Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities

Federal RegisterOct 25, 2022

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-95763; File No. S7-23-22]

RIN 3235-AN09

Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) proposes to amend the standards applicable to covered clearing agencies for U.S. Treasury securities to require that such covered clearing agencies have written policies and procedures reasonably designed to require that every direct participant of the covered clearing agency submit for clearance and settlement all eligible secondary market transactions in U.S. Treasury securities to which it is a counterparty. In addition, the Commission proposes additional amendments to the Covered Clearing Agency Standards, with respect to risk management. These requirements are designed to protect investors, reduce risk, and increase operational efficiency. Finally, the Commission proposes to amend the broker-dealer customer protection rule to permit margin required and on deposit with covered clearing agencies for U.S. Treasury securities to be included as a debit in the reserve formulas for accounts of customers and proprietary accounts of broker-dealers (“PAB”), subject to certain conditions.

DATES:

Comments should be received on or before December 27, 2022.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (

https://www.sec.gov/rules/submitcomments.htm

); or

• Send an email to

rule-comments@sec.gov.

Please include File Number S7-23-22 on the subject line.

Paper Comments

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

All submissions should refer to File Number S7-23-22. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's website (

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

). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Operating conditions may limit access to the Commission's Public Reference Room. All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment 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 our website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at

www.sec.gov

to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Elizabeth L. Fitzgerald, Assistant Director, Office of Clearance and Settlement at (202) 551-5710, Division of Trading and Markets; Michael A. Macchiaroli, Associate Director, at (202) 551-5525; Thomas K. McGowan, Associate Director, at (202) 551-5521; Randall W. Roy, Deputy Associate Director, at (202) 551-5522; Raymond Lombardo, Assistant Director, at 202-551-5755; Sheila Dombal Swartz, Senior Special Counsel, at (202) 551-5545; or Nina Kostyukovsky, Special Counsel, at (202) 551-8833, Office of Broker-Dealer Finances, Division of Trading and Markets; U.S. Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

First, the Commission proposes to amend 17 CFR 240.17Ad-22(e)(18) (“Rule 17Ad-22(e)(18)”) to require covered clearing agencies that provide central counterparty (“CCP”) services for U.S. Treasury securities to establish, implement, maintain and enforce written policies and procedures reasonably designed, as applicable, to establish objective, risk-based and publicly disclosed criteria for participation, which require that any direct participant of such a covered clearing agency submit for clearance and settlement all the eligible secondary market transactions in U.S. Treasury securities to which such direct participant is a counterparty. In addition, these policies and procedures must be reasonably designed, as applicable, to identify and monitor the covered clearing agency's direct participants' submission of transactions for clearing as required above, including how the covered clearing agency would address a failure to submit transactions. These policies and procedures must also be reasonably designed, as applicable, to ensure that the covered clearing agency has appropriate means to facilitate access to clearance and settlement services of all eligible secondary market transactions in U.S. Treasury securities, including those of indirect participants, which policies and procedures the board of directors of such U.S. Treasury securities CCA must review annually. The Commission would define eligible secondary market transactions as a secondary market transaction in U.S. Treasury securities of a type accepted for clearing by a registered covered clearing agency that is either a repurchase or reverse repurchase agreement collateralized by U.S. Treasury securities, in which one of the counterparties is a direct participant, or certain specified categories of cash purchase or sale transactions. Second, the Commission proposes to amend 17 CFR 240.17Ad-22(e)(6)(i) (“Rule 17Ad-22(e)(6)(i)”) to require that a covered clearing agency providing central counterparty services for U.S. Treasury securities establish, implement, maintain and enforce written policies and procedures reasonably designed to, as applicable, calculate, collect, and hold margin for transactions in U.S. Treasury securities submitted on behalf of an indirect participant separately from those submitted on behalf of the direct participant. In connection with these proposed amendments, the Commission is also proposing to include as part of 17 CFR 240.17Ad-22(a) (“Rule 17Ad-22(a)”) definitions of “U.S. Treasury security,” “central bank,” “eligible secondary market transaction,” “international financial institution,” and “sovereign entity.” Third, the Commission proposes to amend 17 CFR 240.15c3-3a (“Rule 15c3-3a”) to permit margin required and on deposit at covered clearing agencies providing central counterparty services for U.S. Treasury securities to be included by broker-dealers as a debit in the customer and PAB reserve formulas, subject to certain conditions.

Table of Contents

I. Introduction

A. The Commission's Role in Facilitating the National System of Clearance and Settlement for Securities, Including Treasury Securities

B. The Role of Central Counterparty Services

C. Existing CCP Services for the U.S. Treasury Market

D. Proposal

E. Current Regulatory and Industry Discussions Regarding the U.S. Treasury Market

II. Background

A. Current U.S. Treasury Market Structure and Central Clearing Within That Structure

1. Cash Market

2. U.S. Treasury Repo Market

B. Current Regulatory Framework

1. Clearing Agency Regulation Under Section 17A of the Exchange Act

2. The Broker-Dealer Customer Protection Rule

III. Proposed Amendments

A. U.S. Treasury Securities CCA Membership Requirements

1. Requirement To Clear Eligible Secondary Market Transactions

2. Eligible Secondary Market Transactions

a. Repo Transactions

b. Purchases and Sales of U.S. Treasury Securities

i. IDB Transactions

ii. Other Cash Transactions

c. Exclusions From the Definition of an Eligible Secondary Market Transaction

i. Official Sector Exclusions From the Membership Proposal

ii. Natural Person Exclusion

3. How the Membership Proposal Facilitates Prompt and Accurate Clearance and Settlement in the U.S. Treasury Market

4. Policies and Procedures Regarding Direct Participants' Transactions

5. Request for Comment

F. Other Changes to Covered Clearing Agency Standards

1. Netting and Margin Practices for House and Customer Accounts

2. Facilitating Access to U.S. Treasury Securities CCAs

3. Request for Comment

G. Proposed Amendments to Rule15c3-3a

1. Proposal

2. Request for Comment

H. Compliance Date

IV. Economic Analysis

A. Broad Economic Considerations

B. Baseline

1. U.S. Treasury Securities

2. U.S. Treasury Repurchase Transactions

3. Central Clearing in the U.S. Treasury Securities Market

4. Clearing and Settlement by U.S. Treasury Securities Market Segment

a. Dealer-to-Customer Cash U.S. Treasury Securities Market (off-IDBs)

i. Bilateral Clearing

ii. Central Clearing

b. Cash U.S. Treasury Trades Through an IDB

i. Central Clearing

ii. Bilateral Clearing

iii. Hybrid Clearing

5. Margin Practices in U.S. Treasury Secondary Markets

6. Disruptions in the U.S. Treasury Securities Market

a. COVID-19 Shock of March 2020

b. September 2019 Repo Market Disruptions

c. October 2014 Flash Rally

7. Affected Persons

a. Covered Clearing Agencies for U.S. Treasury Securities: FICC

b. Direct Participants at U.S. Treasury Securities CCAs: FICC Netting Members

c. Interdealer Brokers (IDBs)

d. Other Market Participants

i. FICC Sponsored Members

ii. Other Market Participants That Are Not FICC Sponsored Members

e. Triparty Agent: Bank of New York Mellon

f. Custodian Banks/Fedwire Securities Service (FSS)

C. Analysis of Benefits, Costs, and Impact on Efficiency, Competition, and Capital Formation

1. Benefits

a. U.S. Treasury Securities CCA Membership Requirements

i. Scope of the Membership Proposal

ii. Application of the Membership Proposal to Repo Transactions

iii. Application of the Membership Proposal to Purchases and Sales of U.S. Treasury Securities

iv. Policies and Procedures Regarding Direct Participants' Transactions

b. Other Changes to Covered Clearing Agency Standards

i. Netting and Margin Practices for House and Customer Accounts

ii. Facilitating Access to U.S. Treasury Securities CCAs

c. Proposed Amendments to Rules 15c3-3 and 15c3-3a

2. Costs

a. Costs to FICC of the Membership Proposal

i. Costs Attendant to an Increase in CCLF

ii. Costs of the Membership Proposal in Terms of Increased Margining for Existing FICC Members

b. Costs to Non-FICC Members as a Result of the Membership Proposal

c. Other Changes to Covered Clearing Agency Standards

i. Netting and Margin Practices for House and Customer Accounts

ii. Facilitating Access to U.S. Treasury Securities CCAs

d. Proposed Amendments to Rules 15c3-3 and 15c3-3a

3. Effect on Efficiency, Competition, and Capital Formation

a. Efficiency

i. Price Transparency

ii. Operational and Balance Sheet Efficiency

b. Competition

c. Capital Formation

D. Reasonable Alternatives

1. Require U.S. Treasury Securities CCAs to Have Policies and Procedures Requiring Only IDB Clearing Members to Submit U.S. Treasury Securities Trades With Non-members for Central Clearing

2. Require U.S. Treasury Securities CCAs to Have Policies and Procedures Requiring the Submission of All Repurchase Agreements With No Change to Requirements for the Submission of Cash Transactions

3. Include All Cash Transactions Within the Scope of the Membership Proposal With Exceptions for Central Banks, Sovereign Entities, International Financial Institutions, and Natural Persons

4. Require U.S. Treasury Securities CCAs To Change CCA Access Provisions and Netting and Margin Practices for House and Customer Accounts and Rule 15c3-3

E. Request for Comment

V. Paperwork Reduction Act

A. Proposed Amendment to Rule 17Ad-22(e)(6)

B. Proposed Amendment to Rule 17Ad-22(e)(18)(iv)

C. Request for Comment

VI. Small Business Regulatory Enforcement Fairness Act

VII. Regulatory Flexibility Act Certification

A. Clearing Agencies

Statutory Authority

I. Introduction

A. The Commission's Role in Facilitating the National System of Clearance and Settlement for Securities, Including Treasury Securities

In 1975, Congress added section 17A to the Securities Exchange Act of 1934 (“Exchange Act”) as part of the Securities Acts Amendments of 1975, which directed the Commission to facilitate the establishment of (i) a national system for the prompt and accurate clearance and settlement of securities transactions (other than exempt securities which typically includes U.S. Treasury securities, except as discussed further below), and (ii) linked or coordinated facilities for clearance and settlement of securities transactions.

In so doing, Congress made several findings related to the importance of the clearance and settlement of securities transactions and the relationship of clearance and settlement of securities transactions to the protection of investors.

The Commission carries out its statutory mandate in this regard through its supervision and regulation of registered clearing agencies, which may provide

different services to the market including, but not limited to, central counterparty services.

See

15 U.S.C. 78q-1; Report of the Senate Committee on Banking, Housing & Urban Affairs, S. Rep. No. 94-75, at 4 (1975) (stating the Committee's belief that “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)(1)(A) (finding that “[t]he prompt and accurate clearance and settlement of securities transactions . . . are necessary for the protection of investors and persons facilitating transactions by and acting on behalf of investors”);

see also

15 U.S.C. 78q-1(B), (C), and (D) (setting forth additional findings related to the national system of clearance and settlement).

In 1986, Congress passed the Government Securities Act, which, among other things, authorized the Commission to regulate clearing agencies engaged in the clearance and settlement of government securities transactions, including those in U.S. Treasury securities, by providing that government securities would not be considered exempt securities for purposes of section 17A of the Exchange Act.

This inclusion of government securities, including U.S. Treasury securities, within the Commission's authority for the national system of clearance and settlement underscores the importance of, among other things, the U.S. Treasury market.

Government Securities Act of 1986, section 102(a); 15 U.S.C. 78c(a)(12)(B)(i).

U.S. Treasury securities play a critical and unique role in the U.S. and global economy, serving as a significant investment instrument and hedging vehicle for investors, a risk-free benchmark for other financial instruments, and an important mechanism for the Federal Reserve's implementation of monetary policy.

Consequently, confidence in the U.S. Treasury market, and in its ability to function efficiently, even in times of stress, is critical to the stability of the global financial system.

See, e.g.,

Staffs of the U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission, and U.S. Commodity Futures Trading Commission,

Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report,

at 1 (Nov. 2021),

available at https://home.treasury.gov/system/files/136/IAWG-Treasury-Report.pdf

(“Inter-Agency Working Group for Treasury Market Surveillance (“IAWG”) Report”); Staffs of the U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission, and U.S. Commodity Futures Trading Commission,

Joint Staff Report: The U.S. Treasury Market on October 15, 2014,

at 1, 8 (2015),

available at https://home.treasury.gov/system/files/276/joint-staff-report-the-us-treasury-market-on-10-15-2014.pdf

(“Joint Staff Report”). These reports represent the views of Commission and other Federal regulatory staff. The reports are not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved the content in the reports. These reports, like all staff reports, have no legal force or effect: they do not alter or amend applicable law, and they create no new or additional obligations for any person.

Group of Thirty Working Group on Treasury Market Liquidity,

U.S. Treasury Markets: Steps Toward Increased Resilience,

at 1 (2021),

available at https://group30.org/publications/detail/4950

(“G-30 Report”).

B. The Role of Central Counterparty Services

The Commission defines a CCP as a clearing agency that interposes itself between the counterparties to securities transactions, acting functionally as the buyer to every seller and the seller to every buyer.

The Commission previously has stated that registered clearing agencies that provide CCP services can help increase the safety and efficiency of securities trading, while reducing costs.

These benefits could be particularly significant in times of market stress, as CCPs would mitigate the potential for a single market participant's failure to destabilize other market participants or the financial system more broadly, and/or reduce the effects of misinformation and rumors.

A CCP also addresses concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of the counterparties.

Further, the Commission has recognized that “the centralization of clearance and settlement activities at covered clearing agencies allows market participants to reduce costs, increase operational efficiency, and manage risks more effectively.”

However, the Commission has also recognized that this centralization of activity at clearing agencies makes risk management at such entities a critical function, as reflected in the adoption of additional enhanced Commission requirements, discussed further in section II.B.1

infra.

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

Covered Clearing Agency Standards Proposing Release, Exchange Act Release No. 71699 (Mar. 12, 2014), 79 FR 29507, 29510 (May 27, 2014) (“CCA Standards Proposing Release”).

See, e.g.,

Order Granting Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection with Request of Liffe Administration and Management and Lch.Clearnet Ltd. Related to Central Clearing of Credit Default Swaps, and Request for Comments, Exchange Act Release No. 59164 (Dec. 24, 2008), 74 FR 139, 140 (Jan. 2, 2009).

Id.

CCA Standards Proposing Release,

supra

note 7, 79 FR at 29587.

See, e.g., id.

at 29510.

Since the enactment of the Securities Acts Amendments of 1975, the Commission has had extensive experience with the risks associated with bilateral clearing and the benefits of centralized clearance and settlement systems for securities. Based on its experience supervising registered clearing agencies, the Commission believes that, over the years, the clearing agencies registered with the Commission that provide CCP services have reduced costs of securities trading, and have been carefully structured, consistent with the Commission's statutory and regulatory authority, to provide the benefits of clearing, such as multilateral netting

and centralized default management, while also managing and reducing counterparty risk. To further the establishment of linked and coordinated facilities for clearance and settlement of securities transactions, the Commission adopted 17 CFR 240.17Ad-22, which sets forth standards for clearing agencies registered with the Commission. These standards address all aspects of a CCP's operations, including financial risk management, operational risk, default management, governance, and participation requirements.

With multilateral netting, the CCP is able to offset obligations involving the same security across multiple counterparties, thereby reducing the overall amount of securities and funds that need to be delivered.

See

notes 251 and 252 and accompanying text

infra

for additional explanation, as well as an example, of multilateral netting.

C. Existing CCP Services for the U.S. Treasury Market

Currently, only one registered clearing agency, the Fixed Income Clearing Corporation (“FICC”),

provides CCP services for U.S. Treasury securities transactions, including cash transactions and repurchase transactions (“repos”), which are described more fully in section II.A

infra.

As a CCP, FICC novates transactions between two counterparties, effectively becoming the buyer to every seller and the seller to every buyer, and guarantees the settlement of the novated transactions. This means that FICC is exposed to a number of risks arising from such transactions, including counterparty credit risk.

Because the vast majority of counterparty credit risk is managed bilaterally in the U.S. Treasury market, as discussed more fully in section III.A.3

infra,

FICC may face potential contagion risk arising from transactions entered into by one of its participants, even if those transactions are not centrally cleared.

Currently, most of

FICC's direct participants are banks and broker-dealers, while other types of entities, such as registered investment companies, investment advisers, and asset owners, rely on FICC's direct participants to access central clearing indirectly and are not direct participants of FICC.

FICC has two divisions. The Government Securities Division generally provides clearing services for U.S. Treasury securities, and the Mortgage-Backed Securities Division, generally provides clearing services for mortgage-backed securities. For purposes of this release, references to FICC will refer to FICC's Government Securities Division (“GSD”), unless otherwise indicated.

For purposes of this release, an entity providing CCP services in the U.S. Treasury market and therefore serving as a covered clearing agency will be referred to as a “U.S. Treasury securities CCA.”

Counterparty credit risk refers to the potential for a market participant's counterparty to a given transaction to default on the transaction and therefore the market participant will not receive either the cash or securities necessary to settle the transaction.

See, e.g.,

U.S. Department of the Treasury,

A Financial System That Creates Economic Opportunities Capital Markets,

at 81 (Oct. 2017),

available at https://home.treasury.gov/system/files/

136/A-Financial-System-Capital-Markets-FINAL-FINAL.pdf

(“2017 Treasury Report”) (discussing issues caused by fragmented central clearing with respect to [interdealer brokers] at FICC and describing this contagion risk and stating “if a large [proprietary trading firm] with unsettled trading volumes were to fail, the failure could introduce risk to the market and market participants”).

As the only entity providing CCP services in the U.S. Treasury market, if FICC were unable to provide its CCP services for any reason, it could have a broad and severe impact on the overall U.S. economy, as the Financial Stability Oversight Council (“FSOC”) recognized when it designated FICC as a systemically important financial market utility in 2012.

Designation of an entity as a systemically important financial market utility brings heightened risk management requirements and additional regulatory supervision, by both its primary regulator and the Board of Governors of the Federal Reserve System.

The Commission relied, in part, on this heightened supervisory authority under Title VIII of the Dodd-Frank Act to adopt the Covered Clearing Agency Standards.

Financial Stability Oversight Council,

2012 Annual Report,

Appendix A,

available at http://www.treasury.gov/initiatives/fsoc/Documents/2012%20Annual%20Report.pdf

(“FSOC 2012 Annual Report”).

Id.

at 119. The Commission previously has acknowledged that the Clearing Supervision Act reflects Congressional recognition that multilateral clearing or settlement activities “may reduce risks for clearing participants and the broader financial system,” but also may create “new risks that require multilateral payment, clearing or settlement activities to be well-designed and operated in a safe and sound manner.” Exchange Act Release No. 64017 (Mar. 3, 2014), 76 FR 14472, 14474 (Mar. 16, 2011) (“Clearing Agency Standards Proposing Release”);

see also

12 U.S.C. 5462(9), 5463(a)(2). The Commission also recognized that the Clearing Supervision Act is designed, in part, to provide a regulatory framework to help address such risk management issues, “which is generally consistent with the Exchange Act requirement that clearing agencies be organized in a manner so as to facilitate prompt and accurate clearance and settlement, safeguard securities and funds and protect investors.”

Id.

Over the past several years, both the private and public sectors have observed the increased volume of U.S. Treasury secondary market transactions that are not centrally cleared.

However, because data for these transactions is subject to different and incomplete reporting requirements, it is difficult to quantify this activity. The best available estimates at this time are those developed by private sector organizations. In particular, the Treasury Market Practice Group

estimates that only 13 percent of the overall volume in U.S. dollars of U.S. Treasury cash transactions were centrally cleared as of the first half of 2017, and that an additional 19 percent were what the TMPG refers to as “hybrid” clearing, that is, executed on an interdealer broker platform (as described in section II.A.1

infra

) in which one counterparty is a member of a CCA and submits its transaction with the interdealer broker for central clearing, while the other counterparty is not a member of a CCA and bilaterally clears its transaction with the interdealer broker.

In addition, the G-30 Report estimated that “roughly 20 percent of commitments to settle U.S. Treasury security trades are cleared through FICC.”

See, e.g.,

IAWG Report,

supra

note 4, at 5-6; 2017 Treasury Report,

supra

note 15, at 81; Joint Staff Report,

supra

note 4, at 36-37.

The Treasury Market Practices Group (“TMPG”) is a group of “market professionals committed to supporting the integrity and efficiency of the Treasury, agency debt, and agency mortgage-backed securities markets.”

See https://www.newyorkfed.org/TMPG/index.html.

The TMPG is sponsored by the Federal Reserve Bank of New York.

Id.

TMPG,

White Paper on Clearing and Settlement in the Secondary Market for U.S. Treasury Securities,

at 12 (July 2019),

available at https://www.newyorkfed.org/medialibrary/Microsites/tmpg/files/CS_FinalPaper_071119.pdf

(“TMPG White Paper”). These estimates use FR2004 data, which are reports provided to the Federal Reserve Bank of New York regarding primary dealer market activity in U.S. Government securities, covering the first half of 2017 and are based on various assumptions specified in the TMPG White Paper.

See also

FR2004, Government Securities Dealer Reports,

available at https://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDZq2f74T6b1cw.

G-30 Report,

supra

note 5, at 11.

See also

IAWG Report,

supra

note 4, at 5-6; Joint Staff Report,

supra

note 4, at 36-37.

Both the TMPG and the Group of 30 also identified the significant risks associated with bilateral clearing.

For example, the TMPG stated that “[b]ilateral clearing involves varying risk management practices that are less uniform and less transparent to the broader market and may be less efficient with regard to netting exposures and use of collateral as compared to central clearing. An increase in bilaterally cleared trades likely increases the aggregate liquidity risk in the clearing and settlement process because, unlike a CCP, bilateral arrangements may not have the discipline of establishing a contingent liquidity risk framework or uniform requirements for emergency liquidity.”

TMPG White Paper,

supra

note 21, at 3.

Id.

D. Proposal

The Commission believes that a covered clearing agency, including one that provides CCP services,

is most effective when its participation standards enable the CCA to understand and control the risks presented by its direct participants because such standards are an important tool to limit the potential for member defaults and, as a result, losses to non-defaulting members in the event of a member default, thereby protecting the securities market as a whole.

For example, when proposing the Covered Clearing Agency Standards in Rule 17Ad-22 in 2014, the Commission explained that “[a]ppropriate minimum operational, legal, and capital requirements for membership that are maintained and enforced through the supervisory practices of a clearing agency help to ensure all members will be reasonably capable of meeting their various obligations to the clearing agency in stressed market conditions and upon member default.”

To that end, the Commission's rules governing the participation requirements of a CCA are designed to achieve that goal. Rule 17Ad-22(e)(18) requires that a CCA establish, implement, maintain and enforce written policies and procedures reasonably designed to, as applicable, establish objective, risk-based and publicly disclosed criteria for participation,

and 17 CFR 240.17Ad-22(e)(19) (“Rule 17Ad-22(e)(19)”) requires a CCA to maintain written policies and procedures reasonably designed to, as applicable, identify, monitor and manage the material risks to it arising from arrangements in which firms that are indirect participants in the CCA rely on the services provided to it by direct participants to access the CCA's payment, clearing, or settlement facilities.

Hereafter covered clearing agencies are referred to as “CCAs.”

Covered Clearing Agency Standards Adopting Release, Exchange Act Release No. 78961 (Sep. 28, 2016), 81 FR 70786, 70839 (Oct. 13, 2016) (“CCA Standards Adopting Release”);

see also

CCA Standards Proposing Release,

supra

note 7, 79 FR at 29552.

CCA Standards Proposing Release,

supra

note 7, 79 FR at 29552;

see also

CCA Standards Adopting Release,

supra

note 25, 81 FR at 70839.

17 CFR 240.17Ad-22(e)(18).

17 CFR 240.17Ad-22(e)(19).

As described more fully in section III

infra,

the increasing volume of non-centrally cleared transactions in U.S. Treasury securities may render U.S. Treasury securities CCAs more susceptible to member defaults from risks outside the transactions cleared by the CCA, and as a result the

Commission is proposing to amend Rule 17Ad-22(e)(18). In particular, and as set forth more fully below, the Commission believes that amending Rule 17Ad-22(e)(18) to require the CCAs to address their direct participants' non-centrally cleared transactions, both for repos and certain categories of cash transactions, will help reduce contagion risk to the CCA and bring the benefits of central clearing to more transactions involving U.S. Treasury securities, thereby lowering overall systemic risk in the market. As discussed further in section III.A.3

infra,

these benefits include centralized default management, increased multilateral netting, and reduction of settlement fails. The Commission also believes that increasing the volume of transactions submitted for central clearing is consistent with promoting the prompt and accurate clearance and settlement of securities transactions.

See

Self-Regulatory Organizations; Fixed Income Clearing Corporation; Order Granting Approval of a Proposed Rule Change Relating to Trade Submission Requirements and Pre-Netting, Exchange Act Release No. 51908 (June 22, 2005), 70 FR 37450 (June 29, 2005) (describing a rule designed to bring additional transactions into FICC's netting system as “clearly designed to promote the prompt and accurate clearance and settlement of those transactions and to preserve the safety and soundness of the national clearance and settlement system.”).

The Commission also proposes to impose additional requirements on how U.S. Treasury securities CCAs calculate, collect, and hold margin posted on behalf of indirect participants (

i.e.,

customers) who rely on the services of a direct participant (

i.e.,

the member of the U.S. Treasury securities CCA) to access the CCA's services. As set forth in more detail below, the Commission believes that such requirements also will improve the risk management practices at U.S. Treasury securities CCAs and incentivize and facilitate additional central clearing in the U.S. Treasury market, thereby lowering systemic risk. Individually and collectively, these two proposals should further incentivize and facilitate additional central clearing.

In addition, the Commission recognizes that the proposal could cause a substantial increase in the margin broker-dealers must post to a U.S. Treasury securities CCA resulting from their customers' cleared U.S. Treasury securities positions. Currently, broker-dealers are not permitted to include a debit in the customer reserve formula equal to this amount of margin or, more generally, to use customer cash or customer fully paid or excess margin securities to meet a margin requirement. To address this, the Commission proposes an amendment that, subject to certain conditions, would allow the broker-dealer to include a debit in the customer or PAB reserve formula when delivering customer cash or U.S. Treasury securities to meet the margin requirement at an entity providing CCP services in the U.S. Treasury market.

E. Current Regulatory and Industry Discussions Regarding the U.S. Treasury Market

In normal market conditions, the U.S. Treasury market has functioned extremely well. Even under stress, the market generally has been highly resilient. However, several episodes in the U.S. Treasury market, including the “flash rally” of 2014, the U.S. Treasury repo market stress of September 2019, and the COVID-19 shock of March 2020, have raised questions about the U.S. Treasury market's continued capacity to absorb shocks and what factors may be limiting the resilience of the U.S. Treasury market under stress.

Although different in their scope and magnitude, these events all generally involved dramatic increases in market price volatility and/or sharp decreases in available liquidity.

G-30 Report,

supra

note 5, at 1; IAWG Report,

supra

note 4, at 7; Peter Ryan and Robert Toomey,

Improving Capacity and Resiliency in US Treasury Markets: Part I

(Mar. 24, 2021),

available at https://www.sifma.org/resources/news/improving-capacity-and-resiliency-in-us-treasury-markets-part-1/.

A number of recent publications and industry discussions have considered the overall structure and resilience of the U.S. Treasury market, in light of, among other things, the market events noted above.

The Commission believes that, although this proposal will not, by itself, necessarily prevent future market disruptions, the proposal will support efficiency by reducing counterparty credit risk and improving transparency, as discussed in section III.A.3

infra.

Moreover, the Commission believes that enhancing the membership standards applicable to U.S. Treasury securities CCAs should improve the resilience of such CCAs by expanding their ability to manage the risks arising from direct participants who currently engage in non-centrally cleared transactions away from the CCA. In addition, the Commission believes that the risk management standards should facilitate and incentivize additional central clearing, thereby bringing the benefits of additional central clearing to the market for U.S. Treasury securities.

See generally

IAWG Report,

supra

note 4; G-30 Report,

supra

note 5; Nellie Liang & Patrick Parkinson,

Enhancing Liquidity of the U.S. Treasury Market Under Stress

(Dec. 16, 2020),

available at https://www.brookings.edu/wp-content/uploads/2020/12/WP72_Liang-Parkinson.pdf

(“Liang & Parkinson”).

The Commission believes that these changes should lower systemic risk in the U.S. Treasury market by increasing the volume of transactions that are subject to central clearing and ensuring that those additional transactions are subject to standardized risk management. The Commission also believes that increased central clearing would provide greater transparency into the market and could, potentially facilitate all-to-all trading.

The Commission believes that these benefits arising from central clearing should help improve the functioning of the U.S. Treasury market.

See

notes 184 through 186

infra.

II. Background

A. Current U.S. Treasury Market Structure and Central Clearing Within That Structure

U.S. Treasury securities are direct obligations of the U.S. Government issued by the U.S. Department of the Treasury (“Treasury Department”). Market participants use U.S. Treasury securities as an investment instrument and as a hedging vehicle, among other things. For example, U.S. Treasury securities are often used as collateral in lending arrangements or as margin on other financial transactions. The Treasury Department issues several different types of securities, including U.S. Treasury bills, nominal coupons notes and bonds, Floating Rate Notes, and Treasury Inflation-Protected Securities (“TIPS”). For each U.S. Treasury security type, the most recently issued (“on-the-run”) securities are the most liquid in the secondary market.

Market participants commonly refer to securities issued prior to “on-the-run” securities as “off-the-run” securities. Trading in off-the-run U.S. Treasury securities has always been less active than on-the-run trading, and price discovery primarily occurs in on-the-run securities.

On-the-run U.S. Treasury securities are the most recently auctioned nominal coupon securities. These securities are referred to as “on-the-run” starting the day after they are auctioned. Nominal coupon securities pay a fixed semi-annual coupon and are currently issued at original maturities of 2, 3, 5, 7, 10, 20, and 30 years. These standard maturities are commonly referred to as “benchmark” securities because the yields for these securities are used as references to price a number of private market transactions.

Joint Staff Report,

supra

note 4, at 35-36. Price discovery also occurs in when-issued trading of U.S. Treasury securities prior to and on the day of the auction (pre- on-the-run trading).

See

note 38

infra.

The U.S. Treasury market consists of two components: the primary market

and the secondary market. The primary market is where the Treasury Department auctions securities (

i.e.,

debt) to the public through a competitive bidding process and subsequently issues awarded securities to finance the Federal government.

These U.S. Treasury securities, which are issued after the auction, are marketable securities and are primarily sold to financial institutions. Financial institutions designated by the Federal Reserve Bank of New York as “primary dealers” are expected to submit competitive bids on a pro-rata basis and participate meaningfully in all U.S. Treasury auctions at reasonably competitive rates or yields.

U.S. Treasury securities are typically issued a few days after the auction and trade on the secondary market.

The secondary market is where the subsequent trading of U.S. Treasury securities occurs. The secondary market includes the “cash market,” for outright purchases and sales of securities, and the repo market, where one participant sells a U.S. Treasury security to another participant, along with a commitment to repurchase the security at a specified price on a specified later date.

This proposal applies to the secondary market for U.S. Treasury securities.

TMPG White Paper,

supra

note 21, at 6. The Federal Reserve Bank of New York serves as fiscal agent for the U.S. Treasury in conducting auctions of marketable U.S. Treasury debt.

See

12 U.S.C. 391.

See

Federal Reserve Bank of New York, Administration of Relationships with Primary Dealers,

available at https://www.newyorkfed.org/markets/primarydealers.html.

Specifically, primary dealers are required to be either (1) a registered broker-dealer or government securities broker-dealer, which is approved as a member of the Financial Industry Regulatory Authority, Inc. and has net regulatory capital of at least $50 million, or (2) a state or federally chartered bank or savings association (or a state or federally licensed branch or agency of a foreign bank) that is subject to bank supervision and maintains at least $1 billion in Tier 1 capital.

Id.

Thus, for those primary dealers that fall into the former category, they are a subset of the broader set of registered broker-dealers or government securities broker-dealers, which may also participate in the Treasury market, as discussed further in section II.A.1 and 2

infra.

The Treasury Department typically announces a new security that it intends to sell several days before the auction at which it is first sold to the public. These securities begin trading after announcement before the auction and through issuance, which occurs a few days after the auction. Such trading is known generally as “when-issued” trading; however, in the timeframe between the announcement and the auction, such trading is known as when-issued and referred to as such by market participants, but after the auction and before issuance, the securities are typically referred to simply as on-the-run, consistent with market practice. Michael Fleming, Or Shachar, and Peter Van Tassel, Treasury Market When-Issued Trading Activity, Liberty Street Economics (Nov. 30, 2020) (“Fleming, Shachar, and Van Tassel”),

available at https://libertystreeteconomics.newyorkfed.org/2020/11/treasury-market-when-issued-trading-activity/.

See

IAWG Report,

supra

note 4, at 3. The secondary market also includes the market for U.S. Treasury futures, which trade electronically on the Chicago Board of Trade, a designated contract market operated by the Chicago Mercantile Exchange (“CME”) Group, and centrally cleared by CME Clearing. U.S. Treasury futures are generally regulated by the U.S. Commodity Futures Trading Commission and are not the subject of this proposal.

1. Cash Market

The cash market has two main components: the interdealer market and the dealer-to-customer market. In the interdealer market, dealers primarily trade with each other and with principal trading firms (“PTFs”), which trade as principals for their own accounts. The majority of trading in the interdealer market in on-the-run U.S. Treasury securities occurs on electronic platforms operated by interdealer brokers that bring together buyers and sellers anonymously using order books or other trading facilities supported by advanced electronic trading technology (“IDBs”).

These IDBs are generally direct participants of a U.S. Treasury securities CCA and stand as counterparties to both sides of each trade on their platforms.

Joint Staff Report,

supra

note 4, at 11, 35-36.

IAWG Report,

supra

note 4, at 21.

Typically, an IDB provides a trading facility for multiple buyers and sellers for U.S. Treasury securities to enter orders at specified prices and sizes and have these orders displayed to all users on an anonymous basis. The trading facility automatically matches these orders according to priority and execution rules that are programmed in the trading facility. When a match occurs and a trade is executed, the IDB then books two trades, with the IDB functioning as the principal to each respective counterparty, thereby protecting the anonymity of each party, but taking on credit risk from each counterparty.

TMPG White Paper,

supra

note 21, at 6.

Although the term “IDB” is sometimes used to refer to platforms that may provide voice-based or other trading technology, as referenced below, in this release, consistent with existing commentary on the U.S. Treasury markets, the term IDB does not encompass platforms that provide voice-based or other non-anonymous methods of bringing together buyers and sellers of U.S. Treasury securities and instead refers to electronic platforms providing anonymous methods of bringing together buyers and sellers.

The entities referred to as IDBs here are encompassed in the ATSs category in the tables set forth in section IV.B.1

infra

because of the way that such IDBs are categorized in TRACE. Specifically, the “ATS” category in TRACE encompasses these IDBs. By contrast, the non-ATS IDBs category in TRACE encompasses the voice-based or other non-anonymous methods of bringing together buyers and sellers, which are also sometimes referred to as interdealer brokers by market participants.

The majority of trades in the interdealer markets are trades in “on-the-run” issues. The majority of interdealer trading for off-the-run U.S. Treasury securities occurs via bilateral transactions through traditional voice-assisted brokers and electronic trading platforms offering various protocols to bring together buyers and sellers, although some interdealer trading in off-the-run U.S. Treasury securities does occur on IDBs that anonymously bring together buyers and sellers.

Joint Staff Report,

supra

note 4, at 35.

Until the mid-2000s, most interdealer trading occurred between primary dealers, who are required to be members of FICC, and was centrally cleared.

However, in recent years, much of the trading on IDBs, in terms of number of trades and overall volume, has been conducted by PTFs.

G-30 Report,

supra

note 5, at 9; IAWG Report,

supra

note 4, at 5-6; TMPG White Paper,

supra

note 21, at 6.

see also

FICC Rule 3A,

supra

note 47. For general information and statistics regarding the Sponsored Service, see

https://www.dtcc.com/clearing-services/ficc-gov/sponsored-membership,

as well as section IV.B.7.d.i

infra

. The Sponsored Service also allows the submission of cash transactions; however, at this time, the service is generally used only for U.S. Treasury repo transactions.

See

FICC Rule 3A, section 2(a) and (b),

supra

note 47; FICC Membership Listing,

available at https://www.dtcc.com/-/media/Files/Downloads/client-center/FICC/Mem-GOV-by-name.xlsx

(identifying Sponsoring Members as those with Omnibus accounts).

See

FICC Rule 3A, section 3(a),

supra

note 47; FICC Sponsored Membership Listing,

available at https://www.dtcc.com/client-center/ficc-gov-directories.

For non-centrally cleared triparty U.S. Treasury repos, cash lenders (

e.g.,

money market funds) provide financing to cash borrowers (

e.g.,

dealers). The parties agree to the terms of a trade and arrange for a clearing bank to facilitate settlement. Like non-centrally cleared bilateral repos, at least one party to the transaction is not a FICC member. While the clearing bank provides a triparty platform to help facilitate the movement of cash and securities among accounts of counterparties to the transaction, it does not itself become a counterparty to the transactions and does not guarantee either counterparty's performance of its obligations. Collateral posted to the triparty platform generally cannot be repledged outside the platform, thereby protecting against settlement fails.

See generally

Reference Guide to U.S. Repo and Securities Lending Markets (Nov. 9, 2015),

available at https://www.financialresearch.gov/working-papers/files/OFRwp-2015-17_Reference-Guide-to-U.S.-Repo-and-Securities-Lending-Markets.pdf.

For centrally cleared U.S. Treasury triparty repos, the parties are FICC members that submit agreed-upon trade details to FICC for central clearing through FICC's General Collateral Finance (“GCF”) Repo Service. Unlike centrally cleared bilateral repos, these triparty repos are settled on the clearing bank's triparty platform. Like centrally cleared bilateral repos, centrally cleared triparty repos are novated by FICC, and FICC acts as a CCP for these transactions, including by collecting margin pursuant to its margin methodology for such transactions. Until recently, centrally cleared triparty repos were only conducted through the GCF Repo Service,

i.e.,

between two direct members of FICC. However, in September 2021, FICC introduced its Sponsored General Collateral Service (“Sponsored GC Service”), which enables centrally cleared triparty repos between a sponsored member and its sponsoring member.

The Sponsored GC Service accepts general collateral in a number of generic CUSIPs, and though U.S. Treasury securities are among the general collateral types acceptable in the Sponsored GC Service, other types of collateral including agency and mortgage backed securities are acceptable for use as collateral as well.

Each type of eligible collateral for the Sponsored GC Service is assigned its own generic CUSIP number, and security types are not mixed.

Exchange Act Release No. 92808 (Aug. 30, 2021), 86 FR 49580 (Sept. 3, 2021). Currently, the Bank of New York Mellon operates the triparty platform that facilitates trades conducted via the GCF Repo Service and Sponsored GC Service.

See generally

DTCC Sponsored General Collateral Service,

available at https://www.dtcc.com/-/media/Files/Downloads/Clearing-Services/FICC/GOV/SponsoredGC-FS-INTL.pdf.

Id.

B. Current Regulatory Framework

1. Clearing Agency Regulation Under Section 17A of the Exchange Act

As noted above, when Congress added section 17A to the Exchange Act as part of the Securities Acts Amendments of 1975, it directed the Commission to facilitate the establishment of (i) a national system for the prompt and accurate clearance and settlement of securities transactions (other than exempt securities) and (ii) linked or coordinated facilities for clearance and settlement of securities transactions,

and the Government Securities Act of 1986 specifically included government securities within the scope of section 17A.

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.

The Commission's ability to achieve these goals is based upon the regulation of clearing agencies registered with the Commission.

Specifically, section 17A of the Exchange Act provides the Commission with authority to adopt rules as necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the Exchange Act (including for the prompt and accurate clearance and settlement of securities transactions) and prohibits a clearing agency from engaging in any activity in contravention of such rules and regulations.

See supra

note 1.

Specifically, the Government Securities Act, among other things, authorized the Commission to regulate clearing agencies engaged in the clearance and settlement of government securities transactions, including those in U.S. Treasury securities, by providing that government securities would no longer be exempt securities for purposes of section 17A of the Exchange Act. Government Securities Act of 1986, section 102(a); 15 U.S.C. 78c(a)(12)(B)(i).

See

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

Under the Exchange Act and the regulations thereunder, any entity providing such central counterparty services is a clearing agency and must register with the Commission or seek an exemption from registration. 15 U.S.C. 78q-1(b)(1);

see also

17 CFR 240.17Ad-22(a)(5) (defining covered clearing agency).

See

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

see also

15 U.S.C. 78q-1(b)(2) (referring to the Commission's ability to adopt rules with respect to the application of section 17A). As noted above, for purposes of section 17A, the Commission's authority over securities also includes “government securities.” Government Securities Act of 1986, section 102(a); 15 U.S.C. 78c(a)(12)(B)(i).

The Commission has exercised its broad authority to prescribe requirements for the prompt and accurate clearance and settlement of securities transactions and the safeguarding of securities and funds described above. As noted above, most recently, the Commission has promulgated the Covered Clearing Agency standards, which apply to, among others, any entity providing CCP services, such as FICC.

These standards require covered clearing agencies, to establish, implement, maintain, and enforce written policies and procedures reasonably designed to, as applicable, meet certain minimum standards regarding, among other things, operations, governance, and risk management.

See supra

note 7 and 17 CFR 240.17Ad-22(a)(5).

The Commission has previously explained that membership requirements like those set forth in this proposal are an important tool for managing a clearing agency's risk. For example, when proposing the Covered Clearing Agency Standards, the Commission explained that appropriate minimum membership requirements, including operational, legal, and capital requirements, help “to ensure all

members will be reasonably capable of meeting their various obligations to the clearing agency in stressed market conditions and upon member default.”

Clearing agency member defaults have long been a concern of the Commission; the Commission has explained that “[m]ember defaults challenge the safe functioning of a clearing agency by creating credit and liquidity risks, which impede a clearing agency's ability to settle securities transactions in a timely manner.”

CCA Standards Proposing Release,

supra

note 7, 79 FR at 29552;

see also

CCA Standards Adopting Release,

supra

note 25, 81 FR at 70839 (stating that the use of risk-based criteria helps to protect investors “by limiting the participants of a covered clearing agency to those for which the covered clearing agency has assessed the likelihood of default.”).

CCA Standards Proposing Release,

supra

note 7, 79 FR at 29552.

In particular, among other things, the Covered Clearing Agency Standards impose requirements on a covered clearing agency with respect to both its direct and indirect participants. For example, Rule 17Ad-22(e)(18) requires that covered clearing agencies establish implement, maintain and enforce written policies and procedures reasonably designed to, as applicable, establish objective, risk-based and publicly disclosed criteria for participation.

Similarly, Rule 17Ad-22(e)(19) imposes requirements on a covered clearing agency to maintain written policies and procedures reasonably designed to, as applicable, identify, monitor and manage the risks posed to it by indirect participants.

17 CFR 240.17Ad-22(e)(18).

17 CFR 240.17Ad-22(e)(19).

2. The Broker-Dealer Customer Protection Rule

Rule 15c3-3 is designed “to give more specific protection to customer funds and securities, in effect forbidding brokers and dealers from using customer assets to finance any part of their businesses unrelated to servicing securities customers;

e.g.,

a firm is virtually precluded from using customer funds to buy securities for its own account.”

To meet this objective, Rule 15c3-3 requires a broker-dealer that maintains custody of customer securities and cash (a “carrying broker-dealer”) to take two primary steps to safeguard these assets, as described below. The steps are designed to protect customers by segregating their securities and cash from the broker-dealer's proprietary business activities. If the broker-dealer fails financially, the customer securities and cash should be readily available to be returned to the customers. In addition, if the failed broker-dealer is liquidated in a formal proceeding under the Securities Investor Protection Act of 1970 (“SIPA”), the customer securities and cash should be isolated and readily identifiable as “customer property” and, consequently, available to be distributed to customers ahead of other creditors.

See

Exchange Act Release No. 21651 (Jan. 11, 1985), 50 FR 2690, 2690 (Jan. 18, 1985).

See also

Exchange Act Release No. 9856 (Nov. 10, 1972), 37 FR 25224, 25224 (Nov. 29, 1972).

See

15 U.S.C. 78aaa

et seq.

At a high level, in such a liquidation, SIPA would provide for the appointment of a trustee, who is required to return customer name securities to customers of the debtor (15 U.S.C. 78fff-2(c)(2)), distribute the fund of “customer property” ratably to customers (15 U.S.C. 78fff-2(b)), and pay, with money from the SIPC fund, remaining customer net equity claims, to the extent provided by the Act (15 U.S.C. 78fff-2(b) and 3(a)). Customer property is defined as “cash and securities (except customer name securities delivered to the customer) at any time received, acquired, or held by or for the account of a debtor from or for the securities accounts of a customer, and the proceeds of any such property transferred by the debtor, including property unlawfully converted.” 15 U.S.C. 7

lll

(4).

The first step required by Rule 15c3-3 is that a carrying broker-dealer must maintain physical possession or control over customers' fully paid and excess margin securities.

Control means the broker-dealer must hold these securities in one of several locations specified in Rule 15c3-3 and free of liens or any other interest that could be exercised by a third-party to secure an obligation of the broker-dealer.

Permissible locations include a clearing corporation and a bank, as defined in section 3(a)(6) of the Exchange Act.

See

17 CFR 240.15c3-3(d). The term “fully paid securities” means all securities carried for the account of a customer in a cash account as defined in Regulation T (12 CFR 220.1

et seq.

), as well as securities carried for the account of a customer in a margin account or any special account under Regulation T that have no loan value for margin purposes, and all margin equity securities in such accounts if they are fully paid: provided, however, that the term fully paid securities does not apply to any securities purchased in transactions for which the customer has not made full payment. 17 CFR 240.15c3-3(a)(3). The term “margin securities” means those securities carried for the account of a customer in a margin account as defined in section 4 of Regulation T (12 CFR 220.4), as well as securities carried in any other account (such accounts referred to as “margin accounts”) other than the securities referred to in paragraph (a)(3) of Rule 15c3-3. 17 CFR 240.15c3-3(a)(4). The term “excess margin securities” means those securities referred to in paragraph (a)(4) of Rule 15c3-3 carried for the account of a customer having a market value in excess of 140% of the total of the debit balances in the customer's account or accounts encompassed by paragraph (a)(4) of Rule 15c3-3 which the broker-dealer identifies as not constituting margin securities. 17 CFR 240.15c3-3(a)(5).

See

17 CFR 240.15c3-3(c). Customer securities held by the carrying broker-dealer are not assets of the firm. Rather, the carrying broker-dealer holds them in a custodial capacity, and the possession and control requirement is designed to ensure that the carrying broker-dealer treats them in a manner that allows for their prompt return.

Id.

The second step is that a carrying broker-dealer must maintain a reserve of funds or qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers.

The account must be titled “Special Reserve Bank Account for the Exclusive Benefit of Customers” (“customer reserve account”).

The amount of net cash owed to customers is computed weekly pursuant to a formula set forth in 17 CFR 240.15c3-3a (“Rule 15c3-3a”).

Under the formula, the broker-dealer adds up customer credit items and then subtracts from that amount customer debit items.

The credit items include credit balances in customer accounts and funds obtained through the use of customer securities.

The debit items include money owed by customers (

e.g.,

from margin lending), securities borrowed by the broker-dealer to effectuate customer short sales, and required margin posted to certain clearing agencies as a consequence of customer securities transactions.

If credit items exceed debit items, the net amount must be on deposit in the customer reserve account in the form of

cash and/or qualified securities.

A broker-dealer cannot make a withdrawal from the customer reserve account until the next computation and even then only if the computation shows that the reserve requirement has decreased.

The broker-dealer must make a deposit into the customer reserve account if the computation shows an increase in the reserve requirement.

17 CFR 240.15c3-3(e). The term “qualified security” is defined in Rule 15c3-3 to mean a security issued by the United States or a security in respect of which the principal and interest are guaranteed by the United States.

See

17 CFR 240.15c3-3(a)(6).

See

17 CFR 240.15c3-3(e)(1). The purpose of giving the account this title is to alert the bank and creditors of the broker-dealer that this reserve fund is to be used to meet the broker-dealer's obligations to customers (and not the claims of general creditors) in the event the broker-dealer must be liquidated in a formal proceeding.

Some broker-dealers perform a daily computation in order to more dynamically match the deposit requirement with the amount of net cash owed to customers. For example, a broker-dealer that performs a weekly computation generally cannot withdraw excess cash or U.S. Treasury securities from the account until the following week even if the value of the account assets exceeds the net cash owed to customers. Further, the rule permits certain broker-dealers to perform a monthly computation.

See

17 CFR 240.15c3-3(e)(3).

See id.

See

17 CFR 240.15c3-3a, Items 1-9. Broker-dealers are permitted to use customer margin securities to, for example, obtain bank loans to finance the funds used to lend to customers to purchase the securities. The amount of the bank loan is a credit in the formula because this is the amount that the broker-dealer would need to pay the bank to retrieve the securities. Similarly, broker-dealers may use customer margin securities to make stock loans to other broker-dealers in which the lending broker-dealer typically receives cash in return. The amount payable to the other broker-dealer on the stock loan is a credit in the formula because this is the amount the broker-dealer would need to pay the other broker-dealer to retrieve the securities.

See

17 CFR 240.15c3-3a, Items 10-14.

17 CFR 240.15c3-3(e). Customer cash is a balance sheet item of the carrying broker-dealer (

i.e.,

the amount of cash received from a customer increases the amount of the carrying broker-dealer's assets and creates a corresponding liability to the customer). The reserve formula is designed to isolate these broker-dealer assets so that an amount equal to the net liabilities to customers is held as a reserve in the form of cash or U.S. Government securities. The requirement to establish this reserve is designed to effectively prevent the carrying broker-dealer from using customer funds for proprietary business activities such as investing in securities. The goal is to put the carrying broker-dealer in a position to be able to readily meet its cash obligations to customers by requiring the firm to make deposits of cash and/or U.S. Government securities into the customer reserve account in the amount of the net cash owed to customers.

See

17 CFR 240.15c3-3(e).

The Rule 15c3-3a formula permits the broker-dealer to offset customer credit items only with customer debit items.

This means the broker-dealer can use customer cash to facilitate customer transactions such as financing customer margin loans and borrowing securities to make deliveries of securities customers have sold short.

The broker-dealer margin rules require securities customers to maintain a minimum level of equity in their securities accounts. In addition to protecting the broker-dealer from the consequences of a customer default, this equity serves to over-collateralize the customers' obligations to the broker-dealer. This buffer protects the customers whose cash was used to facilitate the broker-dealer's financing of securities purchases. For example, if the broker-dealer fails, the customer debits, because they generally are over-collateralized, should be attractive assets for another broker-dealer to purchase or, if not purchased by another broker-dealer, they should be able to be liquidated to a net positive equity.

The proceeds of the debits sale or liquidation can be used to repay the customer cash used to finance the customer obligations. This cash plus the funds and/or U.S. Treasury securities held in the customer reserve account should equal or exceed the total amount of customer credit items (

i.e.,

the total amount owed by the broker-dealer to its customers).

See

17 CFR 240.15c3-3a.

For example, if a broker-dealer holds $100 for customer A, the broker-dealer can use that $100 to finance a security purchase of customer B. The $100 the broker-dealer owes customer A is a credit in the formula and the $100 customer B owes the broker-dealer is a debit in the formula. Therefore, under the Rule 15c3-3a formula there would be no requirement to maintain cash and/or U.S. Government securities in the customer reserve account. However, if the broker-dealer did not use the $100 held in customer A's account for this purpose, there would be no offsetting debit and, consequently, the broker-dealer would need to have on deposit in the customer reserve account cash and/or U.S. Government securities in an amount at least equal to $100.

The attractiveness of the over-collateralized debits facilitates the bulk transfer of customer accounts from a failing or failed broker-dealer to another broker-dealer.

See

Exchange Act Release No. 18417 (Jan. 13, 1982), 47 FR 3512, 3513 (Jan. 25, 1982) (“The alternative approach is founded on the concept that, if the debit items in the Reserve Formula can be liquidated at or near their contract value, these assets along with any cash required to be on deposit under the [customer protection] rule, will be sufficient to satisfy all liabilities to customers (which are represented as credit items in the Reserve Formula).”).

As noted above, debit items in the Rule 15c3-3a formula include margin required and on deposit at certain clearing agencies. In particular, Item 13 of the Rule 15c3-3a formula identifies as a debit item margin required and on deposit with the Options Clearing Corporation for all option contracts written or purchased in accounts of securities customers.

Similarly, Item 14 of the Rule 15c3-3a formula identifies as a debit item margin related to security futures products written, purchased, or sold in accounts carried for security-based swap customers required and on deposit with a clearing agency registered with the Commission under section 17A of the Exchange Act

or a derivatives clearing organization (“DCO”) registered with the Commodities Futures Trading Commission under section 5b of the Commodity Exchange Act.

These debit items reflect the fact that customer options and security futures transactions that are cleared generate margin requirements in which the broker-dealer must deliver collateral to the Options Clearing Corporation in the case of options or a clearing agency or DCO in the case of security futures products. Further, 17 CFR 240.15c3-3b (“Rule 15c3-3b”) sets forth a customer reserve formula for security-based swaps.

Items 13 and 14 of this formula are identical to Items 13 and 14 of the Rule 15c3-3a formula. The Rule 15c3-3b formula also permits a debit item for margin related to cleared security-based swaps required and on deposit in a qualified clearing agency account at a clearing agency registered pursuant to section 17A of the Exchange Act.

See

17 CFR 240.15c3-3a, Item 13.

15 U.S.C. 78q-1.

7 U.S.C. 78q-1.

See also

Exchange Act Release No. 86175 (Jun. 21, 2019), 84 FR 43872, 43938-42 (Aug. 22, 2019) (adopting a reserve computation for security-based swaps that permits a debit for margin delivered to a security-based swap clearing agency).

Identifying the collateral delivered to the Options Clearing Corporation, a clearing agency, or a DCO as a debit item permits the broker-dealer to offset credit items, which reduces the amount of cash or qualified securities that must be deposited in the customer reserve account. In addition, under SIPA, “customer property” in a liquidation proceeding of a broker-dealer includes resources provided through the use or realization of customers' debit cash balances and other customer-related debit items as defined by the Commission by rule.

100

Therefore, by defining margin required and on deposit at the Options Clearing Corporation, a clearing agency, or a DCO as a debit item in Rule 15c3-3a, this property is available to the trustee to be used to return cash and securities to the failed broker-dealer's customers ahead of any other creditors of the broker-dealer.

100

See

15 U.S.C. 78

lll

(4)(B).

III. Proposed Amendments

A. U.S. Treasury Securities CCA Membership Requirements

For the reasons set forth below, the Commission believes that direct participants in a U.S. Treasury securities CCA not centrally clearing cash or repo transactions in U.S. Treasury securities creates contagion risk to CCAs clearing and settling in these markets, as well as to the market as a whole, and that this contagion risk can be ameliorated at least in part by increasing the number of such transactions that are centrally cleared. Currently, the only U.S. Treasury securities CCA requires its direct participants to submit for central clearing are their cash and repo transactions in U.S. Treasury securities with other direct participants.

101

However, the CCA's rules do not require its direct participants to submit either cash or repo transactions

102

with

persons who are not direct participants for central clearing. The Commission now proposes to amend the Covered Clearing Agency Standards to impose additional requirements for any covered clearing agency that provides central counterparty services for transactions in U.S. Treasury securities regarding membership in such CCA.

101

FICC Rule 2A, section 7(e),

supra

note 47 (requirement that FICC Netting Members submit to FICC all of their eligible trades with other Netting Members); FICC Rule 18, section 2 (similar requirement with regard to Repo transactions);

cf.

FICC Rule 3, section 8(e) (providing clearing requirement for FICC IDB Members).

102

With regard to Sponsored GC Repos, as noted above, these transactions can be secured with generic CUSIPs that include U.S. Treasury securities, and with other generic CUSIPs that include other securities, such as agency securities and mortgage backed securities. Because the Membership Proposal is limited to eligible secondary market transactions in U.S. Treasury

securities, it would not apply to Sponsored GC Repo generic CUSIPs that do not include U.S. Treasury securities.

Specifically, the proposal would require that such CCAs establish written policies and procedures reasonably designed to, as applicable, establish objective, risk-based, and publicly disclosed criteria for participation, which require that the direct participants of such covered clearing agency submit for clearance and settlement all eligible secondary market transactions to which they are a counterparty. As described in more detail below, an eligible secondary market transaction in U.S. Treasury securities would be defined to include:

• Repurchase agreements and reverse repurchase agreements in which one of the counterparties is a direct participant;

• Any purchases and sales entered into by a direct participant if the direct participant (A) brings together multiple buyers and sellers using a trading facility (such as a limit order book) and (B) is a counterparty to both the buyer and seller in two separate transactions; and

• Any purchases and sales of U.S. Treasury securities between a direct participant and a counterparty that is a registered broker-dealer, government securities dealer, or government securities broker, a hedge fund, or an account at a registered broker-dealer, government securities dealer, or government securities broker where such account may borrow an amount in excess of one-half of the value of the account or may have gross notional exposure of the transactions in the account that is more than twice the value of the account.

However, any transaction (both cash transactions and repos) where the counterparty to the direct participant of the CCA is a central bank, sovereign entity, international financial institution, or a natural person would be excluded from the definition of an eligible secondary market transaction. In addition, the proposal would require that such CCAs establish written policies and procedures reasonably designed to, as applicable, identify and monitor their direct participants' submission of transactions for clearing, including how the CCA would address a failure to submit transactions.

For the reasons set forth below, the Commission believes that taking these incremental steps, which build on the existing rules of the only U.S. Treasury securities CCA, will strengthen risk management at the current and any other future U.S. Treasury securities CCA. Further, the Commission believes that this proposal would bring the benefits of clearance and settlement to a potentially significant portion of the U.S. Treasury securities market.

This section first explains what the Membership Proposal is and to whom and what aspects of the U.S. Treasury markets it applies.

103

It then describes what constitutes an eligible secondary market transaction and what transactions are excluded from that definition. Finally, it discusses the benefits of the Membership Proposal.

103

The Commission would add this requirement to the current text of Rule 17Ad-22(e)(18). The Commission is also proposing to adjust the numbering of Rule 17Ad-22(e)(18), 17 CFR 240.17Ad-22(e)(18). But other than adding this proposal as new Rule 17Ad-22(e)(18)(iv), the Commission is not proposing any other substantive changes to the current text of Rule 17Ad-22(e)(18). The other changes to Rule 17Ad-22(e)(18) are entirely stylistic and designed to enhance readability in light of the proposed addition of Rule 17Ad-22(e)(18)(iv). In addition, the Commission proposes to define a U.S. Treasury security as “any security issued by the U.S. Department of the Treasury.” This term is not currently defined in Rule 17Ad-22, and this definition would be codified as Rule 17Ad-22(a)(23).

1. Requirement To Clear Eligible Secondary Market Transactions

The Membership Proposal would apply to “direct participants” in a U.S. Treasury securities CCA, which would distinguish entities that access a CCA directly (

i.e.,

members of the CCA) from indirect participants who “rely on the services provided by direct participants to access the covered clearing agency's payment, clearing or settlement facilities.”

104

For purposes of the Covered Clearing Agency Standards, “participants” of a CCA are referred to as “members” or “direct participants” to differentiate these entities from “direct participants' customers” or “indirect participants.”

105

Consequently, for purposes of this proposal and consistent with the terminology already used in the Covered Clearing Agency Standards,

106

the term “direct participants” would refer to the entities that directly access a U.S. Treasury securities CCA (generally banks and broker-dealers), and the term “indirect participants” would refer to those entities which rely on a direct participant to clear and settle their U.S. Treasury securities transactions with the U.S. Treasury securities CCA (generally their customers or clients).

107

104

17 CFR 240.17Ad-22(e)(18) and (19).

See also

CCA Standards Proposing Release,

supra

note 7, at 29553 (noting that some market participants would not meet a covered clearing agency's direct participation requirements and proposing risk management requirements for indirect and tiered participants).

105

See, e.g.,

17 CFR 240.14Ad-22 (e)(6) (referring to participants) and (e)(2)(vi) (referring to direct participants' customers). In addition, the Exchange Act defines a participant of a clearing agency as “any person who uses a clearing agency to clear or settle securities transactions or to transfer, pledge, lend, or hypothecate securities.” 15 U.S.C. 78c(a)(24). Indirect participants are expressly excluded from the Exchange Act definition of a “participant” of a clearing agency because the Exchange Act provides that a person whose only use of a clearing agency is through another person who is a participant or as a pledgee of securities is not a “participant” of the clearing agency.

Id.

106

See

17 CFR 240.17Ad-22(e)(19) (referring to firms that are indirect participants in a covered clearing agency as those that “rely on the services provided by direct participants to access the covered clearing agency's payment, clearing, or settlement facilities”).

107

For example, FICC maintains the Sponsored Service.

See supra

notes 64 through 66 and accompanying text. Because sponsored members cannot clear or settle government securities transactions without a sponsoring member, the Commission believes that these sponsored members are not “direct participants.” As noted above, such persons are referred to in this release as “indirect participants” or “customers.”

Moreover, persons who provide services in connection with clearance and settlement, such as settlement agent, settlement bank, or clearing bank services, and do not submit trades for clearing to a U.S. Treasury securities CCA would not be “direct participants” or “indirect participants” within the meaning of this proposal and the terminology used in the Covered Clearing Agency Standards.

108

The Commission recognizes that some entities may access more limited services of a U.S. Treasury securities CCA without use of its CCP services. For example, FICC provides “comparison only” services for a certain membership type.

See

FICC Rule 8,

supra

note 47. Consistent with the definition of a “participant” under the Exchange Act, such entities would not be considered participants of a CCA and therefore would not be subject to this proposed requirement.

2. Eligible Secondary Market Transactions

As discussed further below, the Commission would also define what constitutes an eligible secondary market transaction in U.S. Treasury securities subject to the Membership Proposal.

109

This definition would apply to all types of transactions that are of a type currently accepted for clearing at a U.S. Treasury securities CCA; it would not impose a requirement on a U.S.

Treasury securities CCA to offer additional products for clearing.

109

The Commission proposes to define the scope of an “eligible secondary market transaction,” including transactions that would be excluded from that definition, in Proposed Rule 17Ad-22(a).

The proposal does not apply to the primary market,

i.e.,

the issuance and sale of a U.S. Treasury security to a primary dealer or other bidder in a U.S. Treasury auction. By statute, the Treasury Department is authorized to borrow money on behalf of the Federal government through the sale and issuance of U.S. Treasury securities to the public.

110

The terms and conditions for the sale and issuance for these securities are contained in the applicable Treasury Department auction rules or the securities offering (or auction) announcements.

111

The Treasury Department determines when auctions will occur and in what amounts and retains discretion as to the conduct of auctions, including, among other things, whether to award more or less than the amount of securities specified in an auction announcement and reserves the right to modify the terms and conditions of an auction.

112

In addition, the Treasury Department gives successful bidders the option of instructing that “delivery and payment be made through the clearing corporation for securities awarded to the submitter for its own account, but it does not require the use of a clearing corporation for delivery and payment in connection with securities awarded in the auctions.

113

In light of the existing regulatory regime for these primary market transactions, as well as the role of such transactions in directly financing the Federal government, the Commission believes that it would be inappropriate for the Membership Proposal to include primary market transactions.

110

31 U.S.C. 3101

et seq.

111

Uniform Offering Circular, 31 CFR 356. The circular covers all aspects of the sale and issue of U.S. Treasury securities, including bidding, certifications, payment, determination of auction awards, and settlement.

112

See, e.g.,

Treasury Marketable Securities Offering Announcement Press Releases,

available at https://www.treasurydirect.gov/instit/annceresult/press/press_secannpr.htm;

31 CFR 356.33.

113

31 CFR 356.17(d)(2).

As stated above,

114

U.S. Treasury securities start trading after the auction announcement, before the auction and continue trading through issuance and afterwards. The trading that occurs after announcement and prior to issuance is generally referred to as when-issued trading and it covers two distinct periods: before the auction and after the auction. The latter,

i.e.,

when-issued trades that occur the day after the auction are considered on-the-run on some IDBs. All when-issued transactions are reported to TRACE.

115

In addition, based on its supervisory experience, the Commission understands that FICC already clears when-issued securities. Accordingly, in light of the fact that trading in when issued securities that takes place the day after the auction shares similar characteristics to secondary market transactions and such trading is already reported as a secondary market transaction, the Membership Proposal would apply to when-issued trades that occur the day after the auction and are considered on-the-run on some IDBs, to the extent that such when-issued trades otherwise meet the definition of an eligible secondary market transaction, as discussed further in section III.A.2

infra.

However, since when-issued trading that takes place before and including the day of the auction does not share these characteristics and is primarily used as a tool for price discovery leading to the auction, such transactions would not be encompassed by the Membership Proposal.

114

See

note 38

supra.

115

Trades in a security that occurred the day after it was auctioned accounted, on average, for approximately 12% of all trades in U.S. Treasury securities between July 1, 2019, and June 30, 2020, with approximately half of such trades taking place on an IDB.

Id.

a. Repo Transactions

The Commission proposes to include all U.S. Treasury repurchase and reverse repurchase agreements entered into by a direct participant of a U.S. Treasury securities CCA as eligible secondary market transactions subject to the Membership Proposal, subject to the exclusions discussed in section III.A.2.c

infra.

116

As noted above, the U.S. Treasury repo market plays a key role in facilitating the flow of cash and securities in the financial system by allowing market participants to access financing, supporting dealer market-making activities, enabling institutional investors with large cash balances to invest cash on a secured basis, and contributing to price discovery and efficient capital allocation, as well as supporting the calculation of the Secured Overnight Financing Rate (“SOFR”) by the Federal Reserve Bank of New York.

117

Significant gaps persist in the coverage of transaction data in U.S. Treasury repo activity, but the available data indicates that the volume of repo transactions that are bilaterally cleared and settled remains substantial.

118

For example, recent research with respect to primary dealers indicates that 38 percent of their repo and 60 percent of their reverse repo activity is not centrally cleared, and, overall, that 20 percent of all their repo and 30 percent of their reverse repo activity is centrally cleared through FICC.

119

Nevertheless, FICC lacks visibility into its members' non-centrally cleared repo trades, and the default of one counterparty can have cascading effects on multiple other market participants, including members of FICC, thereby risking contagion to the CCP.

116

See

paragraphs (i) and (iii) of the definition of an “eligible secondary market transaction” in Proposed Rule 17Ad-22(a).

117

MMF Primer,

supra note 57; see also

Secured Overnight Financing Rate Data,

available at https://www.newyorkfed.org/markets/reference-rates/sofr.

118

IAWG Report,

supra

note 4, at 29 (stating that non-centrally cleared bilateral repo represents a significant portion of the market, roughly equal in size to centrally cleared repo) (citing a 2015 pilot program by the Treasury Department);

see also

TMPG,

Clearing and Settlement Practices for Treasury Secured Financing Transactions Working Group Update

(“TMPG Repo White Paper”), at 1 (Nov. 5, 2021),

available at https://www.newyorkfed.org/medialibrary/Microsites/tmpg/files/CSP_SFT_Note.pdf;

Katy Burne, “Future Proofing the Treasury Market,” BNY Mellon Aerial View, at 7 (Nov. 2021),

available at https://www.bnymellon.com/content/dam/bnymellon/documents/pdf/aerial-view/future-proofing-the-us-treasury-market.pdf.coredownload.pdf

(noting that 63% of repo transactions remain non-centrally cleared according to Office of Financial Research data as of Sept. 10, 2021).

119

Sebastian Infante,

et al., Insights from revised Form FR2004 into primary dealer securities financing and MBS activity

(Aug. 5, 2022),

available at https://www.federalreserve.gov/econres/notes/feds-notes/insights-from-revised-form-fr2004-into-primary-dealer-securities-financing-and-mbs-activity-20220805.htm. See

section IV.B.2 for a more detailed discussion of this analysis.

In addition, particularly with respect to banks and dealers, an important potential benefit of repo central clearing stems from mitigating the constraints on intermediaries' balance sheets under the existing accounting and regulatory capital rules.

120

Recent research indicates that for primary dealers, use of the centrally cleared bilateral repo market leads to a reduction in balance sheet allocation of approximately 20 percent relative to their total repo exposure.

121

The Commission believes that the benefit of this resulting additional balance sheet capacity could be shared by all market participants

through improved market liquidity and smooth market functioning.

122

120

In effect, accounting rules allow purchases and sales of the same security to be netted but do not allow repos of the same security to be netted, unless the repos are with the same counterparty and the trades have been documented under a master netting agreement.

See, e.g.,

G-30 Report,

supra

note 5, at 13; Program on International Financial Systems,

Mandatory Central Clearing for U.S. Treasuries and U.S. Treasury Repos,

at 25-27 (Nov. 2021),

available at https://www.pifsinternational.org/wp-content/uploads/2021/11/PIFS-Mandatory-Central-Clearing-for-U.S.-Treasury-Markets-11.11.2021.pdf

(“PIFS Paper”). Thus, if a dealer's repos are all with a U.S. Treasury securities CCA, greater netting is allowed.

121

Infante,

et al., supra

note 117.

122

See

Committee on the Global Financial System,

Repo Market Functioning,

at 24 (Apr. 2017),

available at https://www.bis.org/publ/cgfs59.pdf.

Moreover, it appears that, as with cash markets, risk management practices in the bilateral clearance and settlement of repos are not uniform across market participants and are not transparent.

123

Indeed, a recent publication stated that competitive pressures in the bilaterally settled market for repo transactions have exerted downward pressure on haircuts, sometimes to zero.

124

The reduction of haircuts, which serve as a counterparty credit risk mitigant in bilateral repos, could result in greater exposure to potential counterparty default risk in non-centrally cleared repos.

123

TMPG Repo White Paper,

supra

note 118, at 1.

124

G-30 Report,

supra

note 5, at 13.

By contrast, a U.S. Treasury securities CCA is subject to the Commission's risk management requirements addressing financial, operational, and legal risk management, which include, among other things, margin requirements commensurate with the risks and particular attributes of each relevant product, portfolio, and market.

125

Therefore, repos cleared at a U.S. Treasury securities CCA would be subject to transparent risk management standards that are publicly available and applied uniformly and objectively to all participants in the CCA.

125

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

As discussed in section II.A.2

supra,

many market participants have already chosen to centrally clear some of their repo transactions. FICC provides central clearing for its direct participants in both centrally cleared bilateral and triparty repo. In addition, in the Sponsored Program, FICC recently has made several changes to the program with the intent of increasing overall participation in the service and ensuring that market participants can use the service consistent with their applicable regulatory requirements and business strategies. For example, in 2021, FICC expanded the available products to allow Sponsored Members to clear triparty repos through the program,

126

in addition to the existing ability to sponsor bilateral repo into central clearing. There are now approximately 30 Sponsoring Members and 1,900 Sponsored Members with access to central clearing, including money market funds, hedge funds, and other asset managers.

127

126

See, e.g., supra

note 64; Self-Regulatory Organizations; Fixed Income Clearing Corporation; Order Approving a Proposed Rule Change to Expand Sponsoring Member Eligibility in the Government Securities Division Rulebook and Make Other Changes, Exchange Act Release No. 85470 (Mar. 29, 2019), 84 FR 13328 (Apr. 4, 2019).

127

See

FICC Membership Directories,

available at https://www.dtcc.com/client-center/ficc-gov-directories.

Recent research indicates that, as of the second quarter of 2022, money market funds held had close to $63 billion in centrally cleared U.S. Treasury repos, or 3% of their total Treasury repo volume.

128

Most of that centrally cleared repo is through FICC's Sponsored Program away from the triparty platform.

129

In addition, certain private funds participate in the centrally cleared Treasury repo market, through FICC's Sponsored Program. These firms benefit from improved ability to access the repo market and more advantageous pricing.

130

The Commission considered these currently available methods for accessing central clearing for U.S. Treasury repos for both dealers and buy-side entities when determining to propose the inclusion of repos as eligible secondary market transactions and believes that this factor further supports its determination.

128

Viktoria Baklanova

et al., Money Market Funds in the Treasury Market

(Sept. 1, 2022),

available at https://www.sec.gov/files/mmfs-treasury-market-090122.pdf

(“MMFs in the Treasury Market”).

129

Id.

130

See, e.g.,

G-30 Report,

supra

note 5, at 13 (“Buyside firms benefit because dealers are willing to intermediate cleared repos at narrower spreads, which are reflected in part in higher rates paid to buyside repo investors on cleared repos than on uncleared repos and in part in lower rates charged to repo borrowers (including hedge funds and smaller broker-dealers) on cleared repos.”).

b. Purchases and Sales of U.S. Treasury Securities

An estimated 68 percent of the overall dollar value of cash market transactions in U.S. Treasury securities are not centrally cleared, and an estimated 19 percent of the overall dollar value of such transactions are subject to so-called hybrid clearing (as stated above).

131

The Commission has identified certain categories of purchases and sales of U.S. Treasury securities that it believes should be part of the definition of an eligible secondary market transaction subject to the Membership Proposal,

i.e.,

for which U.S. Treasury securities CCAs would be obligated to impose membership rules to require clearing of such transactions, for the reasons described below. The Commission believes that including this set of transactions in the eligible secondary market definition and therefore subjecting these transactions to the Membership Proposal represents an incremental first step to address potential risks arising to a U.S. Treasury securities CCA.

131

IAWG Report,

supra

note 4, at 30;

see also

TMPG White Paper,

supra

note 21, at 12.

i. IDB Transactions

The Commission proposes to include within the definition of an eligible secondary market transaction any purchase or sale between a direct participant of a U.S. Treasury securities CCA and any counterparty, if the direct participant of the covered clearing agency (A) brings together multiple buyers and sellers using a trading facility (such as a limit order book) and (B) is a counterparty to both the buyer and seller in two separate transactions.

132

As a result, this definition will only encompass the transactions of those IDBs in the Treasury market that are direct participants of a U.S. Treasury securities CCA and stand as counterparties to both sides of each trade on their platforms.

133

132

See

paragraph (ii)(A) of the definition of an “eligible secondary market transaction” in Proposed Rule 17Ad-22(a).

133

See

notes 40-43 and accompanying text

supra.

The Commission believes that this aspect of the Membership Proposal generally would result in the benefits described in section III.A.3

infra.

Chiefly, the Commission believes that this aspect of the Membership Proposal would specifically address the potential for contagion risk associated with hybrid clearing that a number of commentators have highlighted. As explained above, the configuration of counterparty risk presented by hybrid clearing allows the U.S. Treasury securities CCA to manage the risks arising from the IDB-CCA direct participant transaction, on the one hand, but the U.S. Treasury securities CCA cannot manage the risks arising from the IDB's offsetting transaction with its non-member counterparty and the potential counterparty credit risk and settlement risk arising to the IDB from that trade.

134

Thus, under the current hybrid clearing model, the U.S. Treasury securities CCA is indirectly exposed to the IDB's non-centrally cleared transaction, but it lacks the ability to risk manage its indirect exposure to this non-centrally cleared leg of the transaction. Specifically, it does not know who the ultimate

counterparty of the transaction is and cannot collect margin on that transaction. This, in turn, results in margin collection at the CCP which is based upon only one transaction and has been calculated to cover this seemingly directional position, as well as an inability to net these offsetting transactions and provide the benefits of central clearing. In particular, if the IDB's non-CCP member counterparty fails to settle a transaction that is subject to hybrid clearing, such IDB may not be able to settle the corresponding transaction that has been cleared with the U.S. Treasury securities CCA due to a lack of financial resources at the IDB, which could lead the IDB to default.

135

As part of its existing default management procedures, the U.S. Treasury securities CCA could seek to mutualize its losses from the IDB's default, which could in turn transmit stress to the market as a whole.

134

See, e.g.,

TMPG White Paper,

supra

note 21, at 22 (noting that in a hybrid clearing arrangement, an IDB's rights and obligations to the CCP are not offset and the IDB is not in a net zero settlement position with respect to the CCP at settlement date). Thus, the IDB is not able to net all of its positions for clearing at a U.S. Treasury securities CCA, and the IDB's positions appear to the CCA to be directional, which impacts the amount of margin that the CCA collects for the transaction.

135

See

IAWG Report,

supra

note 4, at 31; Depository Trust and Clearing Corporation,

More Clearing, Less Risk: Increasing Centrally Cleared Activity in the U.S. Treasury Cash Market,

at 5 (May 2021),

available at https://www.dtcc.com/-/media/Files/PDFs/DTCC-US-Treasury-Whitepaper.pdf

(“DTCC May 2021 White Paper”).

As noted above, the Commission has previously stated that membership requirements help to guard against defaults of any CCP member, as well as to protect the CCP and the financial system as a whole from the risk that one member's default could cause others to default, potentially including the CCP itself. Further, contagion stemming from a CCP member default could undermine confidence in the financial system as a whole, even if the health of the CCP is not implicated. This is because the default could cause others to back away from participating in the market. This risk of decreased participation could be particularly problematic if the defaulting participant was an IDB, whose withdrawal from the market could impact other market participants' ability to access the market for on-the-run U.S. Treasury securities, approximately 49.7% of which trade on IDBs.

136

Including such transactions as eligible secondary market transactions subject to the Membership Proposal would therefore help protect against this risk by requiring that a U.S. Treasury securities CCA ensure that direct participants who are IDBs centrally clear both sides of their transactions, thereby eliminating the various aspects of potential contagion risk posed by so-called hybrid clearing.

136

TMPG White Paper,

supra

note 21, at 32; section IV.B.4 (Table 1)

infra.

ii. Other Cash Transactions

The Commission proposes to include certain additional categories of cash transactions of U.S. Treasury securities by the direct participants of a U.S. Treasury securities CCA in the definition of an eligible secondary market transaction subject to the Membership Proposal.

First, the Commission is proposing that the definition of an eligible secondary market transaction include those cash purchase and sale transactions in which the counterparty of the direct participant is a registered broker-dealer, government securities broker, or government securities dealer.

137

Each of these entities is a type of market intermediary that is engaged in the business of effecting transactions in securities for the account of others (in the case of brokers) or for their own accounts (in the case of dealers).

138

As stated in section II.A.1

supra,

in 2018, the TMPG determined that a majority of trades in the secondary cash Treasury market now clear bilaterally,

139

and estimated that the trading volume of non-FICC members exceeds that of FICC members.

140

As a result, the Commission believes that their collective trading activity likely is responsible for a not insignificant portion of the volume of transactions involving Treasury securities and could present contagion risk to a U.S. Treasury securities CCA.

141

In addition, registered broker-dealers, government securities brokers, or dealers that are not direct members of a U.S. Treasury securities CCA are typically “introducing firms” that establish mechanisms to clear and settle their transactions. For example, currently, many registered brokers and dealers rely on the correspondent clearing service provided by FICC to have a FICC member submit their transactions for clearing at FICC.

142

137

See

paragraph (ii)(B) of the definition of an “eligible secondary market transaction” in Proposed Rule 17Ad-22(a).

See also

15 U.S.C. 78o(a) and 78o-5(a) (requirement to register) and 78c(4), (5), (43), and (44) (definitions of broker, dealer, government securities dealer, and government securities broker). The Commission acknowledges that the transactions encompassed by paragraph (ii)(B) in the definition of an “eligible secondary market transaction” in Proposed Rule 17Ad-22(a) could also encompass certain transactions that would be encompassed by paragraph (ii)(A) of the same proposed definition, in the event that the direct participant is an IDB transacting with a registered broker-dealer. However, the set of transactions encompassed by paragraph (ii)(B) of the proposed definition is broader than that of paragraph (ii)(A). The Commission believes that this overlap is appropriate because these paragraphs of the proposed definition are designed to accomplish different purposes, which is not impacted by the potential overlap.

138

See generally

TMPG,

Automated Trading in Treasury Markets (White Paper)

(June 2015),

available at https://www.newyorkfed.org/TMPG/medialibrary/microsites/tmpg/files/TPMG-June-2015-Automated-Trading-White-Paper.pdf (“TMPG Automated Trading White Paper”).

139

TMPG White Paper,

supra

note 21, at 2.

140

IAWG Report,

supra

note 4, at 30; TMPG White Paper,

supra

note 21, at 12.

141

See supra

note 15 and TMPG Automated Trading White Paper,

supra

note 138.

142

See, e.g.,

FICC Rule 8 (describing the service),

supra

note 47; FICC Executing Firm Master List,

available at https://www.dtcc.com/client-center/ficc-gov-directories.

The Commission believes that the benefits that would result from imposing a requirement on U.S. Treasury securities CCAs to require that their direct participants submit for clearing and settlement such transactions in which their counterparties are registered broker-dealers or government securities brokers or government securities dealers would be consistent with the benefits of central clearing set forth in section III.A.3

infra.

Moreover, because these entities are already either part of or able to access the national system of clearance and settlement, there should be fewer obstacles to submission of such trades.

Second, the Commission proposes to include within the definition of an eligible secondary market transaction any purchase and sale transaction between a direct participant of a U.S. Treasury securities CCA and a hedge fund, that is any private fund (other than a securitized asset fund): (a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses); (b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or (c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration). This definition of a hedge fund is consistent with the Commission's definition of a hedge fund in Form PF.

143

17 CFR 279.9 (Form PF Glossary of Terms).

The Commission's intent in including transactions with hedge funds in the definition of an eligible market transaction is two-fold. First, hedge funds generally can engage in trading

strategies that may pose heightened risks of potential financial distress to their counterparties, including those who are direct participants of a U.S. Treasury securities CCA. For example, the Commission observed when proposing Form PF that hedge funds often use financial institutions that may have systemic importance to obtain leverage, and that hedge funds may employ investment strategies that may use leverage, derivatives, complex structured products, and short selling in an effort to generate returns, as well as employ strategies involving high volumes of trading and concentrated investments.

144

The Commission recognized that the strategies employed by hedge funds “can increase the likelihood that the fund will experience stress or fail, and amplify the effects on financial markets.”

145

The Commission also stated that significant hedge fund failures, resulting from their investment positions or use of leverage or both, could result in material losses at the financial institutions that lend to them if collateral securing this lending is inadequate, and that these losses could have systemic implications if they require these financial institutions to scale back their lending efforts or other financing activities generally.

146

144

Proposing Release, Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Release No. IA-3145 (Jan. 26, 2011), 76 FR 8068, 8073 (Feb. 12, 2011) (“Form PF Proposing Release”). The Commission adopted the hedge fund definition with some amendments thereafter. Final Rule, Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Release No. IA-3308 (Oct. 31, 2011), 76 FR 71127 (Nov. 16, 2011).

145

Form PF Proposing Release,

supra

note 144, 76 FR at 8073 (citing President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long Term Capital Management (Apr. 1999), at 23).

146

Id.

(also noting that the simultaneous failure of several similarly positioned hedge funds could create contagion through the financial markets if the failing funds had to liquidate their investment positions at firesale prices).

Similarly, the FSOC acknowledged, in light of recent market events, the importance of understanding how hedge fund activities may impact the broader market, including “how financial strain at hedge funds—particularly those with significant leverage—could create risks to financial stability, and how a reduction in financial intermediation by hedge funds during periods of market stress could exacerbate market impairment.”

147

Thus, as a general matter, the Commission believes that if any of a hedge fund's activities, even those that are not related to the U.S. Treasury market, cause financial stress to a counterparty that is a direct participant of a U.S. Treasury securities CCA, the inclusion of a hedge fund's U.S. Treasury securities cash transactions with a direct participant in the definition of an eligible secondary market transaction should help ensure that such financial stress would not transmit to the U.S. Treasury securities CCA and through to the U.S. Treasury market.

147

FSOC Statement on Nonbank Financial Intermediation (Feb. 4, 2022),

available at https://home.treasury.gov/news/press-releases/jy0587.

In addition, hedge funds are increasingly large players in the U.S. Treasury market. For example, as of the fourth quarter of 2021, the Commission's Private Funds Statistics indicated that qualifying hedge funds held aggregate gross notional exposure of $1,760 billion in U.S. Treasury securities.

148

However, qualifying hedge funds generally report central clearing of about 15 percent of their overall net asset value.

149

There has been a great deal of commentary regarding the role of hedge funds in the U.S. Treasury markets, particularly with respect to the March 2020 market events.

150

For example, the FSOC observed that hedge funds were among the three largest types of sellers of Treasury securities, materially contributing to the Treasury market disruption during this period, although not as its sole cause.

151

The IAWG staffs stated that, in March 2020, hedge funds were among the largest sellers of Treasury securities as expected price relationships broke down, highly levered positions magnified losses, and some funds faced margin calls.

152

148

Private Funds Statistics for Q4 2021, Table 46 (July 22, 2022),

available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2021-q4.pdf.

Qualifying hedge funds refers to those hedge funds that have a net asset value (individually or in combination with any feeder funds, parallel funds and/or dependent parallel managed accounts) of at least $500 million as of the last day of any month in the fiscal quarter immediately preceding its most recently completed fiscal quarter.

See

Form PF (Glossary of Terms).

149

Private Funds Statistics for Q4 2021, Figure 17 (July 22, 2022),

available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2021-q4.pdf.

150

See generally

Ayelen Banegas

et al., Sizing Hedge Funds' Treasury Market Activities and Holdings

(Oct. 6, 2021),

available at https://www.federalreserve.gov/econres/notes/feds-notes/sizing-hedge-funds-treasury-market-activities-and-holdings-20211006.htm;

see also

Daniel Barth & R. Jay Kahn,

Hedge Funds and the Treasury Cash-Futures Disconnect

(Apr. 1, 2021),

available at https://www.financialresearch.gov/working-papers/2021/04/01/hedge-funds-and-the-treasury-cash-futures-disconnect/;

Hedge Fund Treasury Trading and Funding Fragility: Evidence from the COVID-19 Crisis,

available at https://www.federalreserve.gov/econres/feds/files/2021038pap.pdf.

151

FSOC Feb. 2022,

supra

note 172;

see also

IAWG,

supra

note 4, at 34.

152

IAWG,

supra

note 4, at 34.

See also

SEC Staff Report on U.S. Credit Markets Interconnectedness and the Effects of the COVID-19 Economic Shock (Oct. 2020),

available at https://www.sec.gov/files/US-Credit-Markets_COVID-19_Report.pdf.

This demonstrates the potential contagion risk that could arise from hedge funds' activities in the U.S. Treasury market. Similar to the risks posed to a U.S. Treasury securities CCA by non-centrally cleared trades entered into by an IDB, non-centrally cleared transactions entered into between hedge funds and direct participants of the CCA could cause risks to the CCA in the event that the hedge fund is not able to meet its obligations to the direct participant, which could, in turn, create stress to the direct participant and through to the CCA. Therefore, including the direct participant's purchase and sale transactions with hedge funds within the definition of an eligible secondary market transaction should reduce the potential for financial distress arising from the transactions that could affect the direct participant and the U.S. Treasury securities CCA. This aspect of the proposal would also result in consistent and transparent risk management being applied to such transactions, as discussed further in section III.A.3

infra.

The Commission believes that defining a hedge fund in a manner consistent with Form PF is reasonable, because such definition should encompass those funds that use strategies that the Commission has determined merit additional reporting to allow a better picture of the potential systemic risks posed by such activities.

153

Including transactions with such funds within the definition of an eligible secondary market transaction should help to limit the potential

contagion risk that could arise from any financial distress experienced at such a fund that could, in turn, be transmitted to a direct participant of a U.S. Treasury securities CCA (and to the CCA) via any non-centrally cleared transactions. Specifically, using such definition would allow the definition of an eligible secondary market transaction to include transactions between direct participants of a U.S. Treasury securities CCA and a private fund whose characteristics make it more likely that it would have an impact on systemic risk,

i.e.,

its ability to short sell and take on significant leverage. For example, as the Commission recently stated, large investment losses or a margin default involving one large highly levered hedge fund may have systemic risk implications, and large investment losses at multiple hedge funds may indicate market stress that could have systemic effects.

154

The Commission believes that using a definition consistent with that of Form PF to identify transactions with a U.S. Treasury securities CCA's direct participant as part of the definition of an eligible secondary market transaction subject to the Membership Proposal should capture transactions with entities whose default would be most likely to cause potential contagion risk to the Treasury securities CCA. For example, hedge funds' use of leverage can make them more vulnerable to liquidity shocks, which could, in turn, make them unable to deliver in a transaction with a direct participant of a U.S. Treasury securities CCA.

153

Final Rule, Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Release No. IA-3308 (Oct. 31, 2011), 76 FR 71127 (Nov. 16, 2011). The reporting requirements for Form PF vary based on the amount of private fund assets under management for an investment adviser registered with the Commission. For example, if an investment adviser's private fund assets under management, including with respect to hedge funds, are less than $150 million on the last day of the most recent fiscal year, then the investment adviser is not required to file Form PF. Separately, additional reporting requirements apply to large hedge fund advisers with at least $1.5 billion in hedge fund assets under management.

See

Form PF, Instructions 1 and 3. However, the Commission believes that including all hedge funds within paragraph (ii)(C) of the definition of an “eligible secondary market transaction” in Proposed Rule 17Ad-22(a) would be consistent with its overall policy goals for central clearing in the U.S. Treasury market and ensuring that hedge fund transactions with direct participants in a U.S. Treasury securities CCA do not adversely impact the direct participant and, potentially, the CCA.

154

Proposing Release, Amendments to Form PF To Require Current Reporting and Amend Reporting Requirements for Large Private Equity Advisers and Large Liquidity Fund Advisers, Release No. IA-5950 (Jan. 26, 2022), 87 FR 9106, 9109 (Feb. 17, 2022).

Third, the Commission proposes to include within the definition of an eligible secondary market transaction subject to the Membership Proposal any purchase and sale transaction between a direct participant of a U.S. Treasury securities CCA and an account at a registered broker-dealer, government securities dealer, or government securities broker that either may borrow an amount in excess of one-half of the net value of the account or may have gross notional exposure of the transactions in the account that is more than twice the net value of the account.

155

This would apply to accounts that can take on significant leverage, that is, by borrowing an amount that is more than one half of its net value or take on exposures worth more than twice the account's net value.

155

See

paragraph (ii)(D) of the definition of an “eligible secondary market transaction” in Proposed Rule 17Ad-22(a).

The Commission believes that the inclusion of transactions with such accounts within the definition of an eligible secondary market transaction should allow the proposal to encompass transactions between direct participants of a U.S. Treasury securities CCA and a prime brokerage account, which, based on the Commission's supervisory knowledge, may hold assets of entities, such as, for example, private funds or separately managed accounts, and may use leverage that poses a risk to U.S. Treasury securities CCA and the broader financial system. Covering such accounts would also allow for inclusion of, for example, accounts used by family offices or separately managed accounts that may use strategies more similar to those of a hedge fund. The account provider (

i.e.,

the prime broker) does not have access to, or knowledge of, the account owner's entire portfolio of assets and is limited to the assets in that particular account. Therefore, the account provider may be unable to make a counterparty whole in the event of a default by the account owner if the account has taken on significant leverage. Typically, the entity providing an account has a lien or some other priority on assets in the account to make a counterparty whole if necessary. By including the account, and not the entity using the account, this aspect of the proposal is targeted to the activity that could bring the most potential risk to a U.S. Treasury securities CCA and the financial system more generally.

c. Exclusions From the Definition of an Eligible Secondary Market Transaction

The Commission is proposing to exclude transactions between direct participants of a U.S. Treasury securities CCA and certain counterparties from the definition of an eligible secondary market transaction in U.S. Treasury securities. These exclusions would apply to any purchase or sale transaction in U.S. Treasury securities or repurchase or reverse repurchase agreement collateralized by U.S. Treasury securities. First, recognizing the importance of U.S. Treasury securities not only to the financing of the United States government, but also their central role in the formulation and execution of monetary policy and other governmental functions, the Commission is proposing to exclude any transactions in U.S. Treasury securities between a direct participant of a U.S. Treasury securities CCA and a central bank. For similar reasons, the Commission is also proposing to exclude any transactions in U.S. Treasury securities between a direct participant of a U.S. Treasury securities CCA and a sovereign entity or an international financial institution.

156

Together, these exclusions are referred to as the “Official Sector Exclusions.”

156

As discussed more fully below, these exclusions would be codified in paragraph (iii) of the definition of an “eligible secondary market transaction” in Proposed Rule 17Ad-22(a).

In addition, the Commission is also proposing to exclude transactions in U.S. Treasury securities between a direct participant of a U.S. Treasury securities CCA and a natural person. The Commission does not believe that such transactions should be included in light of the likely low volumes of transactions entered into by natural persons and the low potential for contagion risk arising from such transactions.

i. Official Sector Exclusions From the Membership Proposal

The Official Sector Exclusions are designed to permit domestic and international policy makers,

i.e.,

central banks, to continue to pursue important policy goals. Because these transactions should present limited to no risk of contagion to a U.S. Treasury securities CCA, the Commission believes that these exclusions are appropriate.

For purposes of the Official Sector Exclusion, the Commission proposes to define a central bank as a reserve bank or monetary authority of a central government (including the Board of Governors of the Federal Reserve System or any of the Federal Reserve Banks). The proposed definition would also include the Bank for International Settlements (“BIS”).

157

The BIS is owned by central banks.

158

The Commission therefore believes it is appropriate to include the BIS in the definition of central bank for purposes of this proposal. The Commission proposes to define a sovereign entity as a central government (including the U.S. Government), or an agency, department, or ministry of a central government.

159

Finally, the Commission proposes to define an international financial institution by specifying the entities,

i.e.,

(1) African Development Bank; (2) African Development Fund; (3) Asian Development Bank; (4) Banco Centroamericano de Integración Económica; (5) Bank for Economic Cooperation and Development in the

Middle East and North Africa; (6) Caribbean Development Bank; (7) Corporación Andina de Fomento; (8) Council of Europe Development Bank; (9) European Bank for Reconstruction and Development; (10) European Investment Bank; (11) European Investment Fund; (12) European Stability Mechanism; (13) Inter-American Development Bank; (14) Inter-American Investment Corporation; (15) International Bank for Reconstruction and Development; (16) International Development Association; (17) International Finance Corporation; (18) International Monetary Fund; (19) Islamic Development Bank; (20) Multilateral Investment Guarantee Agency; (21) Nordic Investment Bank; (22) North American Development Bank, and providing that the term would also include any other entity that provides financing for national or regional development in which the United States government is a shareholder or contributing member.

160

157

The Commission proposes to codify this definition in Proposed Rule 17Ad-22(a).

158

See https://www.bis.org/about/index.htm

(noting that “the BIS is owned by 63 central banks, representing countries from around the world that together account for about 95% of world GDP”).

159

The Commission proposes to codify this definition in Proposed Rule 17Ad-22(a).

160

The Commission proposes to codify this definition in Proposed Rule 17Ad-22(a).

Cf.

17 CFR 50.76(b) (CFTC definition of international financial institution for purposes of exemptions from swap clearing requirement).

The Commission believes that the proposed exclusion is appropriate to central banks because these entities are created by statute and are part of, or aligned with, a central government.

161

Further, the purpose of a central bank is generally to effectuate monetary policy for its respective nation.

162

For example, transactions in U.S. Treasury securities are an important tool in the fiscal and monetary policy of the United States, as well as other jurisdictions.

163

In particular, cash and repo transactions in U.S. Treasury securities are one of the primary tools used by the Federal Reserve Bank of New York to conduct open market transactions at the direction of the Federal Open Market Committee.

164

The System Open Market Account, which is managed by the Federal Reserve Bank of New York's System Open Market Trading Desk, is “the largest asset on the Federal Reserve's balance sheet.”

165

In light of the key role of open market operations conducted by the Federal Reserve Bank of New York in the monetary policy of the United States, the Commission believes an exemption from the Membership Proposal is appropriate for the Federal Reserve System.

166

In particular, the Commission believes the Federal Reserve System should be free to choose the clearance and settlement mechanisms that are most appropriate to effectuating its policy objectives.

161

The authorizing statutes generally provide that the government owns all or part of the capital stock or equity interest of the central bank.

See, e.g.,

Capital of the ECB Protocol on the Statute of the European System of Central Banks and of the European Central Bank (“ECB Protocol”), Article 28.2,

available at https://www.ecb.europa.eu/ecb/legal/pdf/en_statute_2.pdf.

162

See, e.g.,

ECB Protocol Statute,

supra

note 106, Article 3.1; Bank of Japan Act, Articles 1 and 2,

available at https://www.boj.or.jp/en/about/boj_law/index.htm/#p01.

163

12 U.S.C. 225a (defining goals of monetary policy);

see also https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm.

164

See

Federal Reserve Bank; Monetary Policy Implementation,

available at https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation.

165

Id.

166

Congress similarly exempted transactions in which one counterparty is a member of the Federal Reserve System from the regulation of swaps and security based swaps in Title VII of the Dodd-Frank Act.

See

15 U.S.C. 78c(a)(68)(A) (noting that a security-based swap is a swap, as defined in 7 U.S.C. 1a(47), subject to certain other conditions); 7 U.S.C. 1a(47)(B)(ix) (excluding from the definition of swap any transaction in which one counterparty “is a Federal Reserve bank, the Federal Government, or a Federal agency that is expressly backed by the full faith and credit of the United States”).

Further, the Commission believes that the Official Sector Exclusion should extend to foreign central banks, sovereign entities and international financial institutions for similar reasons and for reasons of international comity. Congress has decided to permit international financial institutions to enjoy a number of privileges and immunities from U.S. law,

167

which suggests that in these circumstances, the Commission should not place additional requirements on these institutions' transactions in U.S. Treasury securities. In addition, in light of ongoing expectations that Federal Reserve Banks and agencies of the Federal government would not be subject to foreign regulatory requirements in their transactions in the sovereign debt of other nations, the Commission believes principles of international comity counsel in favor of exempting foreign central banks, sovereign entities, and international financial institutions.

168

167

See, e.g.,

the International Organization and Immunities Act (22 U.S.C. 288) and the Foreign Sovereign Immunities Act (28 U.S.C. 1602). The United States has taken appropriate actions to implement international obligations with respect to such immunities and privileges.

See, e.g.,

International Bank for Reconstruction and Development (the “World Bank”) and International Monetary Fund (22 U.S.C. 286g and 22 U.S.C. 286h), the European Bank for Reconstruction and Development (22 U.S.C. 290l-6), the Multilateral Investment Guarantee Agency (22 U.S.C. 290k-10), the Africa Development Bank (22 U.S.C. 290-8), the African Development Fund (22 U.S.C. 290g-7), the Asian Development Bank (22 U.S.C. 285g), the Inter-American Development Bank (22 U.S.C. 283g), the Bank for Economic Cooperation and Development in the Middle East and North Africa (22 U.S.C. 290o), and the Inter-American Investment Corporation (22 U.S.C. 283hh).

168

For similar reasons, the CFTC has similarly determined to exempt swap transactions involving foreign central banks, sovereign entities, and international financial institutions from the statutory requirement that swap transactions be cleared with a Derivatives Clearing Organization.

See

17 CFR 50.75, 50.76; Swap Clearing Exemptions, 85 FR 76428, 76429-30, 76432 (Nov. 30, 2020).

ii. Natural Person Exclusion

The Commission is also proposing to exclude from the Membership Proposal otherwise eligible secondary market transactions in U.S. Treasury securities between a direct participant of a U.S. Treasury securities CCA and a natural person. The Commission believes that such an exclusion is appropriate because natural persons generally transact in small volumes and would not present much, if any, contagion risk to a U.S. Treasury securities CCA.

169

For example, although it is not a precise indicator of activity by natural persons in the U.S. Treasury markets, the data available on household holdings of U.S. Treasury securities indicates that their activity is not significant to the overall market.

See, e.g.,

The Financial Accounts of the United States, at 119 (Q1 2022) (indicating that less than 3.1% of marketable U.S. Treasury securities are held by the household sector),

available at https://www.federalreserve.gov/releases/z1/20220609/z1.pdf.

3. How the Membership Proposal Facilitates Prompt and Accurate Clearance and Settlement in the U.S. Treasury Market

The Commission believes that the Membership Proposal would promote the prompt and accurate clearance and settlement of U.S. Treasury securities transactions, providing several benefits to the market for U.S. Treasury securities as a whole.

First, the Commission believes that the Membership Proposal would decrease the overall amount of counterparty credit risk in the secondary market for U.S. Treasury securities. Because a U.S. Treasury securities CCA would novate and guarantee each transaction submitted for central clearing, it would become a counterparty to each transaction, as the buyer to every seller and the seller to every buyer. The U.S. Treasury securities CCA would be able to risk manage these transactions centrally, pursuant to risk management procedures that the Commission has reviewed and approved, and would guarantee settlement of the trade in the event of a direct participant default.

By contrast, bilaterally cleared cash transactions in U.S. Treasury securities are subject to variable risk management methodologies in which exposures are often less mitigated with less rigorous

practices compared to CCP risk management.

170

Indeed, although various SRO margin rules provide for the collection of margin for certain transactions in U.S. Treasury securities, transactions between dealers and institutional customers are subject to a variable “good-faith” margin standard, which the Commission understands—based on its supervisory experience—can often result in fewer financial resources collected to margin exposures than those that would be collected if a CCP margin model, like the one used at FICC, were used.

171

The Membership Proposal is designed to ameliorate these risks by requiring Treasury securities CCAs to establish policies and procedures that require their direct participants to submit for clearance and settlement their eligible secondary market transactions, which would include all repo transactions, and specified cash transactions in U.S. Treasury securities, which are most likely to pose contagion risk to a U.S. Treasury securities CCA.

170

TMPG White Paper,

supra

note 21, at 29.

171

Although FINRA rules provide for the collection of margin for cash U.S. Treasury transactions,

see

FINRA Rule 4210(e)(2)(A) (setting forth margin rule for FINRA members for collection of margin on Treasuries and certain other bonds) these rules do not necessarily apply to exempt accounts,

see

FINRA Rule 4210(e)(2)(F) (permitting FINRA members not to collect margin from exempt accounts and providing for a capital charge for any uncollected mark-to-market loss); FINRA Rule 4210(a)(13) (defining exempt account). Although SRO rules also require a broker-dealer to establish procedures to review limits and types of credit extended to all customers, formulate their own “house” margin requirements, and review the need for instituting higher margin requirements than are required for individual securities or customer accounts, based on the Commission's supervisory experience, the resulting margin collection is often less than that required pursuant to FICC's margin model.

In particular, the Membership Proposal is designed to reduce the amount of “contagion risk” to a U.S. Treasury securities CCA arising from what has been described as “hybrid clearing,” as discussed above.

172

In a hybrid transaction, the leg of the trade between an IDB, which is a FICC member, and a FICC member counterparty is submitted to FICC for clearance and settlement but the leg between the IDB and a non-FICC member counterparty is not.

173

Consequently, this FICC-member counterparty would no longer have exposure to the IDB and vice versa. But the IDB must settle the other leg of the trade bilaterally with its non-FICC member counterparty, and the IDB and the non-FICC member counterparty would face counterparty credit risk to each other until the transaction settles. Although this release has discussed “hybrid clearing,” and, more generally, contagion risk, with respect to IDB transactions, the general concept can apply more broadly, in that a FICC member's transactions that are not submitted for central clearing pose an indirect risk to the CCP as any default on a bilaterally settled transaction could impact the FICC member's financial resources and ability to meet its obligations to FICC. The Commission believes that requiring U.S. Treasury securities CCAs to impose, as a condition of membership, an obligation on their direct participants to submit all eligible secondary market transactions for central clearing should address the transactions most likely to cause contagion risk.

172

TMPG White Paper,

supra

note 21, at 8 n.11 (“IDB platforms act as blind brokers to provide anonymity to their customers. Under the blind broker model, the IDB serves as principal so what might appear to be a single trade between two customers is really two: one between the broker and the buyer and one between the broker and the seller. The buyer and seller are no longer directly exposed to each other, but both are exposed to the blind broker, and the blind broker is exposed to both buyer and seller.”).

173

TMPG White Paper,

supra

note 21, at 9.

Second, the Commission believes that the Membership Proposal would also help any U.S. Treasury securities CCA to avoid a potential disorderly member default. When cash market transactions are cleared bilaterally, market participants typically enter into bespoke arrangements to govern clearance and settlement with each of their trading counterparties, resulting in multiple interconnected counterparty credit risk exposures. Aside from the inefficiency of multiple sets of bilateral documentation that may differ in key respects, such as the amount of margin required, the default of one counterparty can have cascading effects on multiple other market participants. Defaults in bilaterally settled transactions are likely to be less orderly and subject to variable default management techniques because bilaterally settled transactions are not subject to the default management processes that are required to be in place and publicly disclosed at a CCP.

174

Centralized default management is a key feature of central clearing. Because the CCP has novated and guaranteed the transactions, it is uniquely positioned to coordinate the default of a member for trades that it has centrally cleared, and the non-defaulting members can rely on the CCP to complete the transactions of the defaulting member and cover any resulting losses using the defaulting member's resources and/or its default management tools. Even in a situation where two CCPs have to coordinate the default of a joint member, that coordination should result in more efficiency and market confidence than multiple bilateral settlements.

174

See

Rule 17Ad-22(e)(13) and (e)(23)(i).

The Commission previously has stated that a CCP's default management procedures would provide certainty and predictability about the measures available to a covered clearing agency in the event of a default which would, in turn facilitate the orderly handling of member defaults and would enable members to understand their obligations to the covered clearing agency in extreme circumstances.

175

By contrast, as the TMPG has observed, independent management of bilateral credit risk by each participant in the clearance and settlement chain likely creates uncertainty about the levels of exposure across market participants and may make runs more likely, and any loss stemming from closing out the position of a defaulting counterparty is a loss to the non-defaulting counterparty and hence a reduction in its capital in many scenarios.

176

Moreover, the high quality and credit status of U.S. Treasury securities does not eliminate the potential risk of clearing and settling these securities in the event of a default of a counterparty to a secondary market transaction. For example, if a large participant in a U.S. Treasury trade defaults, it can leave a counterparty with a short position to cover, which may take place as prices of U.S. Treasury securities move rapidly.

177

In particular, the Commission notes that the market for U.S. Treasury securities experienced stresses in 1986, 1994, and 2008, with more recent episodes detailed in the recent IAWG Report.

178

175

CCA Standards Proposing Release,

supra

note 7, 79 FR at 29545.

176

TMPG White Paper,

supra

note 21, at 32.

177

TMPG White Paper,

supra

note 21, at 32 and at 13 n. 17 (noting counterparty risk associated with the Long-Term Capital Management experience in 1998).

178

IAWG Report,

supra

note 4.

Having a CCP drawing on its expertise to manage hedging and an orderly liquidation of the portfolio(s) of a party (or parties) in default would constitute an improvement to uncoordinated liquidations. A covered clearing agency, including a U.S. Treasury securities CCA, is required to establish, implement, maintain and enforce written policies and procedures reasonably designed to, as applicable, ensure the CCA has the authority and operational capacity to contain losses and liquidity demands and continue to meet its obligations, which must be

tested annually.

179

This transparent and established approach to potential defaults stands in contrast to the variable practices that currently prevail in the bilateral market, which are not subject to similar regulation. For these reasons, the Commission believes that a requirement for a U.S. Treasury securities CCA to require that its direct participants submit for clearance and settlement all the transactions encompassed by the definition of an eligible secondary market transaction would help reduce the potential for disorderly defaults, and runs, thereby bolstering the health of the CCP and the market as a whole—consistent with the purpose of robust membership requirements the Commission contemplated in the Covered Clearing Agency Standards, and the Commission's statutory charge to promote the prompt and accurate clearance and settlement of securities transactions.

180

179

See

17 CFR 240.17Ad-22(e)(13).

180

See

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

Third, the Commission believes that the Membership Proposal will further the prompt and accurate clearance and settlement of U.S. Treasury securities by increasing the multilateral netting of transactions in these instruments, thereby reducing operational and liquidity risks, among others. Central clearing of transactions nets down gross exposures across participants, which reduces firms' exposures while positions are open and reduces the magnitude of cash and securities flows required at settlement.

181

Consistent with the Commission's previous statements in this regard, FICC's failure to receive all eligible trading activity of an active market participant reduces the value of its vital multilateral netting process and causes FICC to be less well-situated to prevent future market crises.

182

Others have also noted that these reductions, particularly in cash and securities flow would reduce liquidity risks associated with those settlements and counterparty credit risks associated with failures to deliver on the contractual settlement date,

183

not only for CCP members but for the CCP itself, thereby promoting the safeguarding of U.S. Treasury securities and funds in the custody or control of the CCA and increasing the likelihood of prompt and accurate clearance and settlement of such transactions. In fact, it has been suggested that additional central clearing, based on assumptions broader than the proposal set forth in this release, may have lowered dealers' daily settlement obligations in the cash market by 60 percent in the run-up and aftermath of the March 2020 U.S. Treasury market disruption and reduced settlement obligations by 70 percent during the disruption itself.

184

The reduction in exposure is not limited to the cash market. For example, it has been estimated that introduction of central clearing for dealer-to-client repos would have reduced dealer exposures from U.S. Treasury repos by over 80% (from $66.5 billion to $12.8 billion) in 2015.

185

181

IAWG Report,

supra

note 4, at 30. For an example of multilateral netting, please see note 252 and accompanying text

infra.

182

Exchange Act Release No. 51908,

supra

note 30.

183

G-30 Report,

supra

note 5, at 13;

see also

PIFS Paper,

supra

note 120, at 28-31.

184

G-30 Report,

supra

note 5, at 13 n.21 (citing Michael Fleming & Frank Keane, Staff Report No. 964: Netting Efficiencies of Marketwide Central Clearing, Federal Reserve Bank of New York (Apr. 2021),

available at https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr964.pdf

). However, this analysis relies upon the assumption that all dealers' purchases and sales of U.S. Treasury securities transactions would be centrally cleared and, therefore, netted; this proposal, if adopted, would not result in the same scope of central clearing, as it would apply only to eligible secondary market transactions of direct participants in a U.S. Treasury securities CCA.

185

Office of Financial Research,

Benefits and Risks of Central Clearing in the Repo Market,

5-6 (Mar. 9, 2017),

available at https://www.financialresearch.gov/briefs/files/OFRBr_2017_04_CCP-for-Repos.pdf.

The benefits of multilateral netting flowing from central clearing can improve market safety by lowering exposure to settlement failures, which would also tend to promote the prompt and accurate clearance and settlement of U.S. Treasury securities transactions.

186

Multilateral netting can also reduce the amount of balance sheet required for intermediation and could also enhance dealer capacity to make markets during normal times and stress events because existing bank capital and leverage requirements recognize the risk-reducing effects of multilateral netting of trades that CCP clearing accomplishes.

187

186

Darrel Duffie,

Still the World's Safe Haven,

Hutchison Center on Fiscal & Monetary Policy, at 15 (June 2020),

available at https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_v2.pdf

(“Duffie”).

187

IAWG Report,

supra

note 4, at 30; Liang & Parkinson,

supra

note 32, at 9; Duffie,

supra

note 186, at 16-17.

Fourth, the potential benefits associated with the multilateral netting of transactions at a CCP that the Membership Proposal is designed to bring about could in turn help to unlock further improvements in U.S. Treasury market structure. The increase in clearing and consequent reduction in counterparty credit risk could “enhance the ability of smaller bank and independent dealers to compete with the incumbent bank dealers.”

188

Similarly, decreased counterparty credit risk—and potentially lower costs for intermediation—could result in narrower spreads, thereby enhancing market quality.

189

Moreover, increased accessibility of central clearing in U.S. Treasury markets could support movement toward all-to-all trading, even potentially in the repo market, which would further improve market structure and resiliency, although a movement in that direction is not assured.

190

This potential movement would stem from the fact that increased central clearing of U.S. Treasury securities transactions would, in turn, result in decreased counterparty risk, making all-to-all trading more attractive, that is, a market participant would be more willing to trade with any counterparty if a CCP were to serve as its ultimate counterparty.

188

Liang & Parkinson,

supra

note 32, at 9.

189

G-30 Report,

supra

note 5, at 13

190

IAWG Report,

supra

note 4, at 30; Duffie,

supra

note 186, at 16; G-30 Report,

supra

note 5, at 13. All-to-all trading would be characterized by the ability for a bid or offer submitted by one market participant to be accepted by any other market participant, with trades executed at the best bid or offer.

See, e.g.,

Liang & Parkinson,

supra

note 32, at 9. All-to-all trading could improve the quality of trade execution in normal market conditions and broaden and stabilize the supply of market liquidity under stress.

See, e.g.,

G-30 Report,

supra

note 5, at 10.

Finally, increased central clearing should enhance regulatory visibility in the critically important U.S. Treasury market. Specifically, central clearing increases the transparency of settlement risk to regulators and market participants, and in particular allows a CCP to identify concentrated positions and crowded trades, adjusting margin requirements accordingly, which should help reduce significant risk to the CCP and to the system as a whole.

191

In light of the role of U.S. Treasury securities in financing the federal government, it is important that regulators improve their visibility into this market. Increased clearing would provide greater insight into the often opaque repo market, as discussed further in section III.A.2.a

supra,

as well as to the cash market where TRACE faces certain limitations, as discussed in section IV

infra.

Increased central clearing would also allow for a more aggregated view of market activity in one place.

191

Duffie,

supra

note 186, at 15; IAWG Report,

supra

note 4, at 30 (centralization of transactions at

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