies and procedures produce less
conservative results, the amendments could alter the risk of broker-
dealers' portfolios by causing them to hold positions that they would
not have held when applying the NRSRO credit rating standard. Altering
the risk of broker-dealers' portfolios could affect broker-dealers'
customers, counterparties, and investors, all of whom are protected by
Rule 15c3-1.
Finally, today's amendments could have a significant effect on the
credit ratings industry. Currently there are ten NRSROs with the three
largest accounting for the majority of all credit ratings.\269\ The
favorable regulatory treatment of NRSRO-rated securities increases
demand for securities that have been favorably rated by at least two
NRSROs. Eliminating this favorable treatment may alter incentives for
broker-dealers to hold NRSRO-rated securities and may increase a
broker-dealer's use of alternative providers of credit risk analysis,
which could increase competition in the credit ratings industry.
---------------------------------------------------------------------------
\269\ See Commission, Annual Report on Nationally Recognized
Statistical Rating Organizations (December 2012) (estimating that as
of December 2011, the three largest NRSROs accounted for
approximately 96% of all outstanding credit ratings); Commission,
Report to Congress on Assigned Credit Ratings (December 2012)
(estimating that as of December 2011, the three largest credit
rating agencies accounted for approximately 91% of structured
product ratings).
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1. Overview of Rule 15c3-1, Appendices A, E, F, and G to Rule 15c3-1,
Exhibit A to Rule 15c3-3, the General Instructions to Form X-17A-5,
Part IIB, and Rule 10b-10 Prior to Today's Amendments
a. Rule 15c3-1
As discussed above, Rule 15c3-1 prescribes minimum regulatory
capital requirements for broker-dealers.\270\ Rule 15c3-1 prescribes a
``net liquid assets test'' designed to require a broker-dealer to
maintain at all times more than one dollar of highly liquid assets for
each dollar of liabilities (e.g., money owed to customers and
counterparties), excluding liabilities subordinated by contract to all
other creditors. Under the economic baseline, Rule 15c3-1 prescribed a
lower haircut to certain types of debt instruments held by a broker-
dealer if the securities were rated in higher rating categories by at
least two NRSROs, since those securities typically are less volatile in
price than securities that are rated in the lower categories or are
unrated. Specifically, to receive the benefit of a reduced haircut on
commercial paper, the commercial paper had to be rated in one of the
three highest rating categories by at least two NRSROs; \271\ to
receive the benefit of a reduced haircut on a nonconvertible debt
security and preferred stock, the security had to be
[[Page 1543]]
rated in one of the four highest rating categories by at least two
NRSROs.\272\ If securities were not eligible for the reduced haircut,
they were subject to a greater haircut (e.g., 15%), provided they had a
ready market. The 15% haircut is derived from the catchall haircut
amount that applies to a security not specifically identified in Rule
15c3-1 as having an asset-class specific haircut, provided the security
is otherwise deemed to have a ready market, among other requirements.
Securities without a ready market are subject to a 100% haircut.
---------------------------------------------------------------------------
\270\ See 17 CFR 240.15c3-1; see also discussion in section
II.B.1.a.i., supra.
\271\ 17 CFR 240.15c3-1(c)(2)(vi)(E).
\272\ 17 CFR 240.15c3-1(c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2) and
(c)(2)(vi)(H).
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b. Appendix A to Rule 15c3-1
Appendix A to Rule 15c3-1 permits broker-dealers to employ a
standardized theoretical option pricing model to determine a potential
loss for a portfolio of listed options positions and related positions
to compute a single haircut for the group of positions.\273\ Under
Appendix A, a broker-dealer groups the options and related positions in
a portfolio and stresses the current market price for each position at
ten equidistant points along a range of positive and negative potential
future market movements, using an approved theoretical option pricing
model that satisfies certain conditions specified in the rule.\274\
Positions that have more potential price volatility must be stressed
across a wider range of positive and negative potential future market
movements than positions with lower price volatility.\275\ For example,
a broker-dealer other than a non-clearing option specialist or market
maker must employ a range of potential future market movements for
major market foreign currencies of () 6%, whereas the range
for all other foreign currencies is () 20%.\276\ Thus,
major market foreign currency options receive more favorable treatment
than options on all other currencies when using theoretical option
pricing models to compute net capital deductions.\277\ Under the
economic baseline, the rule defined the term major market foreign
currency to mean ``the currency of a sovereign nation whose short term
debt is rated in one of the two highest categories by at least two
nationally recognized statistical rating organizations and for which
there is a substantial inter-bank forward currency market.''
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\273\ See 17 CFR 240.15c3-1a(b)(1); see also discussion in
section II.B.1.b.i., supra.
\274\ See 17 CFR 240.15c3-1a(b)(1).
\275\ See 17 CFR 240.15c3-1a(b)(1)(iii).
\276\ See 17 CFR 240.15c3-1a(b)(1)(iii)(B) through (C).
\277\ See 17 CFR 240.15c3-1a(b)(1)(iii)(B) through (C) and
(b)(1)(iv)(A).
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c. Appendix E to Rule 15c3-1
Under Appendix E to Rule 15c3-1, ANC broker-dealers are permitted
to add back to net worth uncollateralized receivables from
counterparties arising from OTC derivatives transactions (i.e., they
can add back the amount of the uncollateralized current exposure).\278\
Instead of the 100% deduction that applies to most unsecured
receivables under Rule 15c3-1, ANC broker-dealers are permitted to take
a credit risk charge based on the uncollateralized credit exposure to
the counterparty.\279\ The credit risk charge is derived, in part, by
using an applicable credit risk weight factor.\280\ Appendix E to Rule
15c3-1 prescribes three standardized credit risk weight factors (20%,
50%, and 150%) and, as an alternative, permits an ANC broker-dealer
with Commission approval to use internal methodologies to determine
appropriate credit risk weights to apply to counterparties.\281\ Under
the economic baseline, ANC broker-dealers were permitted to use NRSRO
credit ratings or internally derived credit ratings to determine the
appropriate credit risk weight factor.
---------------------------------------------------------------------------
\278\ See 17 CFR 240.15c3-1e(c); see also discussion in section
II.B.1.c.i., supra.
\279\ See 17 CFR 240.15c3-1e(c); 17 CFR 240.15c3-1(a)(7).
\280\ See 17 CFR 240.15c3-1e(c)(1)(ii).
\281\ See 17 CFR 240.15c3-1e(c)(4)(vi).
---------------------------------------------------------------------------
d. Appendix F to Rule 15c3-1 and Form X-17A-5, Part IIB
Under Appendix F to Rule 15c3-1, OTC derivatives dealers are
required to deduct from their net capital credit risk charges that take
counterparty risk into consideration.\282\ As part of this deduction,
the OTC derivatives dealer must apply a counterparty risk weight factor
of either 20%, 50%, or 100%.\283\ In addition, OTC derivatives dealers
must take a concentration charge where the net replacement value in the
account of any one counterparty exceeds 25% of the OTC derivatives
dealer's tentative net capital.\284\ Under the economic baseline, the
counterparty risk weight factor (i.e., 20%, 50%, or 100%) was
determined using either NRSRO credit ratings or the firm's internal
credit ratings.\285\ The concentration charge also was determined using
either NRSRO credit ratings or the firm's internal credit ratings.
---------------------------------------------------------------------------
\282\ See 17 CFR 240.15c3-1f(d); see also discussion in section
II.B.1.d.i., supra.
\283\ See 17 CFR 240.15c3-1f(d)(2).
\284\ See 17 CFR 240.15c3-1f(d)(3).
\285\ See 17 CFR 240.15c3-1f(d)(2) and (4); see also discussion
in section II.B.1.d.i., supra.
---------------------------------------------------------------------------
e. Appendix G to Rule 15c3-1
Appendix G to Rule 15c3-1 provides that broker-dealers may use the
ANC computation only if their ultimate holding companies agree to
provide the Commission with additional information about the financial
condition of the holding company and its affiliates.\286\ Paragraph (a)
of Appendix G sets forth a methodology for computing allowable capital
and allowances for market and credit risk at the consolidated holding
company level. Under the economic baseline, one aspect of calculating
credit risk in Appendix G provided that those firms must use credit
ratings in accordance with the applicable provisions of Appendix E.
---------------------------------------------------------------------------
\286\ 17 CFR 240.15c3-1g.
---------------------------------------------------------------------------
f. Exhibit A to Rule 15c3-3
Rule 15c3-3 is designed to protect customer funds and securities
held by broker-dealers.\287\ In general, Rule 15c3-3 requires a broker-
dealer to take two steps. First, a broker-dealer must maintain
possession or control of all fully paid and excess margin securities of
its customers. In this regard, a broker-dealer must make a daily
determination in order to comply with this aspect of the rule. Second,
the broker-dealer must make a periodic computation to determine how
much money it is holding that is either customer money or money
obtained from the use of customer securities (``credits''). From that
figure, the broker-dealer subtracts the amount of money that it is owed
by customers relating to customer transactions (``debits''). If the
credits exceed the debits after this ``reserve formula'' computation,
the broker-dealer must deposit the excess in a customer reserve
account. If the debits exceed credits, no deposit is necessary. Funds
deposited in a customer reserve account cannot be withdrawn until the
broker-dealer completes another computation that shows that the firm
has on deposit more funds than the reserve formula requires.
---------------------------------------------------------------------------
\287\ See 17 CFR 240.15c3-3; see also discussion in section
II.B.1.f., supra.
---------------------------------------------------------------------------
Exhibit A to Rule 15c3-3 prescribes the formula that a broker-
dealer must use to determine its reserve requirement. Under the
economic baseline, Note G to Exhibit A provided that a broker-dealer
could include margin required for customer transactions in security
futures products as a debit in its reserve formula computation if that
margin is on deposit
[[Page 1544]]
at a clearing agency or derivatives clearing organization that: (1)
Maintains the highest investment-grade rating from an NRSRO; (2)
maintains security deposits from clearing members in connection with
regulated options or futures transactions and assessment power over
member firms that equal a combined total of at least $2 billion, at
least $500 million of which must be in the form of security deposits;
(3) maintains at least $3 billion in margin deposits; or (4) obtains an
exemption from the Commission.\288\
---------------------------------------------------------------------------
\288\ 17 CFR 240.15c3-3a, Note G.
---------------------------------------------------------------------------
g. Rule 10b-10
Rule 10b-10, the Commission's customer confirmation rule, generally
requires broker-dealers effecting transactions for customers in
securities, other than U.S. savings bonds or municipal securities, to
provide those customers with a written notification, at or before
completion of the securities transaction, disclosing certain
information about the terms of the transaction.\289\ This required
disclosure includes the date, time, identity, and number of securities
bought or sold; the capacity in which the broker-dealer acted (e.g., as
agent or principal); yields on debt securities; and, in some
circumstances, the amount of compensation the broker-dealer will
receive from the customer and any other parties. By requiring these
disclosures, the rule serves a basic customer protection function by
conveying information that: (1) Allows customers to verify the terms of
their transactions; (2) alerts customers to potential conflicts of
interest; (3) acts as a safeguard against fraud; and (4) allows
customers a means of evaluating the costs of their transactions and the
quality of the broker-dealer's execution. Under the economic baseline,
Rule 10b-10 required a broker-dealer to inform the customer in the
confirmation if a debt security, other than a government security, is
unrated by an NRSRO.
---------------------------------------------------------------------------
\289\ 17 CFR 240.10b-10; see also discussion in section
II.B.2.a., supra.
---------------------------------------------------------------------------
C. Effect on Efficiency, Competition, and Capital Formation
The amendments adopted today have the potential to affect
competition, efficiency, and capital formation. This section discusses
what the Commission believes to be potential effects across three
groups of market participants: (1) Broker-dealers, (2) security
issuers, and (3) issuers of credit ratings.\290\
---------------------------------------------------------------------------
\290\ Although this section IV.C. of the release focuses on
these three groups of market participants whose businesses may be
more directly impacted by the final rules, the impacts on other
participants are discussed elsewhere in the release. See, e.g.,
section IV.D., infra.
---------------------------------------------------------------------------
1. Effects on the Broker-Dealer Industry
Under the economic baseline, all broker-dealers employ a uniform
standard--an NRSRO credit rating--to determine whether a position in
commercial paper, nonconvertible debt, or preferred stock is entitled
to a lower haircut for purposes of Rule 15c3-1. Today's amendments
eliminate this uniform standard and require that broker-dealers develop
internal policies and procedures for determining whether these types of
positions have only a minimal amount of credit risk and, therefore, are
entitled to the lower haircut. As one commenter noted, ``the cost and
complexity of developing a credit evaluation infrastructure covering
many issuers and securities may be beyond the means of many broker-
dealers.'' \291\ Also, as the FOCUS Report data for calendar year 2012
makes clear, the majority of broker-dealers are small (with capital
less than $500,000).\292\ As noted by several commenters, any new
regulatory requirement with significant fixed costs has the potential
to disadvantage small and medium-sized broker-dealers.\293\ Such
disadvantages could result in increased concentration in the broker-
dealer industry.
---------------------------------------------------------------------------
\291\ SIFMA Letter, at 18.
\292\ See section IV.B., supra.
\293\ SIFMA Letter, at 11; Bond Dealers Letter, at 2.
---------------------------------------------------------------------------
However, the Commission does not intend or expect broker-dealers to
individually duplicate the function of credit rating agencies. To do so
would require broker-dealers, particularly small and medium sized
broker-dealers, to incur significant expense, potentially reducing
competition in the broker-dealer industry and harming economic
efficiency through duplication of effort.\294\ Instead, the Commission
expects that today's amendments will create opportunities for NRSROs,
non-NRSRO credit rating agencies, and other providers of credit risk
analysis to offer products and services that facilitate compliance with
today's amendments. Although broker-dealers with large portfolios of
debt securities and well-developed credit analysis capabilities may
prefer to use an internal credit risk function for assessing
creditworthiness, it will not be cost effective or practical for other
broker-dealers to support an internal credit risk department comprised
of analysts who perform internal credit assessments. These broker-
dealers may instead establish a process for assessing creditworthiness
that relies more on external factors, such as external credit
assessments and market data, and that process will be evaluated for
reasonableness in light of the firm's circumstances (e.g., the size of
the broker-dealer and the types and sizes of the positions typically
held by the broker-dealer). The Commission also anticipates that some
broker-dealers, particularly those with minimal proprietary positions
in commercial paper, nonconvertible debt, and preferred stock, will
choose to devote no resources toward credit risk analysis and to
maintenance of policies and procedures, and instead will apply a
greater haircut to their proprietary positions as permitted by the
rule.\295\
---------------------------------------------------------------------------
\294\ See generally SIFMA Letter, at 11.
\295\ Although this approach would decrease the firm's direct
cost of complying with the rule amendments, it would increase the
amount of capital the broker-dealer is required to maintain to
comply with Rule 15c3-1, increasing the indirect compliance costs.
---------------------------------------------------------------------------
Based on these considerations, the Commission does not believe that
the burden of complying with today's amendments will result in
significant changes to the competitive structure of the broker-dealer
industry in general, nor to the small subset of broker-dealers with
positions in commercial paper, nonconvertible debt, and preferred stock
that are directly affected by today's amendments.
In addition to the aforementioned potential direct effects on
efficiency and competition, today's amendments may affect economic
efficiency indirectly by altering the net capital levels in the broker-
dealer industry. A broker-dealer that elects to take a higher haircut
rather than make a credit risk determination or one that overestimates
the credit risk in its position will reserve more net capital than is
required by Rule 15c3-1. This could affect the broker-dealer's ability
to hold (or add to) its positions. Conversely, some broker-dealers may
underestimate the credit risk of their positions. Indeed, broker-
dealers have an incentive to underestimate credit risk in order to
apply the lower capital charge. Such a determination could have a
potential impact on the firm's ability, if it experiences financial
difficulties, to be in a position to meet its obligations to customers,
investors, and other counterparties and generate resources to wind-down
its operations in an orderly manner without the need of a formal
liquidation proceeding, with attendant costs. Increasing discretion in
assessing creditworthiness for purposes of Rule 15c3-1 can facilitate
such underestimation of credit risk. The Commission believes that this
represents a significant risk in today's amendments. Broker-dealers
whose internal evaluations typically are inconsistent with market data
likely will
[[Page 1545]]
need to spend more time addressing examiners' concerns regarding the
reasonableness of their policies and procedures and the accuracy of
their determinations that a security or money market instrument has
only a minimal amount of credit risk; a broker-dealer's desire to avoid
these costs may help mitigate the broker-dealers' incentives to
underestimate credit risk.
2. Effects on Security Issuers
Today's amendments could impact capital formation by altering the
set of securities that qualify for preferential treatment under Rule
15c3-1. Under the economic baseline, issuers of commercial paper,
nonconvertible debt securities, and preferred stock who obtain
favorable ratings from two or more NRSROs benefit from having lower
haircuts apply to their issuances. Consequently, these issuers may have
greater access to the capital markets, while issuers without such a
rating may have more limited access. The regulatory preference for
NRSRO-rated securities also benefits issuers who can afford to have
their securities rated by NRSROs, and discourages broker-dealers from
considering all the relevant credit risk factors when making portfolio
decisions. By eliminating the regulatory preference for NRSRO-rated
securities, today's amendments could alter the set of securities
qualifying for lower net capital charges, which would affect broker-
dealers' portfolio preferences. For example, the amendments could
increase access to capital markets for smaller issuers whose commercial
paper, nonconvertible debt securities, or preferred stock have only a
minimal amount of credit risk, but for whom the costs of obtaining an
NRSRO rating is potentially prohibitive. Such changes could increase
competition among issuers for capital and improve the efficiency of the
capital allocation process.
While it is the intent of the Commission that today's amendments
not alter the quality of assets that qualify for the lower haircut, it
is nonetheless a possibility that the policies and procedures that
broker-dealers establish will change the risk and/or net capital levels
of broker-dealers. Changes or perceived changes to the amount of net
capital being held by a broker-dealer could have negative repercussions
on confidence in broker-dealers' financial position among their
customers, counterparties, and investors. These impacts on confidence
could disrupt the orderly functioning of the markets--for example, by
encouraging counterparties to reduce their exposures to broker-dealers
in response to uncertainty about broker-dealers' financial positions--
and thereby harm the capital formation process.
3. Effects on the Credit Ratings Industry
Finally, today's amendments could have an effect on competition in
the credit rating agency industry with consequences on economic
efficiency. Currently there are ten NRSROs with the three largest
accounting for the majority of all credit ratings. As noted earlier,
the favorable regulatory treatment of NRSRO-rated securities increases
demand for securities that have been rated by at least two NRSROs.
Eliminating this favorable treatment may increase broker-dealers' use
of alternative providers of credit risk analysis, which could increase
competition in the credit rating agency industry. Furthermore, to the
extent that NRSRO ratings are biased, as some have argued, additional
competition among credit rating providers could help expose any such
biases and increase incentives for NRSROs to produce accurate ratings.
Reducing the emphasis on NRSRO ratings also could adversely affect
the quality of NRSRO ratings. Currently, the importance attached to
NRSRO ratings may impart franchise value to the NRSRO's ratings
business. Eliminating references to NRSRO ratings in certain federal
regulations could reduce these franchise values and mitigate NRSROs'
incentives to produce credible and reliable ratings. Moreover, the
Commission recognizes that the elimination of the required use of
credit ratings in the specified Commission rules and forms may reduce
the incentive for credit rating agencies to register as NRSROs with the
Commission and thereby be subject to the Commission's oversight and the
statutory and regulatory requirements applicable to NRSROs. To the
extent that the quality and accuracy of NRSRO ratings is adversely
affected, negative impacts on the capital allocation process and
economic efficiency could result.
D. Costs and Benefits of the Rule Amendments
1. Rule 15c3-1 and Rule 17a-4
a. Benefits
The Commission requested comment on all aspects of the benefits
associated with the amendments to Rule 15c3-1, the appendices to Rule
15c3-1, and Rule 17a-4, and received no comments. The Commission
believes that one of the primary benefits of the amendments being
adopted today is reducing potential undue reliance on NRSRO ratings
that could be caused by references to NRSROs in Commission rules.
Significantly, the Commission believes that eliminating references to
NRSRO ratings in its rules would remove any appearance that the
Commission has placed its imprimatur on such ratings. The Commission,
however, also recognizes that credit ratings provide useful information
to institutional and retail investors as part of the process of making
an investment decision.
The Commission believes that the amendments to Rule 15c3-1 and its
appendices, as well as the conforming amendment to Rule 17a-4, will
encourage a more complete assessment of the credit risks associated
with securities held by broker-dealers. As the NRSROs themselves have
stressed, NRSRO ratings are a one-dimensional measure that summarizes
the likelihood that an obligor or financial obligation will fail to
repay investors in accordance with the terms on which they made their
investment and investors' expected recoveries in the event of such a
failure.\296\ The simplicity of a one-dimensional measure is both its
major advantage and its main limitation. For comparing securities with
similar risk profiles, one-dimensional credit ratings are a useful
summary measure. However, for securities with different risk profiles,
such ratings can obscure important information about underlying
differences in risk, such as time effects, default correlations, and
the shape of loss distributions. The Commission expects that the
amendments adopted today will encourage broker-dealers to incorporate
this additional information in their credit risk evaluation process.
---------------------------------------------------------------------------
\296\ See, e.g., Fitch, Inside the Ratings: What Credit Ratings
Mean, (Aug. 2007), at 1; Testimony of Michael Kanef, Group Managing
Director, Moody's Investors Service, Before the United States Senate
Committee on Banking, Housing, and Urban Affairs (Sep. 26, 2007), at
2; Testimony of Vickie A. Tillman, Executive Vice President,
Standard & Poor's Credit Market Services, Before the United States
Senate Committee on Banking, Housing, and Urban Affairs (Sep. 26,
2007), at 3.
---------------------------------------------------------------------------
Many broker-dealers already conduct their own risk evaluation. As
one commenter noted ``[a] significant number of large broker-dealers
have sophisticated internal credit review functions.'' \297\ However,
for those broker-dealers that do not currently have their own means of
evaluating risk for purposes of the amendments to Rule 15c3-1, the
approach being adopted today will allow them to incorporate various
observable factors and external
[[Page 1546]]
information sources in their new risk evaluation processes, which will
lead to a better understanding of the risks associated with those
securities.
---------------------------------------------------------------------------
\297\ SIFMA Letter, at 11.
---------------------------------------------------------------------------
b. Costs
The Commission recognizes, as a result of today's amendments, that
broker-dealers may incur additional costs associated with performing a
more detailed and comprehensive analysis of the debt securities they
own. The Commission received two comments on the costs associated with
the proposed amendments to Rule 15c3-1.\298\ As stated above, one
commenter noted that ``the cost and complexity of developing a credit
evaluation infrastructure covering many issuers and securities may be
beyond the means of many broker-dealers.'' \299\ Another commenter
worried that ``the cost to comply may be prohibitively high for the
smaller or middle-market broker-dealers.'' \300\ As has been noted
above, the Commission does not intend or expect broker-dealers to
individually duplicate the function of credit rating agencies. Thus,
the Commission believes that the costs of compliance with the
amendments to Rule 15c3-1 and its appendices, as well as the conforming
amendment to Rule 17a-4, would be minimal for the ``significant number
of large broker-dealers'' that have a ``sophisticated internal credit
review function'' for net capital purposes.\301\ Of the approximately
434 broker-dealers that hold proprietary debt positions, the Commission
recognizes that the level of sophistication varies widely. The broker-
dealers with less sophisticated internal procedures for analyzing
credit risk may incur costs to establish and develop procedures that
would be used to assess financial instruments for the purposes of
determining whether the lower haircuts could appropriately be applied.
However, the Commission believes that because the determination of a
minimal amount of credit risk will vary among firms, and because
broker-dealers may create policies and procedures using a small number
of objective factors and external assessments, firms will be able to
keep costs lower than if they were mandated to create policies and
procedures based on numerous specified factors.\302\
---------------------------------------------------------------------------
\298\ Bond Dealers Letter, at 2; SIFMA Letter, at 11, 18.
\299\ SIFMA Letter, at 18.
\300\ Bond Dealers Letter, at 2.
\301\ SIFMA Letter, at 11.
\302\ See SIFMA Letter, at 18 (``we believe the burden on small
and medium-sized broker-dealers would be significantly reduced if
the proposed amendment were to be interpreted . . . to permit
policies and procedures that base the credit risk analysis solely on
a small number of objectively determinable factors . . .'').
---------------------------------------------------------------------------
There will be minimal costs associated with the amendments for
firms that use Appendix A to Rule 15c3-1. The amendment to the
definition of major market foreign currency is not intended to change
the foreign currencies that currently receive lower haircuts under the
rule. Therefore, the Commission does not believe there will be any
costs associated with the amendments.
Firms that use Appendices E and F to Rule 15c3-1 already undergo an
approval process to use internal credit ratings to determine credit
risk charges for each counterparty. Any new firms that apply to use
either Appendix E or Appendix F will not incur any separate costs as a
result of the amendments. Currently, firms that apply to use these
appendices must have their internal models approved by the Commission
prior to using their selected appendix. Although the Commission will
have to assess the firm's process for determining internal credit
ratings, this step will not cause broker-dealers who are applying to
use these appendices to incur any additional costs. Furthermore,
because the firms currently using these appendices have traditionally
used models to compute capital charges, as opposed to NRSRO ratings,
these firms will not incur any additional costs by complying with the
amendments.
2. Exhibit A to Rule 15c3-3
a. Benefits
The Commission requested comment on all aspects of the benefits
associated with the amendment to Exhibit A to Rule 15c3-3 and received
no comments. The amendment eliminates a criterion that qualified the
debits at a clearing agency or derivatives clearing organization if it
was assigned the highest credit rating given by any NRSRO. Broker-
dealers instead will be required to look to two other criterions based
on financial metrics.
b. Costs
The Commission requested comment on all aspects of the costs
associated with Note G to Exhibit A to Rule 15c3-3 and received no
comments. The total cost of compliance with Note G to Exhibit A to Rule
15c3-3 will be minimal as the removal of the NRSRO credit ratings
criterion from Note G is neither intended nor expected to change
current security futures margining practices by broker-dealers. As
stated in the PRA section, the Commission anticipates that a broker-
dealer will incur a one-time cost to verify that a clearing or
derivatives clearing organization meets the requirements of Note G. If
a broker-dealer is currently using one of the non-NRSRO criterions, it
will not incur any one-time costs.
3. Rule 10b-10
a. Benefits
The Commission believes that the amendment to Rule 10b-10 will
benefit investors. As explained previously, the existing requirement to
inform customers if a debt security, other than a government security,
is unrated by an NRSRO may have the unintended effect of suggesting
that rated securities are inherently better or less risky than unrated
debt securities. The Commission believes that the existence of a rating
should not give an investor extra comfort regarding the risks
associated with the rated security. The amendment, by removing
paragraph (a)(8)'s requirement to disclose whether certain securities
are rated by an NRSRO, should help avoid promoting excessive reliance
on NRSRO ratings. It also should help encourage investors to view NRSRO
ratings as only one of multiple types of information relevant to
evaluating credit risk. This in turn should help investors make more
informed decisions regarding investments in debt securities.
b. Costs
As stated in the proposing release, the Commission does not expect
the amendment to result in any significant changes in the costs
associated with Rule 10b-10. Broker-dealers will continue to generate
transaction confirmations and send those confirmations to customers,
and the amendment is not expected to change the cost of generating and
sending confirmations. Moreover, the Commission believes that broker-
dealers may not incur costs if they choose not to input information
that a debt security is unrated into their existing confirmation
systems.
As stated above, the Commission acknowledges that, in some
instances, eliminating paragraph (a)(8) of Rule 10b-10 may remove some
incentive to investigate the quality of unrated debt securities. The
Commission believes, however, that any such potential cost would be
balanced by the benefit of encouraging investors not to rely
excessively on credit ratings for information about credit risk and to
consider additional information.
[[Page 1547]]
E. Alternatives
1. Rule 15c3-1 and Rule 17a-4
In adopting the amendments to Rule 15c3-1, the Commission
considered several alternative approaches, including suggestions by
commenters. The main suggestion by commenters was to use an objective
standard of creditworthiness instead of a subjective standard of
creditworthiness.\303\ Specifically, one commenter suggested the use of
credit spreads and/or inclusion on an index as an objective
standard.\304\ Although the Commission considered these standards, it
determined the alternatives would not be practical because not all
bonds are included on an index and for bonds that are thinly traded the
yield spreads could include liquidity premia that have little relation
to the credit risk of the bond, reducing the usefulness of the yield
spreads as a signal for credit risk. Furthermore, creating different
standards of creditworthiness for different securities could increase
costs for broker-dealers that hold multiple types of securities. The
Commission does, however, believe that objective factors could play an
important role in determining whether a security or money market
instrument has a minimal amount of credit risk. To emphasize this
point, the Commission added language to paragraph (c)(2)(vi)(I) that
was not in the proposed rule text that states that policies and
procedures that are reasonably designed ``should result in assessments
of creditworthiness that typically are consistent with market data.''
This language should encourage broker-dealers to review at least one
external factor, such as credit spreads or pricing, when making its
credit risk determination. In addition, assessments that are consistent
with market data should take some of the subjectivity away from each
broker-dealer when making a credit risk determination. Rather than
mandate a specific set of factors that broker-dealers must use when
assessing credit risk, the Commission thought it was better to allow
broker-dealers to determine what specific factors would work best for
their specific circumstances.
---------------------------------------------------------------------------
\303\ See Bond Dealers Letter, at 3; SIFMA Letter, at 11.
\304\ Bond Dealers Letter, at 3.
---------------------------------------------------------------------------
The Commission understands that by not mandating an objective
standard to determine the creditworthiness of a security or money
market instrument there is a risk that a broker-dealer may incorrectly
assess the credit risk. Using a subjective standard also could lead to
inconsistent determinations of credit risk of the same security or
money market instrument among broker-dealers. Inconsistent
determinations of credit risk will lead to situations where broker-
dealers that determine the security has only a minimal amount of credit
risk will apply a lower haircut to the position than broker-dealers
that determine that the security does not have a minimal amount of
credit risk. The Commission expects, however, that the risk of this
occurring will be mitigated by the Commission and SRO examination
process, during which Commission and SRO examiners will assess the
reasonableness of broker-dealers' policies and procedures for
determining net capital haircuts under the minimal amount of credit
risk standard and review the firms' adherence to the policies and
procedures. A broker-dealer will need to be able to explain its credit
risk analysis and ultimate determination to examiners as part of the
examination process. If a broker-dealer has reasonable policies and
procedures in place for determining credit risk, and those policies and
procedures are followed, the potential for bias to be a part of the
assessment process should be mitigated.
The Commission also considered mandating that broker-dealers use a
certain number of factors or specific factors when making a credit risk
determination. Ultimately, the Commission decided that allowing broker-
dealers to establish policies and procedures that are tailored to the
size and activities of the broker-dealer would keep costs down.
Further, a given factor may be appropriate only for certain types of
positions and could, if applied inappropriately, lead to inaccurate
credit risk determinations. Allowing a broker-dealer the flexibility in
selecting the factors it uses to assess the credit risk of its
portfolio could lead to more accurate credit risk determinations.
In adopting the amendments to Appendices E and F of Rule 15c3-1,
the Commission considered the alternative proposed by commenters that
the minimal amount of credit risk standard be used. However, as
explained earlier, the Commission does not believe such a standard
would work in Appendices E and F because the minimal amount of credit
risk standard in Rule 15c3-1 replaced a binary NRSRO credit rating
standard under which the application of a lower or higher haircut
amount depends on whether the commercial paper is rated in the top
three rating categories and the nonconvertible debt and preferred stock
is rated in the top four rating categories. Thus, the instrument either
meets the requirement to apply the lower haircut or is subject to the
higher haircut. The NRSRO credit ratings standard in Appendices E and F
to Rule 15c3-1 is not binary because there are three gradations for
credit risk weights. Thus, the minimal amount of credit risk standard
would not be a suitable replacement.\305\
---------------------------------------------------------------------------
\305\ See sections II.B.1.c.iii. and II.B.1.d.iii., supra.
---------------------------------------------------------------------------
2. Exhibit A to Rule 15c3-3
In adopting the amendments to Exhibit A to Rule 15c3-3, the
Commission did not consider any alternatives to the proposal and did
not receive comments offering any alternatives to the proposal. The
Commission could have established an alternative criterion but chose
not to because the remaining three criteria in the rule are
alternatives that permit broker-dealers to meet the objectives of the
rule.
3. Rule 10b-10
In adopting the amendments to Rule 10b-10, the Commission
considered not deleting paragraph (a)(8) as proposed. The Commission
also considered requiring broker-dealers to disclose alternative
information relating to the credit risk of certain debt securities. The
Commission determined, however, that requiring the disclosure of
alternative information regarding credit risk associated with debt
securities similar to that required by paragraph (a)(8) would be
inconsistent with the goal of reducing investors' reliance on credit
ratings. Elevating an alternative measure of credit risk to the status
now conferred upon NRSRO ratings by paragraph (a)(8) would merely
substitute one standard upon which investors may have come to rely upon
excessively for another. Prohibiting any reference to NRSRO credit
ratings in confirmations, however, would seem to go too far by
preventing broker-dealers from including information that they believe
a reasonable investor would want to consider in particular
circumstances. The Commission also determined that substituting another
credit risk-related disclosure requirement for paragraph (a)(8) was
unnecessary, given that credit risk information is likely to be
disclosed before a transaction for reasons independent of paragraph
(a)(8),\306\ and given the other disclosures required by Rule 10b-10 in
connection with
[[Page 1548]]
transactions in certain asset-backed securities.\307\
---------------------------------------------------------------------------
\306\ See Confirmation of Transactions, at 59 FR 59617
(explaining that the information required by paragraph (a)(8)
should, in most cases, ``verify information that was disclosed to
the investor prior to the transaction.'').
\307\ For example, in connection with transactions in certain
asset-backed securities, paragraphs (a)(4) through (a)(7) of Rule
10b-10 require disclosure of information relating to prepayment risk
and yield information.
---------------------------------------------------------------------------
V. Final Regulatory Flexibility Analysis
The Regulatory Flexibility Act of 1980 (``RFA'') \308\ requires the
Commission, in promulgating rules, to consider the impact of those
rules on small entities. An Initial Regulatory Flexibility Act Analysis
was prepared in accordance with the Regulatory Flexibility Act and
included in the proposing release. The Commission certified in the
proposing release, pursuant to section 605(b) of the RFA,\309\ that the
proposed rule would not, if adopted, have a significant impact on a
substantial number of small entities. The Commission received no
comments on this certification.
---------------------------------------------------------------------------
\308\ 5 U.S.C. 601 et seq.
\309\ See 5 U.S.C. 605(b).
---------------------------------------------------------------------------
For purposes of Commission rulemaking in connection with the RFA,
small entities include broker-dealers with total capital (net worth
plus subordinated liabilities) of less than $500,000 on the date in the
prior fiscal year as of which its audited financial statements were
prepared pursuant to Rule 17a-5 under the Exchange Act,\310\ or, if not
required to file such statements, a broker or dealer that had total
capital (net worth plus subordinated liabilities) of less than $500,000
on the last day of the preceding fiscal year (or in the time that it
has been in business, if shorter) and is not affiliated with any person
(other than a natural person) that is not a small business or small
organization.\311\
---------------------------------------------------------------------------
\310\ See 17 CFR 240.17a-5(d).
\311\ See 17 CFR 240.0-10(c).
---------------------------------------------------------------------------
The amendments adopted today relating to the securities haircut
provisions in Rule 15c3-1 and the conforming amendment to Rule 17a-4
will not have a significant economic impact on a small number of
entities. Only seven of the 434 broker-dealers that hold proprietary
debt positions are considered small for purposes of the RFA and, in the
staff's experience, broker-dealers with less than $500,000 in total
capital typically hold very few proprietary securities positions and,
in particular, a small number of debt securities. Thus, there are few
small entities that will be impacted by these amendments. In addition,
the amendments allow broker-dealers that hold these debt positions,
including those broker-dealers that are considered small for purposes
of the RFA, to establish policies and procedures that rely on only a
few factors to keep costs low. Further, a small broker-dealer could
choose to take the 15% catchall haircut instead of establishing
policies and procedures if it determines such an approach is cost-
effective. Accordingly, the amendments will not have a significant
economic impact on a substantial number of small entities because even
if the small entities have to change their current process, they can do
so in such a way to minimize economic impact and still comply with the
rule amendments.
The amendment to Appendix A to Rule 15c3-1 will not result in a
significant impact on small entities. Although the definition of major
market foreign currency will change, the Commission does not intend
that the currencies that meet the definition of major market foreign
currency will change because the currency will still have to have a
substantial inter-bank forward currency market. Consequently, the
amendments should not have a significant impact on broker-dealers,
including small broker-dealers. Furthermore, the broker-dealers that
operate under Appendix A to Rule 15c3-1 generally are market makers and
trading firms that are not small entities as defined in Rule 0-10.
The amendments to the Appendices E and F to Rule 15c3-1 (which
include conforming amendments to Appendix G to Rule 15c3-1 and the
General Instructions to Form X-17A-5, Part IIB) will not apply to small
entities. Appendices E and G apply to ANC broker-dealers and Appendix F
and Form X-17A-5, Part IIB apply to OTC derivatives dealers. The ANC
broker-dealers and the OTC derivatives dealers are not small entities
as defined in Rule 0-10.
The amendments to Exhibit A to Rule 15c3-3 will not have a
significant economic impact on a substantial number of small entities.
As noted above, the OCC is the only clearing agency that meets the
criteria to qualify for the debit for purposes of the reserve
computation. The fact that the OCC meets the criteria to qualify for
the debit is well understood among broker-dealers, including small
broker-dealers.
The amendment to Rule 10b-10 will not have a significant economic
impact on a substantial number of small entities. While a number of the
broker-dealers that effect transactions in the debt securities
currently subject to paragraph (a)(8) may be small entities, the
Commission believes that it is uncommon for small broker-dealers to
issue confirmations.\312\ The Commission does not have a precise
numerical estimate of the small broker-dealers that issue confirmations
in connection with transactions in securities covered by paragraph
(a)(8). The Commission believes, however, that the number is unlikely
to be significant. In addition, the Commission continues to believe
that the proposed amendment should not result in any significant change
to the cost of providing confirmations to customers in connection with
transactions in securities covered by paragraph (a)(8). Consequently,
the Commission continues to believe that the removal of paragraph
(a)(8) from Rule 10b-10 should not have a significant economic impact
on a substantial number of small entities.
---------------------------------------------------------------------------
\312\ The Commission understands that most small broker-dealers
introduce their accounts to clearing firms that, in turn, would
typically issue the confirmations.
---------------------------------------------------------------------------
For the reasons described above, the Commission again certifies
that the amendments to Rule 15c3-1, Appendices A, E, F, and G to Rule
15c3-1, Exhibit A to Rule 15c3-3, Rule 17a-4, the General Instructions
to Form X-17A-5, Part IIB, and Rule 10b-10 will not have a significant
economic impact on a substantial number of small entities.
VI. Statutory Basis and Text of the Proposed Amendments
Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and
particularly, Sections 3(b), 15, 23(a), and 36 (15 U.S.C. 78c(b), 78o,
78w(a), and 78mm), thereof, and Sections 939 and 939A of the Dodd-Frank
Act, the Commission is amending Sec. Sec. 240.10b-10, 240.15c3-1,
240.15c3-1a, 240.15c3-1e, 240.15c3-1f, 240.15c3-1g, 240.15c3-3a,
240.17a-4, and Form X-17A-5 Part IIB General Instructions under the
Exchange Act.
List of Subjects in 17 CFR Parts 240 and 249
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
Text of Amendment
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
1. The authority citation for part 240 is amended by revising the
general authority and adding sectional authorities for Sec. Sec.
240.15c3-1a, 240.15c3-1e, 240.15c3-1f, 240.15c3-1g
[[Page 1549]]
and Sec. 240.15c3-3a in numerical order to read as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20,
80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et seq., and
8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350,
unless otherwise noted.
* * * * *
Sections 240.15c3-1a, 240.15c3-1e, 240.15c3-1f, 240.15c3-1g are
also issued under Pub. L. 111-203, secs. 939, 939A, 124. Stat. 1376
(2010) (15 U.S.C. 78c, 15 U.S.C. 78o-7 note).
* * * * *
Section 240.15c3-3a is also issued under Pub. L. 111-203,
Sec. Sec. 939, 939A, 124. Stat. 1376 (2010) (15 U.S.C. 78c, 15
U.S.C. 78o-7 note).
* * * * *
Sec. 240.10b-10 [Amended]
0
2. Section 240.10b-10 is amended by removing paragraph (a)(8) and
redesignating paragraph (a)(9) as paragraph (a)(8).
0
3. Section 240.15c3-1 is amended by:
0
a. Revising paragraphs (c)(2)(vi)(E) introductory text,
(c)(2)(vi)(F)(1) introductory text, (c)(2)(vi)(F)(2) introductory text,
and (c)(2)(vi)(H); and
0
b. Adding paragraph (c)(2)(vi)(I).
The revisions and addition read as follows:
Sec. 240.15c3-1 Net capital requirements for brokers or dealers.
* * * * *
(c) * * *
(2) * * *
(vi) * * *
(E) Commercial paper, bankers' acceptances and certificates of
deposit. In the case of any short term promissory note or evidence of
indebtedness which has a fixed rate of interest or is sold at a
discount, which has a maturity date at date of issuance not exceeding
nine months exclusive of days of grace, or any renewal thereof, the
maturity of which is likewise limited and has only a minimal amount of
credit risk, or in the case of any negotiable certificates of deposit
or bankers' acceptance or similar type of instrument issued or
guaranteed by any bank as defined in section 3(a)(6) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(6)), the applicable percentage
of the market value of the greater of the long or short position in
each of the categories specified below are:
* * * * *
(F)(1) Nonconvertible debt securities. In the case of
nonconvertible debt securities having a fixed interest rate and a fixed
maturity date, which are not traded flat or in default as to principal
or interest and which have only a minimal amount of credit risk, the
applicable percentages of the market value of the greater of the long
or short position in each of the categories specified below are:
* * * * *
(2) A broker or dealer may elect to exclude from the above
categories long or short positions that are hedged with short or long
positions in securities issued by the United States or any agency
thereof or nonconvertible debt securities having a fixed interest rate
and a fixed maturity date and which are not traded flat or in default
as to principal or interest, and which have only a minimal amount of
credit risk if such securities have maturity dates:
* * * * *
(H) In the case of cumulative, non-convertible preferred stock
ranking prior to all other classes of stock of the same issuer, which
has only a minimal amount of credit risk and which are not in arrears
as to dividends, the deduction shall be 10% of the market value of the
greater of the long or short position.
(I) In order to apply a deduction under paragraphs (c)(2)(vi)(E),
(c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2), or (c)(2)(vi)(H) of this section,
the broker or dealer must assess the creditworthiness of the security
or money market instrument pursuant to policies and procedures for
assessing and monitoring creditworthiness that the broker or dealer
establishes, documents, maintains, and enforces. The policies and
procedures must be reasonably designed for the purpose of determining
whether a security or money market instrument has only a minimal amount
of credit risk. Policies and procedures that are reasonably designed
for this purpose should result in assessments of creditworthiness that
typically are consistent with market data. A broker-dealer that opts
not to make an assessment of creditworthiness under this paragraph may
not apply the deductions under paragraphs (c)(2)(vi)(E),
(c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2), or (c)(2)(vi)(H) of this section.
Note to paragraph (c)(2)(vi)(I): For a discussion of the
``minimal amount of credit risk'' standard, see Removal of Certain
References to Credit Ratings Under the Securities Exchange Act of
1934, Exchange Act Release No. 34-71194 (Dec. 27, 2013), at http://www.sec.gov/rules/final.shtml.
* * * * *
Sec. 240.15c3-1a [Amended]
0
4. Section 240.15c3-1a, paragraph (b)(1)(i)(C), is amended by removing
the phrase ``whose short term debt is rated in one of the two highest
categories by at least two nationally recognized statistical rating
organizations and'' and by removing the last sentence.
0
5. Section 240.15c3-1e is amended by:
0
a. Revising the introductory text in paragraph (c)(4)(vi);
0
b. Removing paragraphs (c)(4)(vi)(A) through (c)(4)(iv)(D);
0
c. Redesignating paragraphs (c)(4)(vi)(E), (F), and (G) as paragraphs
(c)(4)(vi)(A), (B), and (C), respectively; and
0
d. Revising newly redesignated paragraph (c)(4)(vi)(A).
The revisions read as follows:
Sec. 240.15c3-1e Deductions for market and credit risk for certain
brokers or dealers (Appendix E to 17 CFR 240.15c3-1).
* * * * *
(c) * * *
(4) * * *
(vi) Credit risk weights of counterparties. A broker or dealer that
computes its deductions for credit risk pursuant to this Appendix E
shall apply a credit risk weight for transactions with a counterparty
of either 20%, 50%, or 150% based on an internal credit rating the
broker or dealer determines for the counterparty.
(A) As part of its initial application or in an amendment, the
broker or dealer may request Commission approval to apply a credit risk
weight of either 20%, 50%, or 150% based on internal calculations of
credit ratings, including internal estimates of the maturity
adjustment. Based on the strength of the broker's or dealer's internal
credit risk management system, the Commission may approve the
application. The broker or dealer must make and keep current a record
of the basis for the credit rating of each counterparty;
* * * * *
0
6. Section 240.15c3-1f is amended by:
0
a. Removing from paragraph (d)(2) introductory text the phrase ``the
counterparty factor. The counter party factors are:'' and adding in its
place ``a counterparty factor of 20%, 50%, or 100% based on an internal
credit rating the OTC derivatives dealer determines for the
counterparty; and'';
0
b. Removing paragraphs (d)(2)(i) through (d)(2)(iii); and
0
c. Revising paragraphs (d)(3)(i), (d)(3)(ii), (d)(3)(iii), and (d)(4).
The revisions read as follows:
[[Page 1550]]
Sec. 240.15c3-1f Optional market and credit risk requirements for OTC
derivatives dealers (Appendix F to 17 CFR 240.15c3-1).
* * * * *
(d) * * *
(3) * * *
(i) For counterparties for which an OTC derivatives dealer assigns
an internal rating for senior unsecured long-term debt or commercial
paper that would apply a 20% counterparty factor under paragraph (d)(2)
of this section, 5% of the amount of the net replacement value in
excess of 25% of the OTC derivatives dealer's tentative net capital;
(ii) For counterparties for which an OTC derivatives dealer assigns
an internal rating for senior unsecured long-term debt that would apply
a 50% counterparty factor under paragraph (d)(2) of this section, 20%
of the amount of the net replacement value in excess of 25% of the OTC
derivatives dealer's tentative net capital;
(iii) For counterparties for which an OTC derivatives dealer
assigns an internal rating for senior unsecured long-term debt that
would apply a 100% counterparty factor under paragraph (d)(2) of this
section, 50% of the amount of the net replacement value in excess of
25% of the OTC derivatives dealer's tentative net capital.
(4) Counterparties may be rated by the OTC derivatives dealer, or
by an affiliated bank or affiliated broker-dealer of the OTC
derivatives dealer, upon approval by the Commission on application by
the OTC derivatives dealer. Based on the strength of the OTC
derivatives dealer's internal credit risk management system, the
Commission may approve the application. The OTC derivatives dealer must
make and keep current a record of the basis for the credit rating for
each counterparty.
* * * * *
Sec. 240.15c3-1g [Amended]
0
7. Section 240.15c3-1g(a)(3)(i)(F) is amended by removing the phrase
``paragraphs (c)(4)(vi)(D) and (c)(4)(vi)(E)'' and adding in its place
``paragraphs (c)(4)(vi)(A) and (c)(4)(vi)(B)''.
Sec. 240.15c3-3a [Amended]
0
8. Section 240.15c3-3a is amended by removing paragraph (b)(1)(i) of
Note G and redesignating paragraphs (b)(1)(ii), (iii), and (iv) of Note
G as paragraphs (b)(1)(i), (ii), and (iii), respectively.
0
9. Section 240.17a-4 is amended by:
0
a. Removing from paragraph (b)(12) the phrase ``Sec. 240.15c3-
1e(c)(4)(vi)(D) and (E)'' and adding in its place ``Sec. 240.15c3-
1e(c)(4)(vi) ''; and
0
b. Adding paragraph (b)(13).
The addition reads as follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(13) The written policies and procedures the broker-dealer
establishes, documents, maintains, and enforces to assess
creditworthiness for the purpose of Sec. 240.15c3-1(c)(2)(vi)(E),
(c)(2)(vi)(F)(1), (c)(2)(vi)(F)(2), and (c)(2)(vi)(H).
* * * * *
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
0
10. The authority citation for Part 249 is amended by adding a
sectional authority for Sec. 249.617 in numerical order to read as
follows:
Authority: 15 U.S.C. 78a et seq. and 7201 et. seq.; 12 U.S.C.
5461 et seq.; and 18 U.S.C. 1350, unless otherwise noted.
* * * * *
Section 249.617 is also issued under Pub. L. 111-203, Sec. Sec.
939, 939A, 124. Stat. 1376 (2010) (15 U.S.C. 78c, 15 U.S.C. 78o-7
note).
* * * * *
0
11. Amend Form X-17A-5 Part IIB General Instructions (referenced in
Sec. 249.617) by:
0
a. Removing Schedule IV: Internal Credit Rating Conversion; and
0
b. Removing all but the first sentence in the section ``Credit risk
exposure'' under the heading ``Computation of Net Capital and Required
Net Capital,'' and adding a second sentence that reads ``The counter-
party charge is computed using the credit risk weights assigned to the
OTC derivatives dealer's internal calculations by the Commission under
paragraph (d)(2) of Appendix F.''
Note: The text of Form X-17A-5 Part IIB does not, and this
amendment will not, appear in the Code of Federal Regulations.
* * * * *
By the Commission.
Dated: December 27, 2013.
Lynn M. Powalski,
Deputy Secretary.
[FR Doc. 2013-31426 Filed 1-7-14; 8:45 am]
BILLING CODE 8011-01-P