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GSCC Netting Member Exemption

August 26, 1997

Jeffrey F. Ingber
General Counsel
Government Securities Clearing Corporation
55 Water Street
New York, New York 10041

Dear Mr. Ingber:

This is in response to your letter of May 9, 1997, in which you request an exemption from the credit risk haircut under §§ 402.1(e)(8) and 402.2(g)(1) of the Treasury regulations implementing the Government Securities Act of 1986 (GSA regulations, 17 CFR 400, et seq.). Specifically, you request that registered government securities brokers and dealers that participate in the Government Securities Clearing Corporation (GSCC) system for netting compared trades (Netting System) (including any government securities interdealer broker as defined in § 402.1(e)(2) that has elected not to be subject to the limitations of § 402.2 ("Interdealer Broker")) be granted an exemption in determining their "credit risk haircut" under § 402.2(g)(1) (or, in the case of an Interdealer Broker, the "net exposure to each counterparty" under § 402.1(e) (8)) with respect to Clearing Fund deposits held by GSCC./fn1/

We understand the facts to be as follows. GSCC is registered as a clearing agency with the Securities and Exchange Commission (SEC) pursuant to §§ 17(A)(b)(2) and 19(a) of the Securities Exchange Act of 1934, as amended (Exchange Act) (15 U.S.C. 78q-1(b)(2) and 78s(a)). On May 30, 1997, the SEC extended GSCC's temporary registration as a clearing agency until February 28, 1998.

Over the years, Treasury has granted interpretations of, and various conditional exemptions from, certain GSA capital and customer protection regulations to registered government securities brokers and dealers that participate in the GSCC Netting System (Netting Members)./fn2/ The exemptions were primarily based on our belief that the Netting System greatly reduces credit risk and your representations that GSCC performs risk management and settlement efficiencies with regard to the government securities market afforded by: (1) multilateral netting of members' trades, which significantly decreases the number of deliver and receive obligations necessary to settle members' trades; (2) novation of netted trades, with GSCC assuming the position of counterparty to its members on all trades going into the net for settlement purposes; (3) daily marking-to-market (taking into account accrued interest) of the net settlement positions of each member of the Netting System; (4) the maintenance of Clearing Fund collateral and other margin to protect GSCC members against settlement default risks; and (5) a centralized loss allocation procedure for handling the close out of positions carried by an insolvent market participant that is a Netting Member.

As you note, in a letter dated December 11, 1990 (Exemptive Letter), Treasury granted conditional exemptions from certain liquid capital provisions of the GSA regulations to permit Netting Members to exclude from their net credit exposure and net exposure computations all calculations based on trades that have been netted and novated by GSCC. In a subsequent letter dated January 9, 1995, we extended the exemptions to include the when-issued trades of Netting Members. However, the Exemptive Letter explicitly excluded Clearing Fund deposits from the relief granted netted and novated trades.

Your current letter represents that in 1990, the SEC, in granting temporary approval to GSCC's Clearing Fund formula, directed GSCC to assess the operation of the formula before it became a permanent part of GSCC's Netting System. GSCC was required to monitor its formula on a daily basis to determine the effectiveness of its formula in protecting GSCC against risks associated with forward-settling and regular trades. You further explain that GSCC was also required to regularly report to the SEC, among other things, any situation where GSCC could make a special call for additional Clearing Fund deposits or where the collected deposits for a particular month were less than certain parameters, and also the accuracy of the formula's margin factors and disallowance percentages. You also note that GSCC was directed by the SEC to conduct monitoring on a daily basis to ensure that GSCC -- principally through the Clearing Fund -- had sufficient liquidity during periods of high volatility to protect GSCC and its solvent members.

You also represent that, in 1993, the SEC granted permanent approval to GSCC's Clearing Fund formula, the amount a member must contribute to the fund to collateralize the risk its daily settlement activities pose for GSCC. In granting this approval, the SEC stated that GSCC's formula, by providing GSCC with effective methods for measuring the risk profile of its members' securities and funds settlement obligations, was consistent with GSCC's responsibilities relating to the safeguarding of funds and securities under the Exchange Act. You also represent that GSCC has continued to modify its Clearing Fund formula to ensure that it protects GSCC and its Netting Members from credit and liquidity exposure. With the introduction of repurchase and reverse repurchase netting (Repo Netting), you note that GSCC amended its Clearing Fund rules to incorporate provisions appropriate to accommodate the risks associated with Repo Netting. You explain that the SEC, in granting approval to GSCC's Repo Netting program, stated that it believed that the margin and Clearing Fund contributions appropriately take into account the risks posed to GSCC by the settlement of repos.

You further contend that credit risk is very low for Netting Members. You state that a comprehensive risk assessment of GSCC concluded, among other things, that GSCC's methodologies for computing risk, and its mechanisms for collateralizing and mitigating this exposure -- particularly clearing fund margin -- are sound and provide GSCC with a high level of confidence that the liquidation of an insolvent member's portfolio and the subsequent application of its collateral deposit would not likely result in either a loss or any liquidation risk to GSCC. The assessment also determined that, in those unlikely scenarios where a loss may occur, such loss would not induce the failure of any other member. Based on the specific findings in the assessment, you contend that in the event of a Netting Member's insolvency, the insolvent Netting Member's Clearing Fund deposit would be sufficient in virtually every circumstance to permit GSCC to close out the insolvent Netting Member's obligation without a loss that would require the use of solvent Netting Members' Clearing Fund deposits.

However, net credit exposure, as defined in § 402.2(g)(1)(i) of the GSA regulations, must be computed irrespective of the probability that a registered government securities broker's or dealer's counterparty will default. In fact, this provision assumes that there is a counterparty default. Accordingly, we are unable to grant you the exemption as you request since we believe this would be inconsistent with the application of the credit risk haircut.

Nevertheless, our analysis of your request pertaining to credit exposure indicates that the GSCC Netting System greatly reduces credit risk. The elimination of the vast majority of transactions between Netting Members, novation by GSCC, the daily marking-to-market of Netting Members' net settlement positions, and other credit protections previously mentioned greatly reduce the risk that GSCC, acting as the counterparty to trades with Netting Members, will fail to settle its securities and funds obligations. GSCC's experience during the last six years with the Clearing Fund formula, including its expansion of the formula to accommodate Repo Netting, demonstrates that the risk of loss of solvent Netting Members' Clearing Fund deposits, which can only arise as the result of another Netting Member's default and the incurring of a loss by GSCC as the result of liquidation of the defaulting member's positions, is also reduced.

Based on these factors, and your representations of the structure and operation of the GSCC Netting System and Clearing Fund, we believe that a conditional exemption from certain GSA capital rules is warranted. We have consulted with the staff of the SEC in arriving at this decision, and we have determined that such an exemption is consistent with the public interest, the protection of investors, and the purposes of the GSA given GSCC's current operating structure.

Accordingly, pursuant to 15 U.S.C. 78o-5(a)(5), we hereby grant to all Netting Members that are registered government securities brokers and dealers subject to the capital requirements of § 402.2 an exemption from the haircut calculation requirements of § 402.2(g)(1)(iii), the 25% concentration of credit haircut for net credit exposure to GSCC involving GSCC Netting Members' Clearing Fund deposits held by GSCC. However, this exemption is conditioned upon the application of the 5% counterparty exposure haircut factor applied to any net credit exposures in excess of 15% of the firm's liquid capital (which had been the subject of the 25% concentration of credit haircut factor). Only Netting Members' Clearing Fund deposits are provided relief from the concentration of credit haircut by this exemption. Those firms subject to the capital requirements of 17 CFR 402.1(e) (i.e., Interdealer Brokers) are not subject to the concentration of credit haircut and therefore do not require this exemption. The credit volatility haircut, defined in § 402.2(g)(1)(iv), is not relevant to Netting Member Clearing Fund deposits because it applies to the risks arising from securities that are currently not eligible for GSCC's Clearing Fund -- certificates of deposit, bankers acceptances, and commercial paper of no more than one year to maturity.

This relief is granted in recognition of the fact that GSCC provides clearance and settlement services to government securities brokers and dealers and reduces counterparty risk for GSCC Netting Members, thereby enhancing the liquidity of the government securities market.

This exemption is confined solely to GSCC Netting Members' Clearing Fund deposits held by GSCC and is conditioned upon the facts as represented in your letter. Any change in the facts or circumstances of your request would require further analysis and could lead to a termination of the exemption.

Pursuant to 17 CFR 400.2(c)(7)(i), your incoming letter and this response will be immediately available to the public.

Van Zeck
(for) Richard L. Gregg

/fn1/ The credit risk haircut defined in § 402.2(g)(1) equals the sum of the total counterparty exposure haircut, the total concentration of credit haircut, and the credit volatility haircut.

/fn2/ See letter of November 22, 1989 from Bureau of the Public Debt, Commissioner Richard L. Gregg, to Jeffrey F. Ingber, Associate General Counsel, GSCC; letter of December 11, 1990 from Bureau of the Public Debt, Commissioner Richard L. Gregg, to Jeffrey F. Ingber, Associate General Counsel, GSCC; letter of January 9, 1995 from Bureau of the Public Debt, Commissioner Richard L. Gregg to Jeffrey F. Ingber, General Counsel, GSCC.