Definition of Covered Clearing Agency

Federal RegisterOct 13, 2016

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-78963; File No. S7-23-16]

RIN 3235-AL48

Definition of Covered Clearing Agency

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule amendments.

SUMMARY:

The Securities and Exchange Commission (“SEC” or “Commission”) proposes to amend the definition of “covered clearing agency” under Rule 17Ad-22 to mean a registered clearing agency that provides the services of a central counterparty (“CCP”), central securities depository (“CSD”), or a securities settlement system (“SSS”). The Commission also proposes a definition of “securities settlement system” and proposes to amend the definitions of “central securities depository services” to facilitate the proposed amendment to “covered clearing agency.” In addition, the Commission proposes to amend the definition of “sensitivity analysis” under Rule 17Ad-22 to expand the scope of covered clearing agencies subject to requirements thereunder. These amendments are proposed pursuant to Section 17A of the Securities Exchange Act of 1934 (“Exchange Act”) and the Payment, Clearing, and Settlement Supervision Act of 2010 (“Clearing Supervision Act”), enacted in Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”).

DATES:

Submit comments on or before December 12, 2016.

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 S7-23-16 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 to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-23-16. To help us 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 are also 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 10:00 a.m. and 3:00 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 available publicly.

Studies, memoranda or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission's Web site. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at

http://www.sec.gov

to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Jeffrey Mooney, Assistant Director; Stephanie Park, Senior Special Counsel; Matthew Lee, Branch Chief; Elizabeth Fitzgerald, Branch Chief; or DeCarlo McLaren, Attorney-Adviser; Office of Market Infrastructure, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010, at (202) 551-5710.

SUPPLEMENTARY INFORMATION:

The Commission proposes to amend the definition of “covered clearing agency” in Rule 17Ad-22(a)(5) to mean a registered clearing agency that provides the services of a CCP, CSD, or SSS. The Commission further proposes to define “securities settlement system” under Rule 17Ad-22 to mean a clearing agency that enables securities to be transferred and settled by book entry according to a set of predetermined multilateral rules.

The Commission also proposes to amend Rule 17Ad-22(a)(3) to define “central securities depository” to mean a clearing agency that is a securities depository as described in Section 3(a)(23)(A) of the Exchange Act.

To facilitate this proposed addition, the Commission would renumber the remaining definitions in Rule 17Ad-22(a).

See

15 U.S.C. 78c(a)(23)(A).

In addition, the Commission proposes to amend the definition of “sensitivity analysis” in Rule 17Ad-22(a)(16) to expand its coverage, so that the policies and procedures of all covered clearing agencies that are CCPs provide for a sensitivity analysis that considers the most volatile relevant periods, where practical, that have been experienced by the markets served by the covered clearing agency.

If the proposed definition of “securities settlement system” is adopted, the definition of “sensitivity analysis” would move to Rule 17Ad-22(a)(17).

In developing these proposed amendments, Commission staff has consulted with the Financial Stability Oversight Council (“FSOC”), Commodity Futures Trading Commission (“CFTC”), and Board of Governors of the Federal Reserve System (“FRB”).

The Commission has also considered the relevant international standards as required by Section 805(a)(2)(A) of the Clearing Supervision Act.

The relevant international standards for CCPs, CSDs, and SSSs are the

Principles for Financial Market Infrastructures

(“PFMI”).

See

12 U.S.C. 5472.

See

12 U.S.C. 5464(a)(2)(A).

See

Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions (“CPSS-IOSCO”), Principles for Financial Market Infrastructures (Apr. 16, 2012),

available at http://www.bis.org/publ/cpss101a.pdf

The PFMI sets forth twenty-four principles for financial market infrastructures (“FMIs”), each of which includes a headline standard and a list of key considerations that further explain the headline standard. Accompanying explanatory notes further discuss the objectives of and rationales for the standards, as well as provide guidance on how the standards can be implemented.

See id.

at 17. Commission staff co-chaired the working group within CPSS-IOSCO that drafted both the consultative and final versions of the PFMI. In 2014, the CPSS became the Committee on Payments and Market Infrastructures (“CPMI”).

CPMI-IOSCO has published subsequent guidance relevant to implementation of the PFMI.

See

PFMI: Disclosure framework and Assessment methodology (Dec. 2012),

available at http://www.bis.org/cpmi/publ/d106.pdf

(“PFMI disclosure framework”); Recovery of FMIs (Oct. 2014),

available at

http://www.bis.org/cpmi/publ/d121.pdf

; Public quantitative disclosure standards for CCPs (Feb. 2015),

available at http://www.bis.org/cpmi/publ/d125.pdf

(“PFMI quantitative disclosures”); Guidance on cyber resilience for FMIs (Nov. 2015, consultative report),

available at http://www.bis.org/cpmi/publ/d138.pdf

; Resilience and recovery of CCPs: Further guidance on the PFMI (Aug. 2016, consultative report),

available at http://www.bis.org/cpmi/publ/d149.pdf

Table of Contents

I. Introduction

A. Regulatory Framework

1. Exchange Act

2. Dodd-Frank Act

3. Rule 17Ad-22

B. Distinctions among Clearing Agencies

1. Registered Clearing Agencies

2. Exempt Clearing Agencies

II. Proposed Amendments Under Rule 17AD-22

A. Definition of “Covered Clearing Agency”

1. Critical Functions Common among CCPs, CSDs, and SSSs

2. Critical Functions Specific to CCPs, CSDs, or SSSs

3. Increasing Scrutiny of CCP, CSD, and SSS Functions

4. Expanded Coverage under the Definition of “Covered Clearing Agency”

B. Definition of “Securities Settlement System”

C. Definition of “Central Securities Depository”

D. Definition of “Sensitivity Analysis”

E. Request for Comments

III. Economic Analysis

A. Economic Background

B. Baseline

1. Regulatory Framework for Registered Clearing Agencies

2. Current Practices

C. Consideration of Benefits, Costs, and the Effect on Competition, Efficiency, and Capital Formation

1. Economic Effects Related to Registered Clearing Agencies

2. Economic Effects Related to Future Registrants

3. Alternatives

IV. Paperwork Reduction Act

A. Summary of Collection of Information and Use of Information

1. Rule 17Ad-22(e)(1)

2. Rule 17Ad-22(e)(2)

3. Rule 17Ad-22(e)(3)

4. Rule 17Ad-22(e)(4)

5. Rule 17Ad-22(e)(5)

6. Rule 17Ad-22(e)(6)

7. Rule 17Ad-22(e)(7)

8. Rule 17Ad-22(e)(8)

9. Rule 17Ad-22(e)(9)

10. Rule 17Ad-22(e)(10)

11. Rule 17Ad-22(e)(11)

12. Rule 17Ad-22(e)(12)

13. Rule 17Ad-22(e)(13)

14. Rule 17Ad-22(e)(14)

15. Rule 17Ad-22(e)(15)

16. Rule 17Ad-22(e)(16)

17. Rule 17Ad-22(e)(17)

18. Rule 17Ad-22(e)(18)

19. Rule 17Ad-22(e)(19)

20. Rule 17Ad-22(e)(20)

21. Rule 17Ad-22(e)(21)

22. Rule 17Ad-22(e)(22)

23. Rule 17Ad-22(e)(23)

24. Rule 17Ad-22(c)(1)

B. Respondents

C. Total Annual Reporting and Recordkeeping Burdens

1. Rule 17Ad-22(e)(1)

2. Rule 17Ad-22(e)(2)

3. Rule 17Ad-22(e)(3)

4. Rule 17Ad-22(e)(4)

5. Rule 17Ad-22(e)(5)

6. Rule 17Ad-22(e)(6)

7. Rule 17Ad-22(e)(7)

8. Rule 17Ad-22(e)(8)

9. Rule 17Ad-22(e)(9)

10. Rule 17Ad-22(e)(10)

11. Rule 17Ad-22(e)(12)

12. Rule 17Ad-22(e)(13)

13. Rule 17Ad-22(e)(14)

14. Rule 17Ad-22(e)(15)

15. Rule 17Ad-22(e)(16)

16. Rule 17Ad-22(e)(17)

17. Rule 17Ad-22(e)(18)

18. Rule 17Ad-22(e)(19)

19. Rule 17Ad-22(e)(20)

20. Rule 17Ad-22(e)(21)

21. Rule 17Ad-22(e)(22)

22. Rule 17Ad-22(e)(23)

23. Total Burden for Rule 17Ad-22(e)

24. Total Burden for Rule 17Ad-22(c)(1)

D. Collection of Information is Mandatory

E. Confidentiality

F. Request for Comments

V. Small Business Regulatory Enforcement Fairness Act

VI. Regulatory Flexibility Act Certification

A. Registered Clearing Agencies

B. Certification

VII. Statutory Authority

I. Introduction

The Commission preliminarily believes that amending the definition of “covered clearing agency” would further the Commission's ongoing efforts to enhance the regulatory framework for clearing agencies.

As discussed below, the Commission preliminarily believes that registered clearing agencies providing the services of CCPs, CSDs, and SSSs perform a critical role for the U.S. securities markets and the broader U.S. financial system by helping to reduce risk and by providing transparency to the markets. In light of this critical role, the Commission preliminary believes that the definition of “covered clearing agency” should be expanded to include all such clearing agencies, which would make them subject to the enhanced requirements of Rule 17Ad-22(e).

With these proposed rule amendments and guidance, the Commission is not re-opening comment on the rules adopted by the Commission in the CCA Standards adopting release with respect to those entities already subject to the adopted rules.

See

Exchange Act Release No. 34-78961, (Sept. 28, 2016) (“CCA Standards adopting release”).

A. Regulatory Framework

Below is an overview of the relevant regulatory requirements for registered clearing agencies and for clearing agencies operating pursuant to an exemption from registration (“exempt clearing agencies”).

1. Exchange Act

Section 17A of the Exchange Act directs the Commission to facilitate the establishment of (i) a national system for the prompt and accurate clearance and settlement of securities transactions and (ii) linked or coordinated facilities for clearance and settlement of securities transactions.

In facilitating the establishment of the national clearance and settlement system, the Commission must have due regard for the public interest, the protection of investors, the safeguarding of securities and funds, and maintenance of fair competition among brokers and dealers, clearing agencies, and transfer agents.

See

15 U.S.C. 78q-1(a)(2);

see also

Report of the Senate Committee on Banking, Housing & Urban Affairs, S. Rep. No. 94-75, at 4 (1975) (urging that “[t]he Committee believes the banking and security industries must move quickly toward the establishment of a fully integrated national system for the prompt and accurate processing and settlement of securities transactions”).

See

15 U.S.C. 78q-1(a)(2)(A).

As discussed further below, clearing agencies are broadly defined in the Exchange Act and undertake a variety of functions.

Under Section 17A and Rule 17Ab2-1,

an entity that meets the definition of a clearing agency is required to register with the Commission or obtain from the Commission an exemption from registration prior to performing the functions of a clearing agency. To grant registration to a clearing agency, the Exchange Act requires the Commission to determine that the rules and operations of the applicant clearing agency meet the standards set forth in Section 17A.

Specifically, Section 17A(b)(3) provides that a clearing agency shall not be registered unless the Commission determines that the clearing agency's rules are consistent with the Exchange Act. In so doing, the Commission must determine that, among other things, (i) the clearing agency is so organized and has the capacity to be able to facilitate the prompt and accurate clearance and settlement of securities transactions and to safeguard securities or funds in its custody or control, (ii) the rules of the clearing agency assure a fair representation of its members and participants in the selection of its directors and administration of its affairs, (iii) the rules of the clearing agency provide for the equitable allocation of reasonable dues and fees, and (iv) the rules of the clearing agency are designed to promote the prompt and accurate clearance and settlement of securities transactions.

Section 17A(b)(1) further provides that upon the

Commission's motion or upon a clearing agency's application, the Commission may conditionally or unconditionally exempt a clearing agency from any provision of Section 17A of the Exchange Act or the rules or regulations thereunder if the Commission finds that such exemption is consistent with the public interest, the protection of investors, and the purposes of Section 17A, including the prompt and accurate clearance and settlement of securities and funds.

See

15 U.S.C. 78c(a)(23)(A);

see also

15 U.S.C 78q(a)(1), (2).

Upon registration, registered clearing agencies are SROs under Section 3(a)(26) of the Exchange Act.

See

15 U.S.C. 78c(a)(26).

An SRO must submit proposed rule changes to the Commission for review and approval pursuant to Rule 19b-4 under the Exchange Act. A stated policy, practice, or interpretation of an SRO, such as its written policies and procedures, would generally be deemed to be a proposed rule change.

See

15 U.S.C. 78s(b)(1); 17 CFR 240.19b-4.

See

15 U.S.C. 78s(b)(3)(A) (setting forth the types of proposed rule changes that take effect upon filing with the Commission). The Commission may temporarily suspend those rule changes within 60 days of filing and institute proceedings to determine whether to approve or disapprove the rule changes.

See

15 U.S.C. 78s(b)(3)(C).

See

15 U.S.C. 78q-1(d).

In addition, Commission staff conducts examinations of registered and exempt clearing agencies to assess, among other things, existing and emerging risks, compliance with applicable statutory and regulatory requirements (including any terms and conditions set forth in an order granting registration or an exemption from registration), and a clearing agency's oversight of compliance by its participants with its rules. Section 21(a) of the Exchange Act provides the Commission with authority to initiate and conduct investigations to determine if there have been violations of the federal securities laws.

Section 19(h) of the Exchange Act also provides the Commission with authority to institute civil actions seeking injunctive and other equitable remedies and/or administrative proceedings arising out of such investigations.

See

15 U.S.C. 78u(a).

See

15 U.S.C. 78s(h).

2. Dodd-Frank Act

Title VII of the Dodd-Frank Act provides the Commission with authority to regulate certain over-the-counter (“OTC”) derivatives. Specifically, Title VII added provisions to the Exchange Act that (i) require entities performing the functions of a clearing agency with respect to security-based swaps (“security-based swap clearing agencies”) to register with the Commission, and (ii) direct the Commission to adopt rules with respect to security-based swap clearing agencies.

See

15 U.S.C. 78q-1(i), (j); Dodd-Frank Act, Sec. 763(b), 124 Stat. at 1768-69 (adding paragraphs (i) and (j) to Section 17A of the Exchange Act).

The Clearing Supervision Act, enacted in Title VIII of the Dodd-Frank Act, provides for the enhanced regulation of certain financial market utilities (“FMUs”).

FMUs include clearing agencies that manage or operate a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the FMU.

FSOC has designated certain FMUs as systemically important or likely to become systemically important (“SIFMUs”).

SIFMUs are required to file 60-days advance notice of changes to rules, procedures, and operations that could materially affect the nature or level of risk presented by the SIFMU (“advance notice”).

The Clearing Supervision Act authorizes the Commission to object to changes proposed in such an advance notice, which would prevent the clearing agency from implementing the change.

The Clearing Supervision Act also provides for enhanced coordination between the Commission and FRB by allowing for regular on-site examinations and information sharing.

The Clearing Supervision Act further provides that the Commission and CFTC shall coordinate with the FRB to jointly develop risk management supervision programs for SIFMUs.

addition, the Clearing Supervision Act provides that the Commission and CFTC may each prescribe risk management standards governing the operations related to payment, clearing, and settlement activities (“PCS activities”) of SIFMUs for which each is the supervisory agency, in consultation with the FSOC and FRB and taking into consideration relevant international standards and existing prudential requirements.

The objectives and principles for the risk management standards prescribed under the Clearing Supervision Act shall be to (i) promote robust risk management; (ii) promote safety and soundness; (iii) reduce systemic risks; and (iv) support the stability of the broader financial system. Further, the Clearing Supervision Act states that the standards may address areas such as risk management policies and procedures; margin and collateral requirements; participant or counterparty default policies and procedures; the ability to complete timely clearing and settlement of financial transactions; capital and financial resources requirements for designated FMUs; and other areas that are necessary to achieve the objectives and principles described above.

See

12 U.S.C. 5464(b), (c).

See

12 U.S.C. 5462(6). The definition of “financial market utility” in Section 803(6) of the Clearing Supervision Act contains a number of exclusions that include, but are not limited to, certain designated contract markets, registered futures associations, swap data repositories, swap execution facilities, national securities exchanges, national securities associations, alternative trading systems, security-based swap data repositories, security-based swap execution facilities, brokers, dealers, transfer agents, investment companies, and futures commission merchants.

See

12 U.S.C. 5462(6)(B).

See

12 U.S.C. 5463. An FMU is systemically important if the failure of or a disruption to the functioning of such FMU could create or increase the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the U.S. financial system.

See

12 U.S.C. 5462(9).

See

12 U.S.C. 5465(e)(1)(A); 17 CFR 240.19b-4(n). The Commission published a final rule concerning the filing of advance notices for designated clearing agencies in 2012.

See

Exchange Act Release No. 34-67286 (June 28, 2012), 77 FR 41602 (July 13, 2012);

see also

17 CFR 240.17Ad-22(a)(8) (defining “designated clearing agency”).

See

12 U.S.C. 5465(e).

See

12 U.S.C. 5466.

See

12 U.S.C. 5472;

see also

Risk Management Supervision of Designated Clearing Entities (July

2011),

available at

https://www.federalreserve.gov/publications/other-reports/files/risk-management-supervision-report-201107.pdf

(describing the joint supervisory framework of the Commission, CFTC, and FRB) (“Risk Management Supervision Report”).

See

12 U.S.C. 5464(a)(2). The Commission notes that, under Rule 17Ad-22(a)(8), a SIFMU for which the Commission is the supervisory agency is a “designated clearing agency.”

See

17 CFR 240.17Ad-22(a)(8).

3. Rule 17Ad-22

In 2012, the Commission adopted Rule 17Ad-22 under the Exchange Act to strengthen the substantive regulation of registered clearing agencies, promote the safe and reliable operation of registered clearing agencies, and improve efficiency, transparency, and access to registered clearing agencies.

At that time, the Commission noted that the implementation of Rule 17Ad-22 would be an important first step in developing the regulatory changes contemplated by Titles VII and VIII of the Dodd-Frank Act.

In this regard, Rule 17Ad-22(b) established certain requirements for clearing agencies that provide CCP services, and Rule 17Ad-22(d) established requirements for the operation and governance of all registered clearing agencies.

See

Exchange Act Release No. 34-71699 (Mar. 12, 2014), 79 FR 16865 (Mar. 26, 2014),

corrected at

79 FR 29507, 29513 (May 22, 2014) (“CCA Standards proposing release”);

see also

17 CFR 240.17Ad-22; Exchange Act Release No. 34-68080 (Oct. 22, 2012), 77 FR 66219, 66225-26 (Nov. 2, 2012) (“Clearing Agency Standards adopting release”).

See

Clearing Agency Standards adopting release,

supra

note 31, at 66224-25.

See

17 CFR 240.17Ad-22(b), (d).

Contemporaneously with this proposal, the Commission has taken another step in its development of an enhanced regulatory regime for clearing agencies and expanded the requirements under Rule 17Ad-22 by adopting new paragraph (e).

Rule 17Ad-22(e) builds on the existing framework by establishing requirements for registered clearing agencies that meet the definition of a “covered clearing agency,” as discussed further below. Rule 17Ad-22(e) requires a covered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to address the following topics concerning its operation and governance:

See

CCA Standards adopting release,

supra

note 7, at 463-477.

• General organization (including legal basis, governance, a framework for the comprehensive management of risks, and recovery planning);

• financial risk management (including credit risk, collateral, margin, and liquidity risk);

• settlement (including settlement finality, money settlements, and physical deliveries);

• CSDs and exchange-of-value settlement systems;

• default management (including default rules and procedures and segregation and portability);

• business and operational risk management (including general business risk, custody and investment risks, and operational risk);

• access (including access and participation requirements, tiered participation arrangements, and links);

• efficiency (including efficiency and effectiveness and communication procedures and standards); and

• transparency.

As described in the CCA Standards adopting release, a covered clearing agency is subject to the requirements in Rule 17Ad-22(e), whereas a registered clearing agency that is not a covered clearing agency is subject to the requirements in Rule 17Ad-22(d).

As noted in the CCA Standards adopting release, the Commission continues to believe that the availability of Rules 17Ad-22(d) and (e) help ensure that the Commission can efficiently regulate registered clearing agencies depending on the specific activity and risks that each type of clearing agency poses to the U.S. markets.

In particular, Rule 17Ad-22(d) provides a set of requirements for registered clearing agencies that are not covered clearing agencies. The Commission expects to continue to use these two sets of requirements to regulate the national system for clearance and settlement as the varied entities that constitute it, including both covered clearing agencies and registered clearing agencies that are not covered clearing agencies, continue to emerge and evolve.

See

CCA Standards adopting release,

supra

note 7, at 36-40. Rule 17Ad-22(d) sets forth minimum requirements for the operation and governance of registered clearing agencies. Under this rule proposal, all registered clearing agencies and covered clearing agencies would remain subject to the requirements in Section 17A of the Exchange Act and the relevant Commission rules and regulations thereunder, including Rules 17Ad-22(a) and (c). Covered clearing agencies would also remain subject to Rule 17Ad-22(e), and registered clearing agencies that are not covered clearing agencies would remain subject to Rule 17Ad-22(d). Registered clearing agencies that provide CCP services would also remain subject to Rule 17Ad-22(b).

See id.

at 38.

B. Distinctions Among Clearing Agencies

Section 17A of the Exchange Act was adopted in response to the paperwork crisis of the late 1960s that nearly brought the securities industry to a standstill and directly or indirectly resulted in the failure of large numbers of broker-dealers because the industry's clearance and settlement procedures were inefficient and lacked automation.

When Congress added Section 17A to the Exchange Act as part of the Securities Acts Amendments of 1975, it made the following four findings: (i) The prompt and accurate clearance and settlement of securities transactions, including the transfer of record ownership and the safeguarding of securities and funds related thereto, are necessary for the protection of investors and persons facilitating transactions by and acting on behalf of investors; (ii) inefficient procedures for clearance and settlement impose unnecessary costs on investors and persons facilitating transactions by and acting on behalf of investors; (iii) new data processing and communications techniques create the opportunity for more efficient, effective, and safe procedures for clearance and settlement; and (iv) the linking of all clearance and settlement facilities and the development of uniform standards and procedures for clearance and settlement will reduce unnecessary costs and increase the protection of investors and persons facilitating transactions by and acting on behalf of investors.

Congress therefore directed the Commission to facilitate the establishment of a national system for the prompt and accurate clearance and settlement of securities transactions.

The Commission's ability to achieve these goals and its supervision of the national system for clearance and settlement is based upon

the regulation of the various entities that operate as clearing agencies.

The paperwork crisis resulted from sharply increased trading volumes and historic industry inattention to securities processing, as demonstrated by inefficient, duplicative and highly manual clearance and settlement system, poor records, insufficient controls over funds and securities, and use of untrained personnel to perform processing functions.

See, e.g.,

Commission, Study of Unsafe and Unsound Practices of Brokers and Dealers, H.R. Doc. No. 231, 92d Cong., 1st Sess. 13 (1971).

See

15 U.S.C. 78q-1(a)(1)(A) through (D).

See

15 U.S.C. 78q-1

et seq.; see also

supra

note 8.

In defining “clearing agency,” Section 3(a)(23) of the Exchange Act contemplates a broad variety of roles and functions. Pursuant to Section 3(a)(23), a “clearing agency” is any person who does the following:

• Acts as an intermediary in making payments or deliveries or both in connection with securities transactions;

• provides facilities for the comparison of data regarding the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities;

• acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned, or pledged by bookkeeping entry, without physical delivery of securities certificates (such as a securities depository); or

• otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of securities certificates (such as a securities depository).

See

15 U.S.C. 78c(a)(23)(A);

see also

Exchange Act Release No. 34-39829 (Apr. 6, 1998), 63 FR 17943 (Apr. 13, 1998) (providing interpretive guidance and requesting comment on the confirmation and affirmation of securities trades and matching).

See

Exchange Act Release No. 34-39643 (February 11, 1998), 63 FR 8232 (Feb. 18, 1998),

as modified by

Exchange Act Release No. 34-43775 (Dec. 28, 2000), 66 FR 819 (Jan. 4, 2001); Exchange Act Release No. 34-38328 (Feb. 24, 1997), 62 FR 9225 (Feb. 28, 1997).

In addition, prior to the effective date of Title VII of the Dodd-Frank Act, the Commission issued a temporary exemption from the registration requirements for clearing agencies in Section 17A(b) of the Exchange Act to entities providing certain services, now sometimes referred to as post-trade processing services, for security-based swaps (“SBS exemption order”).

To date, six entities providing a range of such post-trade processing services are relying upon the SBS exemption order. The Commission stated that the exemptive order was necessary because the Dodd-Frank Act had expanded the definition of “security” to include security-based swaps, and therefore entities performing the functions of a clearing agency with respect to security-based swaps would be required to register under Section 17A(b)(1) of the Exchange Act upon the effective date of Title VII.

Those functions, as described by the Commission in the SBS exemption order, generally constitute certain collateral management, trade matching, and tear up or compression functions.

See

Exchange Act Release No. 34-64796 (July 1, 2011), 76 FR 39963 (July 7, 2011).

In addition, as part of its consideration of whether future rulemaking for post-trade processing clearing agencies would be appropriate, the Commission noted that it may consider whether to apply rules to clearing agencies engaged in PCS activities identified in the Clearing Supervision Act.

See

Clearing Agency Standards adopting release,

supra

note 31, at 66228. In particular, the Clearing Supervision Act identifies the following as PCS activities: (i) calculation and communication of unsettled financial transactions between counterparties; (ii) netting of transactions; (iii) provision and maintenance of trade, contract, or instrument information; (iv) management of risks and activities associated with continuing financial transactions; (v) transmittal and storage of payment instructions; (vi) movement of funds; (vii) final settlement of financial transactions; and (viii) other similar functions that the FSOC may determine.

See

12 U.S.C. 5462(7);

see also supra

note 34 and accompanying text.

The Commission is proposing to expand the coverage of Rule 17Ad-22(e) so that all registered clearing agencies performing the functions of a CCP, CSD, or SSS would be subject to Rule 17Ad-22(e). To facilitate this amendment, the Commission is proposing in Part II.B a definition of “securities settlement system” and in Part II.C to amend the definition of “central securities depository services.” In addition, the Commission also is proposing in Part II.D to amend the definition of “sensitivity analysis” to expand its coverage, so that the policies and procedures of all covered clearing agencies that are CCPs provide for a sensitivity analysis that considers the most volatile relevant periods, where practical, that have been experienced by the markets served by the covered clearing agency. In Part II.E, the Commission seeks comment on each of the proposed amendments.

A. Definition of “Covered Clearing Agency”

Rule 17Ad-22(a)(5) currently defines a covered clearing agency as a registered clearing agency that: (i) has been designated as systemically important by the FSOC and for which the Commission is the supervisory agency under the Clearing Supervision Act (“designated clearing agency”); or (ii) provides CCP services for security-based swaps or is determined by the Commission to be involved in activities with a more complex risk profile (“complex risk profile clearing agency”), for which the CFTC is not the supervisory agency under the Clearing Supervision Act.

In the CCA Standards proposing release, the Commission sought comment on whether the scope of Rule 17Ad-22(e) was appropriate and whether the definition of “covered clearing agency” was appropriate and sufficiently clear given the requirements proposed.

See

17 CFR 240.17Ad-22(a)(5).

See id.

at 29516-17.

In the CCA Standards adopting release, the Commission took an important first step to establish coverage of the enhanced requirements in Rule 17Ad-22(e) over an initial group of registered clearing agencies. In light of the comments received on the CCA Standards proposing release, the Commission is now proposing to amend the definition of a “covered clearing agency” to broaden this coverage so that it encompasses all registered clearing agencies performing the functions of a CCP, CSD, or SSS. These functions are critical to the U.S. securities markets and the broader U.S. financial system and implicate the types of activities and risks that Rule 17Ad-22(e) is designed to address. Specifically, the Commission proposes that the definition of “covered clearing agency” be amended to mean a registered clearing agency that provides the services of a CCP, CSD, or SSS.

The Commission preliminarily believes that the proposed amendment to the “covered clearing agency” definition, which takes into account the specific functions performed by registered clearing agencies, would lead to greater regulatory consistency among

all registered clearing agencies that perform these critical functions. Additionally, by focusing on functions rather than designation as systemically important, activities with a more complex risk profile, or the presence of another regulator, the proposed definition of “covered clearing agency” would ensure that all clearing agencies performing these critical functions are subject to enhanced requirements that address the particular services provided by and risks inherent in these critical functions.

1. Critical Functions Common among CCPs, CSDs, and SSSs

Although the definition of “clearing agency” in the Exchange Act is broad, there are certain activities which, by virtue of their significance to the U.S. financial system generally, and the national system for clearance and settlement in particular, support the application of enhanced requirements. Among these are those clearing agency activities that, at a general level, concern the concentration and management of risk and the potential transmission of systemic risk. Registered clearing agencies that provide CCP, CSD, or SSS services perform common functions that implicate the concentration and management of risk and the resulting systemic risk concerns. The Commission therefore believes that it is appropriate to propose to expand the definition of “covered clearing agency” to subject all such registered clearing agencies to Rule 17Ad-22(e) because Rule 17Ad-22(e) includes enhanced requirements that help mitigate the systemic risk concerns raised by these activities, such as a requirement for policies and procedures regarding a framework for the comprehensive management of such risk and requirements for policies and procedures that address, among other things, financial and general business risk management, settlement risks, and transparency.

See

17 CFR 240.17Ad-22(e)(3) through (10), (15), (23).

Financial risk management is an essential aspect of the role that each of these registered clearing agencies provides for the U.S. securities markets, both for their own participants and participants in the broader U.S. financial system. Establishing requirements for policies and procedures governing such risk management practices is a cornerstone of Rule 17Ad-22(e). For example, with respect to credit risk, Rule 17Ad-22(e)(4) requires that each covered clearing agency establish, implement, maintain, and enforce written policies and procedures reasonably designed to effectively identify, measure, monitor, and manage its credit exposures to participants and those arising from its payment, clearing, and settlement processes.

With respect to liquidity risk, Rule 17Ad-22(e)(7) requires that each covered clearing agency establish, implement, maintain, and enforce written policies and procedures reasonably designed to effectively measure, monitor, and manage the liquidity risk that arises in or is borne by the covered clearing agency, including measuring, monitoring, and managing its settlement and funding flows on an ongoing and timely basis and its use of intraday liquidity.

Rule 17Ad-22(e)(5) and (6) also include enhanced requirements for policies and procedures to manage collateral and maintain a risk-based margin, with particular requirements that help to ensure resilient stress testing of a covered clearing agency's financial resources.

See

17 CFR 240.17Ad-22(e)(3). While Rule 17Ad-22(d) also includes some requirements for policies and procedures related to credit risk, Rule 17Ad-22(e) includes enhanced requirements related to, among other things, stress testing.

See

17 CFR 240.17Ad-22(e)(7). Rule 17Ad-22(d) does not include requirements for policies and procedures related to the management of liquidity risk.

See

17 CFR 240.17Ad-22(e)(5), (6).

General business risk is another potential risk that these types of registered clearing agencies, as entities that concentrate risk, must manage, and Rule 17Ad-22(e) includes enhanced requirements for policies and procedures that manage general business risk. Specifically, Rule 17Ad-22(e)(3) requires policies and procedures that provide for a comprehensive risk management framework that addresses a variety of risks, including both financial risk and general business risk.

Rule 17Ad-22(e)(15) further requires that each covered clearing agency establish, implement, maintain, and enforce written policies and procedures reasonably designed to identify, monitor, and manage the covered clearing agency's general business risk and hold sufficient liquid net assets funded by equity to cover potential general business losses so that the covered clearing agency can continue operations as a going concern if those losses materialize.

Other requirements in Rule 17Ad-22(e) flow from the management of these risks as well. Notably, Rule 17Ad-22(e)(3) requires policies and procedures reasonably designed to ensure that a covered clearing agency establishes plans for the recovery and orderly wind-down of the covered clearing agency necessitated by credit losses, liquidity shortfalls, losses from general business risk, or any other losses.

Rule 17Ad-22(e)(15) complements this requirement with requirements for policies and procedures reasonably designed to provide for holding liquid net assets funded by equity equal to the greater of either six months of its current operating expenses or the amount determined by the board of directors to be sufficient to ensure a recovery or orderly wind-down of critical operations and services of the covered clearing agency, as contemplated by the plans established under Rule 17Ad-22(e)(3).

The Commission preliminarily believes that a registered clearing agency that provides CCP, CSD, or SSS services should be subject to enhanced requirements for maintaining policies and procedures that manage business risk and provide for recovery and wind-down plans. These enhanced business risk requirements would benefit not only the clearing agency but also participants and the public. Likewise, recovery and wind-down plans help ensure that CCPs, CSDs, SSSs, and policymakers can plan for and mitigate the potential systemic consequences of a wind-down or failure.

See

17 CFR 240.17Ad-22(e)(3). Rule 17Ad-22(d) does not include comparable requirements.

See

17 CFR 240.17Ad-22(e)(15). Rule 17Ad-22(d) does not include requirements for policies and procedures related to the management of business risk.

See

17 CFR 240.17Ad-22(e)(3)(ii).

See

17 CFR 240.17Ad-22(e)(15)(ii).

Facilitating settlement and mitigating settlement risks is another essential role played by these registered clearing agencies, CSDs and SSSs in particular, and another important component of Rule 17Ad-22(e) is enhanced requirements for policies and procedures governing settlement. For example, Rule 17Ad-22(e) includes requirements directed to settlement finality, physical delivery, and money settlements.

Importantly, it also includes rules with enhanced requirements for depository functions and settlement systems.

See

17 CFR 240.17Ad-22(e)(8), (9), (10).

See

17 CFR 240.17Ad-22(e)(11). Rule 17Ad-22(d)(10) also includes requirements for policies and procedures related to the immobilization or dematerialization of securities certificates and the transfer of them by book entry, but does not include requirements for, among other things, policies and procedures relating to ensuring the integrity of securities issues, safeguarding the rights of securities issuers and holders, preventing the unauthorized creation or deletion of securities, or conducting periodic and at least daily

reconciliation of securities issues.

See

17 CFR 240.17Ad-22(d)(10).

Providing transparency to the markets is another essential role that these registered clearing agencies facilitate in the markets they serve by each maintaining a set of rules and procedures that govern their participants, their clearance and settlement services, and their risk management framework. Each registered clearing agency that provides CCP, CSD, or SSS services has rules that, while they may vary according to the characteristics of the markets they serve, generally govern how they clear transactions or trades submitted by participants, calculate whether and how much each participant owes in margin or to the clearing or participant fund on either a gross or net basis, receive securities from participants that owe securities, deliver securities to participants that are owed securities, collect payments from participants that owe money, and pay participants that are owed money. Rule 17Ad-22(e)(23)(iv) also requires a covered clearing agency to have policies and procedures that provide for a comprehensive public disclosure of its material rules, policies, and procedures regarding the requirements in Rule 17Ad-22(e).

Increased transparency helps market participants manage their risks, thereby reducing systemic risk concerns across the U.S. financial system.

See

17 CFR 240.17Ad-22(e)(23)(iv). No comparable requirement exists in Rule 17Ad-22(d).

Each of the above roles, common across the registered clearing agencies that provide CCP, CSD, and SSS services, is addressed by the enhanced requirements in Rule 17Ad-22(e), and therefore the Commission believes that expanding the definition of “covered clearing agency” to include those registered clearing agencies that are integral in either performing these functions or managing these risks, as appropriate, will help to further strengthen the national system for clearance and settlement and help to further mitigate risk to the broader U.S. financial system.

2. Critical Functions Specific to CCPs, CSDs, or SSSs

In addition to the critical roles common across CCPs, CSDs, and SSSs, each such clearing agency also performs unique functions that support expanded coverage of the “covered clearing agency” definition and, through it, application of Rule 17Ad-22(e) to such clearing agencies because, as discussed further below, Rule 17Ad-22(e) also includes enhanced requirements with respect to these functions.

First, with respect to CCPs, the Commission is proposing that the definition of “covered clearing agency” be expanded so that CCPs would be subject to Rule 17Ad-22(e) in all circumstances. The Commission has, on previous occasions, noted that increasing reliance by market participants on CCPs supports the application of enhanced regulatory requirements that address the risks posed by such activity.

For example, market participants may rely on CCPs because clearing and settling a high volume of financial transactions multilaterally through a CCP can allow for greater efficiency and lower costs than settling bilaterally.

In addition, CCPs are often able to manage risks for their participants related to the clearing and settling of financial transactions more effectively, and, in some cases, reduce certain risks such as the risk that a purchaser of a security will not receive the security or that a seller of a security will not receive payment for the security.

CCPs have also become increasingly important given the mandated central clearing of certain swaps and security-based swaps that is required by the Dodd-Frank Act.

See

CCA Standards adopting release,

supra

note 7, at 257-264; Clearing Agency Standards adopting release,

supra

note 31, at 66264-65 (noting, among other things, that the effectiveness of a CCP's risk controls and the adequacy of its financial resources are critical aspects of the infrastructure of the market it serves).

See, e.g.,

Risk Management Supervision Report,

supra

note 29, at 8.

See, e.g.,

id.

at 8.

See, e.g.,

id.

at 3.

CCPs confer certain benefits to the markets in which they operate, but can also pose substantial risk not only to individual market participants but also to the broader financial system, due in part to the fact that central clearing concentrates risk. Disruption to such functions, or failure on the part of the clearing agency to meet its obligations, could, result in significant costs to the clearing agency itself and its members and create a potential source of contagion affecting other market participants or the broader U.S. financial system.

As a result, proper management of the risks associated with central clearing is necessary to ensure the stability of the U.S. securities markets and the broader U.S. financial system. Each CCP determines how best to manage its credit and liquidity risks, consistent with its regulatory framework and as appropriate for the products it clears and the market it serves. For example, participants must meet membership requirements to join a CCP. Each CCP determines who meets its membership criteria and continues to monitor its membership to ensure that the members continue to meet these criteria. Similarly, each CCP is responsible for determining its own margin models and ensuring that each member meets its obligations under the margin models. When the Commission adopted Rule 17Ad-22(e), it sought to impose enhanced requirements to an initial group of registered clearing agencies that concentrated risk because they were either designated systemically important or engaged in activities with a more complex risk profile. Now, the Commission believes it is appropriate to propose to expand the coverage of the “covered clearing agency” definition to include all CCPs because, as described above, CCP operations generally concentrate risk and can also act as a transfer mechanism for risk, and Rule 17Ad-22(e) includes enhanced requirements that help mitigate the risks that CCP functions carry. In particular, Rule 17Ad-22(e) includes requirements

for the management of credit and liquidity risk, the development of recovery and wind-down plans, and tiered participation arrangements,

and the Commission believes that applying these requirements to all CCPs will help further mitigate systemic risk to the U.S. financial system.

See generally

Darrell Duffie, Ada Li & Theo Lubke, Policy Perspectives on OTC Derivatives Market Infrastructure, at 9 (Fed. Reserve Bank N.Y. Staff Reps., Mar. 2010),

available at

http://www.newyorkfed.org/research/staff_reports/sr424.pdf

(“If a CCP is successful in clearing a large quantity of derivatives trades, the CCP is itself a systemically important financial institution. The failure of a CCP could suddenly expose many major market participants to losses. Any such failure, moreover, is likely to have been triggered by the failure of one or more large clearing members, and therefore to occur during a period of extreme market fragility.”); Craig Pirrong, The Inefficiency of Clearing Mandates, Policy Analysis, No. 655, at 11-14, 16-17, 24-26 (2010),

available at

http://www.cato.org/pubs/pas/PA665.pdf

, at 11-14, 16-17, 24-26 (stating, among other things, that “CCPs are concentrated points of potential failure that can create their own systemic risks,” that “[a]t most, creation of CCPs changes the topology of the network of connections among firms, but it does not eliminate these connections,” that clearing may lead speculators and hedgers to take larger positions, that a CCP's failure to effectively price counterparty risks may lead to moral hazard and adverse selection problems, that the main effect of clearing would be to “redistribute losses consequent to a bankruptcy or run,” and that clearing entities have failed or come close to failing in the past, including in connection with the 1987 market break); Manmohan Singh, Making OTC Derivatives Safe—A Fresh Look, at 5-11 (IMF Working Paper, Mar. 2011),

available at

http://www.imf.org/external/pubs/ft/wp/2011/wp1166.pdf

(addressing factors that could lead central counterparties to be “risk nodes” that may threaten systemic disruption); Domanski, Dietrich, Leonardo Gambacorta, and Cristina Picillo. “Central clearing: trends and current issues.” BIS Quarterly Review December (2015),

available at

https://www.bis.org/publ/qtrpdf/r_qt1512g.pdf

(describing links between CCP financial risk management and systemic risk); Wendt, Froukelien, Central counterparties: addressing their too important to fail nature (2015),

available at

http://papers.ssrn.com/sol3/Delivery.cfm/wp1521.pdf?abstractid=2568596&mirid=1&type=2

(assessing the potential channels for contagion arising from CCP interconnectedness).

See

17 CFR 240.17Ad-22(e)(4), (7), (19).

Second, the Commission is similarly proposing that a clearing agency providing CSD services also be a covered clearing agency. The Commission has noted on previous occasions the importance of CSDs to the U.S. securities markets. For example, the Commission has noted that CSDs are critical elements of the national system for clearance and settlement,

and that the establishment of consistent standards for CCP and CSD operations is an important goal that underpinned the enactment of Section 17A of the Exchange Act.

CSDs play a key role in modern financial markets, where, for many issuers, transactions in securities often involve no transfer of physical certificates.

Such paperless trading generally improves transactional efficiency but for such benefits to accrue, market participants must have confidence that CSDs can correctly account for the number of securities in their custody and for the book entries that allocate securities across participant accounts. The Commission therefore is proposing that CSDs also be subject to Rule 17Ad-22(e) in all circumstances because of the important role they play in the national system for clearance and settlement of securities. Rule 17Ad-22(e)(11) established enhanced requirements specific to CSDs. Rule 17Ad-22(e)(11)(i) requires a covered clearing agency that provides central securities depository (“CSD”) services to establish, implement, maintain and enforce written policies and procedures reasonably designed to maintain securities in an immobilized or dematerialized form for their transfer by book entry, ensure the integrity of securities issues, and minimize and manage the risks associated with the safekeeping and transfer of securities. Rule 17Ad-22(e)(11)(ii) requires a covered clearing agency that provides CSD services to establish, implement, maintain and enforce written policies and procedures reasonably designed to implement internal auditing and other controls to safeguard the rights of securities issuers and holders, prevent the unauthorized creation or deletion of securities, and conduct periodic and at least daily reconciliation of securities issues it maintains. Finally, Rule 17Ad-22(e)(11)(iii) requires a covered clearing agency that provides CSD services to establish, implement, maintain and enforce written policies and procedures reasonably designed to protect assets against custody risk through appropriate rules and procedures consistent with relevant laws, rules, and regulations in jurisdictions where it operates.

In addition, Rule 17Ad-22(e) generally strengthens the substantive regulations of clearing agencies through, among other things, requirements for the comprehensive management of risk and the development of recovery and wind-down plans, which are equally important to CSDs.

Therefore, the Commission believes that applying Rule 17Ad-22(e) to all clearing agencies providing CSD services will further help mitigate risk to the U.S. financial system.

See

BSTP and SS&C exemption,

supra

note 53, at 75398 (noting that a CSD is “a critical element of the national system for clearance and settlement”).

See

Clearing Agency Standards adopting release,

supra

note 34, at 66273.

See

CCA Standards proposing release,

supra

note 31, at 29603.

See

CCA Standards adopting release,

supra

note 7, at 472.

See id.

at 91-105 (describing the requirements under Rule 17Ad-22(e)(3)).

Lastly, while in the U.S. securities markets the functions of an SSS are typically performed by a registered clearing agency that also provides CSD services, the Commission has also noted that clearing agencies provide a broad range of services in connection with the settlement of securities transactions.

For example, the Commission has previously noted that clearing agencies “provide differing clusters of services for their participants.”

In particular, “[c]learing corporations generally receive trade data respecting exchanges or [over-the-counter] trades between broker-dealers and compare, account for and settle the netted securities transactions.”

Over the years, the Commission has registered a number of entities as clearing agencies that provide a variety of securities settlement services. These services include facilitating the settlement of transactions executed by specialists on an exchange,

providing clearance and settlement services for mortgage-backed securities transactions,

and facilitating the clearance and settlement of cross-border transactions.

These SSSs play a vital role in fostering the proper functioning of financial markets, but if they are not effectively managed they have the potential to act as transmission channels for financial shocks, particularly on days of market stress.

See

Exchange Act Release No. 34-20221 (Sept. 23, 1983), 48 FR 45167, 45169 & n.32 (Oct. 3, 1983) (in describing the accounting processes that generate securities settlement obligations, distinguishing NSCC's “continuous net settlement” system from a “daily balance order” system); Exchange Act Release No. 34-21335 (Sept. 20, 1984), 49 FR 37879, 37879 (Sept. 26, 1984) (in describing the functions performed by the Boston Stock Exchange Clearing Corporation (“BSECC”), noting that BSECC transmits data to NSCC for processing and collects and pays members' daily settlement obligations at NSCC and DTC);

See

48 FR at 45169.

See id.

(citations omitted).

See id.

at 45173-77 (approving the registration of the Stock Clearing Corporation of Philadelphia subject to conditions).

See

Exchange Act Release No. 34-24046 (Feb. 2, 1987), 52 FR 4218 (Feb. 10. 1987) (order granting registration as a clearing agency to MBS Clearing Corporation).

See

Exchange Act Release No. 34-26812 (May 12, 1989), 54 FR 21691 (May 19, 1989) (order approving temporary registration as a clearing agency of the International Securities Clearing Corporation).

The Commission also believes that a clearing agency providing SSS services can raise credit, market, and operational risk concerns.

The Commission preliminarily believes that these functions, whether performed independently or consolidated with other clearing agency functions in a single registered clearing agency, support application of the enhanced standards in Rule 17Ad-22(e).

In recent years, the Commission has adopted requirements for the policies and procedures of certain clearing agencies under Rule 17Ad-22 to help achieve delivery versus payment and eliminate principal risk,

both of which relate to the provision of SSS services. The Commission adopted Rule 17Ad-22(e) to strengthen the substantive regulations applicable to clearing agencies to address, among other things, credit, market, and operational risk. Because SSS operations present these types of risk, the Commission is proposing to apply Rule 17Ad-22(e) to all entities performing these SSS functions.

The Commission notes that, currently, no registered clearing agency provides only SSS services in the United States. Nonetheless, the Commission preliminarily believes that SSSs, because they are financial market infrastructures that provide centralized services similar to CCPs and CSDs, can also serve as potential transmission mechanisms for systemic risk and should therefore also be subject to the same requirements as CCPs and CSDs. In this regard, the Commission notes that Rule 17Ad-22(e)(12) includes requirements specific to settlement systems.

See

CCA Standards adopting release,

supra

note 7, at 472.

See generally

Report of the Senate Committee on Banking, Housing & Urban Affairs, S. Rep. No. 94-75, at 5, 91 (recognizing book-entry transfer as one of three basic clearing agency functions before consolidating it, along with clearing and the transfer of record ownership, into a single definition of “clearing agency” in the Exchange Act).

See

17 CFR 240.17Ad-22(d)(13), (e)(12).

3. Increasing Scrutiny of CCP, CSD, and SSS Functions

In response to the CCA Standards proposing release, the Commission received a number of comments on the proposed scope of the definition of covered clearing agency asking the Commission to expand the scope of the covered clearing agency definition and therefore the coverage of Rule 17Ad-22(e).

Specifically, one commenter endorsed efforts to promote financial stability through the application of heightened standards for covered clearing agencies, particularly those that provide CCP services for security-based swaps and other derivatives, noting that the mandatory clearing of OTC derivatives introduced following the 2008 financial crisis has heightened the need for enhanced standards for CCPs.

A second commenter suggested that the Commission apply Rule 17Ad-22(e) to all clearing agencies to reduce the risk of failure and the problems such a failure would cause for investors, citing the size of the derivatives markets, and the potential for disruption and systemic risk that these markets may have on covered clearing agencies.

A third commenter recommended that any provision of the proposed rules that reflects best practices should be applied across all clearing agencies.

Each of these comments supports an approach under which registered clearing agencies are subject to the enhanced standards in Rule 17Ad-22(e) where they perform critical clearing agency functions that concentrate risk and could serve as mechanisms for the transfer of systemic risk. Consistent with these comments, the proposed application of Rule 17Ad-22(e) to all registered clearing agencies that provide CCP, CSD, and SSS services would strengthen the Commission's substantive regulation of clearing agencies by imposing enhanced requirements for risk management policies and procedures that help mitigate systemic risk.

See

CCA Standards adopting release,

supra

note 7, at 53-65.

See

The Clearing House at 1.

See

CFA Institute at 2.

See

DTCC at 4.

In contrast to the above commenters, one commenter endorsed the Commission's adopted definition of “covered clearing agency” and supported not applying Rule 17Ad-22(e) to registered clearing agencies that were dually registered with the CFTC and SEC, where the CFTC is the supervisory authority under the Clearing Supervision Act.

The commenter also believed that subjecting a dually registered clearing agency to requirements under Rule 17Ad-22(e) and the CFTC's regime would result in duplicative regulation.

The Commission preliminarily believes that, as discussed in Part II.A.4 below, although the proposed amendment to the definition of “covered clearing agency” would subject some dually registered clearing agencies to similar regulations under the Commission's and CFTC's comparable regimes, expanding the definition to include dually registered clearing agencies is nonetheless appropriate.

See

CME at 2.

See id.

4. Expanded Coverage Under the Definition of “Covered Clearing Agency”

The proposed amendment to the definition of “covered clearing agency” would differ in two ways from the existing definition of “covered clearing agency.” First, it would no longer reference whether a clearing agency has been designated systemically important by the FSOC and for which the Commission is the supervisory agency under the Clearing Supervision Act. Second, it would remove references to clearing agencies that provide CCP services for security-based swaps or are involved in activities the Commission determines to have a more complex risk profile, unless the CFTC is the supervisory agency under the Clearing Supervision Act. Amending the definition of “covered clearing agency” in this way would replace these two categories of clearing agencies with clearing agencies providing the services of a CCP, CSD, or SSS and thereby expand the range of entities that fall within the definition of “covered clearing agency.” Accordingly, under the proposed amendment to the definition, whether a registered clearing agency is a SIFMU or dually registered with the Commission and the CFTC would no longer be relevant to application of the “covered clearing agency” definition or Rule 17Ad-22(e).

Thus, the potential for registered clearing agencies to be subject to Rule 17Ad-22(e) would increase under the proposed amendment. In particular, under the proposed amendment to the definition, the narrower set of complex risk profile clearing agencies for which the CFTC is not the supervisory agency would be replaced with the full universe of registered clearing agencies that provide CCP, CSD, or SSS services. In light of the discussion above regarding the critical functions common among and specific to CCPs, CSDs, and SSSs, the Commission preliminarily believes that such an expansion is appropriate in order to help further mitigate systemic risk to the U.S. financial system.

Preliminarily, the Commission believes that such an approach is appropriate even though it may subject clearing agencies that are dually registered with the Commission and CFTC to similar requirements in some instances. In this regard, the Commission first notes that the staff has consulted with the CFTC, FRB, and FSOC in the development of these rules to, in part, avoid unnecessarily duplicative or inconsistent regulation with respect to clearing agencies that are dually registered in the United States. With respect to such clearing agencies—as well as clearing agencies regulated by authorities in other jurisdictions—the Commission is nonetheless mindful, pursuant to the comprehensive framework for regulating swaps and security-based swaps established in Title VII, that the SEC has been given regulatory authority over security-based swaps.

CCPs that clear security-based swaps present risks to the securities markets that must be subject to appropriate risk management. As noted in the CCA Standards adopting release, the Commission's intent with respect to Rule 17Ad-22(e) was, in part, to take an incremental step under Rule 17Ad-22 to ensure that these risks are appropriately managed consistent with the purposes of the Exchange Act, the Clearing Supervision Act, and Title VII of the Dodd-Frank Act.

The Commission believes that the proposed amendments to the definition of “covered clearing agency” represent another incremental step to help ensure that these risks are appropriately managed consistent with each of the above statutes. The Commission has, through Rule 17Ad-22(e) sought to apply requirements commensurate and appropriate to the risk posed by the clearing agency functions and activities specific to

covered clearing agencies as they exist in, and serve, the U.S. securities markets. The Commission acknowledges that other rules and regulations may apply to a covered clearing agency that are similar in scope or purpose to Rule 17Ad-22(e). However, the presence of similar regulations does not negate the Commission's obligation to ensure that risk in the U.S. securities markets is appropriately managed consistent with the purposes of the Exchange Act, the Clearing Supervision Act, and Title VII of the Dodd-Frank Act. Further, because Rule 17Ad-22(e) and other comparable regulations—including those of the CFTC—are consistent with the same international standards,

100

the potential for inconsistent regulation is low.

This dual framework for the regulation of CCPs for swaps and security-based swaps by the Commission and the CFTC was recently recognized by the European Commission in its equivalence decision for the CFTC. The European Commission has indicated that it will conduct a separate equivalence analysis for CCPs clearing securities and security-based swaps.

See

Commission Implementing Decision (EU) 2016/377 of 15 March 2016 on the equivalence of the regulatory framework of the United States of America for central counterparties that are authorised and supervised by the CFTC to the requirements of Regulation (EU) No 648/2012 of the European Parliament and of the Council,

available at http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32016D0377

See

CCA Standards adopting release,

supra

note 7, at 45.

100

See

CCA Standards adopting release,

supra

note 7, at 45.

Further, in the CCA Standards adopting release, the Commission addressed comments regarding the risk of duplicative regulation that may result for clearing agencies dually registered with the Commission and the CFTC,

101

and noted that the Commission has previously addressed concerns about duplication in the rule filing process by streamlining the process under Rule 19b-4 for dually registered clearing agencies.

102

Specifically, for rule filings that primarily concern the clearing operations of a registered clearing agency that do not pertain to securities clearing operations but only to clearing of products under the authority of the CFTC, the Commission made a policy decision to provide a streamlined process for such rule filings to become effective upon filing with the Commission, without pre-effective notice and opportunity for comment.

103

101

See id.

at 44-46.

102

See

Exchange Act Release No. 34-69284 (Apr. 3, 2013), 78 FR 21046 (Apr. 9, 2013).

103

See id.

at 21047.

Finally, with respect to the proposed removal of designated clearing agencies from the “covered clearing agency” definition, the Commission notes that each designated clearing agency under Title VIII provides either CCP or CSD services and, therefore, would remain a covered clearing agency under the proposed amendment to the definition of “covered clearing agency.”

104

Moreover, the proposed shift to a function-oriented definition of “covered clearing agency” would not cause any of the registered clearing agencies that currently fall within the definition to be excluded. DTC, FICC, ICEEU, NSCC, and OCC all perform CCP, CSD, and/or SSS services.

104

See supra

note 50.

The proposed amendment to the definition would expand the scope of covered clearing agencies by one additional clearing agency, ICC. Although ICC is a designated SIFMU and provides CCP services for security-based swaps, the CFTC is its supervisory agency, so it is not a covered clearing agency under the adopted definition.

B. Definition of “Securities Settlement System”

To facilitate the proposed amendment to the definition of “covered clearing agency,” the Commission is also proposing to define “securities settlement system” to mean a clearing agency that enables securities to be transferred and settled by book entry according to a set of predetermined multilateral rules. The Commission understands that this is the generally accepted meaning of the term.

105

The Commission preliminarily believes that this definition appropriately captures the critical functions performed by SSSs described above, including the role that SSSs have in concentrating and managing risk on behalf of their participants. The proposed definition would, among other things, include a clearing agency that facilitates the settlement of transactions executed by specialists on an exchange, provides clearance and settlement services for mortgage-backed securities transactions, or facilities the clearance and settlement of cross-border transactions.

106

105

See supra

note 6.

106

See supra

notes 83-88.

C. Definition of “Central Securities Depository”

Consistent with the proposed amendment to the definition of “covered clearing agency,” and to improve consistency with both the definition of “central counterparty” in Rule 17Ad-22(a)(2) and the proposed definition of “securities settlement system,” the Commission is proposing to amend the definition of “central securities depository services” in Rule 17Ad-22(a)(3). Rule 17Ad-22(a)(3) as adopted defines “central securities depository services” to mean services of a clearing agency that is a securities depository as described in Section 3(a)(23)(A) of the Exchange Act. The Commission is proposing to amend Rule 17Ad-22(a)(3) so that it would instead define “central securities depository” to mean a clearing agency that is a securities depository as described in Section 3(a)(23)(A) of the Exchange Act.

This modification would not alter the meaning of Rule 17Ad-22(a)(3) other than to improve consistency with (i) the definition of “central counterparty” and its use throughout Rule 17Ad-22, and (ii) the proposed definition of “securities settlement system” and its proposed use under Rule 17Ad-22. The Commission preliminarily believes that this proposed modification is therefore appropriate so that the definition of “covered clearing agency” is workable.

D. Definition of “Sensitivity Analysis”

The Commission is also proposing to amend the definition of “sensitivity analysis” under Rule 17Ad-22 to remove the reference to “a covered clearing agency involved in activities with a more complex risk profile” from paragraph (ii). Pursuant to the proposed amendment, all covered clearing agencies that are CCPs, rather than just those involved in activities with a more complex risk profile, as part of developing and maintaining policies and procedures for performing sensitivity analysis pursuant to Rule 17Ad-22(e)(6), would need to consider the most volatile relevant periods, where practical, that have been experienced by the markets served by the clearing agency.

Under the existing definition of “sensitivity analysis,” the Commission applies the requirements for policies and procedures regarding volatile relevant periods only to covered clearing agencies that are complex risk profile clearing agencies. While this approach applies the requirements related to sensitivity analysis to CCPs that clear security-based swaps, it does not apply the requirements to other clearing agencies that provide CCP services. Under the Commission's proposed amendment to the “sensitivity analysis” definition, these requirements for policies and procedures would apply to all covered clearing agencies that are CCPs. The Commission believes that policies and procedures for considering the most volatile relevant periods, where practical, that have been experienced by the markets served by a covered clearing agency promote sound risk management and help mitigate systemic risk. The Commission therefore preliminarily believes that expanding the coverage of this requirement to all CCPs will help mitigate risks to the U.S. financial system. In light of the Commission's proposal to expand the coverage of the “covered clearing agency” definition to all CCPs, the Commission preliminarily believes it is important to also require that any currently registered CCP or CCP that may register with the Commission in the future be subject to the same requirement to help mitigate risks to the U.S. financial system. Based on its supervisory experience, the Commission

preliminarily believes that all active CCPs currently registered with the Commission have policies and procedures for sensitivity analysis though they may vary in their application.

In addition, in order to improve consistency within the definition of sensitivity analysis, the Commission is proposing to separate the two elements that appear in current paragraph (i) into two separate paragraphs and renumber the existing paragraphs accordingly. Thus, “sensitivity analysis” would mean an analysis that involves analyzing the sensitivity of a model to its assumptions, parameters, and inputs that (i) considers the impact on the model of both moderate and extreme changes in a wide range of inputs, parameters, and assumptions, including correlations of price movements or returns if relevant, which reflect a variety of historical and hypothetical market conditions; (ii) uses actual portfolios and, where applicable, hypothetical portfolios that reflect the characteristics of proprietary positions and customer positions; (iii) considers the most volatile relevant periods, where practical, that have been experienced by the markets served by the clearing agency; and (iv) tests the sensitivity of the model to stressed market conditions, including the market conditions that may ensue after the default of a member and other extreme but plausible conditions as defined in a covered clearing agency's risk policies. This proposed modification would not alter the meaning or application of the definition of “sensitivity analysis,” but is designed to improve clarity regarding the number of discrete elements contained in the definition.

E. Request for Comments

The Commission requests comment on all aspects of the proposed amendments to the definitions of “covered clearing agency,” “central securities depository,” and “sensitivity analysis” and the proposed definition of “securities settlement system,” including whether the definitions are sufficiently clear and, if not, how they should be changed. In addition, the Commission requests comment on the following specific issues. In all cases, responses should be supported by detailed explanation and analysis and, where possible, empirical evidence.

• In describing the functions or services of a covered clearing agency as those of a CCP, CSD, or SSS, has the Commission's proposal appropriately classified the functions/services of a covered clearing agency? Are there other clearing agency functions or services that the Commission should consider including in the definition of “covered clearing agency?” If so, explain why these functions or services should be included and how these functions relate to the policy goals and requirements in Rule 17Ad-22(e). In addition, please explain whether any of the clearing agency functions included in the proposed definition of “covered clearing agency” should be excluded and why such an exclusion is appropriate.

• Will the proposed approach to expanding the definition of “covered clearing agency” result in duplicative costs for CCPs, CSDs, and SSSs? If so, what are these costs?

• Should any of the requirements under Rule 17Ad-22(e) be altered as they relate to the new entities under the proposed expansion of the “covered clearing agency” definition? Please explain.

• In referencing a securities depository as described in Section 3(a)(23)(A) of the Exchange Act, does the proposed definition of “central securities depository” sufficiently describe the functions of a CSD? Why or why not? What other functions, if any, should be included in the definition of “central securities depository?”

• The definition of “central securities depository” would continue to appear in Rule 17Ad-22(d)(14).

107

However, as a result of the proposed amendment to the “covered clearing agency” definition, a registered clearing agency that performs CSD services would be a covered clearing agency subject to Rule 17Ad-22(e) and would not be subject to the requirements in Rule 17Ad-22(d). Accordingly, should the Commission modify Rule 17Ad-22(d)(14) in light of the proposed amendments? If so, how should the Commission apply Rule 17Ad-22(d)(14) to a registered clearing agency that is not a covered clearing agency?

107

Rule 17Ad-22(d)(14) requires a registered clearing agency other than a covered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to institute risk controls, including collateral requirements and limits to cover the clearing agency's credit exposure to each participant family exposure fully, that ensure timely settlement in the event that the participant with the largest payment obligation is unable to settle when the clearing agency provides CSD services and extends intraday credit to participants.

See

17 CFR 240.17Ad-22(d)(14).

• Do commenters agree with the proposed definition of “securities settlement system?” Should there be another definition? If so, why? Does the definition sufficiently describe the functions of an SSS? Is it sufficiently clear what “according to a set of predetermined multilateral rules” means? Please provide examples of SSS activities.

• In light of the proposed amendment to the definition of “sensitivity analysis,” would a covered clearing agency have to make changes to its policies and procedures for conducting sensitivity analysis to comply with the new definition? If so, explain the current policies and procedures of covered clearing agencies relevant to conducting sensitivity analysis and how they would need to be changed. The Commission also requests information regarding the anticipated costs of any such changes to policies and procedures. The Commission also requests information regarding the potential benefits.

III. Economic Analysis

The Commission is sensitive to the economic consequences and effects of the proposed amendments, including their benefits and costs. Under Section 3(f) of the Exchange Act, whenever the Commission engages in rulemaking under the Exchange Act and is required to consider or determine whether an action is necessary or appropriate in the public interest, it must consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.

108

Further, as noted above, Section 17A of the Exchange Act directs the Commission, when using its authority to facilitate the establishment of a national system for clearance and settlement of securities transactions, to have due regard for the public interest, the protection of investors, the safeguarding of securities and funds, and maintenance of fair competition among brokers and dealers, clearing agencies, and transfer agents.

109

Section 23(a)(2) of the Exchange Act also prohibits the Commission from adopting any rule that would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act.

110

108

See

15 U.S.C. 78c(f).

109

See supra

Part I.A.1.

110

See

15 U.S.C. 78w(a)(2).

The proposed amendments to three definitions in Rule 17Ad-22(a) would generally expand the scope of registered clearing agencies subject to Rule 17Ad-22(e). The Commission is proposing to amend the definition of “covered clearing agency” in Rule 17Ad-22(a)(5) by focusing directly on clearing agency functions. Thus the amended definition of “covered clearing agency” covers all clearing agencies that provide the services of a CCP, CSD, or SSS. The Commission is also proposing a

conforming amendment to the definition of “central securities depository services” in Rule 17Ad-22(a)(3), and the Commission is proposing to amend the definition of “sensitivity analysis” in Rule 17Ad-22(a)(17). As discussed in more detail below, the Commission preliminarily believes the proposed amendments to Rule 17Ad-22(a) would cause one additional registered clearing agency to fall within the definition of “covered clearing agency” and become subject to requirements of Rule 17Ad-22(e).

A. Economic Background

The Commission believes that the proposed amendments would support improvements in risk management at registered clearing agencies not currently subject to Rule 17Ad-22(e) as adopted with respect to systemic risk, as well as with respect to legal, credit, liquidity, general business, custody, investment, and operational risk.

As noted in the CCA Standards adopting release, registered clearing agencies have become an essential part of the infrastructure of the U.S. securities markets.

111

While central clearing generally benefits the markets in which it is available, clearing agencies can pose substantial risk to the financial system as a whole, due in part to the fact that central clearing concentrates risk in the clearing agency. Disruption to a clearing agency's operations, or failure on the part of a clearing agency to meet its obligations, could therefore serve as a potential source of contagion, resulting in significant costs not only to the clearing agency itself or its members but also to other market participants or the broader U.S. financial system.

112

As a result, proper management of the risks associated with central clearing is necessary to ensure the stability of the U.S. securities markets and the broader U.S. financial system. The mandate in Title VII of the Dodd-Frank Act for central clearing of security-based swaps, wherever possible and appropriate, further reinforces this need.

113

When a clearing agency provides CCP services, central clearing replaces bilateral counterparty exposures with exposures against the clearing agency. Consequently, a move from voluntary clearing to mandatory clearing of security-based swaps, holding the volume of security-based swap transactions constant, would increase economic exposures against clearing agencies that centrally clear security-based swaps. Increased exposures in turn raise the possibility that these clearing agencies may serve as a transmission mechanism for systemic events.

111

See

CCA Standards adopting release,

supra

note 7, at 257.

112

See generally

Dietrich Domanski, Leonardo Gambacorta, and Cristina Picillo, Central Clearing: Trends and Current Issues, BIS Quarterly Review (Dec. 2015),

available at https://www.bis.org/publ/qtrpdf/r_qt1512g.pdf

(describing links between CCP financial risk management and systemic risk); Darrell Duffie, Ada Li & Theo Lubke, Policy Perspectives on OTC Derivatives Market Infrastructure, at 9 (Fed. Reserve Bank N.Y. Staff Reps., Mar. 2010),

available at http://www.newyorkfed.org/research/staff_reports/sr424.pdf

(“If a CCP is successful in clearing a large quantity of derivatives trades, the CCP is itself a systemically important financial institution. The failure of a CCP could suddenly expose many major market participants to losses. Any such failure, moreover, is likely to have been triggered by the failure of one or more large clearing members, and therefore to occur during a period of extreme market fragility.”); Pirrong, The Inefficiency of Clearing Mandates, Policy Analysis, No. 655, at 11-14, 16-17, 24-26 (2010),

available at http://www.cato.org/pubs/pas/PA665.pdf

, at 11-14, 16-17, 24-26 (stating, among other things, that “CCPs are concentrated points of potential failure that can create their own systemic risks,” that “[a]t most, creation of CCPs changes the topology of the network of connections among firms, but it does not eliminate these connections,” that clearing may lead speculators and hedgers to take larger positions, that a CCP's failure to effectively price counterparty risks may lead to moral hazard and adverse selection problems, that the main effect of clearing would be to “redistribute losses consequent to a bankruptcy or run,” and that clearing entities have failed or come close to failing in the past, including in connection with the 1987 market break); Froukelien Wendt, Central Counterparties: Addressing Their Too Important to Fail Nature (IMF Working Paper, Jan. 2015),

available at http://papers.ssrn.com/sol3/Delivery.cfm/wp1521.pdf

(assessing the potential channels for contagion arising from CCP interconnectedness); Manmohan Singh, Making OTC Derivatives Safe—A Fresh Look, at 5-11 (IMF Working Paper, Mar. 2011),

available at http://www.imf.org/external/pubs/ft/wp/2011/wp1166.pdf

(addressing factors that could lead central counterparties to be “risk nodes” that may threaten systemic disruption).

113

See supra

Part I.A.2.

As the Commission discussed in the CCA Standards adopting release, clearing agencies have incentives to implement a risk management framework that can effectively manage the risks posed by central clearing.

114

First, the ongoing viability of a clearing agency depends on its reputation and the confidence that market participants have in its services. Clearing agencies therefore have an incentive to reduce the likelihood that a member default or operational outage would disrupt settlement of a particular transaction or set of transactions. Second, some clearing agencies operate as member-owned utilities and mutualize default risk across their members, and thus non-defaulting participants are subject to losses that occur above the defaulter's margin and clearing fund. Clearing agencies that operate under such models thus have an economic interest in sound risk management to reduce the expected level of losses that must be mutualized. Other clearing agencies are publicly traded and therefore could have different incentives because non-member-owners have a lower economic stake in the clearing agency than member-owners under a mutualized structure.

114

See

CCA Standards adopting release,

supra

note 7, at 259-260.

Such an ownership structure could increase the incentive for owners, particularly those that are non-members, to take risks, though these incentives may be tempered by rules of the clearing agency that are consistent with Section 17A(b)(3)(C) of the Exchange Act, which requires that the clearing agency's rules assure fair representation of its shareholders and participants in the selection of the clearing agency's directors and administration of its affairs.

115

See

15 U.S.C. 78q-1(b)(3)(C).

Nevertheless, incentives for sound risk management may be tempered by pressures to reduce costs and maximize profits that are distinct from goals set forth in governing statutes.

116

This tension may result in a clearing agency making decisions that result in tradeoffs between the costs and benefits of risk management that may not fully reflect the costs and benefits that accrue to other financial market participants as a result of its decisions. For example, because the current market to provide central clearing is characterized by high barriers to entry and limited competition,

117

the market power exercised by clearing agencies in the markets they serve may reduce incentives to invest in risk management systems.

118

Further, even if clearing agencies do internalize costs that they impose on their clearing members, they may fail to internalize the consequences of their risk management decisions on other entities within the financial system that are connected to them through relationships with their clearing members.

119

Such a failure represents a financial network externality imposed by clearing agencies on the broader financial system and suggests that

financial stability, as a public good, may be under-produced in equilibrium.

116

See supra

Parts I.A.1 and 2 (describing the requirements under the Exchange Act and the Dodd-Frank Act).

117

See

CCA Standards proposing release,

supra

note 31, at 29576.

118

See infra

Part III.C.1.c (discussing the effect on competition).

119

See

Daron Acemoglu, Asuman Ozdaglar & Alireza Tahbaz-Salehi, Systemic Risk and Stability in Financial Networks (NBER Working Paper No. 18727, Jan. 2013),

available at http://www.nber.org/papers/w18727

B. Baseline

In order to perform its analysis of the likely economic effects of the proposed amendments to Rule 17Ad-22(a), the Commission is using an economic baseline that considers the current market for clearance and settlement services as it exists at the time of this proposal. As discussed above,

120

the Commission preliminarily believes that the proposed amendment to the definition of “covered clearing agency” will likely result in one additional registered clearing agency, ICC, becoming subject to the requirements in Rule 17Ad-22(e). Further, as discussed below, the Commission preliminarily believes that the proposed amendments potentially affect ICEEU even though the amendment to the definition of “covered clearing agency” will not change ICEEU's current status as a covered clearing agency.

121

The Commission's baseline therefore includes the two entities in the market for clearance and settlement services—ICC and ICEEU—that the Commission believes would be affected by the proposed amendments. In addition to current market practices at these entities, the baseline includes rules adopted by the Commission, including rules adopted in the CCA Standards adopting release, as well as rules adopted by other regulators, including those in other jurisdictions to the extent that these rules affect the cost structure, business and market practices of the above-mentioned entities. The following section discusses the elements of the baseline that are relevant for the economic analysis of the proposed amendments.

120

See supra

Part II.A.4.

121

See infra

Part III.C.1.c.

Pursuant to the adoption of amendments to Rule 17Ad-22,

122

five registered clearing agencies—DTC, FICC, ICEEU, NSCC and OCC—currently meet the definition of “covered clearing agency”. Table 1 below provides basic membership statistics for the two clearing agencies—ICC and ICEEU—that the Commission preliminarily believes would be affected by the proposed amendments to Rule 17Ad-22(a).

122

See

CCA Standards adopting release,

supra

note 7, at 458-459.

Table 1—Membership Statistics for ICE Clear Credit & ICE Clear Europe

123

Number

Clear Credit Members

ICE Clear Europe Members

—Clear Europe Members that clear CDS

To further

assess the economic effects of the proposed amendments to Rule 17Ad-22(a), including possible effects on efficiency, competition, and capital formation, the Commission is also considering as part of the baseline (i) the current regulatory framework for registered clearing agencies, and (ii) the current practices of the entities that would be affected by the proposed amendments to Rule 17Ad-22(a). Each is discussed further below.

123

Membership statistics are taken from the Web sites of each of the listed clearing agencies as of March 2016. ICE, ICE Clear Credit Participants,

available at https://www.theice.com/clear-credit/participants

; ICE, ICE Clear Europe Membership,

available at https://www.theice.com/clear-europe/membership

1. Regulatory Framework for Registered Clearing Agencies

As previously discussed, the current regulatory framework for registered clearing agencies begins with Section 17A of the Exchange Act, which directs the Commission to facilitate the establishment of a national system for the prompt and accurate clearance and settlement of securities transactions and provides for the registration of clearing agencies.

124

Section 19 of the Exchange Act sets forth the general registration requirements for clearing agencies as SROs, their responsibility as SROs to file proposed rule changes with the Commission for review and approval, and, in general, the provisions relating to Commission oversight of SROs.

125

Titles VII and VIII of the Dodd-Frank Act have expanded the Commission's role with respect to the regulation of central clearing. Specifically, Title VII amended Section 17A of the Exchange Act by adding new paragraphs (g) through (j), which provide the Commission with authority to adopt rules governing security-based swap clearing agencies.

126

The Clearing Supervision Act, adopted in Title VIII, provides for enhanced regulation of SIFMUs and, more generally, for enhanced coordination among the Commission, CFTC, and FRB by facilitating examinations and information sharing.

127

As noted above, on July 18, 2012, the FSOC designated as SIFMUs five registered clearing agencies.

128

124

See supra

Part I.A.1.

125

See supra

notes 16-18 and accompanying text.

126

See supra

note 22 and accompanying text.

127

See supra

notes 23-30 and accompanying text.

128

See supra

note 50.

129

In its economic analysis of the Clearing Agency Standards release, the Commission noted that the economic characteristics of clearing agencies, including economies of scale, barriers to entry, and the particulars of their legal mandates, may limit competition and confer market power on such clearing agencies, which may lead to lower levels of service, higher prices, or under-investment in risk management systems.

130

To address these potential market failures, Rule 17Ad-22 was adopted to strengthen the substantive regulation of clearing agencies, promote the safe and reliable operation of clearing agencies, improve efficiency, transparency, and access to clearing agencies, and promote consistency with international standards.

131

129

See supra

note 31 and accompanying text.

130

See

Clearing Agency Standards adopting release,

supra

note 31, at 66263.

131

See id.

at 66225-26, 66263-64.

Today, the Commission adopted amendments to Rule 17Ad-22 and new Rule 17Ab2-2. Rule 17Ad-22(a)(5) provides the definition of “covered clearing agency,” and Rule 17Ad-22(e) establishes standards for the operation and governance of registered clearing agencies that meet the definition of a covered clearing agency. Rule 17Ab2-2 provides a process by which the Commission may determine or rescind past determinations about, whether a covered clearing agency is systemically important in multiple jurisdictions, and whether any of the activities of a clearing agency providing CCP services, including clearing agencies registered with the Commission for the purpose of clearing security-based swaps, have a more complex risk profile.

132

See

CCA Standards adopting release,

supra

note 7, at 456-477.

Finally, efforts by the CFTC to adopt rules that are consistent with the PFMI are also relevant to the economic analysis of the proposed amendments to Rule 17Ad-22(a).

133

The CFTC has issued rules for derivatives clearing organizations and systemically important derivatives clearing

organizations (“SIDCOs”) which it indicated are intended to be consistent with the PFMI.

134

ICC, the registered clearing agency that the Commission anticipates will fall into the revised covered clearing agency definition, is a clearing agency registered with the Commission that is also supervised by the CFTC as a SIDCO under subpart C of Part 39 of the Commodity Exchange Act.

133

See id.

at 272.

134

See

Derivatives Clearing Organizations and International Standards, Final Rule, 78 FR 72477 (Dec. 2, 2013).

2. Current Practices

Current industry practices are a critical element of the economic baseline for registered clearing agencies. Registered clearing agencies must operate in compliance with Rule 17Ad-22, though they may vary in the particular ways they achieve such compliance. Some variation in practices across registered clearing agencies derives from the products they clear and the markets they serve.

As discussed above,

135

the Commission preliminarily believes that the proposed revision to Rule 17Ad-22(a) will likely result in one additional registered clearing agency, ICE Clear Credit, falling within the definition of covered clearing agency. Further, the Commission preliminarily believes that the proposed amendments may affect ICE Clear Europe (ICEEU) even though these amendments will not change ICEEU's current status as a covered clearing agency.

136

An overview of the current practices of these entities is set forth below and includes discussion of clearing agency policies and procedures regarding general organization and risk management, including the management of legal, credit, liquidity, business, custody, investment, and operational risk. This discussion is intended solely for the purpose of analyzing the economic effects of the proposed amendments and is based on the Commission's general understanding of current practices as of the date of this proposal, informed by information published by registered clearing agencies, as well as the Commission's experience supervising registered clearing agencies.

135

See

Part II.A.4.

136

See infra

Part III.C.1.c.

a. General Organization

i. Legal Risk

Legal risk is the risk that a registered clearing agency's rules, policies, or procedures may not be enforceable and concerns, among other things, its contracts, the rights of members, netting arrangements, discharge of obligations, and settlement finality. Cross-border activities of a registered clearing agency may also present elements of legal risk.

Rule 17Ad-22(d)(1) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to provide for a well-founded, transparent, and enforceable legal framework for each aspect of its activities in all relevant jurisdictions.

137

Each registered clearing agency makes a large portion of these policies and procedures available to members and participants. In addition, each also publishes their rule books and other key procedures publicly in order to promote the transparency of their legal framework.

138

137

See

17 CFR 240.17Ad-22(d)(1); Clearing Agency Standards adopting release,

supra

note 31, at 66245-46.

138

The rule book of each registered clearing agency, as well as select policies and procedures, are publicly available on each registered clearing agency's Web site.

ii. Governance

Rule 17Ad-22(d)(8) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to have governance arrangements that are clear and transparent to fulfill the public interest requirements in Section 17A of the Exchange Act applicable to clearing agencies, to support the objectives of owners and participants, and to promote the effectiveness of the clearing agency's risk management procedures.

139

Important elements of a registered clearing agency's governance arrangements include its ownership structure; its charter, bylaws, and charters for committees of its board and management committees; its rules, policies, and procedures; the composition and role of its board, including the structure and role of board committees; reporting lines between management and the board; and the processes that provide for management accountability with respect to the registered clearing agency's performance.

139

See

17 CFR 240.17Ad-22(d)(8);

see also

Clearing Agency Standards adopting release,

supra

note 31, at 66251-52.

Each registered clearing agency has a board that governs its operations and supervises senior management. Each registered clearing agency also has an independent audit committee of the board and has established a board committee or committee of members tasked with overseeing the clearing agency's risk management functions.

iii. Amended Framework for the Comprehensive Management of Risks

Rules 17Ad-22(b) and (d) require registered clearing agencies to establish, implement, maintain and enforce written policies and procedures reasonably designed to measure and mitigate credit exposures, identify operational risks, evaluate risks arising in connection with cross-border and domestic links for the purpose of clearing or settling trades, achieve DVP settlement, and implement risk controls to cover the clearing agency's credit exposures to participants.

140

Rule 17Ad-22(d)(4) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to establish business continuity plans setting forth procedures for the recovery of operations in the event of a disruption.

141

Rule 17Ad-22(d)(11) further requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to make key aspects of the clearing agency's default procedures publicly available and establish default procedures that ensure that the clearing agency can take timely action to contain losses and liquidity pressures and to continue meeting its obligations in the event of a participant default.

142

140

See

17 CFR 240.17Ad-22(b) and (d);

see also

Clearing Agency Standards adopting release,

supra

note 31.

141

See

17 CFR 240.17Ad-22(d)(4);

see also

Clearing Agency Standards adopting release,

supra

note 31, at 66248-49.

142

See

17 CFR 240.17Ad-22(d)(11).

In addition to meeting these requirements, the Commission understands that registered clearing agencies also specify actions to be taken when their resources are insufficient to cover losses faced by the registered clearing agency.

143

These actions may include assessment rights on clearing members, forced allocation, and contract termination.

143

See

David Elliot, Central Counterparty Loss-Allocation Rules, at tbl. 1A (Bank of England Financial Stability Paper No. 20, Apr. 2013),

available at

http://www.bankofengland.co.uk/research/Documents/fspapers/fs_paper20.pdf

(noting the loss-allocation rules applied at the end of a clearing agency waterfall).

b. Financial Risk Management

Registered clearing agencies that provide CCP services have a variety of options available to mitigate the financial risks to which they are exposed. While the manner in which a CCP chooses to mitigate these financial risks depends on the precise nature of the CCP's obligations, a common set of procedures have been implemented by

many CCPs to manage credit and liquidity risks. Broadly, these procedures enable CCPs to manage their risks by reducing the likelihood of member defaults, limiting potential losses and liquidity pressure in the event of a member default, implementing mechanisms that allocate losses across members, and providing adequate resources to cover losses and meet payment obligations as required.

Registered clearing agencies that provide CCP services must be able to effectively measure their credit exposures in order to properly manage those exposures. A CCP faces the risk that its exposure to a member can change as a result of a change in prices, positions, or both. CCPs can ascertain current credit exposures to each member by, in some cases, marking each member's outstanding contracts to current market prices and, to the extent permitted by their rules and supported by law, by netting any gains against any losses. Rule 17Ad-22 includes certain requirements related to financial risk management by CCPs, including requirements to measure credit exposures to members and to use margin requirements to limit these exposures. These requirements are general in nature and provide registered clearing agencies flexibility to measure credit risk and set margin. Within the bounds of Rule 17Ad-22, CCPs may employ models and choose parameters that they conclude are appropriate to the markets they serve.

The current practices of registered clearing agencies that provide CCP services generally include the following procedures: (1) Measuring credit exposures at least once a day; (2) setting margin coverage at a 99% confidence level over some set period; (3) using risk-based models; (4) establishing a fund that mutualizes losses of defaults by one or more participants that exceed margin coverage; (5) maintaining sufficient financial resources to withstand the default of at least the largest participant family,

144

and (6), in the case of security-based swap transactions, maintaining enough financial resources to be able to withstand the default of their two largest participant families.

145

144

See, e.g.,

IMF, Publication of Financial Sector Assessment Program Documentation—Detailed Assessment of Observance of the National Securities Clearing Corporation's Observance of the CPSS-IOSCO Recommendations for Central Counterparties, at 10 (May 2010),

available at

http://www.imf.org/external/pubs/ft/scr/2010/cr10129.pdf

(assessing NSCC's observance of Recommendation 5 from the RCCP that a CCP should maintain sufficient financial resources to withstand, at a minimum, the default of a participant to which it has the largest exposure in extreme but plausible market conditions; also noting that NSCC began evaluating itself against this standard in 2009 and has backtesting results to support that it maintained sufficient liquidity to cover the failure of the largest affiliated family 99.98% of the time during the period from January through April 2009); IMF, Publication of Financial Sector Assessment Program Documentation—Detailed Assessment of Observance of the Fixed Income Clearing Corporation—Government Securities Division's Observance of the CPSS-IOSCO Recommendations for Central Counterparties, at 9-10 (2010),

available at

http://www.imf.org/external/pubs/ft/scr/2010/cr10130.pdf

(finding that FICC's Government Securities Division observed the requirement to maintain enough financial resources to meet the default of its largest participant in extreme but plausible market conditions).

145

See, e.g.,

CFTC-SEC Staff Roundtable on Clearing of Credit Default Swaps, at 123 (Oct. 2010),

available at

http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsubmission7_102210-transcrip.pdf

(Stan Ivanov of ICE stating, “[A]t ICE we look at two simultaneous defaults of the two biggest losers upon extreme conditions. . . .”);

see also

ICE, CDS Client Clearing Overview, at 8 (Aug. 2013),

available at

https://www.theice.com/publicdocs/clear_credit/ICE_Clear_Credit_Client_Clearing_Overview.pdf

(noting that the guaranty fund covers the simultaneous default of the two largest clearing members); CME Rulebook, Ch. 8H, Rule 8H07,

available at

http://www.cmegroup.com/rulebook/CME/I/8H/8H.pdf

i. Credit Risk

Rule 17Ad-22(b)(1) requires a registered clearing agency that provides CCP services to establish, implement, maintain and enforce written policies and procedures reasonably designed to measure their credit exposures at least once per day.

146

Several CCPs have policies and procedures designed to require measuring credit exposures multiple times per day.

146

See

17 CFR 240.17Ad-22(b)(1).

Rule 17Ad-22(b)(3) requires a registered clearing agency that provides CCP services to establish, implement, maintain and enforce written policies and procedures reasonably designed to maintain sufficient financial resources to withstand, at a minimum, a default by the participant family to which it has the largest exposure in extreme but plausible market conditions.

147

It further requires CCPs for security-based swaps to establish, implement, maintain and enforce written policies and procedures reasonably designed to maintain additional financial resources sufficient to withstand, at a minimum, a default by the two participant families to which it has the largest exposures in extreme but plausible market conditions, in its capacity as a CCP for security-based swaps.

148

Accordingly, the Commission notes that Rule 17Ad-22(b)(3) imposes a “cover two” requirement on CCPs for security-based swaps in order to protect such CCPs from the extreme jump-to-default risk and nonlinear payoffs associated with the nature of the financial products they clear and the participants in the markets they serve. Meanwhile, CCPs that clear products other than security-based swaps are subject to a “cover one” requirement.

149

Rule 17Ad-22(b)(3) also states that such policies and procedures may provide that additional financial resources be maintained by the CCP in combined or separately maintained funds.

150

147

See

17 CFR 240.17Ad-22(b)(2).

148

See id.

149

See

CCA Standards adopting release,

supra

note 7, at 105-112 (discussing the requirements for “cover one” and “cover two”).

150

See id.

Under existing rules, CCPs collect contributions from their members for the purpose of establishing guaranty or clearing funds to mutualize losses under extreme but plausible market conditions. Currently, the guaranty funds or clearing funds consist of liquid assets and their sizes vary depending on a number of factors, including the products the CCP clears and the characteristics of CCP members. In particular, the guaranty funds for CCPs that clear security-based swaps are relatively larger, as measured by the size of the fund as a percentage of the total and largest exposures, than the guaranty or clearing funds maintained by CCPs for other financial instruments. CCPs generally take the liquidity of collateral into account when determining member obligations. Applying haircuts to assets posted as margin, among other things, mitigates the liquidity risk associated with selling margin assets in the event of a participant default.

ICC recently modified its policies and procedures related to stress testing frameworks indicating that the modifications were designed to ensure that it meets regulatory requirements under Rule 17Ad-22(b)(3).

151

See

Self-Regulatory Organizations; ICE Clear Credit LLC; Notice of Filing of Amendment 1 and Order Approving Proposed Rule Change, as modified by Amendment 1 Thereto, to Update and Formalize the ICC Stress Testing Framework, Exchange Act Release No. 34-77982 (June. 2, 2016).

ii. Collateral and Margin

Rule 17Ad-22(b)(2) requires a registered clearing agency that provides CCP services to establish, implement, maintain and enforce written policies and procedures reasonably designed to use margin requirements to limit their exposures to participants.

152

This margin can also be used to reduce a CCP's losses in the event of a participant default.

152

See

17 CFR 240.17Ad-22(b)(2).

Registered clearing agencies that provide CCP services take positions as substituted counterparties once their

trade guarantee goes into effect. Therefore, if a counterparty whose obligations the registered clearing agency has guaranteed defaults, the covered clearing agency may face market risk, which can take one of two forms. First, a covered clearing agency is subject to the risk of movement in the market prices of the defaulting member's open positions. Where a seller defaults and fails to deliver a security, the covered clearing agency may need to step into the market to buy the security in order to complete settlement and deliver the security to the buyer. Similarly, where a buyer defaults, the covered clearing agency may need to meet payment obligations to the seller. Thus, in the interval between when a member defaults and when the covered clearing agency must meet its obligations as a substituted counterparty in order to complete settlement, market price movements expose the covered clearing agency to market risk. Second, the covered clearing agency may need to liquidate non-cash margin collateral posted by the defaulting member. The covered clearing agency is therefore exposed to the risk that erosion in market prices of the collateral posted by the defaulting member could result in the covered clearing agency having insufficient financial resources to cover the losses in the defaulting member's open positions.

To manage their exposure to market risk resulting from fulfilling a defaulting member's obligations, registered clearing agencies compute margin requirements using inputs such as portfolio size, volatility, and sensitivity to various risk factors that are likely to influence security prices. Moreover, since the size of price movements is, in part, a function of time, registered clearing agencies may limit their exposure to market risk by marking participant positions to market daily and, in some cases, more frequently. CCPs also use similar factors to determine haircuts applied to assets posted by members in satisfaction of margin requirements. To manage market risk associated with collateral liquidation, CCPs consider the current prices of assets posted as collateral and price volatility, asset liquidity, and the correlation of collateral assets and a member's portfolio of open positions. Further, because CCPs need to value their margin assets in times of financial stress, their rulebooks may include features such as market-maker domination charges that increase clearing fund obligations regarding open positions of members in securities in which the member serves as a dominant market maker. The reasoning behind this charge is that, should a member default, liquidity in products in which the member makes markets may fall, leaving these positions more difficult to liquidate for non-defaulting participants.

Rule 17Ab-22(b)(2) also requires a registered clearing agency that provides CCP services to establish, implement, maintain and enforce written policies and procedures reasonably designed to provide for risk-based models and parameters to set margin requirements.

153

The generally recognized standard for such models and parameters is, under normal market conditions, price movements that produce changes in exposures that are expected to breach margin requirements or other risk controls only 1% of the time (

i.e.,

at a 99% confidence interval) over a designated time horizon.

154

Currently, CCPs use margin models to ensure coverage at a single-tailed 99% confidence interval. Losses beyond this level are typically covered by the CCP's guaranty fund. This standard comports with existing international standards for bank capital requirements, which require banks to measure market risks at a 99% confidence interval when determining regulatory capital requirements.

155

153

See id.

154

See

17 CFR 240.17Ad-22(a)(4).

155

See

BCBS, International Convergence of Capital Measurement and Capital Standards: A Amended Framework (June 2004),

available at

http://www.bis.org/publ/bcbs107.pdf

;

see also

Darryll Hendricks & Beverly Hirtle, New Capital Rule Signals Supervisory Shift (Secondary Mortgage Mkts, Sept. 1998),

available at

http://www.freddiemac.com/finance/smm/july98/pdfs/hen_hirt.pdf

Prior to this standard, banks measured value-at-risk using a range of confidence intervals from 90-99%.

See

BCBS, An Internal Model-Based Approach to Market Risk Capital Requirements, at 12 (Apr. 1995),

available at

http://www.bis.org/publ/bcbs17.pdf

. When determining the minimum quantitative standards for calculating risk measurements, the BCBS noted then the importance of specifying “a common and relatively conservative confidence level,” choosing the 99% confidence interval over other less conservative measures.

See id.

Since its adoption in 1998, the standard has become a generally recognized practice of banks to quantify credit risk as the worst expected loss that a portfolio might incur over an appropriate time horizon at a 99% confidence interval.

See

Kenji Nishiguchi, Hiroshi Kawai & Takanori Sazaki, Capital Allocation and Bank Management Based on the Quantification of Credit Risk, at 83 (FRBNY Econ. Policy Rev., Oct. 1998),

available at

http://www.newyorkfed.org/research/epr/98v04n3/9810nish.pdf

; Jeff Aziz & Narat Charupat, Calculating Credit Exposure and Credit Loss: A Case Study, at 34 (Sept. 1998),

available at

http://www.bis.org/bcbs/ca/alrequse98.pdf

Rule 17Ad-22(b)(2) also requires a registered clearing agency that provides CCP services to establish, implement, maintain and enforce written policies and procedures reasonably designed to review such margin requirements and the related risk-based models and parameters at least monthly.

156

CCPs are accordingly required to establish a model validation process that evaluates the adequacy of margin models, parameters, and assumptions. Additionally, CCPs are required to establish, implement, maintain and enforce written policies and procedures reasonably designed to provide for an annual model validation consisting of evaluating the performance of the CCPs' margin models and the related parameters and assumptions associated with such models by a qualified person who is free from influence from the persons responsible for the development or operation of the models being validated.

157

156

See

17 CFR 240.17Ad-22(b)(2).

157

See

17 CFR 240.17Ad-22(b)(4).

To meet resource requirements under Rule 17Ad-22(b)(3),

158

ICC recently adjusted its risk calculations and models to account for accumulation of wrong-way risk at the portfolio level.

159

158

See

Self-Regulatory Organizations; ICE Clear Credit LLC; Notice of Filing of Proposed Rule Change, Exchange Act Release No. 34-75119 (June 8, 2015) at note 7.

159

See

Self-Regulatory Organizations; ICE Clear Credit LLC; Notice of Filing of Amendments No. 1 and 2 and Order Granting Accelerated Approval of Proposed Rule Change, as Modified by Amendments No. 1 and 2, to Revise the ICC Risk Management Framework, Exchange Act Release No. 34-75887 (Sept. 10, 2015).

iii. Liquidity Risk

In addition to credit risk and the aforementioned market risk, registered clearing agencies also face liquidity or funding risk. Currently, covered clearing agencies have varying degrees of formality with respect to their standards and practices relating to liquidity shortfalls. To complete the settlement process, registered clearing agencies that employ netting rely on incoming payments from participants in net debit positions in order to make payments to participants in net credit positions. If a participant does not have sufficient funds or securities in the form required to fulfill a payment obligation immediately when due (even though it may be able to pay at some future time), or if a settlement bank is unable to make an incoming payment on behalf of a participant, a registered clearing agency may face a funding shortfall. Such funding shortfalls may occur due to a lack of financial resources necessary to meet delivery or payment obligations, however even registered clearing agencies that do hold sufficient financial resources to meet their obligations may not carry those in the

form required for delivery or payments to participants.

A registered clearing agency that provides CCP services may hold additional financial resources to cover potential funding shortfalls in the form of collateral. As noted above, CCPs may take the liquidity of collateral into account when determining member obligations. Applying haircuts to illiquid assets posted as margin mitigates the liquidity risk associated with selling margin assets in the event of participant default. Some registered CCPs also arrange for liquidity provision from other financial institutions using lines of credit. Additionally, some registered clearing agencies enter into prearranged funding agreements with their members pursuant to their rules. For example, members of one registered clearing agency are obligated to enter into repurchase agreements against securities that would have been delivered to a defaulting member.

ICC has disclosed a liquidity management program that includes stress testing of liquidity requirements to meet settlement obligations over a range of different horizons under extreme but plausible market conditions.

160

ICC also reports that its liquidity resources include cash, U.S. Treasury securities, and committed repurchase agreements.

161

160

See

ICE Clear Credit Disclosure Framework, note 145

supra,

at 18.

161

See id.

c. Settlement

Rule 17Ad-22(d)(5) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to employ money settlement arrangements that eliminate or strictly limit the clearing agency's settlement bank risks and require funds transfers to the clearing agency to be final when effected.

162

Rule 17Ad-22(d)(12) further requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to ensure that final settlement occurs no later than the end of the settlement day.

163

Accordingly, for example, certain registered clearing agencies have policies and procedures that provide for final settlement of securities transfers no later than the end of the day of the transaction. Rule 17Ad-22(d)(15) also requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to state to its participants the clearing agency's obligations with respect to physical deliveries and identify and manage the risks from these obligations.

164

162

See

17 CFR 240.17Ad-22(d)(5).

163

See

17 CFR 240.17Ad-22(d)(12).

164

See

17 CFR 240.17Ad-22(d)(15).

d. CSDs and Exchange-of-Value Settlement Systems

i. CSDs

Rule 17Ad-22(d)(10) requires a registered clearing agency that provides CSD services to establish, implement, maintain and enforce written policies and procedures reasonably designed to maintain securities in an immobilized or dematerialized form for transfer by book entry to the greatest extent possible. Currently, some securities, such as mutual fund securities and government securities, are issued primarily or solely on a dematerialized basis. Dematerialized shares do not exist as physical certificates but are held in book entry form in the name of the owner (which, where the master security holder file is not maintained on paper due to the use of technology, is also referred to as electronic custody). Other types of securities may be issued in the form of one or more physical security certificates, which could be held by the CSD to facilitate immobilization. Alternatively, securities may be held by the beneficial owner in record name, in the form of book-entry positions, where the issuer offers the ability for a security holder to hold through the direct registration system. Whether immobilization occurs at the CSD or through direct registration depends on what is provided for by the issuer.

When a trade occurs, the depository's accounting system credits one participant account and debits another participant account. Transactions between counterparties in dematerialized shares are recorded by the registrar responsible for maintaining the paper or electronic register of security holders, such as by a transfer agent, and reflected in customer accounts.

Registered CSDs currently reconcile ownership positions in securities against CSD ownership positions on the security holders list daily, mitigating the risk of unauthorized creation or deletion of shares.

ii. Exchange-of-Value Settlement Systems

Rule 17Ad-22(d)(13) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to eliminate principal risk by linking securities transfers to funds transfers in a way that achieves delivery versus payment,

165

which serves to link obligations by conditioning the final settlement of one upon the final settlement of the other. One registered clearing agency, for example, operates a Model 2 DVP system that provides for gross securities transfers during the day followed by an end-of-day net funds settlement. Under the rules governing the clearing agency's system, the delivering party in a DVP transaction is assured that it will be paid for the securities once they are credited to the receiving party's securities account. DVP eliminates the risk that a buyer would lose the purchase price of a security purchased from a defaulting seller or that a seller would lose the sold security without receiving payment for a security acquired by a defaulting buyer.

165

See

17 CFR 240.17Ad-22(d)(13);

see also

Clearing Agency Standards adopting release,

supra

note 31, at 66256.

For example, one registered clearing agency has rules governing its continuous net settlement (“CNS”) system, under which it becomes the counterparty for settlement purposes at the point its trade guarantee attaches, thereby assuming the obligation of its members that are receiving securities to receive and pay for those securities, and the obligation of members that are delivering securities to make the delivery. Unless the clearing agency has invoked its default rules, it is not obligated to make those deliveries until it receives from members with delivery obligations deliveries of such securities; rather, deliveries that come into CNS ordinarily are promptly redelivered to parties that are entitled to receive them through an allocation algorithm. Members are obligated to take and pay for securities allocated to them in the CNS process. These rules also provide mechanisms to allow receiving members a right to receive high priority in the allocation of deliveries, and also permit a member to buy-in long positions that have not been delivered to it by the close of business on the scheduled settlement date.

e. Default Management

i. Participant-Default Rules and Procedures

Rule 17Ad-22(d)(11) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to make key aspects of its default procedures publicly available and establish default procedures that ensure it can take timely action to contain losses and

liquidity pressures and to continue meeting its obligations in the event of a participant default. The rules of registered clearing agencies typically state what constitutes a default, identify whether the board or a committee of the board may make that determination, and describe what steps the clearing agency may take to protect itself and its members. In this regard, registered clearing agencies typically attempt, among other things, to hedge and liquidate a defaulting member's positions. Rules of registered clearing agencies also include information about the allocation of losses across available financial resources. The registered clearing agency the Commission anticipates will fall within the definition of covered clearing agency as a result of the proposed amendments conduct testing of its default procedures at least annually, including participation by clearing members.

ii. Segregation and Portability

No rule under the Exchange Act currently requires a registered clearing agency through its written policies and procedures to enable the portability of positions of a member's customers and the collateral provided in connection therewith. Additionally, no rule under the Exchange Act currently requires a registered clearing agency through its written policies and procedures to protect the positions of a member's customers from the default or insolvency of the member.

166

See

CCA Standards adopting release,

supra

note 7, at 189-193 (discussing existing rules applicable to registered broker-dealers that address customer security positions and funds in cash securities and listed option markets, thereby promoting segregation and portability at the broker-dealer level).

ICC maintains rules and procedures that facilitate the segregation and portability of positions of a clearing member's customers and the collateral provided to it with respect to those positions.

167

ICC's rules are designed to comply with the CFTC's requirements addressing custody, segregation, and investment of customer margin provided in respect of cleared swaps. ICC thus segregates customer funds pursuant to the “legally segregated, operationally commingled” (“LSOC”) model found under Part 22 of the CFTC Regulations.

168

Under the LSOC model if a customer defaults, ICC may apply clearing member funds and defaulting customer funds to cover losses, but may not use collateral provided by non-defaulting customers. Additionally, under ICC rules, each clearing member that carries customer positions must, upon request of a customer, transfer or novate that customers position to one or more other clearing members designated by the customer, subject to the consent of the transferee; satisfaction by the customer of any margin requirements imposed by the transferor on any positions remaining at the transferor; and the completion of all required transfer documentation.

169

167

See

ICE Clear Credit Disclosure Framework,

supra

note 145, at 26.

168

See id.

169

See id.

f. General Business and Operational Risk Management

i. General Business Risk

Business risk refers to the risks and potential losses arising from a registered clearing agency's administration and operation as a business enterprise that are neither related to member default nor separately covered by financial resources designated to mitigate credit or liquidity risk. While Rule 17Ad-22 sets forth requirements for registered clearing agencies to identify, monitor, and mitigate or eliminate a broad array of risks through written policies and procedures, no rule under the Exchange Act expressly requires a registered clearing agency through its written policies and procedures to identify, monitor, and manage general business risk or to meet a capital requirement. Registered clearing agencies currently have certain internal controls in place to mitigate business risk. Some clearing agencies, for instance, have policies and procedures that identify an auditor who is responsible for examining accounts, records, and transactions, as well as other duties prescribed in the audit program. Other registered clearing agencies allow members to collectively audit the books of the clearing agency on an annual basis, at their own expense.

ICC maintains financial resources that, pursuant to regulation as a SIDCO by the CFTC,

170

are sufficient to cover twelve months of operating costs.

171

ICC has publicly stated its belief that an orderly wind-down of its business would take between six and twelve months.

172

170

See

17 CFR 39.39(d).

171

See

ICE Clear Credit Disclosure Framework,

supra

note 145, at 27.

172

See id.

ii. Custody and Investment Risks

Registered clearing agencies face default risk from commercial banks that they use to effect money transfers among participants, to hold overnight deposits, and to safeguard collateral. Rule 17Ad-22(d)(3) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to (i) hold assets in a manner that minimizes risk of loss or delay in its access to them; and (ii) invest assets in instruments with minimal credit, market, and liquidity risks.

173

Registered clearing agencies currently seek to minimize the risk of loss or delay in access by holding assets that are highly liquid (

e.g.,

cash, U.S. Treasury securities, or securities issued by a U.S. government agency) and by engaging banks to custody the assets and facilitate settlement. Typically, registered clearing agencies take steps to ensure that assets held in custody are protected from claims from the custodian's creditors using trust accounts or equivalent arrangements. Additionally, designated clearing agencies may have access to credit at a Federal Reserve Bank or other relevant central bank, to the extent such services are not already available as the result of other laws and regulations.

174

173

See

17 CFR 240.17Ad-22(d)(3).

174

See

CCA Standards adopting release,

supra

note 7, at 159 (discussing the requirements under Rule 17Ad-22(e)(7)(iii)).

ICC's Treasury Operations Policies and Procedures provide for the use of a Federal Reserve Account, the use of a committed repurchase facility and outside investment managers to invest guarantee fund and margin cash.

175

See

“Self-Regulatory Organizations; ICE Clear Credit LLC; Order Approving Proposed Rule Change to Revise the ICC Treasury Operations Policies and Procedures” Exchange Act Release No. 34-74456 (Mar. 6, 2015).

iii. Operational Risk

Operational risk refers to a broad category of potential losses arising from deficiencies in internal processes, personnel, and information technology. Registered clearing agencies face operational risk from both internal and external sources, including human error, system failures, security breaches, and natural or man-made disasters. Rule 17Ad-22(d)(4) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to identify sources of operational risk and to minimize those risks through the development of appropriate systems, controls and procedures.

176

It also requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to (i) implement systems that are reliable and secure, and have adequate, scalable capacity; and (ii) have business continuity plans that

allow for timely recovery of operations and fulfillment of a clearing agency's obligations.

177

176

See

17 CFR 240.17Ad-22(d)(4).

177

See id.

As a result, registered clearing agencies have developed and currently maintain plans to ensure the safeguarding of securities and funds, the integrity of automated data processing systems, and the recovery of securities, funds, or data under a variety of loss or destruction scenarios.

178

These plans may include turning operations over to a secondary site that is located a sufficient distance from the primary location to ensure a distinct geographic risk profile. In addition, registered clearing agencies generally maintain an internal audit department to review the adequacy of their internal controls, procedures, and records with respect to operational risks. Some registered clearing agencies also engage independent accountants to perform an annual study and evaluation of the internal controls relating to their operations.

179

178

Many of these practices had been previously developed pursuant to other Commission requirements.

See

CCA Standards adopting release,

supra

note 7, at 19-21, 181-182, 294-295 (discussing related requirements under Regulation SCI).

179

See, e.g.,

NSCC, Assessment of Compliance with the CPSS/IOSCO Recommendations for Central Counterparties (Nov. 2011),

available at

http://www.dtcc.com/legal/policy-and-compliance.aspx

The Commission adopted Regulation SCI in November 2014, in part, to reduce the occurrence of systems issues, and enhance resiliency when systems problems do occur at certain SROs, such as registered clearing agencies. In particular, Regulation SCI requires that clearance and settlement systems be designed to accomplish end-of-day settlement on the day of a wide-scale disruption. Accordingly, Regulation SCI requires registered clearing agencies to have policies and procedures in place for business continuity as well as disaster recovery plans that include maintaining sufficiently resilient and geographically diverse backup and recovery capabilities that are reasonably designed to achieve two-hour resumption of critical SCI systems following a wide-scale disruption.

180

See

17 CFR 242.1001(a)(2).

g. Access

i. Access and Participation Requirements

Rule 17Ad-22(b)(5) requires a registered clearing agency that provides CCP services to establish, implement, maintain and enforce written policies and procedures reasonably designed to provide the opportunity for a person that does not perform any dealer or security-based swap dealer services to obtain membership on fair and reasonable terms at the clearing agency to clear securities for itself or on behalf of other persons.

181

Rule 17Ad-22(b)(6) requires a registered clearing agency that provides CCP services to establish, implement, maintain and enforce written policies and procedures reasonably designed to have membership standards that do not require participants to maintain a portfolio of any minimum size or a minimum transaction volume.

182

Rule 17Ad-22(b)(7) requires a registered clearing agency that provides CCP services to establish, implement, maintain and enforce written policies and procedures reasonably designed to provide a person that maintains net capital equal or greater than $50 million with the ability to obtain membership at the clearing agency, provided such persons are able to comply with reasonable membership standards, with higher net capital requirements permissible subject to Commission approval.

183

181

See

17 CFR 240.17Ad-22(b)(5).

182

See

17 CFR 240.17Ad-22(b)(6).

183

See

17 CFR 240.17Ad-22(b)(7).

In addition, Rule 17Ad-22(d)(2) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to require participants to have sufficient financial resources and robust operational capacity to meet obligations arising from participation in the clearing agency, have procedures in place to monitor that participation requirements are met on an ongoing basis, and have participation requirements that are objective and publicly disclosed, and permit fair and open access.

184

Typically, a registered clearing agency's rulebook requires applicants for membership to provide certain financial and operational information prior to being admitted as a member and on an ongoing basis as a condition of continuing membership. Registered clearing agencies review this information to ensure that the applicant has the operational capability to meet the other demands of interfacing with the clearing agency. In particular, registered clearing agencies typically require that an applicant demonstrate that it has adequate personnel capable of handling transactions with the clearing agency and adequate physical facilities, books and records, and procedures to fulfill its anticipated commitments to, and to meet the operational requirements of, the clearing agency and other members with necessary promptness and accuracy. As a result, an applicant needs to demonstrate that it has adequate personnel capable of handling transactions with the clearing agency and adequate physical facilities, books and records, and procedures to conform to conditions or requirements in these areas that the clearing agency reasonably may deem necessary for its protection. Registered clearing agencies have published these requirements on their Web sites.

184

See

17 CFR 240.17Ad-22(d)(2).

Registered clearing agencies use an ongoing monitoring process to help them understand relevant changes in the financial condition of their members and to mitigate credit risk exposure of the clearing agency to its members. The risk management staff analyzes financial statements filed with regulators, as well as information obtained from other SROs and gathered from various financial publications, so that the clearing agency may evaluate, for instance, whether members maintain sufficient financial resources and robust operational capacity to meet their obligations as participants in the clearing agency pursuant to existing Rule 17Ad-22(d)(2)(i).

Table 1 contains membership statistics for the registered clearing agencies likely to be affected by the proposed rule amendment.

185

Current membership generally reflects features of cleared markets. The decision to become a clearing member depends on the products being cleared, the structure of these asset markets as well as the current state of regulation for cleared markets.

185

See supra

Part III.B.

ii. Tiered Participation Arrangements

Tiered participation arrangements occur when clearing members (direct participants) provide access to clearing services to third parties (indirect participants). No rule under the Exchange Act currently requires a registered clearing agency through its written policies and procedures to identify, monitor, and manage material risks arising from tiered participation arrangements. The Commission understands, however, that certain registered clearing agencies have policies and procedures currently in place in order to identify, monitor, or manage such arrangements. Specifically, such clearing agencies rely on information gathered from, and distributed by, direct participants in order to manage these tiered participation arrangements. For example, under some covered clearing

agencies' rules, direct participants generally have the responsibility to indicate to the clearing agency whether a transaction submitted for clearing represents a proprietary or customer position. Such rules further require direct participants to calculate, and notify the clearing agency of the value of, each customer's collateral. Direct participants also communicate with indirect participants regarding the clearing agency's margin and other requirements.

ICC does not currently have tiered participation arrangements.

186

See

ICE Clear Credit Disclosure Framework,

supra

note 145, at 32.

iii. Links

Rule 17Ad-22(d)(7) requires a registered clearing agency to establish, implement, maintain and enforce written policies and procedures reasonably designed to evaluate the potential sources of risks that can arise when the clearing agency establishes links either cross-border or domestically to clear or settle trades, and ensure that the risks are managed prudently on an ongoing basis.

187

See

17 CFR 240.17Ad-22(d)(7).

Each registered clearing agency is linked to other

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