Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers

Federal RegisterNov 23, 2012

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-68071; File No. S7-08-12]

RIN 3235-AL12

Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), the Securities and Exchange Commission (“Commission”), pursuant to the Securities Exchange Act of 1934 (“Exchange Act”), is proposing capital and margin requirements for security-based swap dealers (“SBSDs”) and major security-based swap participants (“MSBSPs”), segregation requirements for SBSDs, and notification requirements with respect to segregation for SBSDs and MSBSPs. The Commission also is proposing to increase the minimum net capital requirements for broker-dealers permitted to use the alternative internal model-based method for computing net capital (“ANC broker-dealers”).

DATES:

Comments should be received on or before January 22, 2013.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form (

http://www.sec.gov/rules/proposed.shtml

); or

• Send an email to

rule-comments@sec.gov

. Please include File Number S7-08-12 on the subject line; or

• Use the Federal eRulemaking Portal (

http://www.regulations.gov

). Follow the instructions for submitting comments.

Paper Comments

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

All submissions should refer to File Number S7-08-12. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (

http://www.sec.gov/rules/proposed.shtml

). Comments also are available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT:

Michael A. Macchiaroli, Associate Director, at (202) 551-5525; Thomas K. McGowan, Deputy Associate Director, at (202) 551-5521; Randall W. Roy, Assistant Director, at (202) 551-5522; Mark M. Attar, Branch Chief, at (202) 551-5889; Sheila Dombal Swartz, Special Counsel, at (202) 551-5545; Valentina M. Deng, Attorney, at (202) 551-5778; or Teen I. Sheng, Attorney, at 202-551-5511, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background

II. Proposed Rules and Rule Amendments

A. Capital

1. Introduction

2. Proposed Capital Rules for Nonbank SBSDs

a. Computing Required Minimum Net Capital

i. Stand-alone SBSDs Not Using Internal Models

ii. Broker-Dealer SBSDs Not Using Internal Models

iii. Stand-alone SBSDs Using Internal Models

iv. Broker-Dealer SBSDs Using Internal Models and ANC Broker-Dealers

b. Computing Net Capital

i. The Net Liquid Assets Test

ii. Standardized Haircuts for Security-Based Swaps

iii. VaR Models

iv. Credit Risk Charges

v. Capital Charge In Lieu of Margin Collateral

vi. Treatment of Swaps

c. Risk Management

d. Funding Liquidity Stress Test Requirement

e. Other Rule 15c3-1 Provisions Incorporated into Rule 18a-1

i. Debt-Equity Ratio Requirements

ii. Capital Withdrawal Requirements

iii. Appendix C

iv. Appendix D

3. Proposed Capital Rules for Nonbank MSBSPs

B. Margin

1. Introduction

2. Proposed Margin Requirements for Nonbank SBSDs and Nonbank MSBSPs

a. Scope of Rule 18a-3

b. Daily Calculations

i. Nonbank SBSDs

ii. Nonbank MSBSPs

c. Account Equity Requirements

i. Nonbank SBSDs

ii. Nonbank MSBSPs

d. $100,000 Minimum Transfer Amount

e. Risk Monitoring and Procedures

3. Specific Request for Comment to Limit the Use of Collateral

C. Segregation

1. Background

2. Proposed Rule 18a-4

a. Possession and Control of Excess Securities Collateral

b. Security-Based Swap Customer Reserve Account

c. Special Provisions for Non-cleared Security-Based Swap Counterparties

III. General Request for Comment

IV. Paperwork Reduction Act

A. Summary of Collections of Information Under the Proposed Rules and Rule Amendments

1. Proposed Rule 18a-1 and Amendments to Rule 15c3-1

2. Proposed Rule 18a-2

3. Proposed Rule 18a-3

4. Proposed Rule 18a-4

B. Proposed Use of Information

C. Respondents

D. Total Initial and Annual Recordkeeping and Reporting Burden

1. Proposed Rule 18a-1 and Amendments to Rule 15c3-1

2. Proposed Rule 18a-2

3. Proposed Rule 18a-3

4. Proposed Rule 18a-4

E. Collection Of Information Is Mandatory

F. Confidentiality

G. Retention Period For Recordkeeping Requirements

H. Request For Comment

V. Economic Analysis

A. Baseline Of Economic Analysis

1. Overview of the OTC Derivatives Markets—Baseline for Proposed Rules 18a-1 through 18a-4

2. Baseline for Amendments to Rule 15c3-1

B. Analysis of the Proposals and Alternatives

1. Overview—The Proposed Financial Responsibility Program

a. Nonbank SBSDs

b. Nonbank MSBSPs

2. The Proposed Capital Rules

a. Nonbank SBSDs and ANC Broker-dealers

i. Minimum Capital Requirements

ii. Standardized Haircuts

iii. Capital Charge in Lieu of Margin Collateral

iv. Credit Risk Charge

v. Funding Liquidity Stress Test Requirement

vi. Risk Management Procedures

b. Capital Requirements for MSBSPs

c. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

3. The Proposed Margin Rule—Rule 18a-3

a. Calculation of Margin Amount

b. Account Equity Requirements

i. Commercial end users

ii. SBSDs—Alternatives A and B

c. Margin Requirements for Nonbank-MSBSPs

d. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

4. Proposed Segregation Rule—Rule 18a-4

a. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation

C. Implementation Considerations

D. General Request for Comment

VI. Regulatory Flexibility Act Certification

VII. Statutory Basis and Text of the Proposed Amendments

I. Background

On July 21, 2010, President Obama signed the Dodd-Frank Act into law.

Title VII of the Dodd-Frank Act (“Title VII”) established a new regulatory framework for OTC derivatives.

In this regard, Title VII was enacted, among other reasons, to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things: (i) Providing for the registration and regulation of SBSDs and MSBSPs; (ii) imposing clearing and trade execution requirements on standardized derivative products; (iii) creating recordkeeping and real-time reporting regimes; and (iv) enhancing the Commission's rulemaking and enforcement authorities with respect to all registered entities and intermediaries subject to the Commission's oversight.

See

Public Law 111-203, 124 Stat. 1376 (2010).

Pursuant to section 701 of the Dodd-Frank Act, Title VII may be cited as the “Wall Street Transparency and Accountability Act of 2010.”

See

Public Law 111-203 § 701. The Dodd-Frank Act assigns responsibility for the oversight of the U.S. OTC derivatives markets to the Commission, the Commodity Futures Trading Commission (“CFTC”), and certain “prudential regulators,” discussed below. The Commission has oversight authority with respect to a

security-based swap

as defined in section 3(a)(68) of the Exchange Act (15 U.S.C. 78c(a)(68)), including to implement a registration and oversight program for a

security-based swap dealer

as defined in section 3(a)(71) of the Exchange Act (15 U.S.C. 78c(a)(71)) and a

major security-based swap participant

as defined in section 3(a)(67) of the Exchange Act (15 U.S.C. 78c(a)(67)). The CFTC has oversight authority with respect to a

swap

as defined in section 1(a)(47) of the Commodity Exchange Act (“CEA”) (7 U.S.C. 1(a)(47)), including to implement a registration and oversight program for a

swap dealer

as defined in section 1(a)(49) of the CEA (7 U.S.C. 1(a)(49)) and a

major swap participant

as defined in section 1(a)(33) of the CEA (7 U.S.C. 1(a)(33)). The Commission and the CFTC jointly have adopted rules to further define, among other things, those terms and the terms

swap, security-based swap,

swap dealer, major swap participant,

security-based swap dealer, and major security-based swap participant.

See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping,

Exchange Act Release No. 64372 (Apr. 29, 2011), 76 FR 29818 (May 23, 2011) (“

Product Definitions Proposing Release”

);

Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping,

Exchange Act Release No. 67453 (July 18, 2012), 77 FR 48208 (Aug. 13, 2012) (Joint final rule with the CFTC) (“

Product Definitions Adopting Release”

);

Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant”,

Exchange Act Release No. 63452 (Dec. 7, 2010), 75 FR 80174 (Dec. 21, 2010) (Joint proposal with the CFTC) (“

Entity Definitions Proposing Release”

); and

Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant”,

Exchange Act Release No. 66868 (Apr. 27, 2012), 77 FR 30596 (May 23, 2012) (Joint final rule with the CFTC) (“

Entity Definitions Adopting Release”

See

Public Law 111-203 §§ 701-774.

Section 764 of the Dodd-Frank Act added section 15F to the Exchange Act.

Section 15F(e)(1)(B) of the Exchange Act provides that the Commission shall prescribe capital and margin requirements for SBSDs and nonbank MSBSPs that do not have a prudential regulator (respectively, “nonbank SBSDs” and “nonbank MSBSPs”).

Section 763 of the Dodd-Frank Act added section 3E to the Exchange Act.

Section 3E provides the Commission with authority to establish segregation requirements for SBSDs and MSBSPs.

See id.

§ 764; 15 U.S.C. 78o-10.

See

15 U.S.C. 78o-10(e)(1)(B). Specifically, section 15F(e)(1)(B) of the Exchange Act provides that each registered SBSD and MSBSP for which there is not a prudential regulator shall meet such minimum capital requirements and minimum initial and variation margin requirements as the Commission shall by rule or regulation prescribe. The term “prudential regulator” is defined in section 1(a)(39) of the CEA (7 U.S.C. 1(a)(39)) and that definition is incorporated by reference in section 3(a)(74) of the Exchange Act (15 U.S.C. 78c(a)(74)). Pursuant to the definition, the Board of Governors of the Federal Reserve System (“Federal Reserve”), the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”), the Farm Credit Administration, or the Federal Housing Finance Agency (collectively, the “prudential regulators”) is the “prudential regulator” of an SBSD, MSBSP, swap participant, or major swap participant if the entity is directly supervised by that agency.

See

Public Law 111-203 § 763; 15 U.S.C. 78c-5.

See

15 U.S.C. 78c-5(a)-(g). Section 3E of the Exchange Act does not distinguish between bank and nonbank SBSDs and bank and nonbank MSBSPs, and, consequently, provides the Commission with the authority to establish segregation requirements for SBSDs and MSBSPs, whether or not they have a prudential regulator.

Id.

Section 4s(e)(1)(B) of the CEA provides that the CFTC shall prescribe capital and margin requirements for swap dealers and major swap participants for which there is not a prudential regulator (“nonbank swap dealers” and “nonbank swap participants”).

Section 15F(e)(1)(A) of the Exchange Act provides that the prudential regulators shall prescribe capital and margin requirements for bank SBSDs and bank MSBSPs, and section 4s(e)(1)(A) of the CEA provides that the prudential regulators shall prescribe capital and margin requirements for swap dealers and major swap participants for which there is a prudential regulator (“bank swap dealers” and “bank swap participants”).

The prudential regulators have proposed capital and margin requirements for bank swap dealers, bank SBSDs, bank swap participants, and bank MSBSPs.

The CFTC has proposed capital and margin requirements for nonbank swap dealers and nonbank major swap participants.

The CFTC also has adopted segregation requirements for cleared swaps and proposed segregation requirements for non-cleared swaps.

See

7 U.S.C. 6s(e)(1)(B).

See

15 U.S.C. 78o-10(e)(1)(A); 7 U.S.C. 6s(e)(1)(A).

See Margin and Capital Requirements for Covered Swap Entities,

76 FR 27564 (May 11, 2011) (“

Prudential Regulator Margin and Capital Proposing Release”

). The prudential regulators, as part of their proposed margin requirements for non-cleared security-based swaps, proposed a segregation requirement for collateral received as margin.

Id.

See Capital Requirements of Swap Dealers and Major Swap Participants,

76 FR 27802 (May 12, 2011) (“

CFTC Capital Proposing Release”

);

Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants,

76 FR 23732 (Apr. 28, 2011) (“

CFTC Margin Proposing Release”

). The CFTC reopened the comment period for the CFTC Margin Proposing Release to allow interested parties to comment on the CFTC proposed rules in light of the proposals discussed in the international consultative paper.

See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants,

77 FR 41109 (July 12, 2012).

See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions,

77 FR 6336 (Feb. 7, 2012) and

Protection of Collateral of Counterparties to Non-cleared Swaps; Treatment of Securities in a Portfolio Margining Account in a Commodity Broker Bankruptcy,

75 FR 75432 (Dec. 3, 2010).

Pursuant to sections 763 and 764 of the Dodd-Frank Act, the Commission is proposing to amend Rule 15c3-1 and Rule 15c3-3 and propose new Rules 18a-1 (including appendices to Rule 18a-1), 18a-2, 18a-3, and 18a-4 (including an exhibit to Rule 18a-4).

The proposed amendments and new rules would establish capital and margin requirements for nonbank SBSDs, including broker-dealers that are registered as SBSDs (“broker-dealer SBSDs”), and nonbank MSBSPs. They also would establish segregation requirements for SBSDs and notification requirements with respect to segregation for SBSDs and MSBSPs.

See

17 CFR 240.15c3-1; 17 CFR 240.15c3-3.

Further, the proposals also would increase the minimum net capital

requirements and establish liquidity requirements for ANC broker-dealers.

An ANC broker-dealer is a broker-dealer that has been approved by the Commission to use internal value-at-risk (“VaR”) models to determine market risk charges for proprietary securities and derivatives positions and to take a credit risk charge in lieu of a 100% charge for unsecured receivables related to OTC derivatives transactions (hereinafter, collectively “internal models”). The proposed amendments applicable to ANC broker-dealers are designed to account for their large size, the scale of their custodial activities, and the potential substantial leverage they may take on if they become more active in the security-based swap markets under the Dodd-Frank Act reforms, which, among other things, require dealers in security-based swaps to register with the Commission.

Finally, some of the proposed amendments to Rule 15c3-1 would apply to broker-dealers that are not registered as SBSDs. These proposed amendments are designed to maintain a consistent capital treatment for security-based swaps and swaps under Rule 15c3-1 and proposed new Rule 18a-1.

See

17 CFR 240.15c3-1(a)(7); 17 CFR 240.15c3-1e.

See, e.g.,

15 U.S.C. 78o-10(a)(1) (“It shall be unlawful for any person to act as a security-based swap dealer unless the person is registered as a security-based swap dealer with the Commission.”).

As discussed in detail below, the proposals for capital, margin, and segregation requirements for SBSDs and MSBSPs are based in large part on existing capital, margin, and segregation requirements for broker-dealers (“broker-dealer financial responsibility requirements”).

The broker-dealer financial responsibility requirements served as the model for the proposals because the financial markets in which SBSDs and MSBSPs are expected to operate are similar to the financial markets in which broker-dealers operate. In addition, as discussed below, the objectives of the broker-dealer financial responsibility requirements are similar to the objectives underlying the proposals. Moreover, the broker-dealer financial responsibility requirements have existed for many years and have facilitated the prudent operation of broker-dealers.

Consequently, they provide a reasonable template for building a financial responsibility program for SBSDs and MSBSPs. Furthermore, it is expected that some nonbank SBSDs also will register as broker-dealers in order to be able to offer customers a broader range of services than a nonbank SBSD not registered as a broker-dealer (“stand-alone SBSD”) would be permitted to engage in. Therefore, establishing consistent financial responsibility requirements would avoid potential competitive disparities between stand-alone SBSDs and broker-dealer SBSDs.

See infra

section II.A.1. of this release (describing generally the broker-dealer capital standards); section II.B.1. of this release (describing generally the broker-dealer margin standards); section II.C.1. of this release (describing generally the broker-dealer segregation requirements).

For example, one of the objectives of the broker-dealer financial responsibility requirements is to protect customers from the consequences of the financial failure of a broker-dealer in terms of safeguarding customer securities and funds held by the broker-dealer. It should be noted that the Securities Investor Protection Corporation (“SIPC”), since its inception in 1971, has initiated customer protection proceedings for only 324 broker-dealers, which is less than 1% of the approximately 39,200 broker-dealers that have been members of SIPC during that timeframe. From 1971 through December 31, 2011, approximately 1% of the $117.5 billion of cash and securities distributed for accounts of customers came from the SIPC fund rather than debtors' estates.

See

SIPC,

Annual Report 2011,

available at

http://www.sipc.org/Portals/0/PDF/2011_Annual_Report.pdf

(“

SIPC 2011 Annual Report”

However, the Commission recognizes that there may be other approaches to establishing financial responsibility requirements that may be appropriate—including, for example, applying a standard based on the international capital standard for banks (“Basel Standard”)

in the case of entities that are part of a bank holding company, as has been proposed by the CFTC.

In general, the bank capital model requires the holding of specified levels of capital as a percentage of “risk weighted assets.”

It does not require generally a full capital deduction for unsecured receivables, given that banks, as lending entities, are in the business of extending credit to a range of counterparties.

The Basel Standard was developed by the Basel Committee on Banking Supervision of the Bank for International Settlements (“BCBS”). More information about the Basel Standard is available at the Web site of the Bank for International Settlements (“BIS”) at

http://www.bis.org/bcbs/index.htm

CFTC Capital Proposing Release,

76 FR 27802.

The prudential regulators also have proposed capital rules that would require a covered swap entity to comply with the regulatory capital rules already made applicable to that covered swap entity as part of its prudential regulatory regime.

Prudential Regulator Margin and Capital Proposing Release,

76 FR at 27568. The prudential regulators note that they have “had risk-based capital rules in place for banks to address over-the-counter derivatives since 1989 when the banking agencies implemented their risk-based capital adequacy standards * * * based on the first Basel Accord.”

Id.

This approach could promote a consistent view and management of capital within a bank holding company structure. The Commission is not proposing this approach, however, both because of the distinctions between bank and nonbank dealer business models and access to backstop liquidity, as well as uncertainties as to how a bank capital standard would in practice affect valuations and the conduct of business in a nonbank entity; but the Commission is specifically seeking comment on this approach. In addition, detailed comment is requested below on alternative financial responsibility frameworks that could serve as a model for establishing financial responsibility requirements for SBSDs and MSBSPs.

The minimum financial and customer protection requirements proposed today—like other financial tests that market participants use in the ordinary course of business to manage risk or to comply with applicable regulations—incorporate many specific numerical thresholds, limits, deductions, and ratios.

The Commission recognizes that each such quantitative requirement could be read by some to imply a definitive conclusion based on quantitative analysis of that requirement and its alternatives.

For example, the proposed capital requirements would include in the formula that determines minimum net capital an amount generally equal to 8% of the amount of margin that nonbank SBSDs would be required to collect from counterparties. Similarly, the capital and margin proposals, in setting “haircut” requirements to reflect market risk for certain types of security-based swaps, propose to use a numerical grid that establishes specific deductions depending on spread and tenor, among other factors.

The Commission notes in this regard that the specific quantitative requirements included in this proposal have not been derived directly from econometric or mathematical models, nor has the Commission performed a detailed quantitative analysis of the likely economic consequences of the specific quantitative requirements being included in this proposal. As discussed in the economic analysis below, there are a number of challenges presented in conducting such a quantitative analysis in a robust fashion. Accordingly, the selection of a particular quantitative requirement proposed below reflects a qualitative assessment by the Commission regarding the appropriate financial standard for an identified issue. In making such assessments and in turn selecting proposed quantitative requirements, the Commission has drawn from its experiences in regulating broker-dealers and has frequently looked to comparable quantitative elements in the existing broker-dealer financial responsibility regime (

e.g.,

the current capital charges in the existing broker-dealer net capital rule) or, where appropriate, the existing or proposed regulations of the prudential regulators,

FINRA, or the CFTC with respect to similar activities. For example, the Commission may propose using a specified haircut percentage (

e.g.,

15%, as opposed to a percentage that is higher or lower) because it believes, based on its experience regulating markets, that such percentage should be sufficient to cover a severe market movement. The Commission has used these comparable quantitative requirements as a reasonable starting point for purposes of the various proposals because, as noted above, there are substantial similarities between the proposed rules and those other regimes in terms of the relevant markets, entities, and regulatory objectives, and because many nonbank SBSDs may also be subject to the existing broker-dealer financial responsibility requirements.

The Commission invites comment, including relevant data and analysis, regarding all aspects of the various quantitative requirements reflected in the proposed rules. In particular, data and comment from market participants and other interested parties regarding the likely effect of each proposed quantitative requirement, the effect of such requirements in the aggregate, and potential alternative requirements will be particularly useful to the Commission in evaluating modifications to the proposals. Commenters are also requested to describe in detail any econometric or mathematical models or economic analyses of data, to the extent they exist, that they believe would be relevant for evaluating or modifying any quantitative provisions contained in the proposals.

The Commission staff consulted with the prudential regulators and the CFTC in drafting the proposals discussed in this release.

In addition, the proposals of the prudential regulators and the CFTC were considered in developing the Commission's proposed capital, margin, and segregation requirements for SBSDs and MSBSPs. The Commission's proposals differ in some respects from proposals of the prudential regulators and the CFTC, and such differences are described below in connection with the relevant proposals. While some differences are based on differences in the activities of securities firms, banks, and commodities firms, or differences in the products at issue, other differences may reflect an alternative approach to balancing the relevant policy choices and considerations. Where these differences exist, comment is sought on the advantages and disadvantages of each proposal and whether a given proposal is appropriate based on differences in the business models of the types of entities that would be subject to the respective proposal, the risks of these entities, and any other factors commenters believe relevant.

See

15 U.S.C. 78o-10(e)(3)(D)(i) (“The prudential regulators, the [CFTC], and the [Commission] shall periodically (but not less frequently than annually) consult on the minimum capital requirements and minimum initial and variation margin requirements.”).

See

15 U.S.C. 78o-10(e)(3)(D)(ii) (providing that the prudential regulators, the CFTC, and the Commission “shall, to the maximum extent practicable establish and maintain comparable minimum capital requirements and minimum initial and variation margin requirements, including the use of noncash collateral,” for SBSDs and swap dealers).

The capital, margin, and segregation requirements ultimately adopted, like other requirements established under the Dodd-Frank Act, could have a substantial impact on international commerce and the relative competitive position of intermediaries operating in various, or multiple, jurisdictions. In particular, intermediaries operating in the U.S. and in other jurisdictions could be advantaged or disadvantaged if corresponding requirements are not established in other jurisdictions or if the Commission's rules are substantially more or less stringent than corresponding requirements in other jurisdictions. This could, among other potential impacts, affect the ability of intermediaries and other market participants based in the U.S. to participate in non-U.S. markets, the ability of non-U.S.-based intermediaries and other market participants to participate in U.S. markets, and whether and how international firms make use of global “booking entities” to centralize risks related to security-based swaps. These issues have been the focus of numerous comments to the Commission and other regulators, Congressional inquiries, and other public dialogue.

See, e.g.,

letter from Senator Tim Johnson, Chairman of the U.S. Senate Committee on Banking, Housing, and Urban Affairs, and Congressman Barney Frank, Ranking Member of the U.S. House Committee on Financial Services, to the CFTC, Commission, Federal Reserve, and FDIC (Oct. 4, 2011), available at

http://www.sec.gov/comments/s7-25-11/s72511-34.pdf

(“Given the global nature of this market, U.S. regulators should avoid creating opportunities for international regulatory arbitrage that could increase systemic risk and reduce the competitiveness of U.S. firms abroad”); letter from Barclays Bank PLC, BNP Paribas S.A., Credit Suisse AG, Deutsche Bank AG, HSBC, Nomura Securities International, Inc., Rabobank Nederland, Royal Bank of Canada, The Royal Bank of Scotland Group PLC, Societe Generale, The Toronto-Dominion Bank, and UBS AG, to the CFTC, Commission, and Federal Reserve (Feb. 17, 2011), available at

http://www.sec.gov/comments/s7-39-10/s73910-25.pdf

(“[T]he home country regulator has the greatest interest in and is in the best position to protect a foreign bank swap dealer under its primary supervision by setting appropriate margin requirements or functionally equivalent capital charges for non-cleared swaps”); letter from Carlos Tavares, Vice-Chairman of European Securities and Markets Authority, to the Commission (Jan. 17, 2011), available at

http://www.sec.gov/comments/s7-35-10/s73510-19.pdf

(“if the foreign supervision were not taken into account * * * a foreign [entity would] be subject to multiple regimes * * * [which would be] very challenging for regulated entities and would significantly raise the costs for both the industry and supervisors”); BCBS, Board of the International Organization of Securities Commissions (“IOCSO”), Consultative Document,

Margin Requirements for Non-centrally-cleared Derivatives

(July 2012), available at

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD387.pdf

(consultative document seeking comment on margin requirements for non-centrally-cleared derivatives).

The potential international implications of the proposed capital, margin, and segregation requirements warrant further consideration. However, consistent with the Commission's general approach with respect to its other proposals under Title VII, these implications are recognized here but not fully addressed. Instead, the Commission intends to publish a comprehensive release seeking public comment on the full spectrum of issues relating to the application of Title VII to cross-border security-based swap transactions and non-U.S. persons that act in capacities regulated under the Dodd-Frank Act. This approach will provide market participants, foreign regulators, and other interested parties with an opportunity to consider, as an integrated whole, the proposed approach to the cross-border application of Title VII, including capital, margin, and segregation requirements.

II. Proposed Rules and Rule Amendments

A. Capital

1. Introduction

Section 15F(e)(1)(B) of the Exchange Act requires that the Commission prescribe capital requirements for nonbank SBSDs and nonbank MSBSPs.

The Commission also has concurrent authority under section 15(c)(3) of the Exchange Act to prescribe capital requirements for broker-dealers.

The existing broker-dealer capital requirements are contained in

Rule 15c3-1,

including seven appendices to Rule 15c3-1.

The minimum capital requirements for stand-alone SBSDs would be contained in proposed new Rule 18a-1,

and the minimum capital requirements for broker-dealer SBSDs would be contained in Rule 15c3-1, as proposed to be amended. Proposed Rule 18a-1 would be structured similarly to Rule 15c3-1 and would contain many provisions that correspond to those in Rule 15c3-1.

15 U.S.C. 78o-10(e)(1)(B).

15 U.S.C. 78o(c)(3). Section 771 of the Dodd-Frank Act states that unless otherwise provided by its terms, its provisions relating to the regulation of the security-based swap markets do not divest any appropriate Federal banking agency, the Commission, the CFTC, or any other Federal or State agency, of any authority derived from any other provision of applicable law.

See

Public Law 111-203 § 771. In addition, section 15F(e)(3)(B) of the Exchange Act provides that nothing in section 15F “shall limit, or be construed to limit, the authority” of the Commission “to set financial responsibility rules for a broker or dealer * * * in accordance with Section 15(c)(3).” 15 U.S.C. 78o-8(e)(3)(B).

17 CFR 240.15c3-1.

17 CFR 240.15c3-1a (Options); 17 CFR 240.15c3-1b (Adjustments to net worth and aggregate indebtedness for certain commodities transactions); 17 CFR 240.15c3-1c (Consolidated computations of net capital and aggregate indebtedness for certain subsidiaries and affiliates); 17 CFR 240.15c3-1d (Satisfactory subordination agreements); 17 CFR 240.15c3-1e (Deductions for market and credit risk for certain brokers or dealers); 17 CFR 240.15c3-1f (Optional market and credit risk requirements for OTC derivatives dealers); 17 CFR 240.15c3-1g (Conditions for ultimate holding companies of certain brokers or dealers).

See

proposed new Rule 18a-1.

For example, proposed new Rule 18a-1 would include four appendices: Appendix A (proposed new Rule 18a-1a); Appendix B (proposed new Rule18a-1b); Appendix C (proposed new Rule 18a-1c); and Appendix D (proposed new Rule 18a-1d). The appendices would correspond to the following appendices to Rule 15c3-1: Appendix A (Options) (17 CFR 240.15c3-1a); Appendix B (Adjustments to net worth and aggregate indebtedness for certain commodities transactions) (17 CFR 240.15c3-1b); Appendix C (Consolidated computations of net capital and aggregate indebtedness for certain subsidiaries and affiliates) (17 CFR 240.15c3-1c); and Appendix D (Satisfactory subordination agreements) (17 CFR 240.15c3-1d).

As described above, the capital and other financial responsibility requirements for broker-dealers generally provide a reasonable template for crafting the corresponding requirements for nonbank SBSDs. For example, among other considerations, the objectives of capital standards for both types of entities are similar. Rule 15c3-1, described in detail below, is a net liquid assets test that is designed to require a broker-dealer to maintain sufficient liquid assets to meet all obligations to customers and counterparties and have adequate additional resources to wind-down its business in an orderly manner without the need for a formal proceeding if it fails financially.

In turn, the objective of the proposed capital standards for nonbank SBSDs is to protect customer assets and mitigate the consequences of a firm failure, while allowing these firms the flexibility in how they conduct a security-based swaps business.

See Net Capital Rule,

Exchange Act Release No. 38248 (Feb. 6, 1997), 62 FR 6474 (Feb. 12, 1997) (“Rule 15c3-1 requires registered broker-dealers to maintain sufficient liquid assets to enable those firms that fall below the minimum net capital requirements to liquidate in an orderly fashion without the need for a formal proceeding.”). As indicated, the goal of the rule is to require a broker-dealer to hold sufficient liquid net capital to meet all obligations to creditors, except for creditors who agree to subordinate their claims to all other creditors. As discussed in more detail below, Rule 15c3-1d (Appendix D to Rule 15c3-1) sets forth minimum requirements for a subordinated loan agreement.

See

17 CFR 240.15c3-1d. Typically, affiliates of the broker-dealer (

e.g.,

the firm's holding company) or individual owners of the broker-dealer make subordinated loans to the broker-dealer. If the broker-dealer fails financially and is liquidated, the obligations of the broker-dealer to all other creditors would need to be paid in full before the obligations of the broker-dealer to a subordinated lender are paid.

In addition, the Dodd-Frank Act divided responsibility for SBSDs by providing the prudential regulators with authority to prescribe the capital and margin requirements for bank SBSDs and the Commission with authority to prescribe capital and margin requirements for nonbank SBSDs.

This division also suggests it may be appropriate to model the capital requirements for nonbank SBSDs on the capital standards for broker-dealers, while the capital requirements for bank SBSDs are modeled on capital standards for banks (as reflected in the proposal by the prudential regulators).

Certain operational, policy, and legal differences appear to support this distinction between nonbank SBSDs and bank SBSDs. First, based on the Commission staff's understanding of the activities of nonbank dealers in over-the counter (“OTC”) derivatives, nonbank SBSDs are expected to engage in a securities business with respect to security-based swaps that is more similar to the dealer activities of broker-dealers than to the activities of banks; indeed, some broker-dealers likely will be registered as nonbank SBSDs.

Second, existing capital standards for banks and broker-dealers reflect, in part, differences in their funding models and access to certain types of financial support, and those same differences also will exist between bank SBSDs and nonbank SBSDs. For example, banks obtain funding through customer deposits and can obtain liquidity through the Federal Reserve's discount window, whereas broker-dealers do not—and nonbank SBSDs will not—have access to these sources of funding and liquidity. Third, Rule 15c3-1 currently contains provisions designed to address dealing in OTC derivatives by broker-dealers and, therefore, to some extent already can accommodate this type of activity (although, as discussed below, proposed amendments to Rule 15c3-1 would be designed to more specifically address the risks of security-based swaps and the potential for increased involvement of broker-dealers in the security-based swaps markets).

See

15 U.S.C. 78o-10, in general; 15 U.S.C. 78o-10(e)(2)(A)-(B), in particular.

The prudential regulators have proposed capital requirements for bank SBSDs and bank swap dealers that are based on the capital requirements for banks.

See Prudential Regulator Margin and Capital Proposing Release,

76 FR at 27582.

Id.

See

17 CFR 240.15c3-1f and 17 CFR 240.15c3-1e.

See also Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,

Exchange Act Release No. 49830 (June 8, 2004), 69 FR 34428 (June 21, 2004) (“

Alternative Net Capital Requirements Adopting Release”

);

OTC Derivatives Dealers,

Exchange Act Release No. 40594 (Oct. 23, 1998), 63 FR 59362 (Nov. 3, 1998).

For these reasons, the proposed capital standard for nonbank SBSDs is a net liquid assets test modeled on the broker-dealer capital standard in Rule 15c3-1.

However, the Commission

recognizes that there may be alternative approaches to financial responsibility requirements that may be appropriate.

Accordingly, in the requests for comment below on the various capital standards, commenters are encouraged: (1) To consider alternative approaches to capital for nonbank SBSDs generally; (2) for nonbank SBSDs that are broker-dealers, to identify what, if any, specific amendments to Rule 15c3-1 and its appendices they believe would not be appropriate for broker-dealers; and (3) for stand-alone SBSDs, to identify what, if any, specific provisions in proposed new Rule 18a-1 and its appendices (including those modeled on provisions in Rule 15c3-1 and its appendices) they believe would not be appropriate for stand-alone SBSDs.

As noted above, the prudential regulators similarly proposed capital standards for bank SBSDs based on the capital standards for banks.

See Prudential Regulator Margin and Capital Proposing Release

76 FR 27564. The CFTC has proposed three different capital standards for nonbank swap dealers. First, a futures commission merchant (“FCM”) that is registered as a swap dealer would be subject to the CFTC's net capital rule for FCMs, which is similar to the Commission's net capital rule for broker-dealers in that it imposes a net liquid assets test.

See CFTC Capital Proposing Release,

76 FR 27802. Second, a swap dealer that is not an FCM

and not

affiliated with a U.S. bank holding company would be subject to a “tangible net equity” capital standard (the CFTC proposal defines

tangible net equity

as equity determined under U.S. generally accepted accounting principles (“GAAP”), and excludes goodwill and other intangible assets). Third, a swap dealer that is not an FCM

and is

affiliated with a U.S. bank holding company would be subject to the capital standard that applies to U.S. banking institutions.

Id.

The proposed capital standard for nonbank SBSDs would not make such distinctions and, therefore, all nonbank SBSDs would be subject to the net liquid assets test embodied in Rule 15c3-1 (

i.e.,

regardless of whether they are registered as broker-dealers or affiliates of U.S. bank holding companies). The CFTC proposed a tangible net equity requirement for certain swap dealers to address the probability that commercial entities (

e.g.,

entities engaged in agricultural or energy businesses) may need to register as swap dealers and that imposing a net liquid assets test could require them to engage in significant corporate restructuring and potentially cause undue costs because their equity is comprised of physical and other non-current assets. Differences between the swaps markets and the security-based swaps markets may make a single capital standard more workable for nonbank SBSDs. The swaps market is significantly larger than the security-based swaps market and has many more active participants that are commercial entities.

See

BIS,

OTC Derivatives Market Activity in the Second Half of 2010,

Monetary and Economic Department, (May 2011), available at

http://www.bis.org/publ/otc_hy1105.pdf

. It is expected that financial institutions will comprise a large segment of the security-based swaps market as is currently the case and that these entities are more likely to have affiliates dedicated to OTC derivatives trading and affiliates that are broker-dealers registered with the Commission.

See infra

section V.A. of this release (providing an overview of the security-based swaps markets). Consequently, these affiliates—because their capital structures are geared towards securities trading or because they already are broker-dealers—would be

able to more readily adhere to a net liquid assets test. In addition, many broker-dealers currently are affiliates within bank holding companies. Consequently, these broker-dealers are subject to Rule 15c3-1, while their bank affiliates are subject to bank capital standards.

CFTC Capital Proposing Release,

76 FR 27802.

The capital standard in Rule 15c3-1—that serves as a model for the proposed capital standard for nonbank SBSDs—is a net liquid assets test. This standard is designed to promote liquidity; the rule allows a broker-dealer to engage in activities that are part of conducting a securities business (

e.g.,

taking securities into inventory) but in a manner that places the firm in the position of holding at all times more than one dollar of highly liquid assets for each dollar of unsubordinated liabilities (

e.g.,

money owed to customers, counterparties, and creditors).

For example, Rule 15c3-1 allows securities positions to count as allowable net capital, subject to standardized or internal model-based haircuts.

The rule, however, does not permit most unsecured receivables to count as allowable net capital.

This aspect of the rule severely limits the ability of broker-dealers to engage in activities, such as unsecured lending, that generate unsecured receivables. The rule also does not permit fixed assets or other illiquid assets to count as allowable net capital, which creates disincentives for broker-dealers to own real estate and other fixed assets that cannot be readily converted into cash. For these reasons, Rule 15c3-1 incentivizes broker-dealers to confine their business activities and devote capital to activities such as underwriting, market making, and advising on and facilitating customer securities transactions.

See, e.g., Interpretation Guide to Net Capital Computation for Brokers and Dealers,

Exchange Act Release No. 8024 (Jan. 18, 1967), 32 FR 856 (Jan. 25, 1967) (“Rule 15c3-1 (17 CFR 240.15c3-1) was adopted to provide safeguards for public investors by setting standards of financial responsibility to be met by brokers and dealers. The basic concept of the rule is liquidity; its object being to require a broker-dealer to have at all times sufficient liquid assets to cover his current indebtedness.”) (footnotes omitted);

Net Capital Treatment of Securities Positions, Obligations and Transactions in Suspended Securities,

Exchange Act Release No. 10209 (June 8, 1973), 38 FR 16774 (June 26, 1973) (Commission release of a letter from the Division of Market Regulation) (“The purpose of the net capital rule is to require a broker or dealer to have at all times sufficient liquid assets to cover its current indebtedness. The need for liquidity has long been recognized as vital to the public interest and for the protection of investors and is predicated on the belief that accounts are not opened and maintained with broker-dealers in anticipation of relying upon suit, judgment and execution to collect claims but rather on a reasonable demand one can liquidate his cash or securities positions.”);

Net Capital Requirements for Brokers and Dealers,

Exchange Act Release No. 15426 (Dec. 21, 1978), 44 FR 1754 (Jan. 8, 1979) (“The rule requires brokers or dealers to have sufficient cash or liquid assets to protect the cash or securities positions carried in their customers' accounts. The thrust of the rule is to insure that a broker or dealer has sufficient liquid assets to cover current indebtedness.”);

Net Capital Requirements for Brokers and Dealers,

Exchange Act Release No. 26402 (Dec. 28, 1989), 54 FR 315 (Jan. 5, 1989) (“The rule's design is that broker-dealers maintain liquid assets in sufficient amounts to enable them to satisfy promptly their liabilities. The rule accomplishes this by requiring broker-dealers to maintain liquid assets in excess of their liabilities to protect against potential market and credit risks.”) (footnote omitted).

See

17 CFR 240.15c3-1(c)(2)(vi); 17 CFR 240.15c3-1e; 17 CFR 240.15c3-1f.

See

17 CFR 240.15c3-1(c)(2)(iv).

Rule 15c3-1 requires broker-dealers to maintain a minimum level of net capital (meaning highly liquid capital) at all times.

The rule requires that a broker-dealer perform two calculations: (1) A computation of the minimum amount of net capital the broker-dealer must maintain;

and (2) a computation of the amount of net capital the broker-dealer is maintaining.

The minimum net capital requirement is the greater of a fixed-dollar amount specified in the rule and an amount determined by applying one of two financial ratios: the 15-to-1 aggregate indebtedness to net capital ratio or the 2% of aggregate debit items ratio.

See

17 CFR 240.15c3-1.

See

17 CFR 240.15c3-1(a).

See

17 CFR 240.15c3-1(c)(2). The computation of net capital is based on the definition of

net capital

in paragraph (c)(2) of Rule 15c3-1.

Id.

See

17 CFR 240.15c3-1(a).

In computing net capital, the broker-dealer must, among other things, make certain adjustments to net worth such as deducting illiquid assets and taking other capital charges and adding qualifying subordinated loans.

The amount remaining after these deductions is defined as “tentative net capital.”

The final step in computing net capital is to take prescribed percentage deductions (“standardized haircuts”) from the mark-to-market value of the proprietary positions (

e.g.,

securities, money market instruments, and commodities) that are included in its tentative net capital.

The standardized haircuts are designed to account for the market risk inherent in these positions and to create a buffer of liquidity to protect against other risks associated with the securities business.

ANC broker-dealers and a type of limited purpose broker-dealer that deals solely in OTC derivatives (“OTC derivative dealers”) are permitted, with Commission approval, to calculate net capital using internal models as the basis for taking market risk and credit risk charges in lieu of the standardized haircuts for classes of positions for which they have been approved to use models.

Rule 15c3-1 imposes substantially higher minimum capital requirements for ANC broker-dealers and OTC derivatives dealers, as compared to other types of broker-dealers, because, among other reasons, the use of internal models to compute net capital can substantially reduce the deductions for securities and money market positions as compared with the standardized haircuts.

Consequently, the higher minimum capital requirements are designed to account for risks that may not be addressed by the internal models. A broker-dealer must ensure that its net capital exceeds

its minimum net capital requirement at all times.

See

17 CFR 240.15c3-1(c)(2)(i)-(xiii).

See

17 CFR 240.15c3-1(c)(15).

See

17 CFR 240.15c3-1(c)(2)(vi).

See, e.g., Uniform Net Capital Rule,

Exchange Act Release No. 13635 (June 16, 1977), 42 FR 31778 (June 23, 1977) (“[Haircuts] are intended to enable net capital computations to reflect the market risk inherent in the positioning of the particular types of securities enumerated in [the rule]”);

Net Capital Rule,

Exchange Act Release No. 22532 (Oct. 15, 1985), 50 FR 42961 (Oct. 23, 1985) (“These percentage deductions, or `haircuts', take into account elements of market and credit risk that the broker-dealer is exposed to when holding a particular position.”);

Net Capital Rule,

Exchange Act Release No. 39455 (Dec. 17, 1997), 62 FR 67996 (Dec. 30, 1997) (“Reducing the value of securities owned by broker-dealers for net capital purposes provides a capital cushion against adverse market movements and other risks faced by the firms, including liquidity and operational risks.”) (footnote omitted).

See

17 CFR 240.15c3-1(a)(5) and (a)(7); 17 CFR 240.15c3-1e; 17 CFR 240.15c3-1f. As part of the application to use internal models, an entity seeking to become an ANC broker-dealer or an OTC derivatives dealer must identify the types of positions it intends to include in its model calculation.

See

17 CFR 240.15c3-3e(a)(1)(iii); 17 CFR 240.15c3-1f(a)(1)(ii). After approval, an ANC broker-dealer and OTC derivatives dealer must obtain Commission approval to make a material change to the model, including a change to the types of positions included in the model.

See

17 CFR 240.15c3-1e(a)(8); 17 CFR 240.15c3-f(a)(3).

See

17 CFR 240.15c3-1(a)(5) and (a)(7).

17 CFR 240.15c3-1(a).

A different capital standard than the net liquid assets test is proposed for nonbank MSBSPs. As discussed in more detail below, proposed Rule 18a-2 would require nonbank MSBSPs to maintain positive tangible net worth.

The Commission preliminarily believes that a tangible net worth standard—as opposed to the net liquid assets test—is more workable for nonbank MSBSPs because these entities may engage in a diverse range of business activities different from, and broader than, the securities activities conducted by broker-dealers or SBSDs (and, to the extent they did not, they likely would be required to register as an SBSD and/or broker-dealer).

Consequently, requiring nonbank MSBSPs to adhere to a capital standard based on a net liquid assets test could restrict these entities from engaging in commercial activities that are part of their core business models. For example, some of these entities may engage in manufacturing and supply activities that generate large amounts of unsecured receivables and require substantial fixed assets.

Accordingly, as discussed below, proposed Rule 18a-2 is not modeled on Rule 15c3-1 because of the expected differences between nonbank SBSDs and broker-dealers, on the one hand, and the entities that may register as nonbank MSBSPs, on the other hand.

See

proposed new Rule 18a-2.

An entity will need to register with the Commission as an MSBSP and, consequently, be subject to proposed new Rule 18a-2 if it falls within the definition of

major security-based swap participant

in section 3(a)(67) of the Exchange Act (15 U.S.C. 78c(a)(67)) as further defined by the Commission by rule.

See Entity Definitions Adopting Release,

77 FR 30596.

See CFTC Capital Proposing Release,

76 FR at 27807 (proposing a tangible net equity test for major swap participants that are not part of bank holding companies noting that although these firms “may have significant amounts of balance sheet equity, it may also be the case that significant portions of their equity is comprised of physical and other noncurrent assets, which would preclude the firms from meeting FCM capital requirements without engaging in significant corporate restructuring and incurring potentially undue costs.”).

Request for Comment

The Commission generally requests comment on the proposals to impose a net liquid assets test capital standard for nonbank SBSDs and a tangible net worth standard for nonbank MSBSPs. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Will the entities that register as nonbank SBSDs engage in a securities business with respect to security-based swaps that is similar to the securities business conducted by broker-dealers? If not, describe how the securities activities of nonbank SBSDs will differ from the securities activities of broker-dealers.

2. Will some broker-dealers register as nonbank SBSDs? If so, which types of broker-dealers and which types of activities do these broker-dealers currently engage in?

3. Should there be different capital standards for nonbank SBSDs depending on whether they are registered as broker-dealers or affiliated with bank holding companies, or not registered as broker-dealers and not affiliated with bank holding companies? If so, explain why. If not, explain why not. For example, should stand-alone SBSDs be subject to a tangible net worth standard or, if affiliated with a bank holding company, the bank capital standard? Would different standards create competitive advantages? If so, explain why. If different capital standards would be appropriate, explain the appropriate capital standard that should apply to each of these classes of nonbank SBSDs.

4. Generally, is there a level of capital under which counterparties will not transact with a dealer in OTC derivatives because the counterparty credit risk is too great? If so, identify that level of capital.

5. Will stand-alone SBSDs seek to effect transactions in securities OTC derivatives products other than security-based swaps, such as OTC options, that would necessitate registration as a broker-dealer? If so, would registering as a limited purpose broker-dealer under the provisions applicable to OTC derivatives dealers provide a workable alternative to registering as a full-service broker-dealer? For example, would there be conflicts between the proposed capital, margin, and segregation requirements for SBSDs and the existing requirements for OTC derivatives dealers? If so, identify the conflicts.

6. Should the requirements for OTC derivatives dealers be amended (by exemptive relief or otherwise) to accommodate firms that want to deal in security-based swaps? If so, explain how the requirements should be amended and why.

7. Should the Commission exempt nonbank SBSDs engaged in activities with respect to securities OTC derivatives products other than security-based swaps from any requirements applicable to OTC derivatives dealers? Please identify which requirements and explain why.

8. As discussed below, the proposed minimum net capital requirements would differ substantially for stand-alone SBSDs that are approved to use models in computing net capital (

i.e.,

a $20 million fixed-dollar minimum net capital requirement and $100 million tentative net capital requirement) compared to broker-dealer SBSDs approved to use models (

i.e.,

a $1 billion fixed-dollar minimum net capital requirement and $5 billion tentative net capital requirement). In general, because the definition of “security-based swap dealer” in the Dodd-Frank Act does not include acting as a broker or agent in security-based swaps, entities engaging in brokerage activities with respect to security-based swaps could be required to register as broker-dealers. To the extent these broker-dealer SBSDs wanted to use models to compute net capital, they would be subject to the higher minimum net capital requirements. Accordingly, in order to avoid being subject to higher minimum net capital requirements applicable to broker-dealer SBSDs approved to use models to compute net capital, a stand-alone SBSD may need to limit the activity it could conduct on behalf of customers so that it does not fall within the definition of a “broker” under the Exchange Act and, thereby, need to register as a broker-dealer. Commenters are requested to address this issue, including any potential changes to the proposed capital requirements for stand-alone SBSDs and broker-dealer SBSDs discussed below. For example, should broker-dealer SBSDs approved to use internal models to compute net capital and that register as broker-dealers only in order to conduct brokerage activities with respect to security-based swaps, and that do not conduct a general business in securities with customers, be subject to the minimum net capital requirements applicable to stand-alone SBSDs approved to use internal models? If so, explain why. If not, explain why not. If different capital standards would be appropriate, explain the appropriate capital standard that should apply to this class of broker-dealer SBSDs and whether any limitations should apply, including with respect to the types of broker activities in which the nonbank SBSD may engage in order to qualify for a particular capital treatment. Alternatively, or in addition, should the Commission allow OTC derivatives dealers (which are subject to a $20 million fixed-dollar minimum net capital requirement and $100 million tentative net capital requirement) to be dually registered as nonbank SBSDs and/or amend the rules for OTC derivatives dealers to conduct a broader range of activities than are currently

permitted? If the Commission took this action, should it also remove the exemption for OTC derivatives dealers from membership in a self-regulatory organization (“SRO”)?

9. Describe the types of entities that may need to register as MSBSPs and how the activities that these entities engage in would impact the entity's capital position.

10. Should nonbank MSBSPs be subject to a net liquid assets test capital standard (in contrast to a tangible net worth test)? If so, explain why. If not, explain why not.

2. Proposed Capital Rules for Nonbank SBSDs

As discussed in detail below, proposed new Rule 18a-1 would prescribe capital requirements for stand-alone SBSDs and amendments to Rule 15c3-1 would prescribe capital requirements for broker-dealer SBSDs. Proposed new Rule 18a-1 would require a stand-alone SBSD to compute net capital using standardized haircuts prescribed in the rule (including standardized haircuts specifically for security-based swaps and swaps) or, alternatively, with Commission approval, to use internal models for positions for which the stand-alone SBSD has been approved to use internal models. Under the proposed amendments to Rule 15c3-1, a broker-dealer SBSD would be required to use the existing standardized haircuts in the rule plus proposed new additional standardized haircuts specifically for security-based swaps and swaps. A broker-dealer SBSD that seeks to compute net capital using internal models would need to apply to the Commission for approval to operate as an ANC broker-dealer. A nonbank SBSD permitted to use internal models to compute net capital (whether a stand-alone SBSD subject to proposed new Rule 18a-1 or an ANC broker-dealer subject to Rule 15c3-1, as amended) would need to comply with additional requirements as compared to a nonbank SBSD that is not approved to use internal models. This would be consistent with the existing requirements in Rule 15c3-1, which impose additional requirements on ANC broker-dealers and OTC derivatives dealers as compared with other broker-dealers.

Finally, the amendments to Rule 15c3-1 would apply to broker-dealers that are not registered as SBSDs to the extent they hold positions in security-based swaps and swaps.

See, e.g.,

17 CFR 240.15c3-1(a)(5) and (a)(7); 17 CFR 240.15c3-1e; 17 CFR 240.15c3-1f; 17 CFR 240.15c3-4.

a. Computing Required Minimum Net Capital

Rule 15c3-1 prescribes the minimum net capital requirement for a broker-dealer as the greater of a fixed-dollar amount specified in the rule and an amount determined by applying one of two financial ratios: the 15-to-1 aggregate indebtedness to net capital ratio or the 2% of aggregate debit items ratio.

The proposed capital requirements for nonbank SBSDs would use a similar framework. Under the proposals, there would be different minimum net capital requirements for stand-alone SBSDs that are not approved to use internal models, broker-dealer SBSDs that are not approved to use internal models, stand-alone SBSDs that are approved to use internal models, and broker-dealer SBSDs that are approved to use internal models (

i.e.,

ANC broker-dealers). The following table provides a summary of the proposed minimum net capital requirements, which are discussed in the following sections.

See

17 CFR 240.15c3-1(a).

EP23NO12.000

i. Stand-alone SBSDs Not Using Internal Models

A stand-alone SBSD would be subject to the capital requirements set forth in proposed new Rule 18a-1. Under this proposed new rule, a stand-alone SBSD that is not approved to use internal models to compute haircuts would be required to maintain minimum net capital of not less than the greater of $20 million or 8% of the firm's

risk margin amount

(“8% margin factor”).

The term

risk margin amount

would be defined as the sum of: (1) The greater of the total margin required to be delivered by the nonbank SBSD with respect to security-based swap transactions cleared for security-based swap customers at a clearing agency or the amount of the deductions that would apply to the cleared security-based swap positions of the security-based swap customers pursuant to paragraph (c)(1)(vi) of Rule 18a-1; and (2) the total

margin

amount calculated by the stand-alone SBSD with respect to non-cleared security-based swaps pursuant to proposed new Rule 18a-3.

Accordingly, to determine its minimum net capital requirement, a stand-alone SBSD would need to calculate the amount equal to the 8% margin factor.

The firm's minimum net capital requirement would be the greater of $20 million or the amount equal to the 8% margin factor.

See

paragraph (a)(1) of proposed new Rule 18a-1. The rationales for these minimum requirements are discussed below.

See

paragraph (c)(6) of proposed new Rule 18a-1. The components of the

risk margin amount

are discussed in detail below.

See

paragraphs (a)(1) and (c)(6) of proposed new Rule 18a-1.

See

paragraph (a)(1) of proposed new Rule 18a-1.

The proposed $20 million fixed-dollar minimum requirement would be the same as the fixed-dollar minimum

requirement applicable to OTC derivatives dealers and already familiar to existing market participants.

OTC derivatives dealers are limited purpose broker-dealers that are authorized to trade in certain derivatives, including security-based swaps, and to use internal models to calculate net capital. They are required to maintain minimum tentative net capital of $100 million and minimum net capital of $20 million.

These current fixed-dollar minimums have been the minimum capital standards for OTC derivative dealers for over a decade, and are substantially lower than the fixed-dollar minimums in Rule 15c3-1 currently applicable to ANC broker-dealers, which use internal models to calculate net capital.

In addition, available data regarding the current population of broker-dealers suggests that these minimums would not prevent new entrants in the security-based swap market.

To date, there have been no indications that these minimums are not adequately meeting the objective of requiring OTC derivatives dealers to maintain sufficient levels of regulatory capital to account for the risks inherent in their activities.

See

17 CFR 240.15c3-1(a)(5). The CFTC proposed a $20 million fixed-dollar minimum net capital requirement for FCMs that are registered as swap dealers, regardless of whether the firm is approved to use internal models to compute regulatory capital.

See CFTC Capital Proposing Release,

76 FR 27802.

Further, the CFTC proposed a $20 million fixed-dollar “tangible net equity” minimum requirement for swap dealers and major swap participants that are not FCMs

and are not

affiliated with a U.S. bank holding company. Finally, the CFTC proposed a $20 million fixed-dollar Tier 1 capital minimum requirement for swap dealers and major swap participants that are not FCMs

and are

affiliated with a U.S. bank holding company (the term “Tier 1 capital” refers to the regulatory capital requirement for U.S. banking institutions).

Id.

See

17 CFR 240.15c3-1(a)(5). When adopting the capital requirements for OTC derivatives dealers, the Commission stated “[t]he minimum tentative net capital and net capital requirements are necessary to ensure against excessive leverage and risks other than credit or market risk, all of which are now factored into the current haircuts. Further, while the mathematical assumptions underlying VaR may be useful in projecting possible daily trading losses under `normal' market conditions, VaR may not help firms measure losses that fall outside of normal conditions, such as during steep market declines. Accordingly, the minimum capital requirements provide additional safeguards to account for possible extraordinary losses or decreases in liquidity during times of stress which are not incorporated into VaR calculations.”

See OTC Derivatives Dealers,

63 FR 59362.

Paragraph (a)(7) of Rule 15c3-1 currently requires that ANC broker-dealers at all times maintain tentative net capital of not less than $1 billion and net capital of not less than $500 million. 17 CFR 240.15c3-1(a)(7).

See infra

section V.B.2.a.i. of this release (economic analysis discussion based on year-end 2011 data showing that approximately 270 broker-dealers maintain net capital of $20 million or more).

At the same time, the proposed $20 million fixed-dollar minimum requirement for stand-alone SBSDs that do not use internal models to calculate net capital would be substantially higher than the fixed-dollar minimums in Rule 15c3-1 currently applicable to broker-dealers that do not use internal models (

i.e.,

that are not ANC broker-dealers or OTC derivatives dealers).

Under the proposals, stand-alone SBSDs that do not use models would not be able to avail themselves of such minimums and would be subject to the same $20 million minimum net capital requirement as OTC derivatives dealers, even though they would not be using models like such derivatives dealers. In other words, the same minimum net capital requirement will apply to stand-alone SBSDs regardless of whether or not they use models.

For example, a broker-dealer that carries customer accounts has a fixed-dollar minimum requirement of $250,000; a broker-dealer that does not carry customer accounts but engages in proprietary securities trading (defined as more than ten trades a year) has a fixed-dollar minimum requirement of $100,000; and a broker-dealer that does not carry accounts for customers or otherwise does not receive or hold securities and cash for customers, and does not engage in proprietary trading activities, has a fixed-dollar minimum requirement of $5,000.

See

17 CFR 240.15c3-1(a)(2).

This level of minimum capital may be appropriate because of the nature of the business of a stand-alone SBSD and the differences from the business of a broker-dealer or OTC derivatives dealer. Generally, OTC derivatives, such as security-based swaps, are contracts between a dealer and its counterparty. Consequently, the counterparty's ability to collect amounts owed to it under the contract depends on the financial wherewithal of the dealer. In contrast, the returns on financial instruments held by a broker-dealer for an investor (other than a derivative issued by the broker-dealer) are not linked to the financial wherewithal of the broker-dealer holding the instrument for the customer. Accordingly, if a stand-alone SBSD fails, the counterparty may not be able to liquidate the contract or replace the contract with a new counterparty without incurring a loss on the position. The entities that will register and operate as nonbank SBSDs should be sufficiently capitalized to minimize the risk that they cannot meet their obligations to counterparties, particularly given that the counterparties will not be limited to other dealers but will include customers and other counterparties as well.

In addition, stand-alone SBSDs will not be subject to the same limitations that apply to OTC derivative dealers in effecting transactions with customers and engaging in dealing activities.

Therefore, the failure of a stand-alone SBSD could have a broader adverse impact on a larger number of market participants, including customers and counterparties.

The proposed capital requirements for this group of firms, in part, are meant to account for this potential broader impact on market participants.

See

17 CFR 240.3b-12; 17 CFR 240.15a-1. Rule 3b-12, defining the term OTC derivatives dealer, provides, among other things, that an OTC derivatives dealer's securities activities must be limited to: (1) Engaging in dealer activities in eligible OTC derivative instruments (as defined in the rule) that are securities; (2) issuing and reacquiring securities that are issued by the dealer, including warrants on securities, hybrid securities, and structured notes; (3) engaging in cash management securities activities (as defined in Rule 3b-14 (17 CFR 240.3b-14)); (4) engaging in ancillary portfolio management securities activities (as defined in the rule); and (5) engaging in such other securities activities that the Commission designates by order.

See

17 CFR 240.3b-12. Rule 15a-1, governing the securities activities of OTC derivatives dealers, provides that an OTC derivatives dealer must effect transactions in OTC derivatives with most types of counterparties through an affiliated Commission-registered broker-dealer that is not an OTC derivatives dealer.

See

17 CFR 240.15a-1.

The proposal is consistent with the CFTC's proposed capital requirements for nonbank swap dealers, which impose $20 million fixed-dollar minimum requirements regardless of whether the firm is approved to use internal models to compute regulatory capital.

See CFTC Capital Proposing Release,

76 FR 27802.

As discussed above, stand-alone SBSDs would be subject to a minimum ratio amount based on the 8% margin factor. OTC derivatives dealers are not subject to a minimum ratio amount.

Consequently, stand-alone SBSDs that do not use internal models would be subject to the same $20 million fixed-dollar minimum net capital requirement that applies to OTC derivatives dealers. The same firms would not, however, be subject to a minimum tentative net capital requirement, which is applied to firms that use internal models to account for risks that may not be fully captured by the models.

OTC derivatives dealers are subject to a $100 million minimum tentative net capital requirement. ANC broker-dealers are currently subject to a $1 billion minimum tentative net capital requirement. The minimum tentative net capital requirements are designed to address risks that may not be captured when using internal models rather than standardized haircuts to compute net capital.

See OTC Derivatives Dealers,

63 FR at 59384;

Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities; Proposed Rule,

Exchange Act Release No. 48690 (Oct. 24, 2003), 68 FR 62872, 62875 (Nov. 6, 2003) (“We expect that net capital charges will be reduced for broker-dealers that use the proposed alternative net capital computation. The present haircut structure is designed so that firms will have a sufficient capital base to account for, in addition to market and credit risk, other types of risk, such

as operational risk, leverage risk, and liquidity risk. Raising the minimum tentative net capital requirement to $1 billion and net capital requirement to $500 million is one way to ensure that firms that use the alternative capital computation maintain sufficient capital reserves to account for these other risks. In addition, based on our experience, firms must have this scale of operations in order to have developed internal risk management control systems necessary to support reliable VaR computations.”).

The proposed 8% margin factor would be part of determining the stand-alone SBSD's minimum net capital requirement. As noted above, the stand-alone SBSD would determine this amount by adding:

• The greater of the total margin required to be delivered by the stand-alone SBSD with respect to security-based swap transactions cleared for security-based swap customers at a clearing agency or the amount of the deductions that would apply to the cleared security-based swap positions of the security-based swap customers pursuant to paragraph (c)(1)(vi) of Rule 18a-1;

and

See

paragraph (c)(6) of proposed new Rule 18a-1. As discussed below in section II.B. of this release, nonbank SBSDs will be subject to margin requirements imposed by clearing agencies pursuant to which nonbank SBSDs will be required to collect collateral from customers relating to the customers' cleared security-based swap transactions. The amount of collateral required to be collected as a result of customers' cleared security-based swap transactions would be used to determine the first component of the

risk margin amount.

This amount would be added to the second component of the risk margin amount relating to non-cleared security-based swaps and that amount would be multiplied by 8% to determine the 8% margin factor. However, if the margin requirements of the clearing agencies require the stand-alone SBSD to collect total collateral in an amount that is less than the deductions the firm would apply to the customers' cleared security-based swap positions under proposed new Rule 18a-1, the stand-alone SBSD would need to add the amount of the deductions to the second component of the risk margin amount relating to non-cleared security-based swaps and multiply that amount by 8% to determine the 8% margin factor.

• The total

margin

amount calculated by the stand-alone SBSD with respect to non-cleared security-based swaps pursuant to paragraph (c)(1)(i)(B) of proposed new Rule 18a-3.

See

paragraph (c)(6) of proposed new Rule 18a-1. As discussed below in section II.B. of this release, proposed new Rule 18a-3 would establish margin requirements for nonbank SBSDs with respect to non-cleared security-based swaps.

See

proposed new Rule 18a-3. The proposed rule would define the term

margin

to mean the amount of

positive equity

in an account of a counterparty.

See

paragraph (b)(5) of proposed new Rule 18a-3. Under the proposed rule, a nonbank SBSD would be required to calculate daily a

margin

amount for the account of each counterparty to a non-cleared security-based swap.

See

paragraph (c)(1)(i)(B) of proposed new Rule 18a-3. These calculations of counterparty

margin

amounts for the purposes of proposed new Rule 18a-3 would be used to determine the component of the

risk margin amount

relating to non-cleared security-based swaps. This amount would be added to the first component relating to cleared security-based swaps, and the total amount would be multiplied by 8% to determine the 8% margin factor.

The total of these two amounts—

i.e.,

the risk margin amount—would be multiplied by 8% to determine the amount of the 8% margin factor, which, if greater than the $20 million fixed-dollar amount, would be the stand-alone SBSD's minimum net capital requirement.

This proposed 8% margin factor ratio requirement is similar to an existing requirement in the CFTC's net capital rule for FCMs.

Further, the CFTC has proposed a similar requirement for swap dealers and major swap participants registered as FCMs.

Under the CFTC's proposal, an FCM would be required to maintain adjusted net capital that is equal to or greater than 8% of the risk margin required for customer and non-customer exchange-traded futures and swaps positions that are cleared by a derivatives clearing organization (“DCO”).

The CFTC's proposed 8% of margin, or risk-based capital rule, “is intended to require FCMs to maintain a minimum level of capital that is associated with the level of risk associated with the customer positions that the FCM carries.”

Based on Commission staff experience with dually-registered broker-dealer/FCMs, the Commission preliminarily believes that the 8% margin factor would serve as a reasonable measure to ensure that a firm's minimum capital requirement increases or decreases in tandem with the level of risk arising from customer futures transactions. Consequently, the 8% margin factor is being proposed to provide a similar adjustable minimum net capital requirement for nonbank SBSDs with respect to their security-based swap activity.

See

paragraphs (a)(1) and (c)(6) of proposed new Rule 18a-1.

See

17 CFR 1.17(a)(1)(i)(B).

See also Minimum Financial and Related Reporting Requirements for Futures Commission Merchants and Introducing Brokers,

69 FR 49784 (Aug. 12, 2004). The CFTC proposed the 8% risk margin requirement to establish a margin-based capital computation identical to the margin-based minimum net capital computation that several futures self-regulatory organizations, including one derivatives clearing organization, adopted for their respective member-FCMs.

Id.

at note 16.

See CFTC Capital Proposing Release,

76 FR 27802. The 8% risk margin calculation under the CFTC's proposal relates to cleared swaps or futures transactions, whereas the 8% margin factor proposed in new Rule 18a-1 would be based on cleared and non-cleared security-based swaps. As discussed below, the proposed minimum net capital requirement is based on a nonbank SBSD's cleared and non-cleared security-based swap activity in order to account for the risks of both types of positions.

See CFTC Capital Proposing Release,

76 FR 27802.

Id.

at 27807.

As discussed below in section II.A.2.b.iv. of this release, an 8% multiplier is used for purposes of calculating credit risk charges under Appendix E to Rule 15c3-1. While this is a different calculation than the proposed 8% margin factor, using an 8% multiplier for purposes of computing regulatory capital requirements is an international standard.

See Alternative Net Capital Requirements Adopting Release,

69 FR 34428, note 42 (describing the 8% multiplier in Appendix E to Rule 15c3-1 as being “consistent with the calculation of credit risk in the OTC derivatives dealers rules and with the Basel Standard” and as being “designed to dampen leverage to help ensure that the firm maintains a safe level of capital.”).

Under the proposed rule, nonbank SBSDs—including stand-alone SBSDs that are not approved to use internal models to calculate net capital—would be subject to a minimum net capital requirement that increases in tandem with an increase in the risks associated with nonbank SBSD's security-based swap activities.

Without the 8% margin factor, the minimum net capital requirement for a nonbank SBSD would be the same (

i.e.,

$20 million) regardless of the volume, size, and risk of its outstanding security-based swap transactions.

As discussed below in sections II.A.2.a.ii., II.A.2.a.iii., and II.A.2.a.iv. of this release, the 8% margin factor would be used to compute the minimum net capital requirement for all nonbank SBSDs.

The amount computed under the 8% margin factor generally would increase as the stand-alone SBSD increased the volume, size, and risk of its security-based swap transactions. Specifically, the proposed definition of the term

risk margin amount

is designed to link the stand-alone SBSD's minimum net capital requirement to its cleared and non-cleared security-based swap activity. For example, the definition in proposed new Rule 18a-1 provides that, for cleared security-based swaps, the amount is the greater of the margin required to be collected or the amount of the deductions that would apply pursuant to proposed new Rule 18a-1 (

i.e.,

the amount of the deductions using standardized haircuts).

The margin requirement for cleared security-based swap positions generally should increase with the volume, size, and risk of the positions as would the amount of the standardized haircuts applicable to the positions. Further, the “greater of” provision is designed to ensure that the 8% margin factor requirement is based on, at a minimum, the standardized haircuts as these provide a uniform approach for all cleared security-based

swaps, whereas margin requirements for cleared security-based swaps will vary over time and across different clearing agencies.

For a stand-alone SBSD approved to use internal models and an ANC broker-dealer, it would be the amount of the deductions determined using a VaR model, except for types of positions for which the firm has not been approved to use a VaR model.

As proposed, the 8% margin factor is determined using the greater of required margin or standardized haircuts with respect to cleared security-based swaps

plus

the margin amount for non-cleared security-based swaps calculated under proposed new Rule 18a-3.

Thus, the 8% margin factor would be based on a stand-alone SBSD's activity in both cleared and non-cleared security-based swaps. As noted above, the goal of the provision is to require the stand-alone SBSD to increase its net capital in tandem with an increase in the risk of its security-based swap transactions. The proposal does not limit the computation to only cleared security-based swaps, as proposed by the CFTC, because such a limitation would allow the stand-alone SBSD to increase the amount of its non-cleared security-based swaps positions without a corresponding increase in net capital. This could create greater risk to the stand-alone SBSD's customers because—as discussed above—their ability to collect amounts owing on security-based swaps depends on the ability of the stand-alone SBSD to meets its obligations.

Proposed new Rule 18a-3 would require a nonbank SBSD to calculate daily a margin amount for the account of each counterparty to a non-cleared security-based swap.

See

paragraph (c)(1)(i)(B) of proposed new Rule 18a-3. As discussed below in section II.B. of this release, a nonbank SBSD would be required to perform this calculation even though proposed new Rule 18a-3 would not require the nonbank SBSD to collect collateral from all counterparties to collateralize the margin amount. For example, the Commission is proposing that collateral need not be collected from

commercial end users.

Nonetheless, the calculation of the

margin

amount for purposes of proposed new Rule 18a-3 would determine the non-cleared security-based swap component of the

risk margin amount

regardless of whether the nonbank SBSD would be required to collect collateral from the counterparty to collateralize the margin amount. In other words, the amount of the

risk margin amount

would be based on the calculation required by proposed new Rule 18a-3 for all counterparties to non-cleared security-based swaps and not on whether the stand-alone SBSD would be required to collect collateral from a counterparty to collateralize the

margin

amount. As discussed in section II.B. of this release, this is designed to ensure that the

risk margin amount

is based on all non-cleared security-based swap activity of the stand-alone SBSD and not just on security-based swap activity that would require the firm to collect collateral.

Request for Comment

The Commission generally requests comment on the proposed minimum net capital requirements in proposed new Rule 18a-1 for stand-alone SBSDs that are not approved to use internal models to compute net capital. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Is the proposed $20 million minimum net capital requirement for stand-alone SBSDs not using internal models appropriate? If not, explain why not. What minimum amount would be more appropriate? For example, should the minimum fixed-dollar amount be greater than $20 million to account for the broader range of activities that stand-alone SBSDs will be able to engage in as compared with OTC derivatives dealers? If so, explain why. If it should be a greater amount, how much greater should it be (

e.g.,

$30 million, $50 million, $100 million, or some other amount)? Alternatively, should the minimum fixed-dollar amount be less than $20 million because these firms will not be using internal models to compute net capital? If so, explain why. If it should be a lower amount, how much lower (

e.g.,

$15 million, $10 million, $5 million, or some other amount)? If a greater or lesser alternative amount is recommended, explain why it would be more appropriate for broker-dealer SBSDs that are not approved to use internal models.

2. Is the proposed definition of

risk margin amount

appropriate? If not, explain why and suggest modifications to the definition. For example, are there modifications that could make the definition more accurately reflect the nonbank SBSD's risk exposure from dealing in security-based swaps? If so, describe the modifications and explain why they would achieve this result.

3. Is the component of the

risk margin amount

definition addressing margin delivered for cleared swaps appropriate? If not, explain why not. Would the definition be more appropriate if this component was dropped so that the first prong of the definition only incorporated the haircuts for cleared security-based swaps?

4. Should the proposed definition of

risk margin amount

only address cleared security-based swaps, consistent with the CFTC's proposal? If so, explain why, including how the risk of non-cleared security-based swap activities could be addressed through other measures.

5. Is the component of the

risk margin amount

definition addressing margin collected for non-cleared security-based swaps appropriate? If not, explain why not.

6. Is the 8% margin factor an appropriate metric for determining a nonbank SBSD's minimum net capital requirement in terms of increasing a nonbank SBSD's minimum net capital requirement as the risk of its security-based swap activities increases? If not, explain why not. For example, should the percentage be greater than 8% (

e.g.,

10%, 12%, or some other percentage)? If so, identify the percentage and explain why it would be preferable. Should the percentage be less than 8% (

e.g.,

6%, 4%, or some other percentage)? If so, identify the percentage and explain why it would be preferable.

7. Should the 8% multiplier be tiered as the amount of the risk margin amount increases? If so, explain why. For example, should the multiplier decrease from 8% to 6% for the amount of the risk margin amount that exceeds a certain threshold, such as $1 billion or $5 billion? If so, explain why. Should the amount of the multiplier increase from 8% to 10% for the amount of the risk margin amount that exceeds a certain threshold such as $1 billion or $5 billion? If so, explain why.

8. Should the 8% margin factor be an adjustable ratio (

e.g.,

increase to 10% or decrease to 6%)? For example, should the multiplier adjust periodically if certain conditions occur? If so, explain the conditions under which the 8% multiplier would adjust upward or downward and why having an adjustable ratio would be appropriate.

9. Would the 8% margin factor be a sufficient minimum net capital requirement without the $20 million fixed-dollar minimum? If so, explain why.

10. Are there metrics other than a fixed-dollar minimum and the 8% margin factor for calculating required minimum capital that would more appropriately reflect the risk of nonbank SBSDs? If so, identify them and explain why they would be preferable. For example, instead of an absolute fixed-dollar minimum, should the minimum net capital requirement be linked to a scalable metric such as the size of the nonbank SBSD or the amount of the deductions taken by the nonbank SBSD when computing net capital? For any scalable minimum net capital requirements identified, explain how the computation would work in practice and how the minimum requirement would address the same objectives of a fixed-dollar minimum.

11. Would the 8% margin factor address the risk of extremely large nonbank SBSDs? If not, explain why not. For example, if the customer margin requirements for cleared and non-cleared security-based swaps carried by the nonbank SBSD were low because the positions were hedged or otherwise not high risk, the 8% margin

factor may not increase in tandem with the level of the nonbank SBSD's security-based swap activity. In this case, would the 8% margin factor adequately address the risk of the nonbank SBSD, particularly if it carried substantial security-based swap positions? If not, explain why not. Would the 8% margin factor be necessary for small nonbank SBSDs? If not, explain why not.

12. Would the 8% margin factor provide an appropriate and workable restraint on the amount of leverage incurred by stand-alone SBSDs not using internal models because the amount of minimum net capital would increase as the risk margin amount increases? If not, explain why not. Is there another measure that would more accurately and effectively address the leverage risk of these firms? If so, identify the measure and explain why it would be more accurate and effective.

13. Should the 8% margin factor be applied to margin related to cleared and non-cleared swap transactions in addition to security-based swap transactions? For example, the provision could require that 8% of the margin required for cleared and non-cleared swaps be added to the 8% of margin required for cleared and non-cleared security-based swaps in determining the minimum net capital requirement. Would this be a workable approach to address the fact that the CFTC's proposed 8% margin requirement would not apply to swap dealers that are not registered as FCMs and, with respect to dually-registered FCM swap dealers, it would apply only to cleared swaps? Including swaps in the 8% margin factor calculation would provide for equal treatment of security-based swaps and swaps in determining a minimum net capital requirement. Would this be a workable approach? If so, explain why. If not, explain why not.

14. Would the 8% margin factor be practical as applied to a portfolio margin account that contains security-based swaps and swaps? If so, explain why. If not, explain why not.

15. What will be the practical impacts of the 8% margin factor? For example, what will be the effect on transaction costs, liquidity in security-based swaps, availability of capital to support security-based swap transactions generally and/or for non-security-based swap-related uses, use of security-based swaps for hedging purposes, risk management at SBSDs, the costs for potential new SBSDs to participate in the security-based swap markets, etc.? How would these impacts increase or decrease if the 8% margin factor were set at a higher or lower percentage?

ii. Broker-Dealer SBSDs Not Using Internal Models

A broker-dealer that registers as an SBSD would continue to be subject to the capital requirements in Rule 15c3-1, as proposed to be amended to account for security-based swap activities. Proposed amendments to paragraph (a) of Rule 15c3-1 would establish minimum net capital requirements for a broker-dealer SBSD that is not approved to use internal models to compute net capital.

Under these proposed amendments, the broker-dealer SBSD would be subject to the same $20 million fixed-dollar minimum net capital requirement as a stand-alone SBSD that does not use internal models.

As discussed above in section II.A.2.a.i. of this release, the proposed $20 million fixed-dollar minimum would be consistent with the current fixed-dollar minimum that applies to OTC derivatives dealers, which has been used as a minimum capital standard for OTC derivative dealers for over a decade.

See

proposed new paragraph (a)(10) of Rule 15c3-1.

Id.

In addition, a broker-dealer SBSD that does not use internal models would be required to use the 8% margin factor to compute its minimum net capital amount. As discussed above in section II.A.2.a.i. of this release, the 8% margin factor is designed to adjust the broker-dealer SBSD's minimum net capital requirement in tandem with the risk associated with the broker-dealer SBSD's security-based swap activity. Without the 8% margin factor, the minimum net capital requirement for a broker-dealer SBSD would be the same (

i.e.,

$20 million) regardless of the number, size, and risk of its outstanding security-based swap transactions. Consequently, the proposed rule would include the 8% margin factor in order to increase the broker-dealer SBSD's net capital requirement as the risk of its security-based swap activities increases.

Moreover, the broker-dealer SBSD—as a broker-dealer—would be subject to the existing financial ratio requirements in Rule 15c3-1 and, therefore, would need to include the applicable financial ratio amount when determining the firm's minimum net capital requirement.

A broker-dealer's minimum net capital requirement is the greater of the applicable fixed-dollar amount and one of two alternative financial ratios. The first financial ratio requirement provides that a broker-dealer must not permit its aggregate indebtedness to all other persons to exceed 1500% of its net capital (

i.e.,

a 15-to-1 aggregate indebtedness to net capital requirement).

This is the default financial ratio requirement that all broker-dealers must apply unless they affirmatively elect to be subject to the second financial ratio requirement by notifying their designated examining authority of the election.

The second financial ratio requirement provides that a broker-dealer must not permit its net capital to be less than 2% of aggregate debit items (

i.e.,

customer-related obligations to the broker-dealer).

See

17 CFR 240.15c3-1(a)(1); proposed new paragraph (a)(10)(i) of Rule 15c3-1. Currently, all broker-dealers, including the ANC broker-dealers, are subject either to the aggregate indebtedness standard or the aggregate debit items (alternative standard) financial ratio requirements.

See

17 CFR 240.15c3-1(a)(1)(i). Stated another way, the broker-dealer must maintain, at a minimum, an amount of net capital equal to 1/15th (or 6.67%) of its aggregate indebtedness. This financial ratio generally is used by smaller broker-dealers that do not hold customer securities and cash.

See

17 CFR 240.15c3-1(a)(1)(i)-(ii).

See

17 CFR 240.15c3-1(a)(1)(ii). Customer debit items—computed pursuant to Rule 15c3-3—consist of, among other things, margin loans to customers and securities borrowed by the broker-dealer to effectuate deliveries of securities sold short by customers.

See

17 CFR 240.15c3-3; 17 CFR 240.15c3-3a. This ratio generally is used by larger broker-dealers that hold customer securities and cash.

The proposed amendments to Rule 15c3-1 would provide that a broker-dealer SBSD that is not approved to use internal models would be required to maintain a minimum net capital level of not less than the greater of: (1) $20 million or (2) the financial ratio amount required pursuant to paragraph (a)(1) of Rule 15c3-1

plus

the 8% margin factor.

Thus, the proposed minimum net capital requirement for a broker-dealer SBSD would incorporate the requirement in Rule 15c3-1 that a broker-dealer maintain the greater of a fixed-dollar amount or one of the two financial ratio amounts, as applicable.

The financial ratio requirements in Rule 15c3-1 are designed to link the broker-dealer's minimum net capital requirement to the level of its securities activities. For example, the aggregate debit ratio requirement is designed for broker-dealers that carry customer securities and cash.

This provision increases the minimum net capital requirement for these broker-dealers as they increase their debit items by engaging in margin lending and facilitating of customer short-sale

transactions.

The proposal to combine the Rule 15c3-1 financial ratios with the 8% margin factor in a broker-dealer SBSD's computation of its minimum net capital requirement is designed to require the broker-dealer SBSD to maintain a capital cushion to support its traditional securities activities (

e.g.,

margin lending) and its security-based swap activities.

See

proposed new paragraph (a)(10)(i) of Rule 15c3-1.

Id.

See Net Capital Requirements for Brokers and Dealers,

Exchange Act Release No. 17208 (Oct. 9, 1980), 45 FR 69915 (Oct. 22, 1980).

See

17 CFR 240.15c3-1(a)(1)(ii); 17 CFR 240.15c3-3a.

Request for Comment

The Commission generally requests comment on the proposed minimum net capital requirements for broker-dealer SBSDs that are not approved to use internal models. Commenters are referred to the general questions above in section II.A.2.a.i. of this release about the 8% margin factor as applied broadly to nonbank SBSDs. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Is the proposed $20 million minimum net capital requirement appropriate for broker-dealer SBSDs that are not approved to use internal models? If not, explain why not. What minimum amount would be more appropriate? For example, should the minimum fixed-dollar amount be greater than $20 million to account for the broader range of activities that broker-dealer SBSDs will be able to engage in (

e.g.,

traditional securities activities such as margin lending), as compared with stand-alone SBSDs and OTC derivatives dealers? If it should be a greater amount, how much greater should it be (

e.g.,

$15 million, $10 million, $5 million or some other amount)? If a greater or lesser alternative amount is recommended, explain why it would be preferable for broker-dealer SBSDs that are not approved to use internal models.

2. Is combining the 8% margin factor requirement with the applicable Rule 15c3-1 financial ratio requirement an appropriate way to determine a minimum net capital requirement for broker-dealer SBSDs that are not approved to use internal models? If not, explain why not.

3. Would the 8% margin factor combined with the Rule 15c3-1 financial ratio provide an appropriate and workable restraint on the amount of leverage incurred by broker-dealer SBSDs not using internal models? If not, explain why not. Is there another measure that would more accurately and effectively address the leverage risk of these firms? If so, identify the measure and explain why it would be more accurate and effective.

iii. Stand-Alone SBSDs Using Internal Models

As discussed above, a stand-alone SBSD would be subject to the capital requirements in proposed new Rule 18a-1.

Rule 18a-1 would permit stand-alone SBSDs to apply to use internal models to compute net capital.

In terms of minimum capital requirements, a stand-alone SBSD that has been approved to use internal models would be required to maintain: (1) a minimum tentative net capital level of not less than $100 million; and (2) a minimum net capital level of not less than the greater of $20 million or the 8% margin factor.

The proposed minimum net capital requirement for stand-alone SBSDs using internal models (

i.e.,

the greater of $20 million or the 8% margin factor) is the same as the proposed minimum net capital requirement for stand-alone SBSDs and broker-dealer SBSDs not using internal models (though the latter would need to incorporate the Rule 15c3-1 financial ratio requirement into their minimum net capital computations).

See

proposed new Rule 18a-1.

See

paragraphs (a)(2) and (d) of proposed new Rule 18a-1; the discussion below in section II.A.2.b.iii. of this release.

See

paragraph (a)(2) of proposed Rule 18a-1. As discussed above in section II.A.2.a.i. of this release, the 8% margin factor is designed to adjust the stand-alone SBSD's minimum net capital requirement in tandem with the risk associated with the broker-dealer firm's security-based swap activity.

A stand-alone SBSD approved to use internal models also would be subject to a minimum tentative net capital requirement of $100 million.

This proposed minimum tentative net capital requirement would be consistent with the current minimum tentative net capital requirement applicable to OTC derivatives dealers.

A minimum tentative net capital requirement is designed to operate as a prudential control on the use of internal models for regulatory capital purposes.

Tentative net capital is the amount of net capital maintained by a broker-dealer before applying the standardized haircuts or using internal models to determine deductions on the mark-to-market value of proprietary positions to arrive at the broker-dealer's amount of net capital.

OTC derivatives dealers, therefore, compute tentative net capital before using internal VaR models to take the market risk deductions. The minimum tentative net capital requirement is designed to account for the fact that VaR models, while more risk sensitive than standardized haircuts, tend to substantially reduce the amount of the deductions to tentative net capital in comparison to the standardized haircuts because the models recognize more offsets between related positions (

i.e.,

positions that show historical correlations) than the standardized haircuts.

In addition, VaR models may

not capture all risks and, therefore, having a minimum tentative net capital requirement (

i.e.,

one that is not derived using the VaR model) is designed to require that capital be sufficient to withstand events that the model may not take into account (

e.g.,

extraordinary losses or decreases in liquidity during times of stress that are not incorporated into VaR calculations).

Consequently, the proposed $100 million minimum tentative net capital requirement is designed to provide a sufficient liquid capital cushion for stand-alone SBSDs that use models, just as it has done in practice for entities registered as OTC derivatives dealers.

100

See

paragraph (a)(2) of proposed new Rule 18a-1.

Both ANC broker-dealers and OTC derivatives dealers—entities that use internal models—are subject to a minimum tentative net capital requirement.

See

17 CFR 240.15c3-1(a)(5) and (a)(7).

OTC Derivatives Dealers,

63 FR at 59384 (“The final rule contains the minimum requirements of $100 million in tentative net capital and $20 million in net capital. The minimum tentative net capital and net capital requirements are necessary to ensure against excessive leverage and risks other than credit or market risk, all of which are now factored into the current haircuts. Further, while the mathematical assumptions underlying VaR may be useful in projecting possible daily trading losses under `normal' market conditions, VaR may not help firms measure losses that fall outside of normal conditions, such as during steep market declines. Accordingly, the minimum capital requirements provide additional safeguards to account for possible extraordinary losses or decreases in liquidity during times of stress which are not incorporated into VaR calculations.”).

See also Alternative Net Capital Requirements Adopting Release,

69 FR at 34431 (“The current haircut structure [use of the standardized haircuts] seeks to ensure that broker-dealers maintain a sufficient capital base to account for operational, leverage, and liquidity risk, in addition to market and credit risk. We expect that use of the alternative net capital computation [internal models] will reduce deductions for market and credit risk substantially for broker-dealers that use that method. Moreover, inclusion in net capital of unsecured receivables and securities that do not have a ready market under the current net capital rule will reduce the liquidity standards of Rule 15c3-1. Thus, the alternative method of computing net capital and, in particular, its requirements that broker-dealers using the alternative method of computing [

sic

] maintain minimum tentative net capital of at least $1 billion, maintain net capital of at least $500 million, notify the Commission that same day if their tentative net capital falls below $5 billion, and comply with Rule 15c3-4 are intended to provide broker-dealers with sufficient capital reserves to account for market, credit, operational, and other risks.”) (Text in brackets added).

See

17 CFR 240.15c3-1(c)(10).

See OTC Derivatives Dealers,

63 FR 53962.

See Net Capital Rule,

Exchange Act Release No. 39456 (Dec. 17, 1997), 62 FR 68011 (Dec. 30, 1997) (concept release considering the extent to which statistical models should be used in setting the capital requirements for a broker-dealer's proprietary positions) (“For example, the current method of calculating net capital by deducting fixed percentages from the market value of securities can allow only limited types of hedges without becoming unreasonably complicated. Accordingly, the net capital rule recognizes only certain specified hedging activities, and the Rule does not account

for historical correlations between foreign securities and U.S. securities or between equity securities and debt securities. By failing to recognize offsets from these correlations between and within asset classes, the fixed percentage haircut method may cause firms with large, diverse portfolios to reserve capital that actually overcompensates for market risk.”

Id.

“The primary advantage of incorporating models into the net capital rule is that a firm would be able to recognize, to a greater extent, the correlations and hedges in its securities portfolio and have a comparatively smaller capital charge for market risk.”).

See OTC Derivatives Dealers,

63 FR 59362;

Alternative Net Capital Requirements Adopting Release,

69 FR 34428. Further, the deductions to tentative net capital taken by nonbank SBSDs and broker-dealers are intended to create a pool of new liquid assets that can be used for any risk assumed by the firm and not only market risk. A tentative net capital requirement also serves as a capital buffer for these other risks to offset the narrower type of risk intended to be covered by calculating net capital using internal models.

100

OTC Derivatives Dealers,

63 FR 59362.

Request for Comment

The Commission generally requests comment on the proposed capital requirements for stand-alone SBSDs using internal models. Commenters are referred to the general questions above in section II.A.2.a.i. of this release about the 8% margin factor as applied broadly to nonbank SBSDs. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Is the proposed minimum net capital requirement of $20 million appropriate for stand-alone SBSDs that are approved to use internal models, in comparison to OTC derivatives dealers which are more limited by the activities they are permitted to conduct (such as being prohibited from effecting transactions with customers)? If not, explain why not. What minimum amount would be more appropriate? For example, should the minimum fixed-dollar amount be greater than $20 million to account for the use of internal models? If it should be a greater amount, how much greater should it be (

e.g.,

$30 million, $50 million, $100 million, or some other amount)? Alternatively, should the minimum fixed-dollar amount be less than $20 million? If it should be a lower amount, how much lower (

e.g.,

$15 million, $10 million, $5 million or some other amount)? If a greater or lesser alternative amount is recommended, explain why it would be more appropriate for stand-alone SBSDs that are approved to use internal models.

2. Is it necessary to impose a minimum tentative net capital requirement for stand-alone SBSDs using internal models to capture additional risks not incorporated into VaR models (consistent with those tentative minimum met capital requirements imposed on OTC derivatives dealers)? If not, why not?

3. Is the proposed amount of the minimum tentative net capital level of $100 million for stand-alone SBSDs using internal models appropriate? If not, explain why not. For example, should the minimum tentative net capital amount be greater than $100 million to account for the use of internal models? If it should be a greater amount, how much greater should it be (

e.g.,

$150 million, $200 million, $250 million, or some other amount)? Should it be a lesser amount (

e.g.,

$75 million, $50 million, or some other amount)? If a greater or lesser alternative amount is recommended, explain why it would be more appropriate for stand-alone SBSDs that are approved to use internal models.

4. Are there metrics other than a fixed-dollar minimum tentative net capital requirement that would more appropriately reflect the risk of nonbank SBSDs? If so, identify them and explain why they would be preferable. For example, instead of an absolute fixed-dollar minimum tentative net capital requirement, should the minimum tentative net capital requirement be linked to a scalable metric such as the size of a nonbank SBSD? For any scalable minimum tentative net capital requirements identified, explain how the computation would work in practice and how the minimum requirement would address the same objectives of a fixed-dollar minimum. Would the 8% margin factor provide an appropriate and workable restraint on the amount of leverage incurred by stand-alone SBSDs that are approved to use internal models? Is there another measure that would more accurately and effectively address the leverage risk of these firms? If so, identify the measure and explain why it would be more accurate and effective.

iv. Broker-Dealer SBSDs Using Internal Models and ANC Broker-Dealers

Under the current requirements of Rule 15c3-1, a broker-dealer that seeks to use internal models to compute net capital must apply to the Commission to become an ANC broker-dealer.

101

If the application is granted, the ANC broker-dealer is able to take less than 100% deductions for unsecured receivables from OTC derivatives counterparties (non-ANC broker-dealers must deduct these receivables in full) and can use VaR models in lieu of the standardized haircuts to take deductions on their proprietary positions in securities and money market instruments to the extent the firm has been approved to use an internal model for the type of position.

102

It is expected that some broker-dealer SBSDs would seek to use internal models to compute net capital—as have some broker-dealers—by applying to become ANC broker-dealers. Broker-dealer SBSDs using internal models would be subject to the existing provisions and proposed amendments to those provisions currently applicable to ANC broker-dealers.

101

See

17 CFR 240.15c3-1e.

102

Id.

Under the proposed amendments, the current net capital requirements for ANC broker-dealers in Rule 15c3-1 would be enhanced to account for the firms' large size, the scale of their custodial activities, and the potential that they may become substantially more active in the security-based swap markets under the Dodd-Frank Act's OTC derivatives reforms. As discussed in more detail below, the proposed enhancements would include increasing the minimum tentative net capital and minimum net capital requirements; increasing the “early warning” notice threshold; narrowing the types of unsecured receivables for which ANC broker-dealers may take a credit risk charge in lieu of a 100% deduction; and requiring ANC broker-dealers to comply with a new liquidity requirement.

103

See

proposed amendments to 17 CFR 240.15c3-1; 17 CFR 240.15c3-1e.

Currently, an ANC broker-dealer must maintain minimum tentative net capital of at least $1 billion and minimum net capital of at least $500 million.

104

In addition, an ANC broker-dealer must provide the Commission with an “early warning” notice when its tentative net capital falls below $5 billion.

105

These relatively high minimum capital requirements (as compared with the requirements for other types of broker-

dealers) reflect the substantial and diverse range of business activities engaged in by ANC broker-dealers and their importance as intermediaries in the securities markets.

106

Further, the heightened capital requirements reflect the fact that, as noted above, VaR models are more risk sensitive but also may not capture all risks and generally permit substantially reduced deductions to tentative net capital as compared to the standardized haircuts.

107

104

See

17 CFR 240.15c3-1(a)(7)(i).

105

See

17 CFR 240.15c3-1(a)(7)(ii).

106

For example, based on data from broker-dealer FOCUS Reports, the six ANC broker-dealers collectively hold in excess of one trillion dollars' worth of customer securities. Under Rule 17a-5 (17 CFR 240.17a-5), broker-dealers must file periodic reports on Form X-17A-5 (Financial and Operational Combined Uniform Single Reports, “FOCUS Reports”). Unless an exception applies, the Commission's rules deem all reports filed under Rule 17a-5 confidential. 17 CFR 240.17a-5(a)(3). The FOCUS Report requires, among other financial information, a balance sheet, income statement, and net capital and customer reserve computations. The FOCUS Report data used in this release is year-end 2011 FOCUS Report data.

107

See Alternative Net Capital Requirements Adopting Release,

69 FR 34428.

The proposals to strengthen the requirements for ANC broker-dealers are made in response to issues that arose during the 2008 financial crisis, recognizing the large size of these firms, and the scale of their custodial responsibilities. The proposals also are based on the Commission staff's experience supervising the ANC broker-dealers. The financial crisis demonstrated the risks to financial firms when market conditions are stressed and how the failure of a large firm can accelerate the further deterioration of market conditions.

108

The proposals are designed to bolster the ANC broker-dealer net capital rules to ensure that these firms continue to maintain sufficient capital reserves to account for market, credit, operational, and other risks.

109

While the rationale for these enhancements exists irrespective of whether the ANC broker-dealers ultimately register as SBSDs, the proposed increased capital requirements also are designed to account for increased security-based swap activities by these firms. FOCUS Report data and the Commission staff's supervision of the ANC broker-dealers indicate that these firms currently do not engage in a substantial business in security-based swaps.

110

It is expected, however, that they may increase their security-based swap activities after the Dodd-Frank Act's OTC derivatives reforms are implemented and become effective because security-based swap activities will need to be conducted in regulated entities.

111

Consequently, financial institutions that currently deal in security-based swaps will need to register as an SBSD or register one or more affiliates as an SBSD. To the extent they want to offer securities products and services beyond those related to security-based swaps, they also will need to be registered as broker-dealers. Using an existing broker-dealer—particularly an ANC broker-dealer that already is capitalized and has risk management systems and personnel in place—could provide efficiencies that create incentives to register the same entity as a nonbank SBSD.

108

See, e.g., World Economic Outlook: Crisis and Recovery,

International Monetary Fund (“IMF”) (Apr. 2009), available at

http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf

109

See Alternative Net Capital Requirements Adopting Release,

69 FR 34428.

110

The ANC broker-dealers are subject to ongoing Commission staff supervision, which includes monthly meetings with senior staff of the ANC broker-dealers. This supervision program provides the Commission with information about the current practices of the ANC broker-dealers.

111

This expectation is based on information gathered as part of the ANC broker-dealer supervision program.

Under the proposed amendments to Rule 15c3-1, ANC broker-dealers would be required to maintain: (1) Tentative net capital of not less than $5 billion; and (2) net capital of not less than the greater of $1 billion or the financial ratio amount required pursuant to paragraph (a)(1) of Rule 15c3-1

plus

the 8% margin factor.

112

FOCUS Report data indicates that the six current ANC broker-dealers report capital levels in excess of these proposed increased minimum requirements. While raising the tentative net capital requirement under Rule 15c3-1 from $1 billion to $5 billion would be a significant increase, the existing “early warning” notice requirement for ANC broker-dealers is $5 billion.

113

This $5 billion “early warning” threshold acts as a

de facto

minimum tentative net capital requirement since ANC broker-dealers seek to maintain sufficient levels of tentative net capital to avoid the necessity of providing this regulatory notice. Accordingly, the objective in raising the minimum capital requirements for ANC broker-dealers is not to require the six existing ANC broker-dealers to increase their current capital levels (as they already maintain tentative net capital in excess of $5 billion).

114

Rather, the goal is to establish new higher minimum requirements designed to ensure that the ANC broker-dealers continue to maintain high capital levels and that any new ANC broker-dealer entrants maintain capital levels commensurate with their peers.

112

See

proposed amendments to paragraph (a)(7)(i) of Rule 15c3-1.

113

See

17 CFR 240.15c3-1(a)(7)(i).

114

The ANC broker-dealers report to the Commission staff, as part of the ANC broker-dealer supervision program, levels of tentative net capital that generally are well in excess of $6 billion, which, as discussed below, is the proposed new “early warning” threshold for ANC broker-dealers.

As indicated above, the proposed amendments to Rule 15c3-1 would require an ANC broker-dealer to incorporate the 8% margin factor into its net capital calculation.

115

Consequently, an ANC broker-dealer would be required at all times to maintain tentative net capital of not less than $5 billion and net capital of not less than the greater of $1 billion or the sum of the ratio requirement under paragraph (a)(1) of Rule 15c3-1 and eight percent (8%) of the risk margin amount for security-based swaps carried by the ANC broker-dealer.

116

115

See

proposed amendments to paragraph (a)(7)(i) of Rule 15c3-1. As discussed above in section II.A.2.a.i. of this release, the 8% margin factor is designed to adjust the firm's minimum net capital requirement in tandem with the risk associated with the broker-dealer firm's security-based swap activity.

116

See

proposed amendments to paragraph (a)(7)(i) of Rule 15c3-1.

Under the proposal, an ANC broker-dealer would be required to provide early warning notification to the Commission if its tentative net capital fell below $6 billion.

117

The purpose of an “early warning” notice requirement is to require a broker-dealer to provide notice when its level of regulatory capital falls to a level that approaches its required minimum capital requirement but is sufficiently above the minimum that the Commission and SROs can increase their monitoring of the firm before the minimum is breached. The proposed increase in the minimum tentative net capital requirement to $5 billion necessitates a corresponding increase in the “early warning” threshold to an amount above $5 billion. Existing early warning thresholds for OTC derivatives dealers include a requirement to provide notice when the firm's tentative net capital falls below an amount that is 120% of the firm's required minimum tentative net capital amount.

118

The proposed new “early warning” threshold for ANC broker-dealers of $6 billion in tentative net capital is modeled on this requirement and is equal in percentage terms (120%) to the amount that the early warning level exceeds the minimum tentative net capital

requirement for OTC derivatives dealers.

117

See

proposed amendments to paragraph (a)(7)(ii) of Rule 15c3-1. As noted above, the ANC broker-dealers report to the Commission staff tentative net capital levels that generally are well in excess of $6 billion.

118

See

17 CFR 240.17a-11(c)(3).

The rules applicable to ANC broker-dealers provide that the Commission may impose additional conditions on an ANC broker-dealer under certain circumstances.

119

In particular, paragraph (e) of Appendix E to Rule 15c3-1 establishes a non-exclusive list of circumstances under which the Commission may restrict the business of an ANC broker-dealer, including when the firm's tentative net capital falls below the early warning threshold.

120

In this event, the Commission—if it finds it is necessary or appropriate in the public interest or for the protection of investors—may impose additional conditions on the firm, including requiring the firm to submit to the Commission a plan to increase its tentative net capital (to an amount above the early warning level).

121

Additional restrictions could include restricting the ANC broker-dealer's business on a product-specific, category-specific, or general basis; requiring the firm to file more frequent reports with the Commission; modifying the firm's internal risk management controls or procedures; requiring the firm to compute deductions for market and credit risk using standardized haircuts; or imposing any other additional conditions, if the Commission finds that imposition of other conditions is necessary or appropriate in the public interest or for the protection of investors.

122

119

See

17 CFR 240.15c3-1e(e)(1).

120

Id.

121

Id. See also

Alternative Net Capital Requirements Adopting Release,

69 FR 34428.

122

See

17 CFR 240.15c3-1e(e).

Request for Comment

The Commission generally requests comment on the proposed minimum capital requirements for ANC broker-dealers. Commenters are referred to the general questions above in section II.A.2.a.i. of this release about the 8% margin factor as applied broadly to nonbank SBSDs. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Is the proposed increased minimum net capital requirement from $500 million to $1 billion for ANC broker-dealers appropriate? If not, explain why not. What minimum amount would be preferable? For example, should the minimum fixed-dollar amount be greater than $1 billion to account for the large size of these firms and the scale of their custodial activities? If so, explain why. If it should be a greater amount, how much greater should it be (

e.g.,

$1.5 billion, $2 billion, $3 billion, or some other amount)? Alternatively, should the minimum fixed-dollar amount be less than $1 billion? If so, explain why. If it should be a lower amount, how much lower (

e.g.,

$950 million, $900 million, $850 million, $800 million, $750 million, or some other amount)? If a greater or lesser alternative amount is recommended, explain why it would be preferable.

2. Is the proposed increase in the minimum tentative net capital level for ANC broker-dealers appropriate? If not, explain why not. For example, should the minimum tentative net capital amount be greater than $5 billion to account for the use of internal models and the large size of these firms and the scale of their custodial activities? If it should be a greater amount, how much greater should it be (

e.g.,

$6 billion, $8 billion, $10 billion, or some other amount)? Should it be lesser amount (

e.g.,

$4 billion, $3 billion, $2 billion or some other amount)? If a greater or lesser alternative amount is recommended, explain why it would be preferable.

3. Is the proposed increase in the early warning threshold from $5 billion to $6 billion for ANC broker-dealers appropriate? If not, explain why not. For example, should the minimum tentative net capital amount be greater than $6 billion, given that the current early warning threshold ($5 billion) is five times the current tentative net capital requirement ($1 billion)? If the early warning level should be a greater amount, how much greater should it be (

e.g.,

$8 billion, $10 billion, $12 billion, $20 billion, $25 billion, or some other amount)? Should it be lesser amount (

e.g.,

$5.8 billion, 5.5 billion, or some other amount)? If a greater or lesser alternative amount is recommended, explain why it would be preferable.

4. Is it appropriate to require broker-dealer SBSDs to become ANC broker-dealers in order to use internal models? For example, would it be appropriate to permit broker-dealer SBSDs to use internal models but subject them to lesser minimum capital requirements than the ANC broker-dealers? If so, explain why. In addition, provide suggested alternative minimum capital requirements.

5. Is combining the 8% margin factor requirement with the applicable Rule 15c3-1 financial ratio requirement an appropriate way to determine a minimum net capital requirement for ANC broker-dealers? If not, explain why not.

6. Would the 8% margin factor provide an appropriate and workable restraint on the amount of leverage incurred by ANC broker-dealers? If not, explain why not. Is there another measure that would more accurately and effectively address the leverage risk of these firms? If so, identify the measure and explain why it would be more accurate and effective.

Additional Request for Comment on VaR-Based Capital Charges

On June 7, 2012, the OCC, the FDIC, and the Federal Reserve (collectively, the “Banking Agencies”) approved a joint final rule (“Final Rule”) regarding market risk capital rules.

123

Certain portions of the Final Rule relate to the use of financial models for regulatory capital purposes. Generally, the Banking Agencies stated that the Final Rule is designed to “better capture positions for which the market risk capital rules are appropriate; to reduce procyclicality; enhance the rules' sensitivity to risks that are not adequately captured under current methodologies; and increase transparency through enhanced disclosures.” The effective date for the Final Rule is January 1, 2013.

123

Risk Based Capital Guidelines: Market Risk,

Federal Reserve, FDIC, OCC, 77 FR 53059 (Aug. 30, 2012).

Under the Final Rule, the capital charge for market risk is the sum of: (1) Its VaR-based capital requirement; (2) its stressed VaR-based capital requirement; (3) any specific risk add-ons; (4) any incremental risk capital requirement; (5) any comprehensive risk capital requirement; and (6) any capital requirement for

de minimis

exposures. Generally, the qualitative and quantitative requirements for the Banking Agencies' VaR-based capital requirement are similar to the VaR-based capital requirements for ANC broker-dealers, OTC derivatives dealers, and, as proposed, for nonbank SBSDs approved to use internal models.

The Banking Agencies' stressed VaR-based capital requirement is a new requirement that banks calculate a VaR measure with model inputs calibrated to reflect historical data from a continuous 12-month period that reflects a period of significant financial stress appropriate to the bank's current portfolio. The stressed VaR requirement is designed to address concerns that the Banking Agencies' existing VaR-based measure, due to inherent limitations, proved inadequate in producing capital requirements appropriate to the level of losses incurred at many banks during the financial crisis and to mitigate

procyclicality in the existing market risk capital requirement for banks.

The Final Rule also specifies modeling standards for specific risk and eliminates the current option for a bank to model some but not all material aspects of specific risk for an individual portfolio of debt or equity positions. To address concerns about the ability to model specific risk of securitization products, the Final Rule would require a bank to calculate an additional capital charge “add-on” for certain securitization positions that are not correlation trading positions.

Further, under the Final Rule, a bank that measures the specific risk of a portfolio of debt positions using internal models is required to calculate an incremental risk measure for those positions using an internal model (an incremental risk model). Generally, incremental risk consists of the risk of default and credit migration risk of a position. Under the Final Rule, an internal model used to calculate capital charges for incremental risk must measure incremental risk over a one-year time horizon and at a one-tail, 99.9% confidence level, either under the assumption of a constant level of risk, or under the assumption of constant positions.

A bank may measure all material price risk of one or more portfolios of correlation trading positions using a comprehensive risk model. Among the requirements for using a comprehensive risk model is that the model measure comprehensive risk consistent with a one-year time horizon and at a one-tail, 99.9% confidence level, under the assumption of either a constant level of risk or constant positions.

The Commission seeks comment on whether the Final Rule adopted by the Banking Agencies for calculating market risk capital requirements should be required for ANC broker-dealers, OTC derivatives dealers, and nonbank SBSDs that have approval to use internal models for regulatory capital purposes, and, if so, which aspects of the proposed rules of the Banking Agencies would be appropriate in this context.

b. Computing Net Capital

i. The Net Liquid Assets Test

The net liquid assets test embodied in Rule 15c3-1 is being proposed as the regulatory capital standard for all nonbank SBSDs (

i.e.,

stand-alone SBSDs and broker-dealer SBSDs) because these firms, as previously noted, are expected to engage in a securities business with respect to security-based swaps that is similar to the dealer activities of broker-dealers and because some broker-dealers likely will be registered as nonbank SBSDs. In addition, Rule 15c3-1 currently contains provisions designed to address dealing in OTC derivatives by broker-dealers.

124

Furthermore, Rule 15c3-1 has been the capital standard for broker-dealers since 1975 and, generally, it has promoted the maintenance of prudent levels of capital. As discussed in section II.A.1. of this release, the net liquid assets test is designed to promote liquidity; the rule allows a broker-dealer to engage in activities that are part of conducting a securities business (

e.g.,

money owed to customers, counterparties, and creditors). Consequently, under the proposed rules, this standard—the net liquid assets test—would be applied to all categories of nonbank SBSDs. The objective is to require the nonbank SBSD to maintain sufficient liquidity so that if it fails financially it can meet all unsubordinated obligations to customers and counterparties and have adequate resources to wind-down in an orderly manner without the need for a formal proceeding.

124

See

17 CFR 240.15c3-1e; 17 CFR 240.15c3-1f.

The net liquid assets test is imposed through the mechanics of how a broker-dealer is required to compute net capital pursuant to Rule 15c3-1. These requirements are set forth in paragraph (c)(2) of Rule 15c3-1, which defines the term “net capital.”

125

The first step is to compute the broker-dealer's net worth under GAAP.

126

Next, the broker-dealer must make certain adjustments to its net worth to calculate net capital.

127

These adjustments are designed to leave the firm in a position where each dollar of unsubordinated liabilities is matched by more than a dollar of highly liquid assets.

128

There are thirteen categories of net worth adjustments required by the rule.

129

The most significant adjustments are briefly discussed below.

125

See

17 CFR 240.15c3-1(c)(2).

126

See id.