Rule2023-27860
Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities
Primary source
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Published
January 16, 2024
Effective
March 18, 2024
Issuing agencies
Securities and Exchange Commission
Abstract
The Securities and Exchange Commission ("Commission") is adopting rules under the Securities Exchange Act of 1934 ("Exchange Act") to amend the standards applicable to covered clearing agencies for U.S. Treasury securities to require that such covered clearing agencies have written policies and procedures reasonably designed to require that every direct participant of the covered clearing agency submit for clearance and settlement all eligible secondary market transactions in U.S. Treasury securities to which it is a counterparty. In addition, the Commission is adopting additional amendments to the Covered Clearing Agency Standards with respect to risk management. These requirements are designed to protect investors, reduce risk, and increase operational efficiency. Finally, the Commission is amending the broker-dealer customer protection rule to permit margin required and on deposit with covered clearing agencies for U.S. Treasury securities to be included as a debit in the reserve formulas for accounts of customers and proprietary accounts of broker-dealers ("PAB"), subject to certain conditions.
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[Federal Register Volume 89, Number 10 (Tuesday, January 16, 2024)]
[Rules and Regulations]
[Pages 2714-2830]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2023-27860]
[[Page 2713]]
Vol. 89
Tuesday,
No. 10
January 16, 2024
Part II
Securities and Exchange Commission
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17 CFR Part 240
Standards for Covered Clearing Agencies for U.S. Treasury Securities
and Application of the Broker-Dealer Customer Protection Rule With
Respect to U.S. Treasury Securities; Final Rule
Federal Register / Vol. 89 , No. 10 / Tuesday, January 16, 2024 /
Rules and Regulations
[[Page 2714]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240
[Release No. 34-99149; File No. S7-23-22]
RIN 3235-AN09
Standards for Covered Clearing Agencies for U.S. Treasury
Securities and Application of the Broker-Dealer Customer Protection
Rule With Respect to U.S. Treasury Securities
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting rules under the Securities Exchange Act of 1934 (``Exchange
Act'') to amend the standards applicable to covered clearing agencies
for U.S. Treasury securities to require that such covered clearing
agencies have written policies and procedures reasonably designed to
require that every direct participant of the covered clearing agency
submit for clearance and settlement all eligible secondary market
transactions in U.S. Treasury securities to which it is a counterparty.
In addition, the Commission is adopting additional amendments to the
Covered Clearing Agency Standards with respect to risk management.
These requirements are designed to protect investors, reduce risk, and
increase operational efficiency. Finally, the Commission is amending
the broker-dealer customer protection rule to permit margin required
and on deposit with covered clearing agencies for U.S. Treasury
securities to be included as a debit in the reserve formulas for
accounts of customers and proprietary accounts of broker-dealers
(``PAB''), subject to certain conditions.
DATES:
Effective date: March 18, 2024.
Compliance date: The applicable compliance dates are discussed in
Part III of this release.
FOR FURTHER INFORMATION CONTACT: Elizabeth L. Fitzgerald, Assistant
Director, and Robert Zak, Special Counsel, Office of Clearance and
Settlement at (202) 551-5710, Division of Trading and Markets; Michael
A. Macchiaroli, Associate Director, at (202) 551-5525; Thomas K.
McGowan, Associate Director, at (202) 551-5521; Randall W. Roy, Deputy
Associate Director, at (202) 551-5522; Raymond Lombardo, Assistant
Director, at 202-551-5755; Sheila Dombal Swartz, Senior Special
Counsel, at (202) 551-5545; or Nina Kostyukovsky, Special Counsel, at
(202) 551-8833, Office of Broker-Dealer Finances, Division of Trading
and Markets; U.S. Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-7010.
SUPPLEMENTARY INFORMATION: First, the Commission is amending 17 CFR
240.17ad-22(e)(18) (``Rule 17ad-22(e)(18)'') to require covered
clearing agencies that provide central counterparty (``CCP'') services
for U.S. Treasury securities to establish, implement, maintain and
enforce written policies and procedures reasonably designed, as
applicable, to establish objective, risk-based and publicly disclosed
criteria for participation, which require that any direct participant
of such a covered clearing agency submit for clearance and settlement
all the eligible secondary market transactions in U.S. Treasury
securities to which such direct participant is a counterparty. In
addition, these policies and procedures must be reasonably designed, as
applicable, to identify and monitor the covered clearing agency's
direct participants' submission of transactions for clearing as
required above, including how the covered clearing agency would address
a failure to submit transactions. These policies and procedures must
also be reasonably designed, as applicable, to ensure that the covered
clearing agency has appropriate means to facilitate access to clearance
and settlement services of all eligible secondary market transactions
in U.S. Treasury securities, including those of indirect participants,
which policies and procedures the board of directors of such U.S.
Treasury securities covered clearing agency (``CCA'') must review
annually. The Commission is defining an eligible secondary market
transaction as a secondary market transaction in U.S. Treasury
securities of a type accepted for clearing by a registered covered
clearing agency that is either a repurchase or reverse repurchase
agreement collateralized by U.S. Treasury securities, in which one of
the counterparties is a direct participant, or certain specified
categories of cash purchase or sale transactions, including certain
exclusions for transactions with sovereign entities, international
financial institutions, natural persons, inter-affiliate repo
transactions, state/local governments, and other clearing
organizations. Second, the Commission is amending 17 CFR 240.17ad-
22(e)(6)(i) (``Rule 17ad-22(e)(6)(i)'') to require that a covered
clearing agency providing central counterparty services for U.S.
Treasury securities establish, implement, maintain and enforce written
policies and procedures reasonably designed to, as applicable,
calculate, collect, and hold margin for transactions in U.S. Treasury
securities submitted on behalf of an indirect participant separately
from those submitted on behalf of the direct participant. Third, the
Commission is amending Rule 17ad-22(e)(18) to require that a covered
clearing agency providing central counterparty services for U.S.
Treasury securities establish, implement, maintain and enforce written
policies and procedures reasonably designed to, as applicable, ensure
that it has appropriate means to facilitate access to clearance and
settlement services of all eligible secondary market transactions in
U.S. Treasury securities, including those of indirect participants,
which policies and procedures the board of directors of such covered
clearing agency reviews annually. In connection with these proposed
amendments, the Commission is including as part of 17 CFR 240.17ad-
22(a) (``Rule 17ad-22(a)'') definitions of ``U.S. Treasury security,''
``central bank,'' ``eligible secondary market transaction,''
``international financial institution,'' ``sovereign entity,'' ``state
and local government,'' and ``affiliated counterparty.'' As part of
this rulemaking, the Commission is also amending the CFR designation of
Rule 17Ad-22 to Rule 17ad-22.\1\ Fourth, the Commission is amending 17
CFR 240.15c3-3a (``Rule 15c3-3a'') to permit margin required and on
deposit at covered clearing agencies providing central counterparty
services for U.S. Treasury securities to be included by broker-dealers
as a debit in the customer and PAB reserve formulas, subject to certain
conditions.
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\1\ See note 71 infra for further discussion of this amendment.
The Commission refers to the redesignated Rule 17ad-22 throughout
this release.
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Table of Contents
I. Introduction
II. Discussion of Comments Received and Final Rules
A. U.S. Treasury Securities CCA Membership Requirements
1. Requirement To Clear Eligible Secondary Market Transactions
a. Comments Regarding the Requirement To Clear Eligible
Secondary Market Transactions
b. Comments Regarding the Concentration of Risk in One Covered
Clearing Agency
c. Final Rule
2. Definition of Eligible Secondary Market Transactions
a. Repo Transactions
i. Triparty Repo
ii. Repos by Registered Funds
iii. Repos by Other Clearing Organizations
iv. Repos by FCMs
v. Repos Involving ``End Users''
[[Page 2715]]
vi. Interaffiliate Repos
vii. Repos by State and Local Governments
viii. Other Repo Comments
ix. Final Rule
b. Purchases and Sales of U.S. Treasury Securities
i. Comments Regarding Cash Clearing Generally
ii. IDB Transactions
iii. Other Cash Transactions
iv. Comments Regarding Cash Transactions for Registered Funds
v. Final Rule
3. Other Exclusions From the Definition of an Eligible Secondary
Market Transaction
4. Policies and Procedures Regarding U.S. Treasury Securities
CCA's Monitoring of Its Direct Participants' Transactions
5. Alternative Approaches Proposed by Commenters
B. Additional Changes to Covered Clearing Agency Standards
1. Netting and Margin Practices for House and Customer Accounts
2. Facilitating Access to U.S. Treasury Securities CCAs
a. Comments Supporting the Commission's Proposed Rule
b. Comments Regarding the Commission's Authority To Require a
CCA To Accept Done Away Transactions
c. Other Comments Regarding Access
d. Final Rule
C. Amendments to Rule 15c3-3a
1. Introduction
2. Credit Items
3. New Debit Item
4. Note to New Debit Item
a. First Condition--Permitted Collateral
b. Second Condition--Customer Position Margin
c. Third Condition--Rules of U.S. Treasury Securities CCA
d. Fourth Condition--Commission Approval of Rules of U.S.
Treasury Securities CCA
5. PAB Reserve Computation
III. Compliance Dates
IV. Economic Analysis
A. Broad Economic Considerations
B. Baseline
1. U.S. Treasury Securities
2. U.S. Treasury Repurchase Transactions
3. Clearance and Settlement of U.S. Treasury Security
Transactions
a. Cash Market
i. Interdealer
ii. Dealer-to-Customer
b. U.S. Treasury Repo Market
i. Non-Centrally Cleared Bilateral Repo
ii. Centrally Cleared Bilateral Repo
iii. Non-Centrally Cleared Repo Settled on a Triparty Platform
iv. Centrally Cleared Repo Settled on a Triparty Platform
v. Inter-Affiliate Repo
4. Central Clearing in the U.S. Treasury Securities Market
5. Margin Practices in U.S. Treasury Secondary Markets
6. Disruptions in the U.S. Treasury Securities Market
a. COVID-19 Shock of March 2020
b. September 2019 Repo Market Disruptions
c. October 2014 Flash Rally
7. Affected Parties
a. Covered Clearing Agencies for U.S. Treasury Securities: FICC
b. Direct Participants at U.S. Treasury Securities CCAs: FICC
Netting Members
c. Interdealer Brokers
d. Other Market Participants
i. Broker-Dealers That Are Not Direct Participants/FICC Netting
Members
ii. Hedge Funds, Family Offices, and Separately Managed Accounts
iii. Registered Investment Companies (RICs) Including Money
Market Funds, Other Mutual Funds, and ETFs
iv. Principal Trading Firms (PTFs)
v. State and Local Governments
vi. Private Pensions Funds and Insurance Companies
e. Triparty Agent: Bank of New York Mellon
f. Custodian Banks/Fedwire Securities Service (FSS)
C. Analysis of Benefits, Costs, and Impact on Efficiency,
Competition, and Capital Formation
1. Benefits
a. U.S. Treasury Securities CCA Membership Requirements
i. Scope of the Requirement To Clear Eligible Secondary Market
Transactions
ii. Application of the Requirement To Clear Eligible Repo
Transactions
iii. Application of the Requirement To Clear Eligible Secondary
Market Transactions to Purchases and Sales of U.S. Treasury
Securities
iv. Exclusions From the Requirement To Clear Eligible Secondary
Market Transactions
b. Other Changes to Covered Clearing Agency Standards
i. Policies and Procedures Regarding Direct Participants'
Transactions
ii. Netting and Margin Practices for House and Customer Accounts
iii. Facilitating Access to U.S. Treasury Securities CCAs
c. Amendments to Rules 15c3-3 and 15c3-3a
2. Costs
a. Costs to FICC and Its Members of the Requirement To Clear
Eligible Secondary Market Transactions
i. Costs Attendant to an Increase in CCLF
ii. Costs of the Requirement To Clear Eligible Secondary Market
Transactions in Terms of Increased Margining for Existing FICC
Members
iii. Other Costs
b. Costs to Non-Members of a U.S Treasury Securities CCA as a
Result of the Requirement To Clear Eligible Secondary Market
Transactions
c. Other Changes to Covered Clearing Agency Standards
i. Netting and Margin Practices for House and Customer Accounts
ii. Facilitating Access to U.S. Treasury Securities CCAs
d. Amendments to Rules 15c3-3 and 15c3-3a
e. Other Costs
3. Effect on Efficiency, Competition, and Capital Formation
a. Efficiency
i. Price Transparency
ii. Operational and Balance Sheet Efficiency
b. Competition
c. Capital Formation
D. Reasonable Alternatives
1. Require U.S. Treasury Securities CCAs To Have Policies and
Procedures Requiring Only IDB Clearing Members To Submit U.S.
Treasury Securities Cash Trades With Non-Members for Central
Clearing
2. Require U.S. Treasury Securities CCAs To Have Policies and
Procedures Requiring the Submission of All Repurchase Agreements
Without Requirements for the Submission of Cash Transactions
3. Include All Cash Transactions Within the Scope of Eligible
Secondary Market Transactions With Exceptions for Central Banks,
Sovereign Entities, International Financial Institutions, and
Natural Persons
4. Require U.S. Treasury Securities CCAs To Change CCA Access
Provisions and Netting and Margin Practices for House and Customer
Accounts and Rule 15c3-3
V. Paperwork Reduction Act
A. Proposed Changes to Covered Clearing Agency Standards
1. Amendment to Rule 17ad-22(e)(6)
2. Amendment to Rule 17ad-22(e)(18)(iv)
B. Broker-Dealers
VI. Regulatory Flexibility Act
A. Clearing Agencies
B. Broker-Dealers
C. Certification
VII. Other Matters
Statutory Authority
I. Introduction
The Commission is responsible for facilitating the establishment of
a national system for the prompt and accurate clearance and settlement
of securities transactions.\2\ This responsibility includes the
authority to regulate clearing agencies engaged in the clearance and
settlement of government securities transactions, including U.S.
Treasury securities.\3\ This inclusion of government securities,
including U.S. Treasury securities, within the Commission's authority
for the national system of clearance and settlement underscores the
importance of, among other things, the U.S. Treasury market.
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\2\ See 15 U.S.C. 78q-1.
\3\ Government Securities Act of 1986, section 102(a); 15 U.S.C.
78c(a)(12)(B)(i).
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U.S. Treasury securities play a critical and unique role in the
U.S. and global economy, serving as a significant investment instrument
and hedging vehicle for investors, a risk-free benchmark for other
financial instruments, and an important mechanism for the Federal
Reserve's
[[Page 2716]]
implementation of monetary policy.\4\ Consequently, confidence in the
U.S. Treasury market, and in its ability to function efficiently, even
in times of stress, is critical to the stability of the global
financial system.\5\
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\4\ See, e.g., Staffs of the U.S. Department of the Treasury,
Board of Governors of the Federal Reserve System, Federal Reserve
Bank of New York, U.S. Securities and Exchange Commission, and U.S.
Commodity Futures Trading Commission, Recent Disruptions and
Potential Reforms in the U.S. Treasury Market: A Staff Progress
Report, at 1 (Nov. 2021), available at <a href="https://home.treasury.gov/system/files/136/IAWG-Treasury-Report.pdf">https://home.treasury.gov/system/files/136/IAWG-Treasury-Report.pdf</a> (``Inter-Agency Working
Group for Treasury Market Surveillance (``2021 IAWG Report'');
Staffs of the U.S. Department of the Treasury, Board of Governors of
the Federal Reserve System, Federal Reserve Bank of New York, U.S.
Securities and Exchange Commission, and U.S. Commodity Futures
Trading Commission, Joint Staff Report: The U.S. Treasury Market on
October 15, 2014, at 1, 8 (2015), available at <a href="https://home.treasury.gov/system/files/276/joint-staff-report-the-us-treasury-market-on-10-15-2014.pdf">https://home.treasury.gov/system/files/276/joint-staff-report-the-us-treasury-market-on-10-15-2014.pdf</a> (``Joint Staff Report''). These
reports represent the views of Commission and other Federal
regulatory staff. The reports are not a rule, regulation, or
statement of the Commission. The Commission has neither approved nor
disapproved the content in the reports. These reports, like all
staff reports, have no legal force or effect: they do not alter or
amend applicable law, and they create no new or additional
obligations for any person.
\5\ Group of Thirty Working Group on Treasury Market Liquidity,
U.S. Treasury Markets: Steps Toward Increased Resilience, at 1
(2021), available at <a href="https://group30.org/publications/detail/4950">https://group30.org/publications/detail/4950</a>
(``G-30 Report'').
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CCPs provide an important role for securities markets, interposing
themselves between the counterparties to securities transactions,
acting functionally as the buyer to every seller and the seller to
every buyer. The Commission regulates CCPs as covered clearing agencies
(``CCA'').\6\ The Commission historically has acknowledged the benefits
that a CCP brings to the markets it serves. By novating transactions
(that is, becoming the counterparty to both sides of a transaction), a
CCP addresses concerns about counterparty risk by substituting its own
creditworthiness and liquidity for the creditworthiness and liquidity
of the counterparties.\7\ Further, the Commission has recognized that
``the centralization of clearance and settlement activities at covered
clearing agencies allows market participants to reduce costs, increase
operational efficiency, and manage risks more effectively.'' \8\ A CCP
also provides a centralized system of default management that can
mitigate the potential for a single market participant's failure to
destabilize other market participants or the financial system more
broadly.\9\ However, the Commission has also recognized that this
centralization of activity at clearing agencies makes risk management
at such entities a critical function.
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\6\ See Rule 17ad-22(a) (defining covered clearing agency and
central counterparty) and Exchange Act Section 3(a)(23) (defining
clearing agency).
\7\ See, e.g., Order Granting Temporary Exemptions Under the
Securities Exchange Act of 1934 in Connection with Request of Liffe
Administration and Management and Lch.Clearnet Ltd. Related to
Central Clearing of Credit Default Swaps, and Request for Comments,
Exchange Act Release No. 59164 (Dec. 24, 2008), 74 FR 139, 140 (Jan.
2, 2009) (``Liffe Order'').
\8\ Covered Clearing Agency Standards Proposing Release,
Exchange Act Release No. 71699 (Mar. 12, 2014), 79 FR 29507, 29587
(May 27, 2014) (``CCA Standards Proposing Release'').
\9\ See, e.g., Liffe Order, supra note 7, 74 FR 140.
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Because of the importance of risk management at CCPs and to further
the establishment of linked and coordinated facilities for clearance
and settlement of securities transactions, in 2016, the Commission
adopted the Covered Clearing Agency Standards.\10\ These standards
address all aspects of a CCP's operations, including financial risk
management, operational risk, default management, governance, and
participation requirements.\11\ The Commission has had the opportunity
to administer this new regulatory framework, considering many rule
filings with respect to proposed rule changes filed by CCAs pursuant to
their rule filing obligations as self-regulatory organizations
(``SROs'') under Section 19(b) of the Exchange Act that address how the
proposed rule changes are consistent with the Exchange Act and the
Covered Clearing Agency Standards thereunder.
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\10\ See Covered Clearing Agency Standards Adopting Release,
Exchange Act Release No. 78961 (Sept. 28, 2016), 81 FR 70786 (Oct.
13, 2016) (``CCA Standards Adopting Release'').
\11\ See generally id.
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The Commission also has had the opportunity to observe the U.S.
Treasury market, including with respect to the clearance and settlement
of U.S. Treasury security transactions in both the cash and repo
market. In particular, the Commission understands that the proportion
of transactions that are centrally cleared has declined over the past
years. One recent analysis by the Treasury Market Practice Group \12\
estimates that only 13 percent of the overall volume in U.S. dollars of
U.S. Treasury cash transactions were centrally cleared as of the first
half of 2017, and that an additional 19 percent were what the TMPG
refers to as ``hybrid'' clearing, that is, executed on an interdealer
broker platform (as discussed in parts II.A.1 and II.A.2.b.ii infra) in
which one counterparty is a member of a CCA and submits its transaction
with the interdealer broker for central clearing, while the other
counterparty is not a member of a CCA and bilaterally clears its
transaction with the interdealer broker.\13\ This use of both centrally
cleared and not centrally cleared transactions introduces risk into the
market, because bilateral clearing involves varying risk management
practices that are less uniform and less transparent to the broader
market and may be less efficient with regard to netting exposures and
use of collateral as compared to central clearing.
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\12\ The Treasury Market Practices Group (``TMPG'') is a group
of ``market professionals committed to supporting the integrity and
efficiency of the Treasury, agency debt, and agency mortgage-backed
securities markets.'' See Treasury Mark Practice Group, About the
TMPG, available at <a href="https://www.newyorkfed.org/TMPG/index.html">https://www.newyorkfed.org/TMPG/index.html</a>. The
TMPG is sponsored by the Federal Reserve Bank of New York. Id.
\13\ TMPG, White Paper on Clearing and Settlement in the
Secondary Market for U.S. Treasury Securities, at 12 (July 2019),
available at <a href="https://www.newyorkfed.org/medialibrary/Microsites/tmpg/files/CS_FinalPaper_071119.pdf">https://www.newyorkfed.org/medialibrary/Microsites/tmpg/files/CS_FinalPaper_071119.pdf</a> (``TMPG White Paper''). These
estimates use FR2004 data, which are reports provided to the Federal
Reserve Bank of New York regarding primary dealer market activity in
U.S. Government securities, covering the first half of 2017 and are
based on various assumptions specified in the TMPG White Paper. See
also FR2004, Government Securities Dealer Reports, available at
<a href="https://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDZq2f74T6b1cw">https://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDZq2f74T6b1cw</a>.
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Therefore, the Commission proposed amendments to Rule 17ad-
22(e)(18) to help reduce contagion risk to the CCA and bring the
benefits of central clearing to more transactions involving U.S.
Treasury securities, thereby lowering overall systemic risk in the
market.\14\ Specifically, the Commission proposed amendments that would
require CCAs for the U.S. Treasury market to establish, implement,
maintain and enforce written policies and procedures reasonably
designed to require that their direct participants submit for clearance
and settlement certain eligible secondary market transactions, both for
repos and certain categories of cash transactions. In addition, the
Commission proposed amendments to address certain other issues that
could help facilitate increased central clearing in the U.S. These
proposed changes included amending Rule 17ad-22(e)(6)(i) to require
that a CCA establish, implement, maintain and
[[Page 2717]]
enforce written policies and procedures reasonably designed to
calculate, collect, and hold proprietary margin separate from customer
margin, amending Rule 17ad-22(e)(18) to require that CCAs establish,
implement, maintain and enforce written policies and procedures
reasonably designed to ensure that they have appropriate means to
facilitate access to clearance and settlement services of all eligible
secondary market transactions in U.S. Treasury securities, including
those of indirect participants, and amending Rule 15c3-3 to permit
margin required and on deposit at covered clearing agencies providing
central counterparty services for U.S. Treasury securities to be
included by broker-dealers as a debit in the customer and PAB reserve
formulas.
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\14\ Proposing Release, Standards for Covered Clearing Agencies
for U.S. Treasury Securities and Application of the Broker-Dealer
Customer Protection Rule With Respect to U.S. Treasury Securities,
Exchange Act Release No. 95763 (Sept. 14, 2022), 87 FR 64610 (Oct.
25, 2022) (``Proposing Release''). See also Report of the Joint
Treasury-Federal Reserve Study of the U.S. Government Securities
Market (Apr. 1969), available at <a href="https://fraser.stlouisfed.org/title/joint-treasury-federal-reserve-study-us-government-securities-market-318/report-joint-treasury-federal-reserve-study-us-government-securities-market-6282">https://fraser.stlouisfed.org/title/joint-treasury-federal-reserve-study-us-government-securities-market-318/report-joint-treasury-federal-reserve-study-us-government-securities-market-6282</a>.
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The Commission received many comments on the proposal.\15\ Having
considered the comments received, the Commission is adopting the
proposed new rules and rule amendments with modifications, as discussed
further below.
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\15\ Copies of all comment letters received by the Commission
are available at <a href="https://www.sec.gov/comments/s7-23-22/s72322.htm">https://www.sec.gov/comments/s7-23-22/s72322.htm</a>.
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II. Discussion of Comments Received and Final Rules
A. U.S. Treasury Securities CCA Membership Requirements
1. Requirement To Clear Eligible Secondary Market Transactions
Proposed Rule 17ad-22(e)(18)(iv)(A) would require that U.S.
Treasury securities CCAs establish, implement, maintain and enforce
written policies and procedures reasonably designed to, as applicable,
establish objective, risk-based, and publicly disclosed criteria for
participation, which require that the direct participants of such
covered clearing agency submit for clearance and settlement all of the
eligible secondary market transactions to which they are a
counterparty. The proposed amendment would apply to ``direct
participants'' in a U.S. Treasury securities CCA, which distinguishes
entities that access a CCA directly (i.e., members of the CCA) from
indirect participants who ``rely on the services provided by direct
participants to access the covered clearing agency's payment, clearing
or settlement facilities.'' \16\ For purposes of the Covered Clearing
Agency Standards, ``participants'' of a CCA are referred to as
``members'' or ``direct participants'' to differentiate these entities
from ``direct participants' customers'' or ``indirect participants.''
\17\ Consequently, for purposes of this amendment and consistent with
the terminology already used in the Covered Clearing Agency
Standards,\18\ the term ``direct participants'' refers to the entities
that directly access a U.S. Treasury securities CCA (generally banks
and broker-dealers), and the term ``indirect participants'' would refer
to those entities which rely on a direct participant to clear and
settle their U.S. Treasury securities transactions with the U.S.
Treasury securities CCA (generally their customers or clients, which
typically include market participants such as money market funds, hedge
funds, other asset managers, and smaller banks or broker-dealers).\19\
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\16\ 17 CFR 240.17ad-22(e)(19). See also CCA Standards Proposing
Release, supra note 8, at 29553 (noting that some market
participants would not meet a covered clearing agency's direct
participation requirements and proposing risk management
requirements for indirect and tiered participants).
\17\ See, e.g., 17 CFR 240.17ad-22(e)(6) (referring to
participants) and (e)(2)(vi) (referring to direct participants'
customers). In addition, the Exchange Act defines a participant of a
clearing agency as ``any person who uses a clearing agency to clear
or settle securities transactions or to transfer, pledge, lend, or
hypothecate securities.'' 15 U.S.C. 78c(a)(24). Indirect
participants are expressly excluded from the Exchange Act definition
of a ``participant'' of a clearing agency because the Exchange Act
provides that a person whose only use of a clearing agency is
through another person who is a participant or as a pledgee of
securities is not a ``participant'' of the clearing agency. Id.
\18\ See 17 CFR 240.17ad-22(e)(19) (referring to firms that are
indirect participants in a covered clearing agency as those that
``rely on the services provided by direct participants to access the
covered clearing agency's payment, clearing, or settlement
facilities'').
\19\ For example, FICC maintains the Sponsored Service. See
Fixed Income Clearing Corporation, Government Securities Division
Rulebook, Rule 3A, available at https://www.dtcc.com/~/media/Files/
Downloads/legal/rules/ficc_gov_rules.pdf (``FICC Rule''). Because
sponsored members cannot clear or settle government securities
transactions without a sponsoring member, the Commission believes
that these sponsored members are not ``direct participants.'' As
noted above, such persons are referred to in this release as
``indirect participants'' or ``customers.''
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Moreover, persons who provide services in connection with clearance
and settlement, such as settlement agent, settlement bank, or clearing
bank services, and do not submit trades for clearing to a U.S. Treasury
securities CCA would not be ``direct participants'' or ``indirect
participants'' within the meaning of this amendment and the terminology
used in the Covered Clearing Agency Standards.\20\
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\20\ The Commission recognizes that some entities may access
more limited services of a U.S. Treasury securities CCA without use
of its CCP services. For example, FICC provides ``comparison only''
services for a certain membership type. See FICC Rule 8, supra note
19. Consistent with the definition of a ``participant'' under the
Exchange Act, such entities would not be considered participants of
a CCA and therefore would not be subject to any rules with respect
to the clearing of eligible secondary market transactions that a CCA
may adopt for its direct participants.
---------------------------------------------------------------------------
In the Proposing Release, the Commission stated that it believes
that the requirement to clear eligible secondary market transactions
would promote the prompt and accurate clearance and settlement of U.S.
Treasury securities transactions, providing several benefits to the
market for U.S. Treasury securities as a whole,\21\ which are
summarized briefly here.
---------------------------------------------------------------------------
\21\ See generally Proposing Release, supra note 14, 87 FR
64626-29; see also part IV.C.1 infra.
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First, the Commission stated that it believes that the requirement
to clear eligible secondary market transactions would decrease the
overall amount of counterparty credit risk in the secondary market for
U.S. Treasury securities. Because a U.S. Treasury securities CCA would
novate and guarantee each transaction submitted for central clearing,
it would become a counterparty to each transaction, as the buyer to
every seller and the seller to every buyer. The U.S. Treasury
securities CCA would be able to risk manage these transactions
centrally, pursuant to risk management procedures that the Commission
has reviewed and approved,\22\ and would guarantee settlement of the
trade in the event of a direct participant default.
---------------------------------------------------------------------------
\22\ See Section 19(b) of the Exchange Act and Rule 19b-4
thereunder.
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In particular, the requirement to clear eligible secondary market
transactions is designed to reduce the amount of ``contagion risk'' to
a U.S. Treasury securities CCA arising from what has been described as
``hybrid clearing,'' as discussed in more detail in part II.A.2.b.iii.
With this type of clearing, a direct participant's transactions that
are not submitted for central clearing pose an indirect risk to the
covered clearing agency, as any default on a bilaterally settled
transaction could impact the direct participant's financial resources
and ability to meet its obligations to the covered clearing agency. The
Commission stated that it believes that requiring U.S. Treasury
securities CCAs to impose, as a condition of membership, an obligation
on their direct participants to submit all eligible secondary market
transactions for central clearing should address the transactions most
likely to cause contagion risk to the CCA.
Second, the Commission stated that it believes that the requirement
to clear eligible secondary market transactions would also help any
U.S. Treasury securities CCA to avoid a potential disorderly member
default. Defaults in bilaterally settled transactions are likely
[[Page 2718]]
to be less orderly and subject to variable default management
techniques because bilaterally settled transactions are not subject to
the default management processes that are required to be in place and
publicly disclosed at a CCP.\23\ Centralized default management is a
key feature of central clearing.\24\ Because the CCP has novated and
guaranteed the transactions, it is uniquely positioned to coordinate
the default of a member for trades that it has centrally cleared, and
the non-defaulting members can rely on the CCP to complete the
transactions of the defaulting member and cover any resulting losses
using the defaulting member's resources and/or its default management
tools. Even in a situation where two CCPs have to coordinate the
default of a joint member, that coordination should result in more
efficiency and market confidence than multiple bilateral settlements.
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\23\ A covered clearing agency, including a U.S. Treasury
securities CCA, is required to establish, implement, maintain and
enforce written policies and procedures reasonably designed to, as
applicable, ensure the CCA has the authority and operational
capacity to contain losses and liquidity demands and continue to
meet its obligations, which must be tested annually, and publicly
disclose all relevant rules and material procedures, including key
aspects of its default rules and procedures. See Rule 17ad-22(e)(13)
and (e)(23)(i).
\24\ CCA Standards Proposing Release, supra note 8, 79 FR 29545
(a CCP's default management procedures would provide certainty and
predictability about the measures available to a covered clearing
agency in the event of a default which would, in turn facilitate the
orderly handling of member defaults and would enable members to
understand their obligations to the covered clearing agency in
extreme circumstances).
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Third, the Commission stated that it believes that the requirement
to clear eligible secondary market transactions will further the prompt
and accurate clearance and settlement of U.S. Treasury securities by
increasing the multilateral netting of transactions in these
instruments, thereby reducing operational and liquidity risks, among
others. Central clearing of transactions nets down gross exposures
across participants, which reduces firms' exposures while positions are
open and reduces the magnitude of cash and securities flows required at
settlement.\25\ As the Commission stated in the Proposing Release,
FICC's failure to receive all eligible trading activity of an active
market participant reduces the value of its vital multilateral netting
process and causes FICC to be less well-situated to prevent future
market crises.\26\
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\25\ 2021 IAWG Report, supra note 4, at 30.
\26\ Proposing Release, supra note 14, 87 FR 64628 & n. 182
(citing Self-Regulatory Organizations; Fixed Income Clearing
Corporation; Order Granting Approval of a Proposed Rule Change
Relating to Trade Submission Requirements and Pre-Netting, Exchange
Act Release No. 51908 (June 22, 2005), 70 FR 37450 (June 29, 2005)
(describing a rule designed to bring additional transactions into
FICC's netting system as ``clearly designed to promote the prompt
and accurate clearance and settlement of those transactions and to
preserve the safety and soundness of the national clearance and
settlement system.'')).
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The benefits of multilateral netting flowing from central clearing
can improve market safety by lowering exposure to settlement failures,
which would also tend to promote the prompt and accurate clearance and
settlement of U.S. Treasury securities transactions.\27\ Multilateral
netting can also reduce the amount of balance sheet required for
intermediation and could also enhance dealer capacity to make markets
during normal times and stress events because existing bank capital and
leverage requirements recognize the risk-reducing effects of
multilateral netting of trades that CCP clearing accomplishes.\28\
---------------------------------------------------------------------------
\27\ Darrell Duffie, Still the World's Safe Haven Redesigning
the U.S. Treasury Market After the COVID-19 Crisis, Hutchins Center
Working Paper # 62 (Brookings Inst.) at 15 (June 2020), available at
<a href="https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_v2.pdf">https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_v2.pdf</a> (``Duffie'').
\28\ 2021 IAWG Report, supra note 4, at 30; Nellie Liang &
Patrick Parkinson, Enhancing Liquidity of the U.S. Treasury Market
Under Stress, at 9 (Dec. 16, 2020), available at <a href="https://www.brookings.edu/wp-content/uploads/2020/12/WP72_Liang-Parkinson.pdf">https://www.brookings.edu/wp-content/uploads/2020/12/WP72_Liang-Parkinson.pdf</a> (``Liang & Parkinson''); Duffie, supra note 27, at 16-
17.
---------------------------------------------------------------------------
Fourth, the Commission stated that the potential benefits
associated with the multilateral netting of transactions at a CCP that
the requirement to clear eligible secondary market transactions is
designed to bring about could, in turn, help to unlock further
improvements in U.S. Treasury market structure. For example, the
increase in clearing and consequent reduction in counterparty credit
risk could ``enhance the ability of smaller bank and independent
dealers to compete with the incumbent bank dealers.'' \29\ Similarly,
decreased counterparty credit risk--and potentially lower costs for
intermediation--could result in narrower spreads, thereby enhancing
market quality.\30\ The Commission also stated that increased
accessibility of central clearing in U.S. Treasury markets could
support movement toward all-to-all trading, even potentially in the
repo market, which would further improve market structure and
resiliency, although a movement in that direction is not assured.\31\
This potential movement would stem from the fact that increased central
clearing of U.S. Treasury securities transactions would, in turn,
result in decreased counterparty risk, making all-to-all trading more
attractive, that is, a market participant would be more willing to
trade with any counterparty if a CCP were to serve as its ultimate
counterparty.
---------------------------------------------------------------------------
\29\ Liang & Parkinson, supra note 28, at 9.
\30\ G-30 Report, supra note 5, at 13.
\31\ 2021 IAWG Report, supra note 4, at 30; Duffie, supra note
27, at 16; G-30 Report, supra note 5, at 13. All-to-all trading
would be characterized by the ability for a bid or offer submitted
by one market participant to be accepted by any other market
participant, with trades executed at the best bid or offer. See,
e.g., Liang & Parkinson, supra note 28, at 9. All-to-all trading
could improve the quality of trade execution in normal market
conditions and broaden and stabilize the supply of market liquidity
under stress. See, e.g., G-30 Report, supra note 5, at 10.
---------------------------------------------------------------------------
Finally, the Commission stated that increased central clearing
should enhance regulatory visibility in the critically important U.S.
Treasury market. Specifically, central clearing increases the
transparency of settlement risk to regulators and market participants,
and in particular allows a CCP to identify concentrated positions and
crowded trades, adjusting margin requirements accordingly, which should
help reduce significant risk to the CCP and to the system as a
whole.\32\ In light of the role of U.S. Treasury securities in
financing the Federal Government, it is important that regulators
improve their visibility into this market. Increased central clearing
would also allow for a more aggregated view of market activity in one
place.
---------------------------------------------------------------------------
\32\ Duffie, supra note 27, at 15;2021 IAWG Report, supra note
4, at 30 (centralization of transactions at a CCP ``can simplify
data collection and improve visibility into market conditions for
the authorities and, to some degree, for market participants'').
---------------------------------------------------------------------------
a. Comments Regarding the Requirement To Clear Eligible Secondary
Market Transactions
Some commenters generally supported the proposal and its approach
to requiring additional central clearing of transactions in U.S.
Treasury securities.\33\ However, other commenters generally opposed
the proposed requirement to clear eligible
[[Page 2719]]
secondary market transactions, arguing that there was not sufficient
information on the costs and benefits of such a requirement, that the
Commission should do further study, and/or that the Commission should
incentivize additional clearing instead of requiring it.\34\
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\33\ See generally Letter from Americans for Financial Reform
Education Fund (Dec. 27, 2022) (``AFREF Letter''); Letter from
Stephen W. Hall, Legal Director and Securities Specialist, and Scott
Farnin, Legal Counsel, Better Markets, Inc. (Dec. 23, 2022)
(``Better Markets Letter''); Letter from Murray Pozmanter, Managing
Director, President of DTCC Clearing Agency Services, Head of Global
Business Operations, and Laura Klimpel, General Manager of FICC,
Head of SIFMU Business Development, Depository Trust and Clearing
Corporation and Fixed Income Clearing Corporation (Dec. 27, 2022)
(``DTCC/FICC Letter''); Letter from Robin Vince, President and Chief
Executive Officer, The Bank of New York Mellon Corporation (Dec. 22,
2022) (``BNY Mellon Letter''); Letter from Rachel Goldberg, Head of
Government Relations and Regulatory Strategy, Americas, London Stock
Exchange Group (Dec. 27, 2022) (``LSEG Letter''); Letter from Chris
Edmonds, Chief Development Officer, Intercontinental Exchange, Inc.
(Jan. 12, 2023) (``ICE Letter'').
\34\ The Commission discusses the comments on incentives in its
discussion of alternative approaches to a clearing requirement in
part II.A.5 infra.
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One commenter also referenced the need to assess the potential
impact of an increased volume of cleared repo transactions on the
Secured Overnight Financing Rate (``SOFR''), given its importance as a
reference rate replacing LIBOR and because SOFR is calculated largely
based on implied financing rates of repo transactions cleared at
FICC.\35\ SOFR is calculated as a volume-weighted median, which is the
rate associated with transactions at the 50th percentile of transaction
volume.\36\ Specifically, the volume-weighted median rate is calculated
by ordering the transactions from lowest to highest rate, taking the
cumulative sum of volumes of these transactions, and identifying the
rate associated with the trades at the 50th percentile of dollar
volume. Such volume weighting should allow preparation of the rate to
take into account any increased transaction volume arising from
additional central clearing in response to a requirement to clear
eligible secondary market transactions, thereby making further study
unnecessary.
---------------------------------------------------------------------------
\35\ Letter from William C. Thum, Managing Director and
Assistant General Counsel, Securities Industry and Financial Markets
Association (``SIFMA'') Asset Management Group, at 7 (Dec. 23, 2022)
(``SIFMA AMG Letter'').
\36\ Additional Information about Reference Rates Administered
by the New York Fed, available at <a href="https://www.newyorkfed.org/markets/reference-rates/additional-information-about-reference-rates#tgcr_bgcr_sofr_calculation_methodology">https://www.newyorkfed.org/markets/reference-rates/additional-information-about-reference-rates#tgcr_bgcr_sofr_calculation_methodology</a>.
---------------------------------------------------------------------------
With respect to costs and benefits, one commenter stated that the
increased costs of centrally clearing U.S. Treasury security
transactions may reduce liquidity and diversity in the Treasury market
if firms reduce activity, leave the market, or if barriers to entry are
too high, given the significant costs of clearing for market
participants.\37\ The commenter identified several types of costs,
including initial margin requirements, clearing fees, obligations with
respect to FICC's Capped Contingent Liquidity Facility (``CCLF''), the
operational build necessary to access central clearing either as a
direct or indirect participant, and legal costs and time associated
with onboarding customers for indirect central clearing, including,
e.g., the need for Sponsoring Members to file UCC financing statements
with respect to Sponsored Members under the Sponsored Member program.
The commenter stated that the impact of these costs would be
disproportionately felt by small and mid-sized participants in the U.S.
Treasury market, and that these costs would reduce diversity in the
market and further increase concentration among market participants
(which may increase systemic risk) if such participants leave the
market.\38\
---------------------------------------------------------------------------
\37\ Letter from Robert Toomey, Managing Director and Associate
General Counsel, Securities Industry and Financial Markets
Association, and Michelle Meertens, Deputy General Counsel,
Institute of International Bankers, at 8 (Dec. 22, 2022) (``SIFMA/
IIB Letter'').
\38\ SIFMA/IIB Letter, supra note 37, at 8.
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As discussed in more detail in part IV.C.2, increased transaction
costs will generally reduce the expected return of a particular
investment. If the amendments regarding eligible secondary market
transactions resulted only in such increased costs, then the potential
risk/return tradeoff would worsen, resulting in decreased transaction
volumes and decreased liquidity. However, central clearing provides
other benefits, including those described in part IV.C.1, many of which
could accrue to small and mid-sized market participants. Moreover,
increased cost does not necessarily mean that firms will reduce
activity or leave the market.
The commenter also stated that these costs may incentivize non-
direct participants of a U.S. Treasury securities CCA to look for ways
to trade away from direct participants in order to not have to
centrally clear U.S. Treasury transactions, undermining the policy
goals of the proposal.\39\ The Commission acknowledges that the
proposed requirement for U.S. Treasury securities CCAs to require their
members to submit eligible secondary market transactions for clearing
and settlement does not limit the ability of market participants to
transact in U.S. Treasury securities transactions away from CCAs. This
requirement is not a mandate to clear all transactions in U.S. Treasury
securities, regardless of who executes the transaction, and differs
from the swaps mandate imposed by Congress in the Dodd-Frank Act in
2010.\40\ However, given current market structure and requirements
applicable to certain market participants, it would be challenging for
market participants to simply shift all their activity to transact away
from CCAs. For example, primary dealers, which serve as trading
counterparties of the New York Fed in its implementation of monetary
policy, are required to maintain a substantial presence as a market
maker that provides two-way liquidity in U.S. government securities,
particularly Treasury cash and repo operations.\41\ These primary
dealers must be participants in FICC, as the CCP for the government
securities market, to support clearing of primary market
transactions.\42\ Therefore, if a market participant wants to transact
with a primary dealer which is required to be a direct participant of
FICC, it would have to determine an appropriate way to submit such
transactions for clearing and settlement. Primary dealers are
responsible for a significant portion of market activity in the U.S.
Treasury market (see part IV.B infra), and therefore, market
participants likely would continue to transact with such primary
dealers.
---------------------------------------------------------------------------
\39\ SIFMA/IIB Letter, supra note 37, at 8.
\40\ Dodd-Frank Act section 723; 15 U.S.C. 3C(a).
\41\ See Primary Dealers, available at <a href="https://www.newyorkfed.org/markets/primarydealers">https://www.newyorkfed.org/markets/primarydealers</a> (``In order to be eligible
as a primary dealer, a firm must . . . Be a participant in the
central counterparty service for the government securities market--
DTCC's FICC-GSD--to support clearing of primary market
transactions.'').
\42\ Id.
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In addition, the commenter stated that central clearing can have
procyclical effects in times of market stress due to the margin
requirements of clearing agencies, further reducing liquidity when it
is most needed.\43\ The commenter stated that, depending on the
applicable margin models, clearing can be procyclical in times of
market turmoil, as increased margin requirements (including intraday
and ad hoc calls) drive demand for liquid assets, which, in turn,
increases the scarcity of those assets and further drives market
stress. The commenter described FICC's rules as allowing FICC to
demand, at any time in its discretion, additional margin from its
members in times of market volatility, including through intraday
calls, to safeguard the clearing infrastructure.\44\ The commenter
suggested that the Commission should engage in additional study on the
procyclical effects of central clearing before implementing a central
clearing requirement, focusing on the appropriate balance from a
systemic risk perspective of rigorously managing the risk of positions
cleared through a CCP as compared to minimizing liquidity strains on
the U.S. Treasury market.\45\
---------------------------------------------------------------------------
\43\ SIFMA/IIB Letter, supra note 37, at 9.
\44\ SIFMA/IIB Letter, supra note 37, at 9.
\45\ SIFMA/IIB Letter, supra note 37, at 9.
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The Commission acknowledges that, in times of market stress, margin
calls
[[Page 2720]]
may increase to address the ongoing market volatility. This is by
design, as margin models are built to be responsive to current market
conditions. The Commission has specifically required that CCAs have the
authority and operational capacity to make intraday margin calls in
defined circumstances.\46\ This ability is important to the CCA's
ability to manage the risk and cover the credit exposures that its
participants may bring to the CCA. When considering a CCA's authority
with respect to intraday margin, the Commission may consider its
potential procyclicality.\47\ In addition, the Commission may consider
the transparency of the margin model, such that market participants can
understand when the CCA may make margin calls.\48\ In addition to the
FICC rules cited by the commenter, FICC has provided additional
transparency regarding how it determines the need for intraday margin
calls, including the specific criteria that it uses to assess the
need.\49\ FICC is also subject to Rule 17ad-22(e)(23), which requires
certain levels of public disclosure regarding FICC's margin methodology
and the costs of participating in FICC, as discussed further in part
II.B.2 infra. The Commission's ongoing consideration of the role and
function of intraday margin calls, as well as market participants'
ability to understand such calls, obviates the need for separate study
in connection with this proposal.\50\
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\46\ 17 CFR 240.17ad-22(e)(6)(ii).
\47\ See, e.g., Self-Regulatory Organizations; Fixed Income
Clearing Corporation; Order Approving a Proposed Rule Change to
Modify the Calculation of the MBSD VaR Floor to Incorporate a
Minimum Margin Amount, Exchange Act Release No. 92303, at 32 (June
30, 2021) (discussing commenter's concern regarding potential
procyclical nature of a margin methodology change); Self-Regulatory
Organizations; The Options Clearing Corporation; Order Granting
Approval of Proposed Rule Change Concerning The Options Clearing
Corporation's Margin Methodology for Incorporating Variations in
Implied Volatility, Exchange Act Release No. 95319, at 3 (July 19,
2022) (referencing the impact of a change to margin methodology on
procyclicality of margin).
\48\ See, e.g., Self-Regulatory Organizations; National
Securities Clearing Corporation; Order Approving a Proposed Rule
Change to Enhance National Securities Clearing Corporation's
Haircut-Based Volatility Charge Applicable to Illiquid Securities
and UITs and Make Certain Other Changes to Procedure XV, Exchange
Act Release No. 34-90502, at 56-59 (Nov. 24, 2020) (discussing
commenter's concerns regarding transparency of change to margin
methodology).
\49\ See Self-Regulatory Organizations; Fixed Income Clearing
Corporation; Notice of Filing of Proposed Rule Changes to the
Required Fund Deposit Calculation in the Government Securities
Division Rulebook, Exchange Act Release No. 82588 (Jan. 26, 2018)
(identifying the following specific parameter breaks: (i) a dollar
threshold that evaluates whether a Netting Member's Intraday VaR
Charge equals or exceeds a set dollar amount (then set at
$1,000,000) when compared to the VaR Charge that was included in the
most recently collected Required Fund Deposit including, any
subsequently collected Intraday Supplemental Fund Deposit; (ii) a
percentage threshold, that evaluates whether the Intraday VaR Charge
equals or exceeds a percentage increase (then set at 100%) of the
VaR Charge that was included in the most recently collected Required
Fund Deposit including, if applicable, any subsequently collected
Intraday Supplemental Fund Deposit; (iii) the coverage target, that
evaluates whether a Netting Member is experiencing backtesting
results below the 99% confidence level). FICC has updated this
information via Important Notices to its participants. See, e.g.,
Important Notice GOV1244-22, GSD Intraday Supplemental Fund Deposit
Parameter Change (Apr. 11, 2022), available at <a href="https://www.dtcc.com/-/media/Files/pdf/2022/4/11/GOV1244-22.pdf">https://www.dtcc.com/-/media/Files/pdf/2022/4/11/GOV1244-22.pdf</a> (raising the coverage
target).
\50\ See also Proposed Rule, Covered Clearing Agency Resilience
and Recovery and Wind-Down Plans, Exchange Act Release No. 97516
(May 17, 2023), 88 FR 34708 (May 30, 2023) (proposing additional
requirements with respect to intraday margin that CCAs require
intraday monitoring of their exposures and specifying particular
circumstances in which the CCA should make intraday margin calls).
---------------------------------------------------------------------------
b. Comments Regarding the Concentration of Risk in One Covered Clearing
Agency
Commenters also mentioned the potential concentration risk that
would arise as a result of the requirement to clear eligible secondary
market transactions, specifically because only one covered clearing
agency currently provides such services. One commenter stated that
concentrating such significant levels of settlement, operational,
liquidity and credit risk in one institution means that were there
operational or liquidity stress at FICC, widespread dysfunction in the
Treasury markets could result.\51\ Another commenter which analyzed
market views of the proposal identified increased concentration risk as
a primary concern for market participants, who cited potential
technical issues at FICC that would result in a ``pause [of]
counterparty trade transactions and lead to substantial losses for
market participants.'' However, the commenter also acknowledged that a
smaller group of market participants explained that they were not
opposed to a single clearinghouse model through FICC, stating that FICC
has adequate risk models and that the concentration in one CCP is not
of concern in the futures or derivatives markets, which, like FICC,
also only have one CCP to serve their respective markets.\52\
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\51\ SIFMA/IIB Letter, supra note 37, at 10.
\52\ Comment Submission from SIA Partners, entitled CENTRAL
CLEARING OF U.S. TREASURIES & REPO, A Study on the Impact to the
Market and Market Participants, at 79-80 (Mar. 2023) (``SIA Partners
Comment''); see also id. at 8.
---------------------------------------------------------------------------
In addition, one commenter stated that the Commission should only
impose a clearing mandate once FICC and at least a second covered
clearing agency are able to offer access to clearing solutions that
will fulfill the enhanced rule requirements and meet the needs of
market participants.\53\ The commenter noted that the existence of one
covered clearing agency serving the U.S. Treasury market is highly
problematic as it creates enormous concentration risk for market
participants, and highlighted that, given the importance of the U.S.
Treasury market to the overall global economy, there needs to be a
compelling reason for increasing the concentration of cleared trading
activity in a single clearing house that is member owned and operated
on a for-profit basis, particularly when there is no alternative or
fallback venue should the clearing house experience a disruption to its
operations or more significantly were it to fail.\54\
---------------------------------------------------------------------------
\53\ SIFMA/AMG Letter, supra note 37, at 3, 9.
\54\ SIFMA/AMG Letter, supra note 37, at 9.
---------------------------------------------------------------------------
The Commission acknowledges that, currently, there is only one U.S.
Treasury securities CCA, FICC, and that this does create concentration
risk for the clearing of U.S. Treasury securities transactions.
However, this concentration risk is mitigated by the existence of a
supervisory framework for the existing U.S. Treasury securities CCA,
and it is not uncommon for one CCA to serve a particular market.\55\
The Commission therefore disagrees with the commenter that the
existence of two CCAs is necessary for this requirement to be
implemented. Moreover, the Commission is not requiring that the
additional central clearing of U.S. Treasury securities transactions be
concentrated in one clearing house. But, if that remains the case going
forward, the benefits expected to arise from this additional clearing,
as discussed further in part IV.C.1 infra, constitute a sufficient
compelling reason to adopt the final rule, even if such concentration
is present, which, as discussed, is subject to the appropriate
mitigation of risk arising from the regulatory framework applicable to
CCAs as discussed in this section.
---------------------------------------------------------------------------
\55\ For example, there is only one CCA in the U.S. equities
market and in the U.S. listed derivatives market.
---------------------------------------------------------------------------
FICC has been designated by the Financial Stability Oversight
Council as systemically important under Title VIII of the Dodd-Frank
Act. This designation means that FICC is subject to heightened
supervision and examination by the Commission, in consultation with the
Board of Governors of the Federal Reserve System (``Board of
Governors''.
[[Page 2721]]
FICC is subject to the Covered Clearing Agency Standards, which address
the various types of risk that FICC faces as a CCP, including
settlement, operational, liquidity, and credit risk.
A CCA must be able to meet the requirements of the Covered Clearing
Agency Standards regardless of the presence or absence of other CCAs.
The Covered Clearing Agency Standards specifically address a CCA's
obligations in 23 specific areas, many of which directly relate to the
CCA's ability to manage the risks presented to it as a CCA. For
example, a CCA must have policies and procedures in place to
effectively identify, measure, monitor, and manage its credit exposures
to participants and those arising from its payment, clearing, and
settlement processes, including by, among other things, maintaining
sufficient financial resources to cover its credit exposure to each
participant fully with a high degree of confidence and maintain
additional financial resources to enable it to cover a wide range of
foreseeable stress scenarios, including the default of the largest or
two largest participant families (depending on the nature of the CCA's
activities). A CCA also must have policies and procedures in place to
effectively measure, monitor, and manage the liquidity risk that arises
in or is borne by the CCA, including measuring, monitoring, and
managing its settlement and funding flows on an ongoing and timely
basis, and its use of intraday liquidity, by, among other things,
holding qualifying liquid resources in an amount sufficient to effect
same-day and, where appropriate, intraday and multiday settlement of
payment obligations with a high degree of confidence under a wide range
of foreseeable stress scenarios that includes, but is not limited to,
the default of the largest participant family in extreme but plausible
market conditions. With respect to both its credit and liquidity
resources, the CCA is required to, among other things, test the
sufficiency of such resources at least once each day using standard and
predetermined parameters and assumptions, conduct a comprehensive
analysis on at least a monthly basis of the existing scenarios, models,
and underlying parameters and assumptions used to ensure that they are
appropriate for determining the CCA's needs and resources in light of
current and evolving market conditions, and to perform a model
validation of the models used for such testing at least annually.\56\
---------------------------------------------------------------------------
\56\ 17 CFR 240.17ad-22(e)(4)(vi) and (vii) and (e)(7)(vi) and
(vii).
---------------------------------------------------------------------------
In addition, a CCA is required to establish, implement, maintain
and enforce written policies and procedures reasonably designed to
cover its credit exposures to its participants by establishing a risk-
based margin system that, at a minimum and among other things,
calculates margin sufficient to cover its potential future exposure to
participants in the interval between the last margin collection and the
close out of positions following a participant default, and is
monitored by management on an ongoing basis and is regularly reviewed,
tested, and verified by conducting backtests of its margin model at
least once each day using standard predetermined parameters and
assumptions and conducting a sensitivity analysis of its margin model
and a review of its parameters and assumptions for backtesting on at
least a monthly basis, among other things.\57\ A CCA also is required
to have policies and procedures reasonably designed to establish
objective, risk-based, and publicly disclosed criteria for
participation, which permit fair and open access by direct and, where
relevant, indirect participants and other financial market utilities,
require participants to have sufficient financial resources and robust
operational capacity to meet obligations arising from participation in
the clearing agency, and monitor compliance with such participation
requirements on an ongoing basis; and identify, monitor, and manage the
material risks to the CCA arising from arrangements in which firms that
are indirect participants in the CCA rely on the services provided by
direct participants to access the CCA's payment, clearing, or
settlement facilities.\58\
---------------------------------------------------------------------------
\57\ 17 CFR 240.17ad-22(e)(6).
\58\ 17 CFR 240.17ad-22(e)(18) and (19).
---------------------------------------------------------------------------
These requirements should ensure that a CCA is able to accommodate
the market needs for its clearance and settlement activity and that a
CCA can appropriately risk manage the activity that its participants
submit for clearing and settlement, which should, in turn, mitigate the
potential concentration risk arising from the existence of only one CCA
for a particular asset class.
Further, regarding the comments raising concerns about potential
operational or technical issues at a single CCA, the Covered Clearing
Agency Standards include Rule 17ad-22(e)(17), which requires written
policies and procedures reasonably designed to manage the covered
clearing agency's operational risks by (i) identifying the plausible
sources of operational risk, both internal and external, and mitigating
their impact through the use of appropriate systems, policies,
procedures, and controls; (ii) ensuring that systems have a high degree
of security, resiliency, operational reliability, and adequate,
scalable capacity; and (iii) establishing and maintaining a business
continuity plan that addresses events posing a significant risk of
disrupting operations.\59\ In addition, CCAs, as registered clearing
agencies, are subject to the requirements of Regulation Systems
Compliance Integrity (``Regulation SCI''). Regulation SCI is designed
to strengthen the infrastructure of the U.S. securities markets, reduce
the occurrence of systems issues in those markets, improve their
resiliency when technological issues arise, and implement an updated
and formalized regulatory framework, thereby helping to ensure more
effective Commission oversight of such systems.\60\ As entities subject
to Regulation SCI, CCAs are required to have written policies and
procedures reasonably designed to ensure that their key automated
systems have levels of capacity, integrity, resiliency, availability,
and security adequate to maintain their operational capability and
promote the maintenance of fair and orderly markets, and that such
systems operate in accordance with the Exchange Act and the rules and
regulations thereunder and the entities' rules and governing documents,
as applicable.\61\ These requirements should work to mitigate the
possibility that a CCA would experience an interruption to its
operations. In the event that a CCA were to fail, it is required to
have policies and procedures to establish a recovery and wind-down plan
to address that situation.\62\
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\59\ 17 CFR 240.17ad-22(e)(17).
\60\ Securities Exchange Act Release No. 73639 (Nov. 19, 2014),
79 FR 72252, 72253, 72256 (Dec. 5, 2014).
\61\ See 17 CFR 242.1001.
\62\ 17 CFR 240.17ad-22(e)(3)(ii). In the event of a wind-down
in which the result is that the U.S. Treasury securities CCA no
longer exists, Rule 17ad-22(e)(18)(iv) would not apply, as there
would be no CCA to impose such membership requirements. The
requirement to clear eligible secondary market transactions arises
under the CCA's rules and is not a mandate to clear based on the
nature of the security.
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FICC also must meet its obligations under both Section 19(b) of the
Exchange Act, as a self-regulatory organization, and Title VIII of the
Dodd-Frank Act. This means that the Commission has the opportunity to
review any proposed rule changes and imposes specific additional filing
obligations for an entity designated as systemically important under
Title VIII
[[Page 2722]]
of the Dodd-Frank Act to provide advance notice to the Commission,
which must consult with the Board of Governors, of any change to the
entity's procedures that may materially alter the nature or level of
risk presented.\63\ This overall supervisory framework, including the
Covered Clearing Agency Standards, should help ensure that FICC
continues to be subject to robust supervision and oversight and to be
able to manage the risks presented to it, even those arising from
increased Treasury clearing. In light of the robust regulatory
framework applicable to CCAs, the fact that only one CCA serves the
market should not preclude the imposition of a requirement to clear
eligible secondary market transactions.
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\63\ 12 U.S.C. 5465(e); 17 CFR 240.19b-4.
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Further, the Commission is not persuaded that the ownership or
organizational structure of the present U.S. Treasury securities CCA
has an effect on its ability to serve the market. The Commission has
not imposed particular requirements for the ownership or corporate
structure of CCAs, and CCAs currently exhibit a variety of ownership
and corporate structures. For example, FICC is wholly owned by the
Depository Trust & Clearing Corporation (``DTCC''), which is, in turn,
owned by the members of the clearing agencies owned by the DTCC.\64\
FICC operates on a cost plus low-margin model, meaning that its fees
are cost-based plus a markup as approved by the Board or management and
that this markup or ``low margin'' is applied to recover development
costs and operating expenses and to accumulate capital sufficient to
meet regulatory and economic requirements.\65\ Nevertheless, a CCA's
status as a for-profit organization does not preclude its ability to
meet its requirements under the Covered Clearing Agency Standards.
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\64\ The members of such clearing agencies are required to
purchase common shares under DTCC's Shareholders Agreement as a
condition to use the clearing agencies' services and facilities.
See, e.g., FICC Rule 49, section 2, supra note 19. This differs from
other clearing agencies or clearing organizations in which the
shareholders are not limited to the participants of the clearing
agency and the clearing agency may be owned by a publicly traded
company.
\65\ See, e.g., Self-Regulatory Organizations; Fixed Income
Clearing Corporation; Notice of Filing and Immediate Effectiveness
of Proposed Rule Change to Amend Certain MBSD Fees, Exchange Act
Release No. 96575 (Dec. 22, 2022). In addition, because FICC is
member-owned, members may receive rebates when FICC collects excess
net income, which is defined as either income of FICC or one
business line of FICC after application of expenses, capitalization
costs, and applicable regulatory requirements. See FICC Rules, Fee
Structure, Section XII, supra note 19.
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An additional commenter stated its belief that relinquishing
control of credit approval to a single entity poses a significant
problem, particularly, with all transactions going through FICC and
where margin requirements can be changed at any time. The commenter
stated that every firm has a different risk appetite and quantitative
and qualitative perspectives as it relates to credit analysis, which
are part of the professional services and expertise that well-run firms
offer, and that by inserting FICC into the center of the credit
approval process, firms lose their ability to apply their deeply
informed market views and differentiate themselves from
competitors.\66\
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\66\ Letter from the Independent Dealer & Trader Association, at
9 (Dec. 27, 2022) (``IDTA Letter'').
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The Commission disagrees that the requirement to clear eligible
secondary market transactions, which currently can be done only at
FICC, will remove firms' ability to differentiate themselves from their
competitors. FICC has no role in the relationship between a direct
participant and the direct participant's customers, and, indeed, the
Exchange Act provides that its rules cannot impose any schedule of
prices, or fix rates or other fees, for its participants' services.\67\
FICC's direct participants will remain free to determine what services
they will offer to their customers, and at what price, thereby
providing the ability for the direct participants to differentiate
themselves from their competitors.
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\67\ 15 U.S.C. 78q-1(b)(3)(E).
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The Commission also disagrees that margin requirements at FICC can
change at any time. FICC's margin methodology is part of its rules that
have been approved by the Commission, and changes to that methodology
must be filed with and reviewed by the Commission because of FICC's
status as a self-regulatory organization. The margin methodology, which
is part of FICC's approved rules, does provide some flexibility to FICC
to manage risk, and potentially increase margin requirements, in times
of market volatility and to guard against exposure to the CCP, but this
flexibility is not equivalent to FICC being able to alter its margin
requirements at any time. Pursuant to the Commission's rules, FICC
would be obligated to file for Commission review any proposed change to
its margin methodology and to file an advance notice of any proposed
change to its rules in the event that the change would materially alter
the nature or level of risk presented by the CCA, with both of these
processes involving notice and the opportunity for public comment.\68\
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\68\ 15 U.S.C. 78s(b); Dodd-Frank Act Section 806(e); 17 CFR
240.19b-4.
---------------------------------------------------------------------------
Finally, one commenter also stated that any final rule should
expressly acknowledge the potential for multiple U.S. Treasury
securities CCAs and prohibit a clearing agency's rules from restricting
or impeding in any way their members' ability to clear U.S. Treasury
securities cash or repo transactions at another CCA.\69\ Such
clarification is unnecessary. The requirements being adopted apply to
any U.S. Treasury securities CCA and do not rely on the existence of
only one U.S. Treasury securities CCA. The Commission acknowledges that
there is the potential for multiple clearing agencies serving the U.S.
Treasury market under its regulatory framework, and that the existence
of additional U.S. Treasury securities CCAs would lower the
concentration risk that currently exists due to having a single CCA for
that market. Moreover, a rule prohibiting a clearing agency from
restricting or impeding in any way its member's ability to clear at
another CCA is also unnecessary because to be registered under Section
17A of the Exchange Act, a clearing agency's rules must not impose any
burden on competition not necessary or appropriate in furtherance of
the purposes of Section 17A.\70\
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\69\ ICE Letter, supra note 33, at 2-3.
\70\ 15 U.S.C. 78q-1(b)(3)(I).
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c. Final Rule
For the reasons discussed in parts II.A.1.a and b supra, the
Commission is adopting Rule 17ad-22(e)(18)(iv) as proposed.\71\ This
requirement applies to all types of transactions that are of a type
currently accepted for clearing at a U.S. Treasury securities CCA; it
does not impose a requirement on a U.S. Treasury securities CCA to
offer additional products for clearing.
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\71\ The Commission also amends the CFR designation of Rule
17Ad-22 in order to ensure the regulatory text conforms more
consistently with section 2.13 of the Document Drafting Handbook.
See Office of the Federal Register, Document Drafting Handbook (Aug.
2018 Edition, Revision 2.1, dated Oct. 2023), available at <a href="https://www.archives.gov/files/federal-register/write/handbook/ddh.pdf">https://www.archives.gov/files/federal-register/write/handbook/ddh.pdf</a>. In
particular, the Commission amends the CFR section designation for 17
CFR 240.17Ad-22 (Rule 17Ad-22) to replace the uppercase letter with
the corresponding lowercase letter, such that the rule is
redesignated as 17 CFR 240.17ad-22 (Rule 17ad-22).
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2. Definition of Eligible Secondary Market Transactions
As part of Rule 17ad-22(a), the Proposing Release set forth a
definition of an eligible secondary market
[[Page 2723]]
transaction in U.S. Treasury securities \72\ subject to the requirement
to submit for clearance and settlement discussed in part II.A.1 above.
Specifically, the definition of an eligible secondary market
transaction \73\ would include:
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\72\ The Commission did not receive any comments on its proposed
definition of ``U.S. Treasury security'' and is adopting that
definition as proposed.
\73\ As the Commission stated in the Proposing Release, the
amendment does not apply to the primary market, i.e., the issuance
and sale of a U.S. Treasury security to a primary dealer or other
bidder in a U.S. Treasury auction. Proposing Release, supra note 14,
87 FR 64621. Further, as the Commission also stated in the Proposing
Release, because trading in when-issued securities occurring the day
after the auction shares similar characteristics to secondary market
transactions and because such trading is already reported as a
secondary market transaction, the definition of an eligible
secondary market transaction would apply to when-issued trades that
occur the day after the auction and are considered on-the-run on
some IDBs, to the extent that such when-issued trades otherwise meet
the definition of an eligible secondary market transaction, as
discussed further in part II.A.2.ii infra. Id. However, because
when-issued trading occurring before and on the day of the auction
does not share these characteristics and is primarily used as a tool
for price discovery leading to the auction, such transactions would
not be encompassed by the definition. Id.
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<bullet> Repurchase agreements and reverse repurchase agreements in
which one of the counterparties is a direct participant;
<bullet> Any purchases and sales entered into by a direct
participant if the direct participant (A) brings together multiple
buyers and sellers using a trading facility (such as a limit order
book) and (B) is a counterparty to both the buyer and seller in two
separate transactions; and
<bullet> Any purchases and sales of U.S. Treasury securities
between a direct participant and a counterparty that is a registered
broker-dealer, government securities dealer, or government securities
broker, a hedge fund, or an account at a registered broker-dealer,
government securities dealer, or government securities broker where
such account may borrow an amount in excess of one-half of the value of
the account or may have gross notional exposure of the transactions in
the account that is more than twice the value of the account.
The Commission is adopting this rule, with modifications related to
repos by other clearing organizations (see part II.A.2.a.iii), inter-
affiliate repo transactions (see part II.A.2.a.vi), and state and local
government repo transactions (see part II.A.2.a.vii) and related to
cash transactions by hedge funds and leveraged accounts (see part
II.A.2.b.iii). The Commission discusses the proposed definitions and
the comments received thereupon in the following sections.
a. Repo Transactions
The proposed definition of an eligible secondary market transaction
would include, among other things, all U.S. Treasury repurchase and
reverse repurchase agreements entered into by a direct participant of a
U.S. Treasury securities CCA, subject to the exclusions discussed in
part XX infra. As explained in the Proposing Release, in a U.S.
Treasury repo transaction, one party sells a U.S. Treasury security to
another party (often referred to as the ``start leg'') and commits to
repurchase the security at a specified price on a specified later date
(often referred to as the ``end leg''), and a reverse repo transaction
is the same transaction from the buyer's perspective.\74\
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\74\ Proposing Release, supra note 14, 87 FR 64616. The effect
of a repo transaction is similar to a cash loan, using U.S. Treasury
securities as collateral. Id. However, standard industry
documentation classifies the start and end legs of the repo
transaction as purchases and sales of securities. See, e.g., SIFMA,
Master Repurchase Agreement (September 1996 Version), available at
<a href="https://www.sifma.org/wp-content/uploads/2017/08/MRA_Agreement.pdf">https://www.sifma.org/wp-content/uploads/2017/08/MRA_Agreement.pdf</a>.
In this release, the term ``seller'' refers to the party selling
U.S. Treasury securities on the start leg of the transaction and
repurchasing them on the end leg of the transaction. The term
``buyer'' refers to the party purchasing the U.S. Treasury
securities on the start leg of the transaction and selling them on
the end leg of the transaction.
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In the Proposing Release, the Commission stated that the available
data indicates that the volume of repo transactions that are
bilaterally cleared and settled remains substantial.\75\ Because of
this, FICC lacks visibility into its members' non-centrally cleared
repo trades, and the default of one counterparty can have cascading
effects on multiple other market participants, including members of
FICC, thereby risking contagion to the CCP.
---------------------------------------------------------------------------
\75\ Proposing Release, supra note 14, 87 FR 64616 (citing 2021
IAWG Report, supra note 4, at 29 (stating that non-centrally cleared
bilateral repo represents a significant portion of the market,
roughly equal in size to centrally cleared repo) (citing a 2015
pilot program by the Treasury Department); TMPG, Clearing and
Settlement Practices for Treasury Secured Financing Transactions
Working Group Update (``TMPG Repo White Paper''), at 1 (Nov. 5,
2021), available at <a href="https://www.newyorkfed.org/medialibrary/Microsites/tmpg/files/CSP_SFT_Note.pdf">https://www.newyorkfed.org/medialibrary/Microsites/tmpg/files/CSP_SFT_Note.pdf</a>; Katy Burne, ``Future
Proofing the Treasury Market,'' BNY Mellon Aerial View, at 7 (Nov.
2021), available at <a href="https://www.bnymellon.com/content/dam/bnymellon/documents/pdf/aerial-view/future-proofing-the-us-treasury-market.pdf.coredownload.pdf">https://www.bnymellon.com/content/dam/bnymellon/documents/pdf/aerial-view/future-proofing-the-us-treasury-market.pdf.coredownload.pdf</a> (noting that 63% of repo transactions
remain non-centrally cleared according to Office of Financial
Research data as of Sept. 10, 2021); Sebastian Infante et al.,
Insights from revised Form FR2004 into primary dealer securities
financing and MBS activity (Aug. 5, 2022), available at <a href="https://www.federalreserve.gov/econres/notes/feds-notes/insights-from-revised-form-fr2004-into-primary-dealer-securities-financing-and-mbs-activity-20220805.htm">https://www.federalreserve.gov/econres/notes/feds-notes/insights-from-revised-form-fr2004-into-primary-dealer-securities-financing-and-mbs-activity-20220805.htm</a> (recent research with respect to primary
dealers indicates that 38% of their repo and 60% of their reverse
repo activity is not centrally cleared, and, overall, that 20% of
all their repo and 30% of their reverse repo activity is centrally
cleared through FICC)).
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The Commission also stated its belief that, particularly with
respect to banks and dealers, an important potential benefit of repo
central clearing stems from mitigating the constraints on
intermediaries' balance sheets under the existing accounting and
regulatory capital rules.\76\ The Commission further stated that it
believes that the benefit of this resulting additional balance sheet
capacity could be shared by all market participants through improved
market liquidity and smooth market functioning.\77\
---------------------------------------------------------------------------
\76\ In effect, accounting rules allow purchases and sales of
the same security to be netted but do not allow repos of the same
security to be netted, unless the repos are with the same
counterparty and the trades have been documented under a master
netting agreement. See, e.g., Proposing Release, supra note 14, 87
FR 64621 (citing G-30 Report, supra note 5, at 13; Program on
International Financial Systems, Mandatory Central Clearing for U.S.
Treasuries and U.S. Treasury Repos, at 25-27 (Nov. 2021), available
at <a href="https://www.pifsinternational.org/wp-content/uploads/2021/11/PIFS-Mandatory-Central-Clearing-for-U.S.-Treasury-Markets-11.11.2021.pdf">https://www.pifsinternational.org/wp-content/uploads/2021/11/PIFS-Mandatory-Central-Clearing-for-U.S.-Treasury-Markets-11.11.2021.pdf</a> (``PIFS Paper'')). Thus, if a dealer's repos are all
with a U.S. Treasury securities CCA, greater netting is allowed.
\77\ See Committee on the Global Financial System, Repo Market
Functioning, at 24 (Apr. 2017), available at <a href="https://www.bis.org/publ/cgfs59.pdf">https://www.bis.org/publ/cgfs59.pdf</a>.
---------------------------------------------------------------------------
The Commission also referenced that, as with cash markets, risk
management practices in the bilateral clearance and settlement of repos
are not uniform across market participants and are not transparent.\78\
Indeed, a recent publication stated that competitive pressures in the
bilaterally settled market for repo transactions have exerted downward
pressure on haircuts, sometimes to zero.\79\ The reduction of haircuts,
which serve as a counterparty credit risk mitigant in bilateral repos,
could result in greater exposure to potential counterparty default risk
in non-centrally cleared repos. The Commission stated that by contrast,
a U.S. Treasury securities CCA is subject to the Commission's risk
management requirements addressing financial, operational, and legal
risk management, which include, among other things, margin requirements
commensurate with the risks and particular attributes of each relevant
product, portfolio, and market.\80\ Therefore, repos cleared at a U.S.
Treasury securities CCA would be subject to transparent risk management
standards that are publicly available and
[[Page 2724]]
applied uniformly and objectively to all participants in the CCA.
---------------------------------------------------------------------------
\78\ TMPG Repo White Paper, supra note 75, at 1.
\79\ G-30 Report, supra note 5, at 13.
\80\ 17 CFR 240.17ad-22(e)(6).
---------------------------------------------------------------------------
Many commenters supported the definition of an eligible secondary
market transaction as it relates to repo and reverse repo
transactions.\81\ These commenters encouraged a broad and comprehensive
definition to limit market fragmentation and avoidance of central
clearing. Several other commenters that did not support a requirement
to clear eligible secondary market transactions still acknowledged that
repos were the most appropriate scope for such a requirement if one
were to be adopted. For example, one commenter agreed that a clearing
mandate applied to bilateral repo transactions would be beneficial,
pointing to the balance sheet efficiency resulting from repo clearing,
but stressing that this requirement be put in place only after the
Commission has strengthened the ability for market participants to
access central clearing.\82\ Another commenter stated that while the
case for clearing repos is ``marginally stronger'' than the case for
clearing cash transactions, it is ``far from convincing.'' \83\
---------------------------------------------------------------------------
\81\ See Letter from Jir[iacute] Kr[oacute]l, Deputy CEO, Global
Head of Government Affairs, Alternative Investment Management
Association, at 6-7 (Dec. 22, 2022) (``AIMA Letter''); AFREF Letter,
supra note 33, at 3; see generally Better Markets Letter, supra note
33; DTCC/FICC Letter, note 33; Letter from Ryan Sheftel, Global Head
of Fixed Income, GTS Securities, LLC (Jan. 6, 2023) (``GTS
Securities Letter''); LSEG Letter, supra note 33; Letter from ARB
Trading Group LP, Citadel Securities, DRW Holdings, LLC, Eagle Seven
LLC, Geneva Trading USA, LLC, Hard Eight Futures, LLC, Hudson River
Trading LLC, IMC Trading, Jump Trading Group, Kore Trading LLC,
Optiver, Quantlab Financial, LLC, WH Trading LLC, and XR Trading
LLC, at 4 (Dec. 27, 2022) (``ARB et al. Letter''); Letter from
Manfred E. Will, Founder & CEO, MEW Consul (Oct. 24, 2022); Letter
from Shiv Rao, Chairman, Sunthay Holdings LLC, at 2 (Dec. 27, 2022);
and Letter from Elisabeth Kirby, Head of U.S. Market Structure,
Tradeweb Markets Inc. (Dec. 27, 2022). One commenter, while broadly
supporting the definition of an eligible secondary market repo and
reverse repo transaction, recommended excluding Derivatives Clearing
Organizations (``DCO'') registered with the CFTC. See Letter from
Jonathan Marcus, Senior Managing Director and General Counsel, CME
Group Inc., at 6-7 (Dec. 27, 2022) (``CME Letter'') and part
II.A.2.iii infra. Other commenters, while broadly supporting the
definition, recommended excluding transactions executed on the
triparty repo platform. See Letter from Stephen John Berger,
Managing Director, Global Head of Government & Regulatory Policy,
Citadel and Citadel Securities (Dec. 27, 2022) (``Citadel Letter''),
Letter from Jennifer W. Han, Executive Vice President, Chief Counsel
& Head of Global Regulatory Affairs, Managed Funds Association at 6,
14 (Dec. 21, 2022) (``MFA Letter''), and part II.A.2.i infra.
\82\ MFA Letter, supra note 81, at 13 (supporting inclusion of
bilateral repo and reverse repo).
\83\ SIFMA AMG Letter, supra note 35, at 11.
---------------------------------------------------------------------------
Other commenters questioned the need for a requirement with respect
to repo, noting that the balance sheet netting efficiencies already
exist, providing a natural incentive to centrally clear such
transactions.\84\ The Commission agrees that centrally cleared repo
already benefits from favorable treatment on balance sheet, but also
recognizes that, by definition, a requirement to clear repo
transactions should result in more transactions being centrally
cleared. Thus, there would still be benefits from the requirement,
despite the currently existing balance sheet treatment, as discussed
further in part IV.C.1.a.ii.
---------------------------------------------------------------------------
\84\ See, e.g., SIFMA AMG Letter, supra note 35, at 4; SIFMA-IIB
Letter, supra note 37, at 4.
---------------------------------------------------------------------------
In addition, some commenters supported excluding particular types
of repos from the definition, and other commenters supported excluding
particular types of market participants engaging in repos from the
definition. The Commission discusses these comments in the following
parts.
i. Triparty Repo
Several commenters supported excluding triparty repos from the
definition of an eligible secondary market transaction.\85\ One
commenter suggested that the cost of including triparty repos would
outweigh the benefits, and other commenters raised similar
concerns.\86\ The discussion of additional costs and benefits arising
from the inclusion of triparty repos within the definition of an
eligible secondary market transaction is provided in part IV.C.2 infra.
Several commenters argued that including triparty repos would not
significantly reduce the risks that the proposal seeks to address
because the current triparty market infrastructure inherently mitigates
the associated risks.\87\ Specifically, these commenters argue that
credit risk in the triparty market is mitigated by the triparty agent's
provision of custodial, collateral management, and settlement
services.\88\
---------------------------------------------------------------------------
\85\ See MFA Letter, supra note 81, at 6, 14; SIFMA-IIB Letter,
supra note 37, at 20-21; SIFMA AMG Letter, supra note 35, at 6, 11;
Letter from Sarah A. Bessin, Deputy General Counsel, and Nhan
Nguyen, Assistant General Counsel, Investment Company Institute at
22-23 (Dec. 23, 2022) (``ICI Letter''); Citadel Letter, supra note
81, at 6; Letter from Deborah A. Cunningham, Executive Vice
President, Chief Investment Officer of Global Liquidity Markets, and
Senior Portfolio Manager, Susan R. Hill, Senior Vice President,
Senior Portfolio Manager and Head of Government Liquidity, and David
R. McCandless, Corporate Counsel, Federated Hermes at 5 (Dec. 28,
2022) (``Federated Letter''); Letter from Sebastian Crapanzano,
Managing Director, Morgan Stanley, at 2 (Nov. 15, 2023) (``Morgan
Stanley Letter'').
\86\ See MFA Letter, supra note 81, at 6, 14; see also SIFMA/IIB
Letter, supra note 37, at 20; ICI Letter, supra note 85, at 11;
Federated Letter, supra note 85, at 5.
\87\ See MFA Letter, supra note 81, at 14; SIFMA/AMG Letter,
supra note 35, at 11; ICI Letter, supra note 85, at 12, 22; Citadel
Letter, supra note 81, at 6; Federated Letter, supra note 85, at 5.
\88\ See id.
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Moreover, one commenter stated that the infrastructure underlying
the triparty repo market is robust and provides credit protections,
operational safeguards, and strict internal controls akin to central
clearing.\89\ One commenter stated that the triparty agent's ability to
handle the settlement of triparty repos through its collateral
allocation system has resulted in a well-functioning process that
operates under severe time constraints.\90\ One commenter added that
the triparty market is relatively safe from credit risk because the
triparty agent is subject to prudential regulation.\91\ One commenter
added that settlement risk in the triparty market is nearly eliminated
because collateral posted to the triparty platform cannot generally be
repledged outside the platform.\92\ The commenter stated, therefore,
that the only significant source of settlement risk is the rare
occurrence of a counterparty's nonpayment of the repurchase price,
which is generally attributable to operational risk as opposed to
credit risk.\93\ Another commenter stated that these types of triparty
repos, described as secured funding transactions where the funding
counterparty has no rehypothecation rights, do not appear to raise
concerns discussed in the proposal regarding the use of transactions to
generate leverage that would warrant imposition of the requirement to
clear eligible secondary market transactions.\94\
---------------------------------------------------------------------------
\89\ See ICI Letter, supra note 85, at 22.
\90\ See Federated Letter, supra note 85, at 3.
\91\ See MFA Letter, supra note 81, at 14.
\92\ See Federated Letter, supra note 85, at 5.
\93\ See Federated Letter, supra note 85, at 5.
\94\ Morgan Stanley Letter, supra note 85, at 2.
---------------------------------------------------------------------------
Despite supporting the exclusion of triparty repos from the
definition of an eligible secondary market transaction, one commenter
acknowledged that the triparty agent ``does not fulfill a CCP role--it
does not guarantee either counterparty's performance through novation
or otherwise and does not assume counterparty risk.'' \95\ For this
reason, triparty repos will not be excluded from the definition of an
eligible secondary market transaction.
---------------------------------------------------------------------------
\95\ ICI Letter, supra note 85, at 33.
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The Commission recognizes that the current triparty market
infrastructure incorporates credit protections, operational safeguards,
and strict internal controls. The Commission also recognizes that the
triparty agent's current processes for handling the settlement of
triparty repos generally
[[Page 2725]]
function well. However, the triparty agent does not serve as a central
counterparty, meaning that it does not guarantee either counterparty's
performance through novation or assume counterparty risk, and
therefore, the Commission disagrees with the contention that the
current market infrastructure incorporates controls equivalent to those
available through central clearing. The Commission recognizes that the
triparty agent is subject to heightened prudential regulation.\96\
However, the triparty agent is not subject to regulatory supervision as
a CCP, which entails additional protections against the risk of many
market participants acting to liquidate similar collateral in the event
of a default in a non-centrally cleared environment. A U.S. Treasury
securities CCA is subject to the Commission's risk management
requirements addressing financial, operational, and legal risk
management, which include, among other things, margin requirements
commensurate with the risks and particular attributes of each relevant
product, portfolio, and market and also include certain requirements
applicable only to covered clearing agencies that are serving as
central counterparties.\97\ In contrast, a triparty agent is not
equipped with a mechanism to manage the risk of collateral fire-sale in
the aftermath of a counterparty default.\98\ As a result, a U.S.
Treasury securities CCA is better positioned to handle a large,
unexpected default than a triparty agent. The possibility that a direct
participant in a U.S. Treasury securities CCA with large, unsettled
trading volumes (bilateral or triparty) could fail creates contagion
risk to the CCA, as well as to the market as a whole. This rulemaking
is designed to ameliorate that contagion risk, at least in part.
Accordingly, the Commission does not believe that the current triparty
market infrastructure alone mitigates the aforementioned contagion risk
sufficiently to warrant excluding triparty repos from the definition of
an eligible secondary market transaction. In response to the commenter
who stated that most risks are eliminated because collateral cannot be
posted outside the triparty platform, the Commission disagrees.
Significant risks exist if concerns emerge regarding the financial
condition of sellers in the triparty market.\99\ In such scenarios,
even though collateral stays within the triparty platform, the buyer
could still experience distress following a sudden default of a
triparty repo counterparty.\100\ For example, a triparty repo default
may leave a money market fund holding long-dated Treasury securities
collateral, which may cause the money market fund to no longer meet
requirements under rule 2a-7 relating to the weighted average life to
maturity of the fund's portfolio.\101\ A spike in market volatility
accompanying an event of default and potential collateral liquidation
activity by buyers could cause liquidity stress for the financial
system leading to decline in collateral value even for the most
creditworthy assets such as U.S. Treasury securities. A U.S. Treasury
securities CCA is better positioned to manage a repo counterparty
default by employing a range of available pre-funded resources without
reliance on repo collateral liquidation.\102\ In contrast, the triparty
platform is not designed to manage risks associated with a repo
counterparty default and a potential collateral liquidation following
the default. In a triparty repo transaction, the triparty custodian
bank holds the collateral on behalf of the buyer. However, the buyer is
responsible for initiating and managing the collateral liquidation
process, including Treasury securities, if the liquidation is
necessary.\103\
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\96\ The triparty agent is supervised and/or regulated by, among
others, New York State Department of Financial Services, and the
Federal Reserve Bank of New York. See <a href="https://www.bnymellon.com/us/en/disclaimers/business-disclaimers">https://www.bnymellon.com/us/en/disclaimers/business-disclaimers</a>. Additionally, the triparty
agent is designated as a Global Systemically Important Bank by the
Financial Stability Board. See <a href="https://www.fsb.org/wp-content/uploads/P211122.pdf">https://www.fsb.org/wp-content/uploads/P211122.pdf</a>.
\97\ 17 CFR 240.17ad-22(e)(6).
\98\ See, e.g, Brian Begalle et al., The Risk of Fire Sales in
the Tri-Party Repo Market, N.Y. Fed Staff Report No. 616 (``Begalle
et al.''), at 9-14, available at, <a href="https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr616.pdf">https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr616.pdf</a>.
\99\ See 2013 Annual Report of the Financial Stability Oversight
Council, at 4, 12-13, 133-134, available at <a href="https://home.treasury.gov/system/files/261/FSOC-2013-Annual-Report.pdf">https://home.treasury.gov/system/files/261/FSOC-2013-Annual-Report.pdf</a>
(``FSOC 2013 Annual Report''); Begalle et al., supra note 98
(discussing concern that stress caused by a potential default of a
triparty repo counterparty can lead to either pre-default fire sales
of assets by the counterparty or post-default fire sales of
collateral by the triparty repo investor and the related financial
stability concerns). See also 2019 Annual Report of the Financial
Stability Oversight Council, at 11, available at <a href="https://home.treasury.gov/system/files/261/FSOC2019AnnualReport.pdf">https://home.treasury.gov/system/files/261/FSOC2019AnnualReport.pdf</a>
(highlighting that the possibility of fire sales of collateral by
creditors of a defaulted counterparty in the triparty repo market
remains a financial system vulnerability despite the triparty repo
infrastructure reform).
\100\ See FSOC 2013 Annual Report, supra note 99, at 12-13
(recognizing that a major broker-dealer's default could threaten
financial stability as the broker-dealers' creditors liquidate the
collateral pledged against their tri-party repo lending, with the
fire sales of this collateral potentially destabilizing financial
markets and amplifying the negative consequences of such a default).
\101\ See 17 CFR 270.2a-7(d)(1). In addition, the money market
fund holding the collateral may cause liquidity concerns under rule
2a-7. See 17 CFR 270.2a-7(d)(4).
\102\ 17 CFR 240.17ad-22(e)(13).
\103\ Baklanova, et al., Reference Guide to U.S. Repo and
Securities Lending Markets, OFR Working Paper No15-17 (Sept. 2015),
available at: <a href="https://www.financialresearch.gov/working-papers/files/OFRwp-2015-17_Reference-Guide-to-U.S.-Repo-and-Securities-Lending-Markets.pdf">https://www.financialresearch.gov/working-papers/files/OFRwp-2015-17_Reference-Guide-to-U.S.-Repo-and-Securities-Lending-Markets.pdf</a>.
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One commenter argued that including triparty repos in the
definition of an eligible secondary market transaction would likely
impair the cash and collateral management processes of hedge funds and
alternative asset managers.\104\ Specifically, the commenter suggested
that such firms currently conduct same-day bilateral transactions that
they would not be able to conduct with a direct participant of a U.S.
Treasury securities CCA required to centrally clear its repo
transactions.\105\ Similarly, another commenter argued that including
triparty repos would prevent participants, such as money market funds,
from conducting transactions on a short term (i.e., overnight) basis
when U.S. Treasury securities CCAs are at full capacity.\106\
---------------------------------------------------------------------------
\104\ See MFA Letter, supra note 81, at 17.
\105\ See id.
\106\ See ICI Letter, supra note 85, at 12, 22.
---------------------------------------------------------------------------
The Commission disagrees with these commenters. In its supervisory
capacity, the Commission is aware that registered funds, hedge funds,
and alternative asset managers currently conduct centrally cleared
triparty repo transactions. For example, the Commission is aware that
numerous hedge funds conduct such same-day transactions as sponsored
members of FICC. Therefore, the existing operational infrastructure
supports centrally cleared triparty repo transactions. The FICC
novation window for all delivery-versus-payment trades, including the
sponsored repo service, remains open until 8 p.m. (ET) and therefore is
available for a later-day trading.\107\ Additionally, the Commission
disagrees that there is a finite ``full capacity'' at a U.S. Treasury
securities CCA. The Commission understands that increased demand for a
CCA service may lead to a higher volume of trading activity by existing
members and, in certain circumstances, reduce members' ability or
willingness to facilitate their clients' access to central clearing, if
such members do not wish to grow this line of business. However, higher
demand for access to central clearing could also present an opportunity
for dealers that
[[Page 2726]]
do not currently offer such services to enter the market, resulting in
growing CCA capacity, more competition among its members, and a wider
range of available repo counterparties. The Commission also understands
that the existing U.S. Treasury securities CCA may consider, as
appropriate, additional changes to their operational infrastructure and
trading capacity, including revisions to the eligibility criteria for
sponsored membership and an extension of the trade submission and
novation windows later in the day,\108\ to enhance their ability to
accommodate any increase in the volume of centrally cleared triparty
repo transactions resulting from this rulemaking.
---------------------------------------------------------------------------
\107\ See DTCC, Looking to the Horizon: Assessing a Potential
Expansion of U.S. Treasury Central Clearing, Sept. 2023 (``DTCC 2023
White Paper''), available at <a href="https://www.dtcc.com/-/media/Files/Downloads/WhitePapers/Accessing-Potential-Expansion-US-Treasury-Clearing-White-Paper.pdf">https://www.dtcc.com/-/media/Files/Downloads/WhitePapers/Accessing-Potential-Expansion-US-Treasury-Clearing-White-Paper.pdf</a>.
\108\ Id.
---------------------------------------------------------------------------
One commenter expressed concern that the centrally cleared triparty
repo market has only been available since 2021 and is therefore,
relatively untested.\109\ Therefore, the commenter suggested that the
Commission should delay its decision whether to include triparty repos
in the definition of an eligible secondary market transaction until
after the Commission has had an opportunity to evaluate the
effectiveness of the centrally cleared triparty repo
infrastructure.\110\ The Commission disagrees. While FICC expanded its
Sponsored Service in 2021 to enable sponsored members (e.g., registered
funds) to conduct centrally cleared triparty repo transactions,\111\
FICC has been facilitating such transactions for its direct
participants via the General Collateral Finance (``GCF'') Repo Service
since 1998.\112\ Additionally, although the expanded Sponsored Service
is relatively new, the infrastructure is operational, and its usage
appears to be increasing. Data provided by the Federal Reserve show a
significant increase in the gross value of Treasury securities traded
in GCF Repo since March 2020.\113\ Additionally, as stated above, the
Commission understands that the U.S. Treasury securities CCA is
consulting with market participants and is considering steps to further
enhance its operational infrastructure to support any increase in the
volume of centrally cleared triparty repo transactions resulting from
this rulemaking.\114\
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\109\ See MFA Letter, supra note 81, at 12, 14.
\110\ See id.
\111\ Securities Exchange Act Release No. 92799 (Aug. 27, 2021),
86 FR 49387 (Sept. 2, 2021) (SR-FICC-2021-801); Securities Exchange
Act Release No. 92014 (May 25, 2021), 86 FR 29334 (June 1, 2021)
(SR-FICC-2021-003).
\112\ Securities Exchange Act Release No. 40623 (Oct. 30, 1998),
63 FR 59831 (Nov. 5, 1998) (SR-GSCC-98-02).
\113\ Federal Reserve, GCF Repo (showing that the daily snapshot
of the Treasury securities value traded in the GCF repo segment was
under $120 billion on Mar. 10, 2020. The value reported on June 9,
2023 was over $320 billion, which includes sponsored activity),
available at <a href="https://www.newyorkfed.org/data-and-statistics/data-visualization/tri-party-repo#interactive/tripartygcf">https://www.newyorkfed.org/data-and-statistics/data-visualization/tri-party-repo#interactive/tripartygcf</a>.
\114\ See DTCC 2023 White Paper, supra note 107.
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Finally, commenters argued for the exclusion from the definition of
an eligible secondary market transaction of triparty repos involving
purchased securities that include both Treasury CUSIPs and securities
with other CUSIPs or where permitted substitution may be made in CUSIPs
other than Treasury CUSIPs. According to the commenters, the fact that
some CUSIPs in a mixed triparty repo are U.S. Treasury security CUSIPs
should not bring that transaction into the definition of an eligible
secondary market transaction if it were of a type that is entered into
in the ordinary course of business or otherwise in connection with a
legitimate business purpose. The commenters stated that without such an
exemption, the definition of an eligible secondary market transaction
could scope in transactions of which U.S. Treasury securities only
represent a small component, which would exceed the regulatory
objective behind the proposal, and stated that such transactions do
have margin collected.\115\
---------------------------------------------------------------------------
\115\ See SIFMA/IIB Letter, supra note 37, at 20-21; Letter from
Jiri Krol, Deputy CEO, Global Head of Government Affairs,
Alternative Investment Management Association (Oct. 20, 2023) at 3
(``AIMA Letter II''); see also Citadel Letter, supra note 81, at 6
(supporting that the Commission exclude triparty repos at this
stage, noting that they may include both Treasury and non-Treasury
securities as collateral).
---------------------------------------------------------------------------
The Commission understands that market participants may use U.S.
Treasury securities as permissible substitutions for other types of
collateral and generally should not consider mixed CUSIP triparty repos
resulting from such a permissible substitution as within the scope of
part (i) of the definition of an eligible secondary market transaction.
Collateral substitution allows a repo seller to complete trade
settlement even if the type of collateral securities agreed upon at the
time of trade initiation is no longer available. Typically, Treasury
securities or cash can be permissible substitution.\116\ However, to
the extent that a mixed CUSIP triparty repo contains U.S. Treasury
CUSIPs from the outset of the transaction, such a transaction would be
included in the scope of part (i) of the definition of an eligible
secondary market transaction. An exclusion for such transactions is not
necessary because the counterparties specifically structured the
transaction to include U.S. Treasury securities; therefore, such a
transaction is within the scope of the definition. Data submitted by
money market funds on Form N-MFP shows that the holdings reported as
U.S. Government Agency Repurchase Agreements are typically
collateralized by U.S. government agency securities and are also
partially collateralized by Treasury securities.\117\ Collateral
management practices may evolve to better delineate collateral types in
light of the definition of an eligible secondary market transaction.
---------------------------------------------------------------------------
\116\ For example, money market fund filings of portfolio data
show that, on average, Treasury securities account for around 3% of
collateral backing investments in non-government repos.
\117\ Money market fund filings of portfolio data show that, on
average, Treasury securities account for around 20% of collateral
backing investments in U.S. government agency repos.
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ii. Repos by Registered Funds
Registered investment companies, or registered funds, that is,
those entities that are registered under the Investment Company Act of
1940 (``1940 Act''), including money market funds and exchange-traded
funds, are important participants in the U.S. Treasury repo market.
Filings of Form N-MFP by money market funds show that, as of September
30, 2023, these funds invested approximately $2.2 trillion in Treasury
repos.\118\ In addition, mutual funds invested $37 billion in
repurchase agreements, including those backed by Treasury
securities.\119\ Generally, commenters acknowledged that central
clearing of Treasury repos and reverse repos through the FICC Sponsored
Service, which has been available to registered funds since 2005,
provides additional collateral supply.\120\ FICC data shows that at the
end of November 2023, the daily volume of sponsored ``delivery-versus-
payment'' Treasury repo activity was approximately $820 billion, while
the daily volume of sponsored activity in the triparty GCF repo was
close to $130 billion.\121\
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\118\ Of this amount, approximately $1.5 trillion was invested
in the Federal Reserve's overnight reverse repo facility. See U.S.
Securities and Exchange Commission, Money Market Fund Statistics
(Sept. 2023), available at <a href="https://www.sec.gov/divisions/investment/mmf-statistics">https://www.sec.gov/divisions/investment/mmf-statistics</a>. Repo transactions with the central bank are excluded
from the scope of Eligible Secondary Market Transactions.
\119\ Federal Reserve, Financial Accounts of the United States,
Table L.207 Federal Funds and Security Repurchase Agreements (2023
Q2).
\120\ ICI Letter, supra note 85, at 13; Federated Letter, supra
note 85, at 2; DTCC/FICC Letter, supra note 33, at 17.
\121\ See DTCC, Sponsored DVP and Sponsored GC Activity,
available at <a href="https://www.dtcc.com/charts/membership">https://www.dtcc.com/charts/membership</a>, which also
shows data over a longer timeframe for reference.
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[[Page 2727]]
Several commenters stated that they did not support including repo
transactions with registered funds as a counterparty in the definition
of an eligible secondary market transaction, which, as proposed, would
include repo transactions with all counterparties.\122\ One commenter
stated that the Commission should not, at this time, require that repos
between a fund and a direct participant of a U.S. Treasury securities
CCA be subject to a clearing requirement because the current clearing
framework is not sufficiently developed to support such a mandate.\123\
The commenter identified several issues to be addressed prior to
adopting such a requirement, which are discussed in the following
paragraphs.
---------------------------------------------------------------------------
\122\ ICI Letter, supra note 85, at 12-28; Federated Letter,
supra note 85, at 2-6.
\123\ ICI Letter, supra note 85, at 12.
---------------------------------------------------------------------------
First, the commenter stated that the Commission should encourage
FICC to enhance its Sponsored Service in several ways, to address
regulatory, structural, and operational issues raised by the proposal.
The commenter stated that the Commission should encourage FICC to
further develop a ``give up'' structure to facilitate best execution.
The commenter described this as a ``critically important step'' to
incentivize voluntary clearing, because it would generate increased
competition among market participants, which may result in more
efficient pricing. The commenter also stated that a ``give up''
structure would be essential under a requirement to centrally clear
eligible secondary market transactions because the Sponsored Service
may not be able to meet the increased capacity requirements due to the
limited number of sponsoring members and the increased demand for
sponsored clearing under such a requirement. The commenter suggested
that the infrastructure currently used by FICC for prime brokerage
clearing could be leveraged to develop a give up model, stating that
any such model will need to provide for standardized documentation that
facilitates additions and deletions of approved brokers, agreed-upon
terms for rejection of trades by a sponsoring member, and centralized
storage of delegation.\124\
---------------------------------------------------------------------------
\124\ ICI Letter, supra note 85, at 13-14.
---------------------------------------------------------------------------
The commenter requested that the SEC encourage FICC to establish a
feature allowing (but not requiring) registered fund sponsored members
to support their obligations by having margin posted with FICC (``FICC
registered fund margin arrangement'') rather than by paying fees to the
sponsoring member.\125\ FICC's rules currently provide that each
sponsoring member must make a deposit to FICC's Clearing Fund based on
the activity of its sponsored members.\126\ The contributions of all
Netting Members, including those that are sponsoring members, are
commingled in the Clearing Fund and are available to FICC for, among
other things, securing members' obligations and providing liquidity to
meet its settlement obligations.\127\ While the commenter stated that
the Sponsored Service under current FICC rules does not raise custody
issues for registered funds under the 1940 Act because registered funds
are not required to post margin to FICC, if a fund's margin were
permitted to be posted with FICC, that could raise custody issues for
funds unless such funds receive relief from certain provisions of the
1940 Act.\128\ The commenter stated that permitting registered funds'
margin to be posted with FICC could reduce costs for registered funds
and facilitate their use of cleared reverse repos and term repos.\129\
The commenter also stated that the final rule should require FICC to
establish margin rules that ensure that margin is held in a segregated
manner, not commingled with any direct participant's house margin, and
not be subject to loss mutualization associated with other direct
participants.\130\ Finally, the commenter stated that in order to
address concerns regarding the security of registered fund assets under
a Treasury repo clearing mandate, FICC rules addressing margin posting
would need to be amended to provide for enhanced recordkeeping,
internal controls, and transparency around the positions and related
margin.\131\
---------------------------------------------------------------------------
\125\ ICI Letter, supra note 85, at 14; Letter from Jennifer W.
Han, Executive Vice President, Chief Counsel & Head of Global
Regulatory Affairs, Managed Funds Association (Dec. 4, 2023), at 4
(``MFA Letter II''). See also MFA Letter, supra note 81, at 7
(noting that ``an indirect participant should have the ability
(although not the obligation) to fund the margin obligations of the
direct participant clearing on its behalf which are attributable to
the indirect participant. In such case, the margin posted by the
indirect participant should be segregated from the direct
participant's house margin, and it should not be subject to loss
mutualization vis-[agrave]-vis other direct participants. Given that
many indirect participants have fiduciary obligations to their own
clients, it is crucial that indirect participants are able to post
margin on a segregated basis such that their clients are not subject
to the credit risk of others (and, likewise, that their funds are
not subject to loss mutualization).''); SIFMA/IIB Letter, supra note
37, at 12-13 (noting that ``it will be difficult to support
expanding cleared trading in U.S. Treasury securities until we have
a framework which ensures customers can access clearing solutions
where their margin and collateral will be adequately protected,
including from loss mutualization by the clearing agency'').
\126\ FICC Rule 3A, section 10, supra note 19.
\127\ FICC Rule 4, supra note 19.
\128\ Section 17(f) of the 1940 Act (providing that ``[e]very
registered management company shall place and maintain its
securities and similar investments in the custody of (A) a bank or
banks having the qualifications prescribed in paragraph (1) of
section 26(a) of this title for the trustees of unit investment
trusts; or (B) a company which is a member of a national securities
exchange as defined in the Securities Exchange Act of 1934, subject
to such rules and regulations as the Commission may from time to
time prescribe for the protection of investors; or (C) such
registered company, but only in accordance with such rules and
regulations or orders as the Commission may from time to time
prescribe for the protection of investors.''). See also rule 17f-1
under the 1940 Act (permitting registered funds to custody assets
with a member of a national securities exchange as defined in the
1934 Act pursuant to certain conditions).
\129\ ICI Letter, supra note 85, at 14.
\130\ Id.
\131\ See id. (``Enhanced recordkeeping and related controls are
critical to appropriately identifying ownership of assets during a
Treasury repo or reverse repo transaction particularly since, unlike
a typical derivates or cash transaction, ownership of the Treasury
securities underlying a repo or reverse repo change owners during
the transaction.'').
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In order to support a clearing requirement for eligible secondary
market transactions, the Commission is taking the position that, for a
period of five years, registered funds utilizing such an arrangement in
a manner consistent with the circumstances described below would not
provide a basis for enforcement action under Section 17(f) of the 1940
Act. The Commission takes this position to recognize the unique
circumstances facing registered funds in the context of entering into
eligible secondary market transactions using FICC's Sponsored Program.
Our staff has previously stated that it would not recommend
enforcement action under the custody provisions of the 1940 Act in the
context of certain registered fund trading activities.\132\ For
example, the staff issued the Delta Letter in connection with Delta's
options clearing service, which provided assurances that the staff
would not recommend enforcement action under
[[Page 2728]]
Section 17(f) of the 1940 Act if registered investment companies
deposited margin with Delta.\133\ One representation in the Delta
Letter was that Delta was permitted to withdraw the margin provided
``only upon the investment company's default on the option contract.''
\134\ Other previous staff no-action positions have been provided in
different contexts. In one such no-action position, FICC represented
that a registered fund's margin would not be used to cover another
client's default and segregating fund assets from the custodian's
proprietary assets and other customers' assets.\135\ These types of
features would help protect fund client assets consistent with the 1940
Act under the FICC registered fund margin arrangement, and we have
included similar types of features for purposes of our position that
follows below.
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\132\ See e.g., Delta Government Options Corp. No-Action Letter
(pub. avail. Sept. 27, 1990) (``Delta Letter''); cf. CME Group, Inc.
No-Action Letter (pub. avail. Dec. 19, 2017); FICC No-Action Letter
(pub. avail. Mar. 13, 2003) (``FICC 2003 Letter''). In the FICC
Letter, the staff observed certain operational features of FICC's
Mortgage-Backed Securities Division (``MBSD''), which differ from
the current circumstances of FICC's Government Securities Division,
such as registered funds being direct participants in MBSD's
clearing scheme and participant trades not being novated to MBSD.
Any staff statements cited represent the views of the staff. They
are not a rule, regulation, or statement of the Commission.
Furthermore, the Commission has neither approved nor disapproved
their content. These staff statements, like all staff statements,
have no legal force or effect: they do not alter or amend applicable
law; and they create no new or additional obligations for any
person.
\133\ Delta Letter.
\134\ Id.
\135\ See FICC 2003 Letter.
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While the final rules do not require registered funds' margin to be
posted with FICC, and no current U.S. Treasury securities CCA has rules
imposing such a requirement, as discussed above, a commenter requested
that the Commission encourage FICC to establish a FICC registered fund
margin arrangement.\136\ The Commission agrees that facilitating the
ability for a registered fund's margin to be posted at FICC as an
alternative to the sponsoring member posting the margin and passing the
cost of doing so through to the registered fund may lower the cost of
trading for the fund, and the Commission position below will help
facilitate the posting of registered fund margin \137\ to satisfy a
U.S. Treasury securities CCA's margin deposit requirements.
---------------------------------------------------------------------------
\136\ See ICI Letter, supra note 85, at 14.
\137\ The Commission position is intended to address certain
considerations under the 1940 Act specific to registered funds.
Other types of buy-side participants may have different
considerations to address in connection with their participation in
the Sponsored Program beyond the scope of the 1940 Act.
---------------------------------------------------------------------------
Specifically, the Commission takes the position that, for a period
of five years beginning on the effective date of this adopting release,
if a registered investment fund's cash and/or securities are placed and
maintained in the custody of FICC for purposes of meeting FICC's margin
deposit requirements that may be imposed for eligible secondary market
transactions in connection with the fund's participation in the
Sponsored Program, it would not provide a basis for enforcement action
under Section 17(f) of the 1940 Act so long as: \138\
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\138\ To the extent a registered fund becomes aware that its
custodial arrangement is no longer consistent with the FICC
registered fund margin framework, the registered fund may not
utilize the FICC registered fund margin framework to enter into
eligible secondary market transactions.
---------------------------------------------------------------------------
<bullet> FICC withdraws the margin provided by a sponsored member
registered fund only upon that registered fund's default; \139\
---------------------------------------------------------------------------
\139\ For the avoidance of doubt, FICC may only withdraw margin
provided by a registered fund in the event that the registered fund
defaults on a transaction that has been novated to FICC.
---------------------------------------------------------------------------
<bullet> The margin provided by a registered fund is not commingled
with, and is kept separate from, FICC's assets; \140\
---------------------------------------------------------------------------
\140\ See FICC Letter; see also Institutional Equity Fund No-
Action Letter (pub. avail. Feb. 27, 1984) (stating that the staff
would not recommend enforcement action under Section 17(f) of the
1940 Act if, among other things, the assets of a registered fund
participating in the Options Clearing Corporation's program were
held in a ``non-proprietary account at OCC which does not include
any assets held by the Clearing Member agent other than as a
fiduciary, custodian or otherwise for customers'').
---------------------------------------------------------------------------
<bullet> FICC segregates on its books and records the margin
provided by a registered fund (or series thereof, as applicable), and
identifies a value of margin in its books and records as being
attributable to the registered fund;
<bullet> The entity that FICC uses to custody such margin is an
eligible fund custodian under the 1940 Act and the applicable rules
thereunder; \141\
---------------------------------------------------------------------------
\141\ See Section 17(f) of the 1940 Act and the rules
thereunder.
---------------------------------------------------------------------------
<bullet> The margin provided by a registered fund is not subject to
loss mutualization \142\ or allocation; \143\
---------------------------------------------------------------------------
\142\ See FICC 2003 Letter at n. 18.
\143\ See e.g., FICC Rule 4, supra note 19.
---------------------------------------------------------------------------
<bullet> The margin provided by a registered fund is not used by
FICC for any purpose other than in connection with that registered
fund's default as a sponsored member; \144\
---------------------------------------------------------------------------
\144\ For purposes of this Commission position, FICC is not
permitted to use registered fund margin for default liquidity
purposes.
---------------------------------------------------------------------------
<bullet> Registered funds receive quarterly statements of accounts
concerning the margin provided in connection with eligible secondary
market transactions showing, at a minimum, the name of the account,
asset movements during the quarter, and quarter-end positions; and
<bullet> The account into which a registered fund's margin is
deposited is governed by a contract by and among the registered fund,
its sponsoring member, and FICC providing for an arrangement consistent
with this Commission position, (together, the ``FICC registered fund
margin framework'').\145\
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\145\ The Commission notes that this position only applies with
respect to the custody of registered fund margin, and does not apply
to cash or collateral received under a sponsored repo or reverse
repo trade. Further, this position does not impact any other
obligation that a registered fund has in connection with its
participation in the Sponsored Program or under the 1940 Act and
rules thereunder.
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In general, Section 17(f) of the 1940 Act and the rules thereunder
govern the safekeeping of investment company assets.\146\ The FICC
registered fund margin framework is designed to protect fund investor
assets, consistent with the principles of the 1940 Act.\147\ The
framework would seek to adequately protect registered fund assets by
isolating them from FICC's proprietary assets and segregating them on
FICC's books and records from the sponsoring member's other customers,
preventing registered fund assets from being used to cover any
obligation other than an obligation of that registered fund, limiting
FICC's ability to use registered fund margin for any purpose other than
an obligation of the registered fund as a sponsored member, and
prohibiting registered fund assets from being subject to loss
mutualization or allocation.\148\ Five years is intended to provide
sufficient time for FICC to develop and file any proposed rule changes
under Section 19(b) of the Exchange Act that may be relevant to
facilitate a registered fund's ability to have its margin posted at
FICC consistent with the FICC registered fund margin framework. The
Commission will consider any proposed rule changes consistent with its
obligations under Section 19(b) of the Exchange Act in the event that
FICC submits any proposal to facilitate a registered fund's ability to
have its margin posted at FICC consistent with the FICC registered fund
margin framework in the future, and providing this position for five
years will also provide sufficient time for the Commission to determine
if extending or revising this position is appropriate. Five years is
intended to provide sufficient time for market participants to consider
other potential frameworks for the posting of registered fund margin to
satisfy FICC's margin deposit requirements and to gain insight into the
merits of such frameworks.\149\
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\146\ The legislative history of section 17(f) indicates that
Congress intended the assets of investment companies to be kept by a
financially secure entity that has sufficient safeguards against
misappropriation. See Investment Trusts and Investment Companies:
Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking
and Currency, 76th Cong., 3d Sess. 264 (1940).
\147\ See e.g., ICI Letter, supra note 85, at 14.
\148\ Cf. infra part II.C.2.
\149\ We note that a U.S. Treasury securities CCA could develop
a different mechanism for a registered fund to post margin. For
example, the Options Clearing Corporation has a ``deposits in lieu
of margin'' framework whereby a customer of a clearing member makes
a deposit in lieu of margin through OCC's escrow deposit program,
and the relevant positions are excluded from the clearing member's
margin requirement to OCC. See OCC Rules 610, 610A, 610B, and 610C;
see also Self-Regulatory Organization: The Options Clearing
Corporation: Notice of Filing of Advance Notice Concerning the
Options Clearing Corporation's Escrow Deposit Program, Securities
Exchange Act Rel. No. 34-78334 (Sept. 14, 2016), 81 FR 64537-38
(Sept. 20, 2016). Although there are fundamental differences in the
purpose and use of margin in the OCC's deposit in lieu of margin
framework, a U.S. Treasury securities CCA could use the principles
underlying the OCC's program by analogy in developing its own margin
posting framework.
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[[Page 2729]]
A registered fund may wish to use a member of a national securities
exchange as a sponsoring member. Such a sponsoring member that receives
and posts margin to a U.S. Treasury securities CCA on behalf of
registered funds may be deemed to have custody of fund assets and
implicate Rule 17f-1 under the 1940 Act. Therefore, the Commission
takes the position, for a period of five years from the effective date
of this adopting release, that if a registered fund's cash and/or
securities are placed and maintained with a sponsoring member that is a
member of a national securities exchange, solely in connection with
facilitating the posting of margin to FICC on behalf of a registered
fund in connection with the registered fund's participation in the
Sponsored Program, it would not provide the basis for an enforcement
action against a registered fund under Section 17(f) of the 1940 Act so
long as: (i) the fund complies with Rule 17f-1(a), (b)(5), and (d), and
(ii) the contract between the registered fund and the member of the
national securities exchange provides for the following:
<bullet> The margin provided by a registered fund is not commingled
with, and is kept separate from, the sponsoring member's assets; \150\
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\150\ See note 140 supra.
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<bullet> The sponsoring member segregates on its books and records
the margin provided by a registered fund (or series thereof, as
applicable), and identifies a value of margin in its books and records
as being attributable to the registered fund;
<bullet> The registered fund's provision of margin is consistent
with the FICC registered fund margin framework; and
<bullet> The sponsoring member does not hold registered fund assets
that exceed the amount that is required to be deposited as margin to
FICC with respect to the registered fund's outstanding eligible
secondary market transactions.\151\
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\151\ This Commission position would not apply to the extent
that the sponsoring member holds an amount of registered fund assets
that exceeds the registered fund's margin obligations. If a
sponsoring member were to hold registered fund assets in an amount
that exceeds the registered fund's margin obligations, then the
sponsoring member would need to return such excess to the registered
fund as promptly as possible or promptly comply with all
requirements of Rule 17f-1 under the 1940 Act.
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As above, such an approach is intended to accomplish a similar
purpose as the FICC registered fund margin framework and additionally
limit the amount of assets held in custody at a sponsoring member that
is a member of a national securities exchange to an amount of margin
that is required by FICC.
More generally, the Commission understands that the commenter which
raised issues regarding the ability of registered funds to post margin
to the CCA is referring to clearing models whereby an indirect
participant in a U.S. Treasury securities CCA executes a transaction
with a counterparty and then ``gives up'' the transaction to another
party to submit for clearance and settlement. The Commission agrees
with the commenter that the use of a ``give up'' model could be helpful
in further facilitating the increased demand for central clearing under
a potential clearing requirement. The Commission understands that FICC
currently has certain models that facilitate ``give up'' style
clearing, and, consistent with the requirement discussed in part II.B.2
infra, encourages U.S. Treasury securities CCAs to consider how best to
facilitate ``give up'' clearing.
The Commission's ability to ``encourage'' FICC, a covered clearing
agency, must be considered in context of the relevant regulatory
framework. Covered clearing agencies are SROs for purposes of the
Exchange Act,\152\ meaning that, as an SRO, a covered clearing agency
is required to file with the Commission any proposed rule or proposed
change in its rules, including additions or deletions from its
rules.\153\ The Commission publishes all proposed rule changes for
comment.\154\ When considering whether to approve or disapprove a
proposed rule change, the Commission shall approve the proposed rule
change if it finds that such proposed rule change is consistent with
the requirements of the Exchange Act and the rules and regulations
thereunder applicable to the particular type of SRO.\155\
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\152\ 17 CFR 240.17ad-22(a)(5) (defining a covered clearing
agency); 15 U.S.C. 78c(a)(26) (defining an SRO to include a
registered clearing agency).
\153\ An SRO must submit proposed rule changes to the Commission
for review and approval pursuant to Rule 19b-4 under the Exchange
Act. A stated policy, practice, or interpretation of an SRO, such as
its written policies and procedures, would generally be deemed to be
a proposed rule change. See 15 U.S.C. 78s(b)(1); 17 CFR 240.19b-4.
See 15 U.S.C. 78s(b)(3)(A) (setting forth the types of proposed rule
changes that take effect upon filing with the Commission). The
Commission may temporarily suspend those rule changes within 60 days
of filing and institute proceedings to determine whether to approve
or disapprove the rule changes. 15 U.S.C. 78s(b)(3)(C).
\154\ See 15 U.S.C. 78s(b)(1). Proposed rule changes are
generally required to be approved by the Commission prior to going
into effect; however, certain types of proposed rule changes take
effect upon filing with the Commission.
\155\ 15 U.S.C. 78s(b)(1)(C)(i). On the other hand, the
Commission shall disapprove a proposed rule change if it cannot make
such a finding. 15 U.S.C. 78s(b)(1)(C)(ii).
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In addition, clearing agencies registered with the Commission are
financial market utilities, as defined in section 803(6) of the Dodd-
Frank Act.\156\ A clearing agency that has been designated by the
Financial Stability Oversight Council as systemically important or
likely to become systemically important, and for which the Commission
is the Supervisory Authority (``designated clearing agency''), is
required to file 60-days advance notice with the Commission of changes
to rules, procedures, and operations that could materially affect the
nature or level of risk presented by the designated clearing agency
(``advance notice'').\157\ Such an advance notice also requires
consultation with the Board of Governors.\158\ The Clearing Supervision
Act authorizes the Commission to object to changes proposed in such an
advance notice, which would prevent the clearing agency from
implementing its proposed change(s).\159\
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\156\ See 12 U.S.C. 5462(6).
\157\ The Dodd-Frank Act defines a ``designated clearing
entity'' as a designated financial market utility that is either a
derivatives clearing organization registered under section 5b of the
Commodity Exchange Act (7 U.S.C. 7a-1) or a clearing agency
registered with the Securities and Exchange Commission under section
17A of the Securities Exchange Act of 1934 (15 U.S.C. 78q-1). See 12
U.S.C. 5462(3). The Commission is the Supervisory Agency, as defined
in 12 U.S.C. 5462(8), for four designated clearing agencies (the
Depository Trust Company, the National Securities Clearing
Corporation, the Fixed Income Clearing Corporation, and the Options
Clearing Corporation). See 12 U.S.C. 5465(e)(1)(A). The Commission
published a final rule concerning the filing of advance notices for
designated clearing agencies in 2012. See 17 CFR 240.19b-4(n);
Exchange Act Release No. 34-67286 (June 28, 2012), 77 FR 41602 (July
13, 2012).
\158\ See 12 U.S.C. 5465(e)(1)(B).
\159\ See 12 U.S.C. 5465(e)(1)(E) and (F).
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These statutory requirements applicable to covered clearing
agencies mean that the Commission must consider proposed rule changes
as they are filed. The Commission does not dictate particular proposed
rule changes that a CCA should adopt, although a CCA may determine that
it should propose certain rule changes in response to a new or amended
Commission rule. In response to this
[[Page 2730]]
commenter, and as discussed in part II.B.2 infra, the Commission will
consider any proposed rule changes filed by FICC, or any other U.S.
Treasury securities CCA, in due course, consistent with its obligations
under Section 19(b) of the Exchange Act. The Commission does not have
the ability to revise particular aspects of the rules of an SRO that is
a registered clearing agency, like a CCA.\160\
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\160\ 15 U.S.C. 78s(c) (establishing the Commission's authority
to, by rule, abrogate, add to, and delete from the rules of an SRO
other than a registered clearing agency).
---------------------------------------------------------------------------
Second, the commenter discussed potential custody issues for
registered funds under Section 17(f) of the 1940 Act and Rule 17f-4
thereunder. Section 17(f) requires that a registered fund maintain its
securities and similar investments in a bank, a company which is a
member of a national securities exchange, or its own custody.\161\ The
commenter stated that substantially all funds use a bank custodian, and
that a bank custodian is particularly beneficial to funds in the
context of repo and reverse repo transactions with respect to
custodying both securities and cash.\162\
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\161\ 15 U.S.C. 80a-17(f)(1).
\162\ ICI Letter, supra note 85, at 15.
---------------------------------------------------------------------------
The Commission has adopted rules that specify required
qualifications for entities other than those named in Section 17(f) to
act as custodians of fund assets, including Rule 17f-4 which permits a
registered fund to deposit the securities it owns in a securities
depository, under certain conditions.\163\ A ``securities depository''
is defined to include a clearing corporation that is registered with
the Commission under Section 17A of the Exchange Act.\164\ The
commenter observed that FICC is registered as a clearing agency, but
that FICC has stated that it is not a securities depository and does
not provide securities depository services.\165\ The commenter asserted
that, because FICC is not deemed to be a securities depository eligible
to custody fund assets, expanding the Sponsored Service for funds would
require addressing Section 17(f) ``if the offering would require margin
posting by funds,'' and stated that one way to do this would be for
FICC to obtain Commission relief to hold fund margin as an eligible
securities depository within the meaning of Rule 17f-4.\166\
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\163\ 17 CFR 270.17f-4.
\164\ 17 CFR 270.17f-4.
\165\ ICI Letter, supra note 85, at 15.
\166\ ICI Letter, supra note 85, at 15-16.
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The Commission is not opining on whether FICC's Government
Securities Division could currently be considered a ``securities
depository'' for purposes of Rule 17f-4.\167\ However, the amendments
to Rule 17ad-22(e) do not require that registered funds post margin
directly to a U.S. Treasury securities CCA, meaning that this issue is
not implicated at this time. Therefore, the Commission does not believe
that such concerns are ripe for consideration, as no U.S. Treasury
securities CCA has proposed particular rules that would require the
posting of registered funds' securities at the CCA and such an
arrangement is not specifically required by the requirement to clear
eligible secondary market transactions. Moreover, as discussed in this
part above, the Commission has taken the position regarding the FICC
registered fund margin framework in light of the commenter's concern.
---------------------------------------------------------------------------
\167\ The commenter's assertion that FICC has stated that it is
not a securities depository and does not provide securities
depository services comes from a statement in FICC's Disclosure
Framework concerning a different regulatory regime. Specifically,
the statement concerns whether FICC is a ``central securities
depository'' or provides ``central securities depository'' services,
for purposes of discussing FICC's obligation to comply with Rule
17ad-22(e)(10), which applies to CCAs that provide central
securities depository services. ``Central securities depository'' is
a defined term in the Covered Clearing Agency Standards, meaning a
clearing agency that is a securities depository as described in
Section 3(a)(23)(A) of the Act (15 U.S.C. 78c(a)(23)(A). Section
3(a)(23)(A) defines a securities depository, in turn, as who (i)
acts as a custodian of securities in connection with a system for
the central handling of securities whereby all securities of a
particular class or series of any issuer deposited within the system
are treated as fungible and may be transferred, loaned, or pledged
by bookkeeping entry without physical delivery of securities
certificates, or (ii) otherwise permits or facilitates the
settlement of securities transactions or the hypothecation or
lending of securities without physical delivery of securities
certificates.
---------------------------------------------------------------------------
The Commission's definition of an eligible secondary market
transaction and the requirement to clear such transactions does not, on
its own, mandate particular changes to FICC's membership models,
including the Sponsored Service. FICC has not proposed any rule changes
with respect to the Sponsored Service in this regard at this time. The
Commission will consider any proposed rule changes consistent with its
obligations under Section 19(b) of the Exchange Act in the event that
FICC submits any such proposal in the future.
Third, the commenter stated that FICC's rules addressing margin
posting will need to be amended to provide for enhanced recordkeeping,
internal controls, and transparency around the positions and related
margin, to address fund concerns regarding the security of fund assets
under a requirement to clear certain transactions. The commenter stated
that enhanced recordkeeping and related controls are critical to
appropriately identifying ownership of assets during a repo transaction
particularly since, unlike a typical derivatives or cash transaction,
ownership of the U.S. Treasury securities underlying a repo transaction
changes during the transaction. The commenter asserted that FICC
currently relies on its broker-dealer members and, in certain cases,
designated agency banks to maintain records regarding margin positions,
and that FICC has indicated that it is not able to identify positions
or possess the assets of its members' customers. The commenter states
that notwithstanding FICC's current lack of infrastructure, ``the
Proposal relies heavily on FICC to intermediate transactions under a
clearing mandate and contemplates that this approach will provide a
higher level of safety to the market than the current bilateral market,
which relies on a well-diversified group of credit-worthy banks to hold
collateral, including through robust tri-party arrangements, and
utilizes an industry standard agreement that is well understood by
market participants.'' \168\
---------------------------------------------------------------------------
\168\ ICI Letter, supra note 85, at 16-17.
---------------------------------------------------------------------------
However, no U.S. Treasury securities CCA has proposed particular
rules that would require the posting of registered funds' securities at
the CCA. The Commission's definition of an eligible secondary market
transaction and the requirement to clear such transactions does not, on
its own, mandate particular changes to FICC's membership models,
including the Sponsored Service. The Commission will consider any
proposed rule changes consistent with its obligations under Section
19(b) of the Exchange Act in the event that FICC submits any such
proposal in the future.
The Commission disagrees with the commenter's assertion that FICC
has indicated that it is not able to identify positions or possess the
assets of its members' customers. FICC currently is able to maintain
position data for customer positions in all its indirect access
models.\169\ In addition, under the amendments being adopted in this
release, FICC will, as discussed in section II.B.1 infra, be required
to separately calculate and hold customer margin (which it currently
does for the Sponsored Service), which addresses
[[Page 2731]]
the commenter's concern that FICC calculate and hold customer margin
separately.
---------------------------------------------------------------------------
\169\ FICC Buyside FAQ at 4, available at <a href="https://www.dtcc.com/ustclearing/-/media/Files/Downloads/Microsites/Treasury-Clearing/FICC-GSD-FAQ.pdf">https://www.dtcc.com/ustclearing/-/media/Files/Downloads/Microsites/Treasury-Clearing/FICC-GSD-FAQ.pdf</a> (``FICC records positions of Sponsored Members and
positions of Executing Firms of a Prime Broker as long as the Prime
Broker submits the trades to FICC using a unique client identifier
called the ``Executing Firm symbol.'') (``FICC Buyside FAQ'').
---------------------------------------------------------------------------
Fourth, the commenter highlighted its support for strong
protections for fund assets, including ``legally segregated,
operationally commingled'' (``LSOC'') protections. In addition, another
commenter asserted that, without an exclusion from the definition of an
eligible secondary market transaction for repos with registered funds,
such funds could be subject to greater counterparty credit risk because
the existing Sponsored Member clearing model at FICC has no requirement
to segregate customer assets, while at present most registered funds
use third-party custodians to hold securities and cash.\170\ The
Commission addresses these comments in more detail in part II.B.1
below.
---------------------------------------------------------------------------
\170\ SIFMA AMG Letter, supra note 35, at 5.
---------------------------------------------------------------------------
Fifth, the commenter stated that the Commission and FICC must
address the bankruptcy treatment of certain fund assets. Specifically,
the commenter stated that FICC's rules should confirm that agreements
entered into by repo counterparties will be enforceable against both
parties, notwithstanding that the transactions are cleared, and provide
a clear process for closeout of transactions by FICC, including both
the start and end legs of the transaction. The commenter also stated
that FICC's rules need to address what happens upon the insolvency of a
sponsoring member in a variety of factual circumstances, including
providing for prompt replacement of the sponsoring member by its
sponsored members and handling of other functions typically performed
by the sponsoring member to ensure that transactions by the sponsored
member are maintained and allowing the sponsored member the authority
to receive certain reports directly and to post to the clearing fund to
preserve pending trades. The commenter also stated that FICC's rules
should provide clarity regarding how non-defaulting parties, such as
funds, can exercise closeout rights, including those available under
Sections 555, 559, 561, and similar sections of the U.S. Bankruptcy
Code. The commenter stated that if, in the future, FICC decides to
expand the Sponsored Service to permit (but not require) sponsored
members to post margin, then the Commission and FICC should clarify
that the margin posted by a sponsored member with its sponsoring member
for on-posting with FICC would be eligible for customer treatment under
the Securities Investor Protection Act (``SIPA''). The commenter also
argues that clarification of FICC's rules regarding closeout rights--
particularly in respect to ``done away'' trades--is important to
clarify a repo counterparty's rights under different insolvency regimes
applicable to cleared transactions.\171\
---------------------------------------------------------------------------
\171\ ICI Letter, supra note 85, at 20-21.
---------------------------------------------------------------------------
Regarding these bankruptcy-related comments, FICC's rules already
address the issues raised by the commenter. For example, with respect
to the enforceability of the agreements entered into by repo
counterparties, FICC requires applicants for membership to execute a
Membership Agreement, in which the applicant agrees to be bound by
FICC's Rules, and FICC further requires applicants for membership to
provide a legal opinion regarding the membership agreement, which
incorporates FICC's Rules.\172\ Novation consists of the termination of
the deliver, receive, and related payment obligations between the
parties to a trade, and their replacement with identical obligations to
and from FICC in accordance with the Rules. Once it novates a
transaction, FICC contractually replaces the original counterparties'
obligations to each other with two sets of obligations, both of which
include FICC and one of the original counterparties.\173\ FICC is not a
party to the pre-novation bilateral agreements between a Sponsoring
Member and its Sponsored Members, and therefore, it cannot guarantee
performance of those contracts.
---------------------------------------------------------------------------
\172\ FICC Rule 2A, Section 7, supra note 19; FICC Disclosure
Framework, Principle 1, available at <a href="https://www.dtcc.com/-/media/Files/Downloads/legal/policy-and-compliance/FICC_Disclosure_Framework.pdf">https://www.dtcc.com/-/media/Files/Downloads/legal/policy-and-compliance/FICC_Disclosure_Framework.pdf</a>.
\173\ FICC Rule 5, section 8 (regarding novation generally) and
Rule 3A, section 7(a) (regarding novation in the Sponsored Service),
supra note 19.
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In addition, with respect to FICC's need to establish a process for
closeout, FICC's Rules contain these processes. Upon ceasing to act for
an insolvent member, FICC may promptly close out and manage the
member's positions, including with respect to the member's pending
transactions with non-defaulting members.\174\ Specifically, FICC would
terminate and net all of the insolvent member's positions, after which
FICC would liquidate the net positions through market action and
determine a single net amount owed to or from the insolvent member from
or to FICC.\175\ After closing out the insolvent member's final net
positions, FICC's Rules provide for the timely settlement of all
deliver, receive, and related payment obligations that would have
arisen had FICC not ceased to act for the insolvent member (i.e., FICC
would seek to fulfill its settlement obligations with respect to the
insolvent member's pending transactions with non-defaulting members.)
\176\ Similarly, in the event that FICC determines to treat a
Sponsoring Member as insolvent, FICC would cease to act for the
Sponsoring Member.\177\ FICC would determine whether to close-out the
affected Sponsored Member Trades and/or permit the Sponsored Members to
complete their settlement.\178\ In the event that it closes out the
Sponsored Member's transactions, it would follow the same closeout
process.\179\
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\174\ FICC Rule 22A, Section 2, supra note 19.
\175\ See id.
\176\ See id.
\177\ FICC Rule 3A, Section 16(b), supra note 19.
\178\ Id.
\179\ Id.
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Moreover, these comments generally relate to particular features of
FICC's Sponsored Service, including how the sponsored member is able to
interact with FICC, FICC's ability to settle the transactions in the
event of a Sponsoring Member default, and the operation of certain
bankruptcy provisions. For the reasons discussed in more detail in part
II.B.2 infra, the Commission cannot change the rules governing the
Sponsored Service.
Sixth, the commenter identified issues for registered funds that
would arise if additional clearing were to require funds to contribute
to FICC's CCLF. The commenter explained that contribution by a
registered fund to the CCLF could result in a prohibited joint
transaction in violation of: Section 17(d) of the 1940 Act if
affiliates of the fund (e.g., other funds managed by the same
investment adviser) also contribute to the fund; Section 18 of the 1940
Act, which prohibits a registered fund from issuing ``senior
securities;'' Section 17(f) of the 1940 Act; the fund's investment
purpose, policies, and organization documents; or the fiduciary duties
of the fund's board and its investment adviser. The commenter asserts
that the Commission would need to carefully evaluate the ability of a
registered fund to become a FICC netting member and contribute to the
CCLF, as well as amending its rules to confirm that view, or that, in
the alternative, FICC could create a special category of netting member
that would not require a fund to contribute to the CCLF.\180\
---------------------------------------------------------------------------
\180\ ICI Letter, supra note 85, at 22.
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In response to this commenter, any requirement for a U.S. Treasury
securities CCA to have policies and procedures requiring its direct
participants to clear eligible secondary market transactions does not,
on its
[[Page 2732]]
own, require any particular market participant to become a direct
participant of a U.S. Treasury securities CCA, thereby taking on the
membership obligations of such participation, including contribution to
the CCLF. The Commission acknowledges the commenter's view that certain
regulatory provisions applicable to registered funds could effect a
registered fund's ability to join a U.S. Treasury securities CCA
directly, but the Commission does not believe that these concerns
should impact its consideration of the proposal as the proposal would
not impose such requirements. Consistent with its obligations under
Section 19 of the Exchange Act, in its review of any rule filings, the
Commission would consider issues related to the ability of market
participants, including registered funds, to participate in FICC.
Seventh, the commenter stated that bilateral tri-party repo should
be exempted from the definition of an eligible secondary market
transaction. The Commission has considered this comment in part
II.A.2.a.i supra.
In addition, certain commenters also provided specific arguments
regarding money market funds subject to Rule 2a-7 under the 1940
Act.\181\ One commenter stated that the Commission should not include
repos with money market funds subject to Rule 2a-7 within the
definition of an eligible secondary market transaction, noting that the
current ability to transact in Treasury repurchase agreements across a
variety of clearance and settlement platforms allows these funds to be
invested in a manner that is in the best interest of their
shareholders. The commenter also referred to the planning and tools
that have been developed that seek to avoid a disorderly default in
repurchase agreement markets. The commenter also stated that the likely
insolvency regimes for the major repurchase agreement participants that
would be facilitated by a receiver (either the Federal Deposit
Insurance Corporation or the Securities Investor Protection
Corporation) allow the receiver to transfer or wind down repurchase
agreements in an orderly manner.\182\
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\181\ Federated Letter, supra note 85, at 3; ICI Letter, supra
note 85, at 5-8.
\182\ Federated Letter, supra note 85, at 3 (citing SEC. & EXCH.
COMM'N, DIV. OF INV. MGMT GUIDANCE UPDATE: COUNTERPARTY RISK
MANAGEMENT PRACTICES WITH RESPECT TO TRI-PARTY REPURCHASE AGREEMENTS
(July 2013), available at <a href="https://www.sec.gov/divisions/investment/guidance/im-guidance-2013-03.pdf">https://www.sec.gov/divisions/investment/guidance/im-guidance-2013-03.pdf</a>).
---------------------------------------------------------------------------
Two commenters raised questions with respect to regulatory
diversification requirements, that is, whether registered funds,
including money market funds, will continue to meet the definition of a
``collateralized fully'' repurchase agreement under Rule 5b-3 under the
Investment Company Act of 1940 if Treasury repo investments through the
Sponsored Service grow significantly.\183\ Commenters explained that
meeting the definition of a ``collateralized fully'' repurchase
agreement under Rule 5b-3 is necessary for Treasury repurchase
agreements to remain permissible investments for a government money
market fund and for achieving ``look through'' treatment for certain
diversification requirements imposed under the 1940 Act and Internal
Revenue Code.\184\ One commenter asked that the Commission confirm
through rulemaking or guidance that repo clearing offerings made
available by FICC to registered funds ``would continue to satisfy'' the
``collateralized fully'' standard set forth in Rules 5b-3 and 2a-7
under the 1940 Act and would allow funds to achieve ``look through
treatment'' for diversification purposes.\185\
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\183\ 17 CFR 270.5b-3(c)(1). Federated Letter, supra note 85, at
6; ICI Letter, supra note 85, at 23-24.
\184\ Federated Letter, supra note 85, at 6; ICI Letter, supra
note 85, at 23-24.
\185\ ICI Letter, supra note 85, at 23-24.
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One commenter also referenced the need for relief for reverse repo
transactions. The commenter stated that, unlike Treasury repo
agreements that are ``collateralized fully,'' Treasury reverse repo
transactions entered into by funds (i.e., where a fund is the seller)
currently are not eligible for look-through treatment. The commenter
concludes that this means that, under the proposal, absent additional
rulemaking or relief, most money market funds would be limited to
investing no more than 5% of their total assets in reverse repo
agreements because funds would face FICC as the counterparty, and that
diversified non-money market funds would be limited to investing either
no more than 25% of their total assets in reverse repo agreements or no
more than 5%, with respect to 75% of their total assets, in reverse
repo agreements. The commenter stated that registered funds may use
Treasury reverse repo agreements as a form of short-term financing to
facilitate shareholder redemption requests.\186\
---------------------------------------------------------------------------
\186\ ICI Letter, supra note 85, at 25.
---------------------------------------------------------------------------
The Commission acknowledges that the final rule could limit the
extent to which some registered funds enter into Treasury reverse repo
agreements. However, the Commission believes that this effect will be
limited because a relatively small number of funds report Treasury
reverse repo agreements on Form N-PORT, and funds generally have other
available means to generate cash to meet shareholder redemption
requests, such as lines of credit, securities lending, interfund
lending, or selling portfolio investments, as applicable. The combined
effect of the final rule and the diversification requirements in
section 5(b) of the 1940 Act could practically limit the amount some
funds may invest in Treasury reverse repo.\187\
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\187\ Section 5(b) divides management investment companies into
``diversified companies'' and ``non-diversified companies.'' Under
this section, (i) a ``diversified company'' means a management
company which meets the following requirements: At least 75 per
centum of the value of its total assets is represented by cash and
cash items (including receivables), Government securities,
securities of other investment companies, and other securities for
the purposes of this calculation limited in respect of any one
issuer to an amount not greater in value than 5 per centum of the
value of the total assets of such management company and to not more
than 10 per centum of the outstanding voting securities of such
issuer and (ii) a ``non-diversified company'' means any management
company other than a diversified company. See section 5 of the 1940
Act.
---------------------------------------------------------------------------
The commenter separately suggested that the final rule would affect
money market funds' use of Treasury reverse repo agreements, in light
of additional diversification requirements for those funds. However,
money market funds are not permitted to rely on rule 18f-4 under the
1940 Act to enter into reverse repo transactions.\188\ Moreover, money
market funds historically have not reported holdings of reverse repo
agreements in their portfolio reports filed with the Commission.
---------------------------------------------------------------------------
\188\ See Use of Derivatives by Registered Investment Companies
and Business Development Companies, Investment Company Act Release
No. 34084 (Nov. 2, 2020), 85 FR 83162 (Dec. 21, 2020); 17 CFR
270.18f-4. Rule 18f-4 establishes a framework for funds' use of
derivatives and certain other transactions, including reverse
repurchase agreements. Money market funds are not permitted to rely
on rule 18f-4 for these transactions.
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The Commission's definition of an eligible secondary market
transaction and the requirement to clear such transactions does not
mandate particular changes to FICC's membership models, including the
Sponsored Service. FICC has not proposed any rule changes with respect
to the Sponsored Service in this regard at this time. The Commission
will consider any proposed rule changes consistent with its obligations
under Section 19(b) of the Exchange Act in the event that FICC submits
any such proposal in the future. In the event that any U.S. Treasury
securities CCA proposes a clearing model in which
[[Page 2733]]
registered funds would be required to place and maintain assets to
effect eligible secondary market transactions at the CCA, the
Commission would consider the applicability of Section 17(f) of the
1940 Act.
One commenter explained that registered funds' access to the
Treasury repo market could be restricted by the number or willingness
of the FICC netting members to provide sponsoring services with
attending negative effect on the market liquidity.\189\ Although
increases in demand for the Sponsored Service may put pressure on
existing sponsoring members and reduce their ability or willingness to
onboard additional clients, this could also present an opportunity for
dealers that currently do not offer the Sponsored Service to enter the
market, resulting in more competition and a wider range of
counterparties. This is supported by an observation of a growing number
of dealers offering the Sponsored Service and the growing volume of
sponsored repo indicating increased adoption of this service by a wider
range of market participants.\190\
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\189\ ICI Letter, supra note 85, at 30-31.
\190\ See Sponsored DVP and GC Repo Activity, available at
<a href="https://www.dtcc.com/charts/membership">https://www.dtcc.com/charts/membership</a>.
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Several commenters raised concerns about the potential effect of
the proposal and a potential resultant high level of exposure to the
U.S. Treasury securities CCA on ratings assigned to certain money
market funds by Nationally Recognized Statistical Rating Organizations
(NRSROs).\191\ The commentators explained that NRSROs typically
establish exposure limits that a rated money market fund may have to
any particular CCA and, if these limits are breached, a fund may not be
able to maintain the currently assigned rating.\192\ The Commission
does not have the authority to adjust the NRSROs' rating criteria and
methodologies, and it cannot anticipate how NRSROs may adjust their
rating criteria and methodologies in response to the U.S. Treasury
market infrastructure changes resulting from the adoption of the
Membership Definition.
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\191\ Federated Letter, supra note 85, at 6-7; ICI Letter, supra
note 85, at 25-26; SIFMA AMG Letter, supra note 35, at 14.
\192\ Id.
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iii. Repos by Other Clearing Organizations
Several commenters supported a limited exclusion from the
definition of an eligible secondary market transaction for U.S.
securities transactions entered into by a derivatives clearing
organization (``DCO''). A DCO is an entity that is regulated by the
CFTC and is defined as a clearinghouse, clearing association, clearing
corporation, or similar entity, facility, system, or organization that,
with respect to an agreement, contract, or transaction (i) enables each
party to the agreement, contract, or transaction to substitute, through
novation or otherwise, the DCO's credit for the credit of the parties;
(ii) arranges or provides, on a multilateral basis, for the settlement
or netting of obligations resulting from such agreements, contracts, or
transactions executed by the DCO's participants; or (iii) otherwise
provides clearing services or arrangements that mutualize or transfer
among the DCO's participants the credit risk arising from such
agreements, contracts, or transactions executed by the
participants.\193\ Generally, DCOs perform similar functions as CCAs,
but for commodities as opposed to securities.
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\193\ 7 U.S.C. 1a(15) (defining DCO) and 7a-1(a) (establishing
DCO registration requirement).
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One commenter recognized that DCOs are not specifically enumerated
as an entity type subject to the expanded clearing requirement, but
stated that, in practice, it would be impractical for DCOs to avoid
entering into repos with direct participants of U.S. Treasury CCAs,
which would therefore be included in the definition of an eligible
secondary market transaction.\194\ First, the commenter stated that an
exclusion for DCOs was necessary to allow DCOs to retain the
flexibility necessary to effectively manage risk when managing the
default of a participant of the DCO, with respect both to access to the
appropriate counterparties and to pressing time considerations. The
commenter stated that requiring the central clearing of repos entered
into for default management by a DCO could undermine the effectiveness
of the DCO's default management practices. Second, the commenter
asserted that including transactions with a DCO within the definition
of an eligible secondary market transaction would threaten DCOs'
effective cash management. The commenter stated that DCOs regularly
receive U.S. dollar cash as margin from their clearing members and then
enter into reverse repos, as permitted under the applicable CFTC
regulations. However, the commenter expressed concern that the
permissible counterparties and counterparty concentration limits
included in CFTC Rule 1.25 would appear to be in tension with the
requirement to clear eligible secondary market transactions because a
clearing agency, which would become the counterparty to any transaction
that is centrally cleared, is not a permissible counterparty. Finally,
the commenter stated that allowing transactions with DCOs to be scoped
into the definition of an eligible secondary market transaction would
be inconsistent with the spirit, and the letter, of Section 5b(f)(1) of
the Commodity Exchange Act, which states that ``under no circumstances
shall a [DCO] be compelled to accept the counterparty credit risk of
another clearing organization.'' \195\
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\194\ CME Letter, supra note 81, at 6.
\195\ CME Letter, supra note 81, at 6-7.
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An additional commenter made similar arguments. This commenter
stated that the rule as proposed could create contagion risk by
increasing linkages between CCPs, stating that this risk would
crystallize if a CCP clearing its investment trades contributed to the
mutualized financial resources of another CCP via its default fund or
was otherwise exposed to loss in the event of a member default of the
other CCP. The commenter further stated that existing regulations under
both U.S. and European regulatory frameworks recognize the potential
financial stability risks of inter-CCP linkages and prohibit them from
accepting the counterparty credit risk of another CCP. According to the
commenter, one such conflict arises under the Commodity Exchange Act
where, to minimize systemic risk, there is a requirement that ``[. . .]
under no circumstances shall a derivatives clearing organization be
compelled to accept the counterparty credit risk of another clearing
organization.'' Finally, the commenter states that a clearing model
tailored to meet CCPs' bespoke collateral management requirements would
need to be developed before they could operationally clear investment
trades.\196\
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\196\ Letter from Rachel Goldberg, Head of Government Relations
and Regulatory Strategy, Americas, London Stock Exchange Group, at
2-3 (June 15, 2023).
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The Commission understands that reverse repos are used heavily by
central counterparties as a means of investing their cash.\197\ The
Commission also agrees that entities that provide central counterparty
services, like DCOs and clearing agencies, must be able to effectively
manage the default of a participant.\198\ In the event of a participant
default, the need for such entities to be able to react within
potentially compressed timeframes, including by engaging in repos of
U.S.
[[Page 2734]]
Treasury securities held as margin to create liquidity, may be
essential to their default management processes. The Commission agrees
that including such transactions within the scope of an eligible
secondary market transaction might have systemic risk implications and
counteract the goals of effective and efficient default management by
CCPs in such scenarios. Accordingly, it is appropriate to exclude repos
entered into by an entity acting as a central counterparty from the
definition of an eligible secondary market transaction.\199\
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\197\ See BIS, Committee on the Global Financial System, Repo
Market Functioning, Apr. 2017.
\198\ Proposing Release, supra note 14, 87 FR at 64627.
\199\ The Commission is not opining on the proposal's
consistency with the Commodity Exchange Act or other regulatory
regimes, but the commenter's concern is moot in light of the
modification to the definition of an eligible secondary market
transaction that the Commission is adopting.
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To do so, the Commission is modifying the definition of an eligible
secondary market transaction in Rule 17ad-22(a) to exclude any
repurchase or reverse repurchase agreement collateralized by U.S.
Treasury securities in which one counterparty is a covered clearing
agency providing central counterparty services, a derivatives clearing
organization (see 7 U.S.C. 7a-1 and 17 CFR 39.3), or is regulated as a
central counterparty in its home jurisdiction. With respect to a
counterparty that is regulated as a central counterparty in its home
jurisdiction, this portion of the exclusion encompasses entities that
may serve as central counterparties in their home jurisdiction and may
transact in repos with direct participants of a U.S. Treasury
securities CCA. Although commenters did not specifically suggest this
exclusion for a counterparty that is regulated as a CCP in its home
jurisdiction, this aspect of the exclusion is appropriate to ensure
that entities serving as central counterparties in other jurisdictions
are similarly excepted from the definition of an eligible secondary
market transaction as repo counterparties.
iv. Repos by FCMs
Two commenters asked the Commission to adopt an exemption that
would allow Futures Commission Merchants (``FCMs'') to continue to
engage in eligible secondary market transactions in U.S. Treasury
securities outside of central clearing, and another commenter
acknowledged the potential interaction between the proposal and the
regulatory framework governing FCMs.\200\ An FCM is an entity engaged
in soliciting or accepting orders for the purchase or sale of
commodities, futures, swaps, or other instruments regulated by the
CFTC.\201\ FCMs can also be registered with the Commission as broker-
dealers.\202\ In their role as market intermediaries, FCMs hold
customer funds and securities. The commenter explained that as of
October 31, 2022, FCMs held an aggregate amount of more than $500
billion in segregated customer accounts, a substantial percentage of
which is held in the form of U.S. Treasury securities.\203\
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\200\ See comments from Walt L. Lukken, President and Chief
Executive Officer, Futures Industry Association, at 2-7 (Dec. 23,
2022) (``FIA Letter''). See also SIFMA/IIB Letter, supra note 37, at
30-31 (recognizing that the absent an exemption for FCMs from the
central clearing requirement, FCMs engaging in repo transactions
would be placed in the untenable position of violating either the
SEC's proposal or existing CFTC regulations). See also DTCC/FICC
Letter, supra note 33, at 25 (recognizing that CFTC regulations
currently limit FCM access to central clearing by preventing FCMs
from entering into FICC-cleared repo transactions using customer
property).
\201\ See 7 U.S.C. 1a(28)(A).
\202\ One commenter states that the majority of FCMs are dually
registered as FCMs and broker-dealers. See FIA Letter, supra note
200, at 2.
\203\ See FIA Letter, supra note 200, at 4.
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As the commenter noted, FCMs are required under the Commodity
Exchange Act \204\ and the regulations promulgated thereunder \205\ to
assure the protection of customer funds. Specifically, as the commenter
explained, FCMs are required to hold customer funds and securities in
segregated accounts with a bank or other permitted depository that
acknowledges such customer assets ``will be separately accounted for
and segregated'' from the FCM's own funds and ``must otherwise be
treated in accordance with the provisions of the [CEA]'' and CFTC
rules.\206\ The commenter highlighted that neither the bank/depository
nor the FCM may use the FCM's customer funds to ``secure or guarantee
any obligations'' that the FCM might owe to the bank/depository or make
the funds ``subject to any right of offset or lien for or on account of
any indebtedness, obligations, or liabilities'' the FCM may owe the
bank/depository.\207\ The commenter expressed concern as to whether the
account structure provided by FICC would be consistent with these
rules.
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\204\ 7 U.S.C. 1-26.
\205\ 17 CFR 1.1-190.19.
\206\ See FIA Letter, supra note 200, at 3 (discussing 17 CFR
1.20 (regarding futures traded on U.S. futures exchanges) and 17 CFR
22.4 (regarding cleared swaps)).
\207\ FIA Letter, supra note 200, at 3-4 (discussing 17 CFR
1.20, 22.2, and 30.7).
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As an initial matter, the requirement for direct participants of a
U.S. Treasury securities CCA to clear eligible secondary market
transactions does not require that an FCM post customer assets directly
to the U.S. Treasury securities CCA. An FCM could access central
clearing through a customer model, such as the Sponsored Service or the
Prime Broker/Correspondent clearing models, that allows the customer/
FCM to hold customer assets elsewhere (such as at the Sponsoring
Member) and does not require that the FCM post customer assets to the
U.S. Treasury securities CCA. Therefore, the ability of the CCA to
provide an account structure consistent with the CFTC Rules should not
prevent an FCM's transactions from being submitted to central clearing.
Moreover, in light of the requirements regarding the segregation of
house and customer margin, as discussed in part II.B.1 infra, and the
amendments to Rule 15c3-3, as discussed in part II.C infra, U.S.
Treasury securities CCAs will have to ensure that they have adopted
policies and procedures to separate house and customer margin and to
establish certain types of segregated accounts. The Commission
encourages FCMs seeking the ability to post customer funds directly to
the CCP to engage with the CCAs to consider whether such new account
structures may be sufficient to comply with the provisions of the CFTC
regulations that the commenter has identified or whether such
structures could be leveraged to meet the commenter's needs. For
example, the Commission understands that the existing U.S. Treasury
securities CCA recently has indicated that it would develop customer
clearing account structures in which each customer's margin would be
calculated on a gross basis and held physically segregated from all
other FICC margin and would also be legally segregated from FICC member
as well as fellow customer exposures.\208\
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\208\ DTCC 2023 White Paper, supra note 107, at 22-23.
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One of the commenters also explained that FCMs are permitted to
invest customer funds in certain securities determined by the CFTC to
be ``consistent with the objectives of preserving capital and
maintaining liquidity.'' \209\ The commenter stated that permitted
investments include, among other things, U.S. Treasury securities, and
investments with U.S. Treasury securities may be made by either direct
purchase or sale or by entering into repo transactions.\210\ The
commenter further explained that, for repo transactions, an FCM's
``permitted
[[Page 2735]]
counterparties are limited to a bank . . . , securities broker-dealer,
or government securities dealer registered with the [Commission],'' and
a clearing agency is not a permitted counterparty.\211\
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\209\ FIA Letter, supra note 200, at 4-5 (discussing 17 CFR
1.25(b)).
\210\ FIA Letter, supra note 200, at 4-5 (discussing 17 CFR
1.25(a)).
\211\ FIA Letter, supra note 200, at 5 (discussing 17 CFR
1.25(d)(2)).
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The commenter stated that, absent relief, conflict between the CFTC
rules and the proposal would effectively prohibit FCMs from entering
into U.S. Treasury security transactions pursuant to CFTC Rule
1.25.\212\ The commenter explained that a U.S. Treasury securities CCA
interposes itself between the counterparties to a securities
transaction through novation, acting functionally as the buyer to every
seller and seller to every buyer.\213\ Therefore, according to the
commenter, if an FCM were to conduct a cleared transaction, the CCA
would become the FCM's counterparty. Since a CCA is not a permitted FCM
counterparty under the CFTC rules, the commenter states that FCMs are
prohibited from conducting such cleared transactions.\214\ The
commenter contended that if the Commission adopts the requirement to
clear eligible secondary transactions as proposed, an FCM would lose
its current ability to conduct transactions in U.S. Treasury securities
with a direct participant of a U.S. Treasury securities CCA in
compliance with CFTC rules.\215\
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\212\ FIA Letter, supra note 200, at 6.
\213\ FIA Letter, supra note 200, at 6; see also Proposing
Release, supra note 14, 87 FR at 64612.
\214\ FIA Letter, supra note 200, at 6 (citing 17 CFR
1.25(d)(2)).
\215\ See FIA Letter, supra note 200, at 6.
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The Commission recognizes that if the FCM were to access a U.S.
Treasury securities CCA through a model like FICC's Sponsored Service,
the CCA would novate the transaction and become the counterparty to the
FCM, which, as the commenter has described it, would not be consistent
with Rule 1.25(d)(2) with respect to permitted counterparties. However,
the requirement to clear eligible secondary market transactions does
not require that the FCM use a particular type of model that would make
the FCM a counterparty to a CCA. The FCM could access central clearing
through an agent clearing model like FICC's Prime Broker or
Correspondent Clearing models, in which it would essentially ``give
up'' its transaction to a direct participant for submission without
becoming a counterparty to the CCA, which should be consistent with the
FCM's obligations under Rule 1.25(d)(2). Therefore, this requirement to
clear eligible secondary market transactions does not obligate the FCM
to use a model that would necessarily result in a transaction with a
clearing agency as the counterparty to the FCM.
The Commission recognizes this apparent tension between the
application of Rule 1.25(d)(2), as described by the commenter, and the
requirement to clear repos as part of the definition of eligible
secondary market transactions.\216\ However, as discussed in the
Proposing Release, when Congress added section 17A to the Exchange Act
as part of the Securities Acts Amendments of 1975, it directed the
Commission to facilitate the establishment of (i) a national system for
the prompt and accurate clearance and settlement of securities
transactions (other than exempt securities) and (ii) linked or
coordinated facilities for clearance and settlement of securities
transactions, and the Government Securities Act of 1986 specifically
included government securities within the scope of section 17A.\217\
The Commission therefore has the ability to make rules governing
central clearing in the U.S. Treasury market, which may affect a
diverse group of market participants, including FCMs. The Commission
encourages interested parties to work with the CCA to identify any
modifications to its client clearing models to better allow FCMs to
access central clearing in the U.S. Treasury market. In addition, FCMs
could enter into repos with market participants that are not direct
participants of a U.S. Treasury securities CCA.\218\
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\216\ See CFTC Global Market Advisory Committee (``GMAC''),
Global Market Structure Subcommittee, CFTC Rule1.25(d)(2)
Recommendation (discussing the impact of Rule 1.25(d)(2) on FCMs'
ability to participate in cleared repo), available at <a href="https://www.cftc.gov/PressRoom/Events/opaeventgmac110623">https://www.cftc.gov/PressRoom/Events/opaeventgmac110623</a>. The CFTC's GMAC
voted in favor of this recommendation to amend Rule 1.25(d)(2) to
include CCAs as permitted counterparties.
\217\ Proposing Release, supra note 14, 88 FR at 64617.
\218\ CFTC Rule 1.25(a)(1) also identifies additional types of
permitted investments available to an FCM for its customer funds,
including municipal bonds, corporate bonds, and interests in money
market mutual funds.
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The commenter also notes that CFTC rules require that securities
transferred to an FCM's customer segregated custodial account must be
``made on a delivery versus payment [(DVP)] basis in immediately
available funds.'' \219\ Even if a U.S. Treasury securities CCA would
be a permitted FCM counterparty under the CFTC rules, the commenter
expressed concern that upon the sale or resale of securities in a repo
transaction, the FCM's customer segregated cash account may not receive
same-day funds credited simultaneously with the delivery or transfer of
securities.\220\ The Commission does not believe that such concer
[…truncated; see source link]Indexed from Federal Register on January 16, 2024.
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