[Federal Register Volume 85, Number 62 (Tuesday, March 31, 2020)]
[Notices]
[Pages 17910-17921]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-06617]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-88474; File No. SR-NSCC-2020-003]
Self-Regulatory Organizations; National Securities Clearing
Corporation; Notice of Filing of 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
March 25, 2020.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on March 16, 2020, National Securities Clearing Corporation (``NSCC'')
filed with the Securities and Exchange Commission (``Commission'') the
proposed rule change as described in Items I, II and III below, which
Items have been prepared by the clearing agency.\3\ The Commission is
publishing this notice to solicit comments on the proposed rule change
from interested persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ On March 16, 2020, NSCC filed this proposed rule change as
an advance notice (SR-NSCC-2020-802) with the Commission pursuant to
Section 806(e)(1) of Title VIII of the Dodd-Frank Wall Street Reform
and Consumer Protection Act entitled the Payment, Clearing, and
Settlement Supervision Act of 2010, 12 U.S.C. 5465(e)(1), and Rule
19b-4(n)(1)(i) under the Act, 17 CFR 240.19b-4(n)(1)(i). A copy of
the advance notice is available at http://www.dtcc.com/legal/sec-rule-filings.aspx.
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I. Clearing Agency's Statement of the Terms of Substance of the
Proposed Rule Change
The proposed rule change consists of modifications to NSCC's Rules
& Procedures (``Rules'') \4\ in order to enhance the calculation of
certain components of the Clearing Fund formula. First, the proposed
rule change would clarify and enhance the methodology for identifying
securities as illiquid for purposes of determining the applicable
calculation of the volatility component of the Clearing Fund formula,
and would revise the definition of ``Illiquid Security'' in the Rules
to reflect these changes.\5\ Second, the proposed rule change would
enhance the calculation of the haircut-based volatility component of
the Clearing Fund formula that is applied to positions in (1) Illiquid
Securities (which include securities that are priced at less than a
penny (``sub-penny securities'') and initial public offerings
(``IPOs'')), and (2) unit investment trusts (``UITs''). Third, the
proposed rule change would eliminate the existing Illiquid Charge, as
the risk it was designed to address would be addressed by the other
enhancements being proposed. Finally, NSCC would make certain changes
to Section I.(A) of Procedure XV (Clearing Fund Formula and Other
Matters) of the Rules (``Procedure XV'') \6\ for greater transparency.
Each of these proposed changes are described in greater detail below.
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\4\ Capitalized terms not defined herein are defined in the
Rules, available at http://dtcc.com/~/media/Files/Downloads/legal/
rules/nscc_rules.pdf.
\5\ See Rule 1 (Definitions and Descriptions). Id.
\6\ Procedure XV, supra note 4.
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II. Clearing Agency's Statement of the Purpose of, and Statutory Basis
for, the Proposed Rule Change
In its filing with the Commission, the clearing agency included
statements concerning the purpose of and basis for the proposed rule
change and discussed any comments it received on the proposed rule
change. The text of these statements may be examined at the places
specified in Item IV below. The clearing agency has prepared summaries,
set forth in sections A, B, and C below, of the most significant
aspects of such statements.
[[Page 17911]]
(A) Clearing Agency's Statement of the Purpose of, and Statutory Basis
for, the Proposed Rule Change
1. Purpose
NSCC is proposing a number of enhancements to its methodology for
calculations of certain components of the Clearing Fund. First, NSCC is
proposing to (1) clarify and improve the transparency and use of the
term ``Illiquid Security'' for purposes of determining the applicable
calculation of the volatility component of the Clearing Fund formula to
Net Unsettled Positions in those securities, and (2) enhance the
methodology used in this term by including additional criteria.\7\
Specifically, certain criteria relating to listing national securities
exchanges would continue to be utilized and would be enhanced and
described with greater clarity and transparency under the proposed
changes. In addition, NSCC would (i) add securities' market
capitalization and a median illiquidity ratio, as described in greater
detail below, as additional measurements of liquidity and (ii) remove
the references to OTC Bulletin Board and OTC Link issue. NSCC would
revise the definition of ``Illiquid Security'' in the Rules to reflect
these enhancements.
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\7\ ``Net Unsettled Positions'' and ``Net Balance Order
Unsettled Positions'' refer to net positions that have not yet
passed their settlement date, or did not settle on their settlement
date, and are referred to collectively in this filing as Net
Unsettled Positions. NSCC does not take into account any offsets,
such as inventory held at other clearing agencies, when determining
Net Unsettled Positions for the purpose of calculating the
volatility component. See Procedure XV, supra note 4.
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Second, NSCC would enhance the calculation of the haircut-based
volatility component of the Clearing Fund methodology for Net Unsettled
Positions in securities whose volatility is less amenable to
statistical analysis and securities whose volatility is amenable to
generally accepted statistical analysis only in a complex manner.
Currently, NSCC uses a fixed percentage in the calculation of charges
for Net Unsettled Positions in each of these securities.\8\ NSCC would
modify these calculations by adding two specific categories for
Illiquid Securities (as newly defined pursuant to the proposed changes)
and UITs. For Illiquid Securities, NSCC would apply a percentage that
is based on the applicable security's price level and for both Illiquid
Securities and UITs, NSCC would recalculate the applicable percentages
applied to such securities at least annually. NSCC would retain the
existing general categories for securities whose volatility is less
amenable to statistical analysis and securities whose volatility is
amenable to generally accepted statistical analysis only in a complex
manner for securities that fall within those descriptions but that are
not Illiquid Securities or UITs, and would continue to apply a fixed
percentage to such securities.
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\8\ See Section I.(A)(1)(a)(ii) and Section I.(A)(2)(a)(ii) of
Procedure XV, supra note 4.
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Third, NSCC would eliminate the existing Illiquid Charge. The
Illiquid Charge was designed to cover the risk that NSCC may be unable
to easily liquidate Net Unsettled Positions in Illiquid Securities in
the event of a Member default due to the securities' lack of
marketability and other characteristics. This risk would be addressed
by the enhanced criteria for identifying Illiquid Securities, and the
enhanced calculation of the applicable haircut-based volatility charge
proposed by this filing. Therefore, NSCC believes the Illiquid Charge
would no longer be needed to address these risks. In connection with
this proposed change, NSCC would also remove the definition of
``Illiquid Position'' from the Rules, as this term is only used in
connection with the calculation of the Illiquid Charge.
Finally, NSCC would provide greater detail to describe the
treatment of Net Unsettled Positions in corporate and municipal bonds
and long Net Unsettled Positions in Family-Issued Securities in Section
I.(A) of Procedure XV for greater transparency.
Each of the proposed changes is described in more detail below.
(i) Overview of the Required Fund Deposit and NSCC's Clearing Fund
As part of its market risk management strategy, NSCC manages its
credit exposure to Members by determining the appropriate Required Fund
Deposits to the Clearing Fund and monitoring its sufficiency, as
provided for in the Rules.\9\ The Required Fund Deposit serves as each
Member's margin. The objective of a Member's Required Fund Deposit
includes mitigation of potential losses to NSCC associated with
liquidation of the Member's portfolio in the event NSCC ceases to act
for that Member (hereinafter referred to as a ``default'').\10\ The
aggregate of all Members' Required Fund Deposits, together with certain
other deposits required under the Rules, constitutes the Clearing Fund
of NSCC, which it would access, among other instances, should a
defaulting Member's own Required Fund Deposit be insufficient to
satisfy losses to NSCC caused by the liquidation of that Member's
portfolio.
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\9\ See Rule 4 (Clearing Fund) and Procedure XV (Clearing Fund
Formula and Other Matters), supra note 4. NSCC's market risk
management strategy is designed to comply with Rules 17Ad-22(e)(4)
and (e)(6) under the Securities Exchange Act of 1934, where these
risks are referred to as ``credit risks.'' 17 CFR 240.17Ad-22(e)(4)
and (e)(6).
\10\ The Rules identify when NSCC may cease to act for a Member
and the types of actions NSCC may take. For example, NSCC may
suspend a firm's membership with NSCC or prohibit or limit a
Member's access to NSCC's services in the event that Member defaults
on a financial or other obligation to NSCC. See Rule 46
(Restrictions on Access to Services) of the Rules, supra note 4.
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Pursuant to the Rules, each Member's Required Fund Deposit amount
consists of a number of applicable components, each of which is
calculated to address specific risks faced by NSCC, as identified
within Procedure XV.\11\ Generally, the largest component of Members'
Required Fund Deposits is the volatility component. The volatility
component is designed to calculate the amount of money that could be
lost on a portfolio over a given period of time assumed necessary to
liquidate the portfolio, within a 99% confidence level.
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\11\ See Procedure XV, supra note 4.
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NSCC has two methodologies for calculating the volatility
component. For the majority of Net Unsettled Positions, NSCC calculates
the volatility component as the greater of (1) the larger of two
separate calculations that utilize a parametric Value at Risk (``VaR'')
model, (2) a gap risk measure calculation based on the concentration
threshold of the largest non-index position in a portfolio, and (3) a
portfolio margin floor calculation based on the market values of the
long and short positions in the portfolio (``VaR Charge'').\12\
Pursuant to Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure
XV, certain Net Unsettled Positions are excluded from the calculation
of the VaR Charge and are instead charged a haircut-based volatility
component that is calculated by multiplying the absolute value of the
position by a percent determined by NSCC that is (i) not less than 10%
for securities whose volatility is less amenable to statistical
analysis and (ii) not less than 2% for securities whose volatility is
amenable to generally accepted statistical analysis only in a complex
manner.\13\ Generally, certain equity securities, including Illiquid
Securities, fall within the first category as securities whose
volatility is less amenable to statistical analysis and fixed-income
securities, including UITs, fall within the second category as
[[Page 17912]]
securities whose volatility is amenable to generally accepted
statistical analysis only in a complex manner.\14\ The securities that
fall within either one of these categories tend to exhibit
unpredictable illiquid characteristics, such as low trading volumes or
infrequent trading. Because the VaR Charge is a model-based
calculation, which generally relies on predictability, this charge may
be less reliable for measuring market risk of securities that exhibit
unpredictable illiquid characteristics.\15\ Therefore, NSCC believes
that the haircut-based volatility charge is a more appropriate measure
of volatility for Net Unsettled Positions in these securities.
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\12\ See Sections I.(A)(1)(a)(i) and I.(A)(2)(a)(i) of Procedure
XV, supra note 4.
\13\ Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure
XV, supra note 4.
\14\ UITs are redeemable securities, or units, issued by
investment companies that offer fixed security portfolios for a
defined period of time.
\15\ More specifically, the model that is used to calculate the
VaR Charge relies on assumptions that are based on historic
observations of a security's price. Such assumptions are not
reliable predictors of price for securities that exhibit illiquid
characteristics, which generally have low trading volumes or are
infrequently traded.
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In addition to charging a haircut-based volatility component rather
than a VaR Charge for certain Illiquid Securities, Members' Required
Fund Deposits may also include an Illiquid Charge, which is calculated
as described in Sections I.(A)(1)(h) and I.(A)(2)(f) of Procedure
XV.\16\ The Illiquid Charge is a component of the Clearing Fund that
may be assessed with respect to ``Illiquid Positions,'' which are Net
Unsettled Positions in ``Illiquid Securities'' that exceed applicable
volume thresholds, as described in the definition of Illiquid Position
in Rule 1 of the Rules.\17\ The Illiquid Charge is designed to mitigate
the risk that NSCC may face when liquidating Net Unsettled Positions in
these securities following a Member default.
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\16\ Sections I.(A)(1)(h) and I.(A)(2)(f) of Procedure XV, supra
note 4.
\17\ Rule 1, supra note 4.
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Currently, an Illiquid Security is defined in the Rules as ``a
security, other than a family-issued security as defined in Procedure
XV, that either (i) is not traded on or subject to the rules of a
national securities exchange registered under [the Act]; or (ii) is an
OTC Bulletin Board \18\ or OTC Link issue.'' \19\
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\18\ The OTC Bulletin Board is an interdealer quotation system
that is used by subscribing members of the Financial Industry
Regulatory Authority (``FINRA'') to reflect market making interest
in eligible securities (as defined in FINRA's Rules). See http://www.finra.org/industry/otcbb/otc-bulletin-board-otcbb.
\19\ OTC Link is an electronic inter-dealer quotation system
that displays quotes from broker-dealers for many over-the-counter
securities. See https://www.otcmarkets.com.
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NSCC regularly assesses its market and credit risks, as such risks
are related to its margining methodologies, to evaluate whether margin
levels are commensurate with the particular risk attributes of each
relevant product, portfolio, and market.\20\ The proposed changes
described below are a result of NSCC's regular review of the
effectiveness of its margining methodology.
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\20\ See 17 CFR 240.17Ad-22(e)(6)(i), (e)(6)(vi).
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(ii) Proposed Enhancements to the Definition of Illiquid Security
NSCC is proposing to revise the Rules to (1) enhance certain
existing criteria used in the definition of Illiquid Security for
purposes of determining the applicable calculation of the volatility
component; (2) remove certain criteria that would become unnecessary
following the proposed enhancements; (3) enhance the definition by
introducing additional criteria; and (4) repurpose the enhanced
definition of Illiquid Security to use with respect to the calculation
of the volatility component, as described below. NSCC believes that the
proposed changes would provide Members with improved clarity and
transparency into the methodology used to apply this definition. The
proposed change would also provide NSCC with additional measures of a
security's liquidity to improve its ability to apply margin that
reflects the risk characteristics of that security.
Following the implementation of the proposed enhancements to this
definition, as described below, the definition of Illiquid Security in
Rule 1 of the Rules would be a security that: (i) Is not listed on a
specified securities exchange (defined below) as determined on a daily
basis; (ii) is listed on a specified securities exchange and, as
determined on a monthly basis, (a)(I) its market capitalization is
considered a micro-capitalization (as described below) as of the last
business day of the prior month or (II) it is an American depositary
receipt (``ADR''); and (b) the median of its calculated illiquidity
ratio (defined below) of the prior six months exceeds a threshold that
would be determined by NSCC on a monthly basis and is based on the 99th
percentile of the illiquidity ratio of non-micro-capitalization common
stocks \21\ over the prior six months; or (iii) is listed on a
specified securities exchange, and, as determined on a monthly basis,
has fewer than 31 business days of trading history over the past 153
business days on such exchange. As discussed above, because the VaR
Charge is a model-based calculation, which generally relies on
predictability, the VaR Charge may be less reliable for measuring
market risk of securities that exhibit unpredictable illiquid
characteristics.\22\ Each of the types of securities that would be in
the definition of Illiquid Security are securities that tend to exhibit
unpredictable illiquid characteristics including limited trading
volumes or infrequent trading.
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\21\ Securities that are exchange-traded products (``ETPs'') or
ADRs would not be included when calculating the illiquidity ratio
threshold. ETPs are not included when calculating the illiquidity
ratio threshold because the underlying common stocks that comprise
the indexes of equity ETPs are included in the calculation. ADRs are
not included when calculating the illiquidity ratio threshold
because the market capitalization of ADRs may be difficult to
calculate because each ADR often converts to different number of
shares of a local security. In addition, if NSCC is unable to
retrieve data to calculate the illiquidity ratio for the median
illiquidity ratio for a security on any day, NSCC would use a
default value for that day for purposes of the calculation for the
security (i.e., the security would essentially be treated as
illiquid for that day).
\22\ See supra note 15.
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For purposes of this definition a ``specified securities exchange''
would be a national securities exchange that has established listing
services and is covered by industry pricing and data vendors.\23\
Initially, NSCC would define micro-capitalization as capitalization of
less than $300 million. Consistent with generally prevailing views,
NSCC believes that given the lack of public information and limited
trading volumes, securities with capitalization below this threshold
tend to involve higher risks and exhibit illiquid characteristics.\24\
NSCC may adjust this definition from time to time as appropriate in
order to continue to reflect a threshold that captures securities with
capitalization that would indicate that the securities exhibit illiquid
characteristics. Changes to the micro-capitalization threshold would be
subject to NSCC's model risk management governance procedures set forth
in the Clearing Agency Model Risk Management Framework (``Model Risk
Management Framework'').\25\ NSCC
[[Page 17913]]
would notify Members of changes to the micro-capitalization threshold
by important notice. For purposes of the definition of Illiquid
Security, the ``illiquidity ratio'' of a security on any day would be
equal to (i) the price return of such security on such day (based on
the natural logarithm of the ratio between the closing price of the
stock on such day to the closing price of the stock on the prior
trading day) divided by (ii) the average daily trading amount \26\ of
such security over the prior 20 business days.\27\
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\23\ The exchanges that would initially be specified securities
exchanges are: New York Stock Exchange LLC, NYSE American LLC, NYSE
Arca, Inc., The Nasdaq Stock Market and Cboe BZX Exchange, Inc.
\24\ See, e.g., https://www.sec.gov/reportspubs/investor-publications/investorpubsmicrocapstockhtm.html.
\25\ See Securities Exchange Act Release No. 81485 (August 25,
2017), 82 FR 41433 (August 31, 2017) (File No. SR-NSCC-2017-008)
(describes the adoption of the Model Risk Management Framework of
NSCC which sets forth the model risk management practices of NSCC)
and Securities Exchange Act Release No. 84458 (October 19, 2018), 83
FR 53925 (October 25, 2018) (File No. SR-NSCC-2018-009) (amends the
Model Risk Management Framework). The Model Risk Management
Framework describes the model management practices adopted by NSCC,
which have been designed to assist NSCC in identifying, measuring,
monitoring, and managing the risks associated with the design,
development, implementation, use, and validation of ``models'' which
would include the methodology for determining the volatility
component of the Clearing Fund. Id.
\26\ The daily trading amount equals the daily trading volume
multiplied by the end-of-day price.
\27\ NSCC believes that the 20-business day period is sufficient
to reflect recent market activity for the security.
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a. Enhancements to the Existing Criteria in the Definition of Illiquid
Security
NSCC is proposing to enhance existing criteria in the definition of
Illiquid Security as set forth below.
In the current definition, an Illiquid Security is a security that
is ``either (i) not traded or subject to the rules of a national
securities exchange registered under the Securities Exchange Act of
1934, as amended; or (ii) is an OTC Bulletin Board or OTC Link issue.''
\28\ On a daily basis, NSCC receives from third party vendors data
relating to securities processed through NSCC which indicates the
exchanges, if any, on which each security is listed. If a security is
not listed on of one of the national securities exchanges covered by
the third party vendors, then, currently, NSCC would consider that
security an Illiquid Security for the purpose of calculating the
Illiquid Charge.\29\ Based on historic performances, NSCC believes the
national securities exchanges that the vendors cover for this purpose
are appropriate for determining if a security exhibits characteristics
of liquidity because such exchanges have established listing services
and are covered by industry pricing and data vendors. NSCC believes
that such exchanges tend to list securities that exhibit liquid
characteristics such as having more available public information,
larger trading volumes and higher capitalization. NSCC continues to
believe this analysis is appropriate for identifying securities that
exhibit illiquid characteristics, and would retain and enhance this
criterion in the definition in the Rules by specifying that it uses the
specified securities exchanges that have established listing services
and that are covered by industry pricing and data vendors and providing
that it would determine on a daily basis whether securities are subject
to the rules of a specified securities exchange.
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\28\ See Rule 1, supra, note 4.
\29\ The exchanges that have established listing services that
the vendors cover for this purpose are: New York Stock Exchange LLC,
NYSE American LLC, NYSE Arca, Inc., The Nasdaq Stock Market and Cboe
BZX Exchange, Inc. Members' Clearing Fund Summary reports, available
through the DTCC Risk Portal, identify securities within their
portfolio by the ticker symbol and whether those securities are
considered Illiquid Securities for purposes of the calculation of
the Illiquid Charge. This information provides Members with insight
into the basis for their margin calculations.
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NSCC would use the same process for determining whether a security
is an Illiquid Security based on if such security is listed on a
national security exchange and would enhance the definition to reflect
the process that will be used. NSCC would change ``national securities
exchange registered under the Securities Exchange Act of 1934, as
amended'' to ``specified securities exchange'' in the definition of
Illiquid Security and add a defined term for ``specified securities
exchange'', which would be a national securities exchange that has
established listing services and is covered by industry pricing and
data vendors.
As a further enhancement, NSCC is proposing to replace the phrase
``not traded on or subject to the rules of'' with ``not listed on'' to
more accurately describe the process that NSCC and its vendors use to
determine if a security is on a national securities exchange. In
addition, determining whether a security is listed on an exchange is
more definitive and more reliably verifiable than determining whether a
security is traded on or subject to the rules of a securities exchange.
NSCC is also proposing to remove references to the OTC Bulletin Board
and OTC Link issues in the definition of Illiquid Security. NSCC
believes that the definition as revised pursuant to this rule change
would capture securities listed on the OTC Bulletin Board and OTC Link
and the reference to such platforms is unnecessary.
NSCC is also proposing to remove the phrase ``other than a family
issued security as defined in Procedure XV'' from the definition of
Illiquid Security because family issued security is not defined in
Procedure XV and, given the new proposed use of the definition of
Illiquid Security together with other proposed changes, it is not
necessary to exclude Family-Issued Securities from the definition. The
current defined term ``Illiquid Security'' is only used in the defined
term ``Illiquid Position'' and in sections relating to the Illiquid
Charge which would be removed pursuant to the proposed changes as
described herein. The phrase ``other than a family issued security as
defined in Procedure XV'' was intended to ensure that long Net
Unsettled Positions in Family-Issued Securities are excluded from the
Illiquid Charge.\30\ Currently, short Net Unsettled Positions in
Family-Issued Securities whose volatility is less amenable to
statistical analysis are subject to the haircut set forth in Sections
I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure XV. In addition, short
Net Unsettled Positions in Family-Issued Securities that are Illiquid
Positions are currently subject to the Illiquid Charge.\31\ Long Net
Unsettled Positions in Family Issued Securities are not subject to the
haircut set forth Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of
Procedure XV nor to the Illiquid Charge.
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\30\ Long Net Unsettled Positions in Family-Issued Securities
are not subject to the Illiquid Charge because the risk that long
Net Unsettled Positions in Family-Issued Securities raise, wrong way
risk, is separately provided for by a separate charge for such
securities. See Section I.(A)(1)(a)(iv) and Section I.(A)(2)(a)(iv),
supra note 4. Wrong way risk is a risk that an exposure to a
counterparty is highly likely to increase when the creditworthiness
of that counterparty deteriorates. See Principles for financial
market infrastructures, issued by the Committee on Payment and
Settlement Systems and the Technical Committee of the International
Organization of Securities Commissions, pg. 47 n.65 (April 2012),
available at http://www.bis.org/publ/cpss101a.pdf. Short Net
Unsettled Positions in Family-Issued Securities do not present the
same wrong way risk as long Net Unsettled Positions in Family-Issued
Securities. See note 29 below.
\31\ The defined term ``Illiquid Security'' currently excludes
``a family issued security as defined in Procedure XV'', however,
family issued security is not defined in Procedure XV. The defined
term Illiquid Security was added to the Rules in 2017. See
Securities Exchange Act Release No. 80260 (March 16, 2017), 82 FR
14781 (March 22, 2017) (File No. SR-NSCC-2017-001). When the defined
term was added, the section where family issued securities was
defined in Procedure XV was referring to a separate charge that was
applied to long Net Unsettled Positions in Family-Issued Securities
and the exclusion of ``family issued security'' from the defined
term Illiquid Security was intended to refer to long Net Unsettled
Positions in Family-Issued Securities not short Net Unsettled
Positions in Family-Issued Securities.
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As described below, following the proposed rule change, the defined
term Illiquid Security would be repurposed to be used in Sections
I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure XV which sections
would apply to certain short Net Unsettled Positions in Family-Issued
Securities.\32\ As is the case
[[Page 17914]]
currently, only long Net Unsettled Positions in Family-Issued
Securities would be excluded from the calculations in Sections
I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure XV which would be
noted in I.(A)(1)(a)(ii) as proposed below. The proposed rule change
would not change the treatment of long Net Unsettled Positions in
Family-Issued Securities which would remain subject to the calculations
set forth in Sections I.(A)(1)(a)(iv) and I.(A)(2)(a)(iv) of Procedure
XV.
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\32\ NSCC has identified exposure to specific wrong-way risk
when it acts as central counterparty to a Member with long positions
in Family-Issued Securities. In the event a Member with long
positions in Family-Issued Securities defaults, NSCC would close out
those positions following a likely drop in the creditworthiness of
the issuer, possibly resulting in a loss to NSCC from a resulting
drop in price in the securities. As such, NSCC provides a specific
charge for such securities. See id. Short positions present a
different risk profile than long positions in this close out
scenario based on, in part, the difference in the potential
responsiveness of price change to quantity that may occur when NSCC
is liquidating a long position in an Illiquid Security, compared to
when it is liquidating a short position. As a result, the charge for
Family-Issued Securities is only applied to long positions in such
securities.
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NSCC believes that each of these proposed changes would improve the
definition for its new proposed purpose and improve Members'
transparency into the application of the existing criteria of the
Illiquid Security definition.
b. New Criteria in the Definition of Illiquid Security
NSCC is also proposing to include additional criteria in order to
identify securities that exhibit illiquid characteristics and may not
be captured by the existing definition as described below.
Although the criterion for this definition relating to whether a
security is traded on or subject to the rules of a specified securities
exchange would be determined on a daily basis, as noted above, under
the proposal, NSCC would also apply new criteria, described below, on a
monthly basis, to identify those securities that are subject to the
rules of a specified securities exchange but may still exhibit illiquid
characteristics and should be identified as Illiquid Securities. The
new criteria would be based on (i) the security's market capitalization
and (ii) the trading history of the security. In addition, ADRs would
also be subject to additional review to determine if they should be
deemed to be Illiquid Securities.
First, NSCC is proposing to revise the definition of Illiquid
Security to identify securities issued by an entity with a micro-
capitalization, which can be a characteristic of illiquidity. For
purposes of this criterion, NSCC would calculate the product of the
outstanding shares and market price on a daily basis for each issuance.
Each month, NSCC would use the average of those calculations over the
prior month to determine market capitalization. If the average for a
particular security is below a threshold determined by NSCC from time
to time, the security would be considered micro-capitalization.
Initially, NSCC would define micro-capitalization as capitalization of
less than $300 million. Securities with a capitalization below $300
million and which are considered micro-capitalization tend to exhibit
illiquid characteristics such as limited public information and lower
trading volumes. NSCC may update the micro-capitalization threshold
from time to time as announced by an important notice to the Members.
Changes to the threshold would be subject to NSCC's model risk
governance procedures set forth in the Model Risk Management
Framework.\33\
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\33\ See supra note 25.
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If the average market capitalization of a security is considered
micro-capitalization or if the security is an ADR, then the security
would be subject to an additional illiquidity ratio test described
below to determine if it is an Illiquid Security. NSCC believes it is
appropriate to subject a security to the illiquidity ratio test if a
security is considered within the range of micro-capitalization because
the capitalization of a security could be an indicator of the lack of
liquidity of a security. In addition, for ADRs, the market
capitalization of the ADR may be difficult to calculate because each
ADR often converts to different number of shares of a local security.
As a result, NSCC has decided to subject all ADRs to the illiquidity
ratio test to determine if it is an Illiquid Security. As noted
above,\34\ ETPs and ADRs would be excluded from the pool of securities
that are used to calculate the illiquidity ratio threshold. However,
ETPs that are considered micro-capitalization and ADRs would be subject
to the illiquidity ratio test to determine if they are Illiquid
Securities.
---------------------------------------------------------------------------
\34\ See supra note 21.
---------------------------------------------------------------------------
If a security is considered within the range of micro-
capitalization or if the security is an ADR, it would be subject to
additional illiquidity ratio test that would include the application of
an ``illiquidity ratio'' to determine if the security should be deemed
an Illiquid Security. The illiquidity ratio of a security on any day
would be equal to (i) the security's price return on such day (based on
the natural logarithm of the ratio between the closing price of the
stock on such day to the closing price of the stock on the prior
trading day) divided by (ii) the average daily trading amount \35\ of
such security over the prior 20 business days.\36\ The illiquidity
ratio for each security that is subject to this illiquidity ratio test
would be determined monthly.
---------------------------------------------------------------------------
\35\ Supra note 26.
\36\ For example, assuming Stock A has a closing price of $10 on
day 1, and a closing price of $11 on day 2, then the ``price
return'' as of day 2 would be abs(log(11/10)) = 0.09531018. Assuming
the average daily trading amount of the stock over the prior 20
business days is $1,100,000, the daily ``illiquidity ratio'' for
Stock A on day 2 is 0.09531018 divided by 1,100,000 x 10[supcaret]6
= 0.0866.
---------------------------------------------------------------------------
A security that is subject to the illiquidity ratio test would only
be deemed an Illiquid Security if the calculated median illiquidity
ratio of the prior six months exceeds a threshold to be determined by
NSCC on a monthly basis based on the 99th percentile of the illiquidity
ratio of non-micro-capitalization common stocks over the prior six
months.\37\ If the calculated median illiquidity ratio of a security
did not exceed such threshold it would not be deemed an Illiquid
Security and would be subject to the VaR Charge. NSCC believes the
illiquidity ratio would provide it with a reliable measurement of a
security's liquidity because NSCC would use the absolute value of the
daily return-to-volume ratio to capture price impact. Given the same
dollar amount of trading activity, higher price impact typically
indicates less liquidity.
---------------------------------------------------------------------------
\37\ See supra note 21.
---------------------------------------------------------------------------
Second, NSCC would include in the Illiquid Security definition
securities that are subject to the rules of a specified securities
exchange, but, as determined on a monthly basis, have fewer than 31
business days of trading history over the past 153 business days on
such exchange. NSCC has historically used this time period to identify
IPOs which tend to exhibit illiquid characteristics due to their
limited trading history.\38\
---------------------------------------------------------------------------
\38\ NSCC has observed that the use of the metric, 31 business
days of trading over the past 153 business days, has been useful in
identifying securities, such as IPOs, that exhibit illiquid
characteristics based on their limited trading history. As such,
NSCC would use this metric in the definition of Illiquid Security to
ensure that these securities, including IPOs, are identified as
Illiquid Securities.
---------------------------------------------------------------------------
In order to implement these proposed changes, NSCC would include
these additional criteria in the revised definition of ``Illiquid
Security'' in Rule 1 of the Rules.
[[Page 17915]]
(iii) Proposed Enhancement to the Volatility Component Applicable to
Illiquid Securities and UITs
NSCC is also proposing to enhance the calculation of the haircut-
based volatility component for Illiquid Securities and UITs. As
described above, Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of
Procedure XV currently provide that NSCC has the discretion to exclude
from the VaR Charge Net Unsettled Positions in classes of securities
whose volatility is (1) less amenable to statistical analysis, or (2)
amenable to generally accepted statistical analysis only in a complex
manner, and permits NSCC to instead calculate the volatility charge for
Net Unsettled Positions in these securities as a haircut-based
charge.\39\
---------------------------------------------------------------------------
\39\ See Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of
Procedure XV, supra note 4.
---------------------------------------------------------------------------
Pursuant to this authority, NSCC calculates the volatility charge
for IPOs by multiplying the absolute value of the Net Unsettled
Position by a fixed 15%, and calculates the volatility charge for all
other Illiquid Securities (as currently defined) and sub-penny
securities by multiplying the absolute value \40\ of the Net Unsettled
Position by a fixed 20%. Net Unsettled Positions in UITs are subject to
the same haircut-based volatility charge as other securities whose
volatility is amenable to generally accepted statistical analysis only
in a complex manner. Today, NSCC generally does not adjust the
applicable haircut-based volatility charge, which is a percent that is
no less than 2%, pursuant to Procedure XV.
---------------------------------------------------------------------------
\40\ For purposes of the calculating the absolute value, the
share price of each sub-penny security is rounded up to one cent. If
a transaction in any security with a share price below one cent is
entered into NSCC's Continuous Net Settlement system or Balance
Order Accounting Operation, NSCC rounds up the price of the security
to one cent.
---------------------------------------------------------------------------
Based on backtesting results, NSCC has observed that market price
movements are correlated to a security's market price. Therefore, NSCC
believes it would be able to calculate a haircut-based volatility
charge that more appropriately addresses the risks presented by a Net
Unsettled Position if NSCC considers a security's price level or risk
profile when determining the haircut percentage to be used in that
calculation. As described below, NSCC is proposing to enhance the
calculation of the haircut-based volatility component for Illiquid
Securities and UITs. In order to implement the changes described below,
NSCC would revise Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of
Procedure XV by including new subsections (A)(I) and (II) and (B)(I)
and (II) relating to such securities.
a. Enhancing the Volatility Charge for Illiquid Securities
First, NSCC is proposing to enhance the haircut-based volatility
charge for Illiquid Securities. The applicable percent would be
determined at least annually \41\ as the highest of (1) 10%, (2) a
percent benchmarked to be sufficient to cover 99.5th percentile of the
historical 3-day return of each group of Illiquid Securities \42\ in
each Member's portfolio and (3) a percent benchmarked to be sufficient
to cover 99th percentile of the historical 3-day return of each group
in each Member's portfolio after incorporating a fixed transaction
cost.\43\ The applicable percent, and the determination of how often
the applicable percent is determined if more often than annually, would
be subject to NSCC's model risk management governance procedures set
forth in the Model Risk Management Framework.\44\ The look-back period
for this calibration would be no less than five years and would
initially be five years to be consistent with the historical data set
used in model development. The look-back period may be adjusted by NSCC
as necessary consistent with the model risk management practices
adopted by NSCC to respond to, for example, market events that impact
liquidity in the market and Member backtesting deficiencies.
Adjustments to the look-back period would be subject to NSCC's model
risk governance procedures set forth in the Model Risk Management
Framework.\45\ Generally, lower priced securities that may present NSCC
with a greater risk would be charged a haircut-based volatility charge
based on a higher percent.
---------------------------------------------------------------------------
\41\ A number of important considerations consistent with the
model risk management practices adopted by NSCC could prompt more
frequent haircut review, such as material deterioration of Members'
backtesting performance, market events or structure changes, and
model validation findings. See also Model Risk Management Framework,
supra note 25.
\42\ NSCC would group Illiquid Securities by price level, and
Illiquid Securities that are sub-penny securities would be
separately grouped by long or short position, as discussed in more
detail below.
\43\ The fixed transaction cost would be equal to one-half of
the estimated bid-ask spread and would be included in the simulated
liquidation gain/loss of the positions in each Member's portfolio.
\44\ See supra note 25.
\45\ See supra note 25.
---------------------------------------------------------------------------
NSCC would group Illiquid Securities by price level, and Illiquid
Securities that are sub-penny securities would be separately grouped by
long or short position, where each group is assigned a percent to be
used in the calculation of the haircut-based volatility charge. The
price level groupings would be subject to NSCC's model risk management
governance procedures set forth in the Model Risk Management
Framework.\46\ The proposal would allow NSCC to calculate this charge
based on the market price of Illiquid Securities. With respect to an
Illiquid Security that is not a sub-penny security, NSCC would
calculate one haircut-based volatility charge for short and long
positions. However, with respect to an Illiquid Security that is a sub-
penny security, NSCC would calculate the haircut-based volatility
charge for short positions and long positions separately. NSCC believes
the proposed change is appropriate for Illiquid Securities that are
sub-penny securities, particularly as short positions in sub-penny
securities could experience price movements of more than 100%. Further,
these securities are typically issued by companies with low market
capitalization, and may be susceptible to market manipulation,
enforcement actions, or private litigation. The proposed change would
allow NSCC to calculate a haircut-based volatility charge that accounts
for this risk of price movements. Although sub-penny securities would
be separately grouped by price level based on the sub-penny values,
since the price of sub-penny securities is rounded up to one cent when
it is entered into the Continuous Net Settlement System and Balance
Order Accounting Operation, the current market price of each sub-penny
security would be deemed to be one cent for purposes of applying the
haircut-based volatility charge.
---------------------------------------------------------------------------
\46\ See supra note 25.
---------------------------------------------------------------------------
By setting a floor of 10%, the proposal would allow NSCC to charge
an amount that has been adequate, based on historical observation, to
address risks presented by Net Unsettled Positions in these securities
and is consistent with the current methodology, which also sets a floor
for the haircut-based volatility charge of no less than 10%. In this
way, the haircut-based volatility charge would be calculated to allow
NSCC to collect margin at levels that reflect the risk presented by
these Net Unsettled Positions. Unlike the current methodology which
provides NSCC the discretion to apply a haircut, NSCC would not have
discretion as to whether to apply the haircut-based volatility charge
to Illiquid Securities and all Illiquid Securities would be subject to
the charge.
In order to implement this proposed change, NSCC would describe the
haircut-based volatility charge applicable to Illiquid Securities in
the
[[Page 17916]]
new Sections I.(A)(1)(a)(ii)(B)(I) and I.(A)(2)(a)(ii)(B)(I) of
Procedure XV.
b. Enhancing the Volatility Charge for UITs
NSCC is also proposing to revise the calculation of the haircut-
based volatility charge applied to UITs by reviewing the percent used
in this calculation at least annually, in order to apply a haircut-
based volatility charge to Net Unsettled Positions in UITs that is more
closely based on a measurement of the risk presented by Members'
portfolio composition and market conditions.
Currently, NSCC applies a haircut-based volatility charge that is a
fixed 2% to Net Unsettled Positions in securities whose volatility is
amenable to generally accepted statistical analysis (for example, the
methodology used to calculate the VaR Charge) only in a complex manner,
which include UITs. NSCC is proposing to continue to apply a haircut-
based volatility charge to Net Unsettled Positions in UITs that would
be no less than 2%, as currently provided for in Procedure XV, but
would re-calculate the applicable percent designated by NSCC at least
annually. The re-calculation of the applicable percent would be subject
to NSCC's model risk management governance procedures set forth in the
Model Risk Management Framework.\47\ Subject to this existing floor,
the applicable percent would be benchmarked to be sufficient to cover
99.5th percentile of the historical 3-day return of UITs in each
Member's portfolio, with a lookback period of no less than five years.
Unlike the current methodology which provides NSCC the discretion to
apply a haircut, NSCC would not have discretion as to whether to apply
the haircut-based volatility charge to UITs and all UITs would be
subject to the charge.
---------------------------------------------------------------------------
\47\ See supra note 25.
---------------------------------------------------------------------------
In order to implement this proposed change, NSCC would describe the
haircut-based volatility charge applicable to UITs in the new Sections
I.(A)(1)(a)(ii)(B)(II) and I.(A)(2)(a)(ii)(B)(II) of Procedure XV.
c. Enhancing Existing Language for Volatility Charge
NSCC is also proposing to re-arrange the existing language relating
to securities whose volatility is (1) less amenable to statistical
analysis, or (2) amenable to generally accepted statistical analysis
only in a complex manner, to clarify the language and make it more
transparent. NSCC would move the description of securities whose
volatility is less amenable to statistical analysis to new Sections
I.(A)(1)(a)(ii)(A)(I) and I.(A)(2)(a)(ii)(A)(I) of Procedure XV and
move the description of securities whose volatility is amenable to
generally accepted statistical analysis only in a complex manner to new
Sections I.(A)(1)(a)(ii)(A)(II) and I.(A)(2)(a)(ii)(A)(II). NSCC would
indicate that securities that are Illiquid Securities or UITs would not
be subject to these general categories. NSCC would also remove the
phrase ``such as OTC Bulletin Board or Pink Sheet issues or issues
trading below a designated dollar threshold (e.g., five dollars)''
which was intended as an example of securities whose volatility is less
amenable to statistical analysis because NSCC does not believe that the
example adequately describes all of the securities that are less
amenable to statistical analysis and may be misleading. In addition,
securities in the example would include securities that are Illiquid
Securities and that would no longer be subject to this general
category. In addition, NSCC is proposing to remove the phrase ``other
than corporate and municipal bonds,'' which qualifies securities
amenable to generally accepted statistical analysis only in a complex
manner, because the treatment of corporate and municipal bonds would be
clarified as set forth in subsection (v) below.
NSCC believes that the new defined term Illiquid Security would
identify all securities for which a haircut is currently applied
because such securities are less amenable to statistical analysis
pursuant to Sections I.(A)(1)(a)(ii)(x) and I.(A)(2)(a)(ii)(x) of
Procedure XV.\48\ The haircut for Illiquid Securities upon
implementation of the rule change would be calculated pursuant to the
new category for Illiquid Securities under Sections
I.(A)(1)(a)(ii)(B)(I) and I.(A)(2)(a)(ii)(B)(I) of Procedure XV rather
than Sections I.(A)(1)(a)(ii)(A)(I) and I.(A)(2)(a)(ii)(A)(I) of
Procedure XV. NSCC believes that UITs are currently substantially all
of the securities for which a haircut is currently applied because such
securities are amenable to generally accepted statistical analysis only
in a complex manner pursuant to Sections I.(A)(1)(a)(ii)(y) and
I.(A)(2)(a)(ii)(y) of Procedure XV.\49\ The haircut for UITs upon
implementation of the rule change would be calculated pursuant to the
new category for UITs under Sections I.(A)(1)(a)(ii)(B)(II) and
I.(A)(2)(a)(ii)(B)(II) of Procedure XV rather than Sections
I.(A)(1)(a)(ii)(A)(II) and I.(A)(2)(a)(ii)(A)(II) of Procedure XV.
---------------------------------------------------------------------------
\48\ See Sections I.(A)(1)(a)(ii)(x) and I.(A)(2)(a)(ii)(x) of
Procedure XV, supra note 4.
\49\ See Sections I.(A)(1)(a)(ii)(y) and I.(A)(2)(a)(ii)(y) of
Procedure XV, supra note 4. Note that the haircuts for municipal and
corporate bonds which are also fixed-income securities that are
amenable to generally accepted statistical analysis only in a
complex manner are separately calculated pursuant to Sections
I.(A)(1)(a)(iii) and I.(A)(2)(a)(iii) of Procedure XV. See Sections
I.(A)(1)(a)(iii) and I.(A)(2)(a)(iii) of Procedure XV, supra note 4.
Examples of fixed income securities that may remain subject to
calculations under Sections I.(A)(1)(a)(ii)(A)(I) and
I.(A)(2)(a)(ii)(A)(I) of Procedure XV would include preferred stock
or other fixed income securities that are amenable to generally
accepted statistical analysis only in a complex manner other than
UITs or corporate or municipal bonds.
---------------------------------------------------------------------------
There are some types of securities that are amenable to generally
accepted statistical analysis only in a complex manner that would not
constitute UITs and for which a haircut would continue to be calculated
using the category for securities that are amenable to generally
accepted statistical analysis only in a complex manner upon
implementation of the rule change. NSCC believes that there are no
current types of securities for which the haircut would be calculated
using the general category for securities that are less amenable to
statistical analysis upon implementation of the rule change. NSCC,
however, may deem it necessary to calculate a haircut for securities
that fall within this existing category, if such securities do not fall
within the categories for Illiquid Securities, after assessing margin
suitability or future asset class reviews. Therefore, NSCC is proposing
to keep these two more general categories in the Rules revised as
contemplated above. As with these existing general categories
currently, NSCC would have the discretion to determine whether a
security fits within one of these categories. NSCC would follow its
existing risk management practices and procedures when determining
whether to apply a security that is not an Illiquid Security or a UIT
to one of these categories. Applying a new security to one of these
categories would be subject to NSCC's model risk management governance
procedures set forth in the Model Risk Management Framework.\50\
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\50\ See supra note 25.
---------------------------------------------------------------------------
(iv) Proposal To Eliminate the Illiquid Charge
NSCC is proposing to eliminate the existing Illiquid Charge in
conjunction with the aforementioned enhancements. The Illiquid Charge
is currently imposed on Net Unsettled Positions in Illiquid Securities,
in addition to other applicable components of the Clearing Fund.
Because the current haircut-based volatility charge is a flat charge,
calculated as a percentage of the
[[Page 17917]]
absolute value of these Net Unsettled Positions, it may not currently
address the lack of liquidity and marketability that are characteristic
of Illiquid Securities. The Illiquid Charge is calculated and applied
to address these additional risks. Currently, due to the existing
definition of Illiquid Security, the Illiquid Charge has limited
applicability, and generally only applies to a small population of
securities that exhibit illiquid characteristics (i.e., over-the-
counter securities traded off-exchange).\51\
---------------------------------------------------------------------------
\51\ Between November 2017 and November 2018, the Illiquid
Charge represented an average of approximately 1.5% of the total
Clearing Fund requirement.
---------------------------------------------------------------------------
However, NSCC believes the proposed enhancements would address the
risks presented by Net Unsettled Positions in Illiquid Securities more
adequately. As described above, the enhanced methodology for
identifying Illiquid Securities would enable NSCC to identify
additional securities that could pose credit exposure to NSCC. Further,
NSCC believes that the proposed methodology for calculating the
applicable haircut-based volatility charge would be more responsive to
the risks presented by Net Unsettled Positions in those securities
because it would be based on historical performance and would be
recalibrated more frequently. Therefore, NSCC is proposing to eliminate
the Illiquid Charge in connection with these proposed rule changes as
it would be no longer needed to address the risks presented by Illiquid
Securities.
In connection with this change, NSCC would also remove the
definition of ``Illiquid Position'' from Rule 1 of the Rules, as this
term is only used in connection with the Illiquid Charge.
In order to implement this proposed change, NSCC would amend Rule 1
of the Rules by removing the definition of ``Illiquid Position,'' and
NSCC would amend Procedure XV by removing references to the Illiquid
Charge in subsection (g) of Section I.(A)(1) and subsection (e) of
Section I.(A)(2) and removing subsection (h) of Section I.(A)(1) and
subsection (f) of Section I.(A)(2) where the Illiquid Charge is
currently described.
(v) Proposal To Enhance Language in Section I.(A) of Procedure XV
In addition to the enhancements described above, NSCC is proposing
to make the following changes to Section I.(A) of Procedure XV: (x) Add
language in subsections (1)(a)(ii) and (iii), and (2)(a)(ii) and (iii),
that indicates that Net Unsettled Positions in corporate and municipal
bonds are excluded from calculations in subsections (1)(a)(i) and (ii),
and (2)(a)(i) and (ii), respectively; and (y) add language in
subsections (1)(a)(ii) and (iv), and 2(a)(ii) and (iv), that indicates
that long Net Unsettled Positions in Family-Issued Securities are
excluded from calculations in subsections (1)(a)(i) and (ii), and
(2)(a)(i) and (ii), respectively. The current language indicates that
corporate and municipal bonds and long Net Unsettled Positions in
Family-Issued Securities are excluded from calculations in subsections
(1)(a)(i) and (2)(a)(i) but does not explicitly indicate that corporate
and municipal bonds and long Net Unsettled Positions in Family-Issued
Securities are excluded from (1)(a)(ii) and (2)(a)(ii). NSCC currently
applies a haircut for corporate and municipal bonds pursuant to
(1)(a)(iii) and (2)(a)(iii) and long Net Unsettled Positions in Family-
Issued Securities pursuant to subsections (1)(a)(iii) and (2)(a)(iii)
and does not apply a haircut for those securities pursuant to
subsections (1)(a)(ii) or (2)(a)(ii).\52\ The proposed changes are
intended to improve Members' transparency into the treatment of Net
Unsettled Positions in corporate and municipal bonds and long Net
Unsettled Positions in Family-Issued Securities in Section I.(A) of
Procedure XV and would not change NSCC's methodology with respect to
corporate and municipal bonds or long Net Unsettled Positions in
Family-Issued Securities.
---------------------------------------------------------------------------
\52\ As discussed above, currently, short Net Unsettled
Positions in Family-Issued Securities whose volatility is less
amenable to statistical analysis are subject to the haircut set
forth in Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure
XV. In addition, short Net Unsettled Positions in Family-Issued
Securities that are Illiquid Positions are currently subject to the
Illiquid Charge.
---------------------------------------------------------------------------
2. Statutory Basis
NSCC believes that the proposed changes described above are
consistent with the requirements of the Act and the rules and
regulations thereunder applicable to a registered clearing agency. In
particular, NSCC believes that the proposed changes are consistent with
Section 17A(b)(3)(F) of the Act,\53\ and Rules 17Ad-22(e)(4)(i),
(e)(6)(i), and (e)(6)(v), each promulgated under the Act,\54\ for the
reasons described below.
---------------------------------------------------------------------------
\53\ 15 U.S.C. 78q-1(b)(3)(F).
\54\ 17 CFR 240.17Ad-22(e)(4)(i), (e)(6)(i), and (e)(6)(v).
---------------------------------------------------------------------------
Section 17A(b)(3)(F) of the Act \55\ requires that the rules of
NSCC be designed to, among other things, assure the safeguarding of
securities and funds which are in the custody or control of the
clearing agency or for which it is responsible. NSCC believes the
proposed changes are designed to assure the safeguarding of securities
and funds which are in its custody or control or for which it is
responsible because they are designed to enable NSCC to better limit
its exposure to Members in the event of a Member default, as described
below.
---------------------------------------------------------------------------
\55\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
First, NSCC is proposing to enhance the definition of Illiquid
Security by (i) enhancing an existing criterion used in this definition
relating to whether a security is subject to the rules of a national
securities exchange by specifying that NSCC would rely on a list of
specified securities exchanges that includes exchanges that have
established listing services and are covered by industry pricing and
data vendors, (ii) deleting references to OTC Link and OTC Bulletin
Board and (iii) adding new criteria it would use to assess the risks a
security may present to NSCC due to its illiquid characteristics based
on the market capitalization of the issuer of the security and the
trading history of the security. The enhancements to the existing
criterion relating to whether a security is subject to the rules of a
national securities exchange would provide that NSCC would utilize a
process that identifies securities listed on national securities
exchanges that have established listing services and are covered by
industry pricing and data vendors and as a result that list securities
that are less likely to exhibit illiquid characteristics. Therefore,
NSCC, by identifying which securities are listed on these exchanges,
would enhance its ability to determine securities that exhibit
illiquidity characteristics. In addition, the enhancements would
improve Members' understanding of the analysis by ensuring that the
Members better understand the process used by NSCC for defining
Illiquid Securities based on whether a security is subject to the rules
of a specified securities exchange. The references to OTC Link and OTC
Bulletin Board would be removed because following the enhancements made
pursuant to this rule change, the definition as revised pursuant to
this rule change would capture securities listed on the OTC Bulletin
Board and OTC Link and the reference to such platforms would be
unnecessary.
The proposed additional criteria are designed to capture additional
risk presented by securities that are subject to the rules of a
specified securities exchange and exhibit illiquid characteristics
based on the capitalization of the issuer or the trading history. NSCC
believes that the new
[[Page 17918]]
criteria would enable NSCC to better limit its exposure to Members by
applying a volatility component that is a more appropriate measure of
volatility for Net Unsettled Positions in these securities exhibiting
illiquid characteristics. Specifically, NSCC has observed that
securities that are on a specified securities exchange but that have
limited trading, such as IPOs, or that are considered micro-
capitalization also exhibit illiquid characteristics. Finally, due to
the potential difficulty in determining market capitalization
accurately with respect to ADRs, NSCC would add ADRs to the definition
of Illiquid Security so that they undergo the same review as if the
ADRs were considered micro-capitalization. As such, NSCC believes that
adding these criteria to the definition of Illiquid Security would
provide a better and more accurate measure of volatility of illiquid
securities.
Second, NSCC proposes enhancements to the haircut-based volatility
charge for Illiquid Securities and UITs to allow NSCC to base this
charge on these securities' price level and risk profile. In this way,
the haircut-based volatility charge for Net Unsettled Positions in
these securities would be calculated to enable NSCC to collect margin
at levels that better reflect the risk presented by these Net Unsettled
Positions and would help NSCC limit its exposures to Members. As an
example, a recent impact study indicated that under the current
methodology short positions in sub-penny securities and securities
priced between one cent and one dollar exhibited the lowest average
backtesting coverage percentages with 96.2% during the study period,
whereas using the proposed methodology average backtesting coverage
percentage for such securities would have increased to 99.5% over the
study period.
Third, NSCC believes that the proposed clarifications to the
language relating to securities whose volatility is (i) less amenable
to statistical analysis or (2) amenable to generally accepted
statistical analysis only in a complex manner would improve Members'
understanding of the current analysis by ensuring that the Members
better understand the process used by NSCC for these categories by
adding clarity and transparency. In addition, by adding that such
categories would not be used for securities that are not Illiquid
Securities or UITs would allow Members to understand that Illiquid
Securities and UITs would be subject to the new sections specific to
those securities.
Fourth, NSCC believes that following the proposed changes, the
Illiquid Charge would no longer be needed to address the credit
exposures presented by Net Unsettled Positions in Illiquid Securities
because such risks would be addressed by of the proposed haircut-based
volatility enhancements.
Finally, NSCC believes that the proposed changes to the language in
Section I.(A) of Procedure XV relating to Net Unsettled Positions in
corporate and municipal bonds and long Net Unsettled Positions in
Family-Issued Securities would improve Members' transparency into the
treatment of Net Unsettled Positions in corporate and municipal bonds
and long Net Unsettled Positions in Family-Issued Securities.
The Clearing Fund is composed of Members' Required Fund Deposits
which include the volatility component, and is a key tool that NSCC
uses to mitigate potential losses to NSCC associated with liquidating a
Member's portfolio in the event of Member default. The changes relating
to (a) enhancing the existing criterion for determining an Illiquid
Security, (b) clarifying and enhancing the language relating to
securities whose volatility is (i) less amenable to statistical
analysis or (ii) amenable to generally accepted statistical analysis
only in a complex manner and (c) changing the language in Section I.(A)
of Procedure XV relating to Net Unsettled Positions in corporate and
municipal bonds and long Net Unsettled Positions in Family-Issued
Securities, would enhance clarity and transparency for Members with
respect to the volatility component allowing Members to have a better
understanding of the Rules. Having clear and accurate Rules would help
Members to better understand their rights and obligations regarding
NSCC's clearance and settlement services. NSCC believes that when
Members better understand their rights and obligations regarding NSCC's
services, they can act in accordance with the Rules. NSCC believes that
better enabling Members to comply with the Rules would promote the
prompt and accurate clearance and settlement of securities transactions
by NSCC consistent with the requirements of the Act, in particular
Section 17A(b)(3)(F) of the Act.\56\
---------------------------------------------------------------------------
\56\ Id.
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Each of the proposed changes listed above would improve the
methodology relating to the volatility component enabling NSCC to
better limit its exposure to Members such that, in the event of Member
default, NSCC's operations would not be disrupted and non-defaulting
Members would not be exposed to losses they cannot anticipate or
control. In this way, the proposed rules are designed to assure the
safeguarding of securities and funds which are in the custody or
control of NSCC or for which it is responsible and therefore consistent
with Section 17A(b)(3)(F) of the Act.\57\
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\57\ Id.
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Rule 17Ad-22(e)(4)(i) under the Act \58\ requires, in part, that
NSCC establish, implement, maintain and enforce written policies and
procedures reasonably designed to effectively identify, measure,
monitor, and manage its credit exposures to participants and those
arising from its payment, clearing, and settlement processes, including
by maintaining sufficient financial resources to cover its credit
exposure to each participant fully with a high degree of confidence.
---------------------------------------------------------------------------
\58\ 17 CFR 240.17Ad-22(e)(4)(i).
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As described above, NSCC believes that the proposed changes would
enable it to better identify, measure, monitor, and, through the
collection of Members' Required Fund Deposits, manage its credit
exposures to Members by maintaining sufficient resources to cover those
credit exposures fully with a high degree of confidence. More
specifically, the proposed changes to the methodology for identifying
Illiquid Securities would allow NSCC to better identify securities that
may present credit exposures, for purposes of applying an appropriate
margin charge. The proposed enhancements to the volatility charge
applicable to Illiquid Securities and UITs would provide NSCC with a
more effective measure of the risks that may be presented to NSCC by
positions in the securities. Specifically, the proposal to base the
calculation of the haircut-based volatility charge applied to positions
in Illiquid Securities and UITs on those securities' price level and
risk profile would enable NSCC to manage its credit exposures by
allowing NSCC to collect and maintain sufficient resources to cover
those credit exposures fully with a high degree of confidence. As an
example, a recent impact study indicated that under the current
methodology short positions in sub-penny securities and securities
priced between one cent and one dollar exhibited the lowest average
backtesting coverage percentages with 96.2% during the study period,
whereas using the proposed methodology average backtesting coverage
percentage for such securities would have increased to 99.5% over the
study period. NSCC also believes that with the proposed changes NSCC
could remove the Illiquid Charge
[[Page 17919]]
from the Clearing Fund formula because the proposed changes would
provide NSCC with a more effective measure of risks related to Net
Unsettled Positions in Illiquid Securities. As such, the proposed
enhancements to the calculation of the volatility component would
permit NSCC to more effectively identify, measure, monitor and manage
its exposures to risk, and would enable it to better limit its exposure
to potential losses from Member default.
Therefore, NSCC believes that the proposal would enhance NSCC's
ability to effectively identify, measure and monitor its credit
exposures and would enhance its ability to maintain sufficient
financial resources to cover its credit exposure to each participant
fully with a high degree of confidence. As such, NSCC believes the
proposed changes are consistent with Rule 17Ad-22(e)(4)(i) under the
Act.\59\
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\59\ Id.
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Rule 17Ad-22(e)(6)(i) under the Act \60\ requires, in part, that
NSCC 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, considers, and produces margin levels commensurate with, the
risks and particular attributes of each relevant product, portfolio,
and market.
---------------------------------------------------------------------------
\60\ 17 CFR 240.17Ad-22(e)(6)(i).
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The Required Fund Deposits are made up of risk-based components (as
margin) that are calculated and assessed daily to limit NSCC's credit
exposures to Members. NSCC is proposing changes that are designed to
more effectively address risk characteristics of Net Unsettled
Positions in Illiquid Securities. NSCC believes that these changes
would enable NSCC to produce margin levels that are more commensurate
with the particular risk attributes of these securities, including the
risk of increased transaction and market costs to NSCC to liquidate or
hedge due to lack of liquidity or marketability of such positions.
For example, by enhancing the methodology for Illiquid Securities
through an additional review of market capitalization of a security and
the use of an illiquidity ratio, NSCC believes that the proposed change
would allow NSCC to better identify those securities that may exhibit
illiquid characteristics. The proposed changes to the haircut-based
methodology to base the calculation on the price level and risk profile
of the applicable security, rather than a static percent, would, NSCC
believes, enable NSCC to more effectively measure the risks that are
particular to Illiquid Securities and UITs. Backtesting results
indicate that by calculating a haircut-based volatility charge that
addresses the risks presented by a security's price level or risk
profile, the proposed methodology would result in a volatility charge
that more appropriately addresses the risk of these securities.
These proposed changes are designed to assist NSCC in maintaining a
risk-based margin system that considers, and produces margin levels
commensurate with, the risks and particular attributes of portfolios
that exhibit illiquid risk attributes. Therefore, NSCC believes the
proposed change is consistent with Rule 17Ad-22(e)(6)(i) under the
Act.\61\
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\61\ Id.
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Rule 17Ad-22(e)(6)(v) under the Act \62\ requires, in part, that
NSCC 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, uses an appropriate method for measuring credit exposure that
accounts for relevant product risk factors and portfolio effects across
products. NSCC is proposing to eliminate the Illiquid Charge because,
NSCC believes, the other proposed changes would provide NSCC with a
more effective measure of the risks presented by Illiquid Securities.
Eliminating this charge would enable NSCC to remove what would become,
with the implementation of the other proposed changes, an unnecessary
component from the Clearing Fund calculation, and would help NSCC to
rely on a more appropriate method of measuring its exposures to this
risk. Therefore, NSCC believes the proposed change is consistent with
Rule 17Ad-22(e)(6)(v) under the Act.\63\
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\62\ 17 CFR 240.17Ad-22(e)(6)(v).
\63\ Id.
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(B) Clearing Agency's Statement on Burden on Competition
NSCC believes that the proposed changes to enhance its risk
management of Illiquid Securities could have an impact on competition.
Specifically, NSCC believes that the proposed changes could burden
competition because they would result in larger Required Fund Deposit
amounts for Members when the enhancements result in a haircut-based
volatility component that is greater than the amount calculated
pursuant to the current methodology. Impact studies indicate that the
proposed changes would have resulted in an approximate 2.6% increase on
average of NSCC's daily Clearing Fund had the proposed changes been in
place over the period from November 2017 to October 2018.
When the proposal results in a larger volatility component, the
proposed changes could burden competition for Members that have lower
operating margins or higher costs of capital compared to other Members.
Impact studies indicate that Members with higher percentages of
Illiquid Securities in their portfolio, particularly penny or sub-penny
securities, are more likely to be impacted by the proposed changes.
However, the increase in Required Fund Deposit would be in direct
relation to the specific risks presented by each Members' Net Unsettled
Positions, and each Member's Required Fund Deposit would continue to be
calculated with the same parameters and at the same confidence level
for each Member. Therefore, Members that present similar Net Unsettled
Positions, regardless of the type of Member, would have similar impacts
on their Required Fund Deposit amounts. As such, NSCC does not believe
that any burden on competition imposed by the proposed changes would be
significant.
Further, NSCC believes that any burden on competition imposed by
the proposed change would be both necessary and appropriate in
furtherance of NSCC's efforts to mitigate risks and meet the
requirements of the Act, as described in this filing and further below.
NSCC believes that the above described burden on competition that
may be created by the proposed changes to margining Illiquid Securities
and UITs would be necessary in furtherance of the Act, specifically
Section 17A(b)(3)(F) of the Act,\64\ because, as described above, the
Rules must be designed to assure the safeguarding of securities and
funds that are in NSCC's custody or control or which it is responsible.
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\64\ 15 U.S.C. 78q-1(b)(3)(F).
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More specifically, NSCC believes these proposed changes are
necessary to support NSCC's compliance with Rules 17Ad-22(e)(4)(i) and
Rule 17Ad-22(e)(6)(i) and (v) under the Act,\65\ which require NSCC to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to (x) effectively identify, measure,
monitor, and manage its credit exposures to participants and those
arising from its payment, clearing, and settlement processes, including
by maintaining sufficient financial resources to cover its credit
exposure to
[[Page 17920]]
each participant fully with a high degree of confidence; (y) cover its
credit exposures to its participants by establishing a risk-based
margin system that, at a minimum, considers, and produces margin levels
commensurate with, the risks and particular attributes of each relevant
product, portfolio, and market; and (z) cover its credit exposures to
its participants by establishing a risk-based margin system that, at a
minimum, uses an appropriate method for measuring credit exposure that
accounts for relevant product risk factors and portfolio effects across
products.
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\65\ 17 CFR 240.17Ad-22(e)(4)(i), (e)(6)(i), (e)(6)(v).
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As described above, NSCC believes implementing the proposed
enhancements to its methodology for identifying Illiquid Securities and
the calculation of the applicable volatility charge would improve the
risk-based methodology that NSCC employs to measure risks related to
securities that exhibit illiquid characteristics. The proposed change
would introduce additional criteria for defining Illiquid Securities to
improve NSCC's methodology for identifying securities that exhibit
illiquid characteristics. The proposed change would also enhance the
calculation of the applicable volatility component to address the
unique risks presented by Members' Net Unsettled Positions in these
securities, regardless of Member type, as described above. Therefore,
NSCC believes that these proposed changes would better limit NSCC's
credit exposures to Members, consistent with the requirements of Rules
17Ad-22(e)(4)(i) and Rule 17Ad-22(e)(6)(i) and (v) under the Act.
NSCC also believes that the above described burden on competition
that could be created by the proposed changes would be appropriate in
furtherance of the Act because such changes have been appropriately
designed to assure the safeguarding of securities and funds which are
in the custody or control of NSCC or for which it is responsible, as
described in detail above. The proposal would enable NSCC to produce
margin levels more commensurate with the risks and particular
attributes of each Member's portfolio. Specifically, the proposal to
enhance the methodology for identifying Illiquid Securities and the
calculation of the haircut-based volatility component applicable to
these securities and UITs would improve the risk-based margining
methodology that NSCC employs to set margin requirements and better
limit NSCC's credit exposures to its Members. Impact studies indicate
that the proposed methodology, by calculating a haircut-based
volatility charge that addresses the risks presented by a security's
price level or risk profile, would result in backtesting coverage that
more appropriately addresses the risk of these securities. Therefore,
because the proposed changes are designed to provide NSCC with a more
appropriate and complete measure of the risks presented by Members' Net
Unsettled Positions, NSCC believes the proposals are appropriately
designed to meet its risk management goals and its regulatory
obligations.
Therefore, as described above, NSCC believes the proposed changes
are necessary and appropriate in furtherance of NSCC's obligations
under the Act, specifically Section 17A(b)(3)(F) of the Act \66\ and
Rules 17Ad-22(e)(4)(i) and Rule 17Ad-22(e)(6)(i) and (e)(6)(v) under
the Act.\67\
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\66\ 15 U.S.C. 78q-1(b)(3)(F).
\67\ 17 CFR 240.17Ad-22(e)(4)(i), (e)(6)(i), (e)(6)(v).
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Because the proposal to eliminate the Illiquid Charge would remove
this charge from the margining methodology as applied to all Members,
when applicable, NSCC does not believe the proposed change to eliminate
the Illiquid Charge would have any impact on competition. NSCC does not
believe that the proposed changes in Section I.(A) of Procedure XV
relating to securities whose volatility is less amenable to statistical
analysis, securities whose volatility is amenable to generally accepted
statistical analysis only in a complex manner, or to corporate and
municipal bonds and long Net Unsettled Positions in Family-Issued
Securities, would have any impact on competition as these changes would
just add clarity and transparency to the Rules and not affect Member's
rights and obligations.
(C) Clearing Agency's Statement on Comments on the Proposed Rule Change
Received From Members, Participants, or Others
NSCC has not received or solicited any written comments relating to
this proposal. NSCC will notify the Commission of any written comments
received by NSCC.
III. Date of Effectiveness of the Proposed Rule Change, and Timing for
Commission Action
Within 45 days of the date of publication of this notice in the
Federal Register or within such longer period up to 90 days (i) as the
Commission may designate if it finds such longer period to be
appropriate and publishes its reasons for so finding or (ii) as to
which the self-regulatory organization consents, the Commission will:
(A) By order approve or disapprove such proposed rule change, or
(B) institute proceedings to determine whether the proposed rule
change should be disapproved.
The proposal shall not take effect until all regulatory actions
required with respect to the proposal are completed.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed rule
change is consistent with the Act. Comments may be submitted by any of
the following methods:
Electronic Comments
Use the Commission's internet comment form (http://www.sec.gov/rules/sro.shtml); or
Send an email to [email protected]. Please include
File Number SR-NSCC-2020-003 on the subject line.
Paper Comments
Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street NE, Washington, DC 20549.
All submissions should refer to File Number SR-NSCC-2020-003. This file
number should be included on the subject line if email is used. To help
the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's internet website (http://www.sec.gov/rules/sro.shtml).
Copies of the submission, all subsequent amendments, all written
statements with respect to the proposed rule change that are filed with
the Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for website viewing and printing in
the Commission's Public Reference Room, 100 F Street NE, Washington, DC
20549 on official business days between the hours of 10:00 a.m. and
3:00 p.m. Copies of the filing also will be available for inspection
and copying at the principal office of NSCC and on DTCC's website
(http://dtcc.com/legal/sec-rule-filings.aspx). All comments received
will be posted without change. Persons submitting comments are
cautioned that we do not redact or edit personal
[[Page 17921]]
identifying information from comment submissions. You should submit
only information that you wish to make available publicly. All
submissions should refer to File Number SR-NSCC-2020-003 and should be
submitted on or before April 21, 2020.
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\68\
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\68\ 17 CFR 200.30-3(a)(12).
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J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2020-06617 Filed 3-30-20; 8:45 am]
BILLING CODE 8011-01-P