# 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 > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2022-20288 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** October 25, 2022 - **Citation:** 87 FR 64610 ## Text 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. 1 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. 2 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. 1 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”). 2 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. 3 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. 3 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. 4 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. 5 4 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. 5 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. 6 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. 7 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. 8 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. 9 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.” 10 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. 11 6 17 CFR 240.17Ad-22(a)(2). 7 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”). 8 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). 9 Id. 10 CCA Standards Proposing Release, supra note 7, 79 FR at 29587. 11 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 12 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. 12 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”), 13 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. 14 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. 15 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. 16 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. 13 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. 14 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.” 15 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. 16 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. 17 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. 18 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. 17 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”). 18 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. 19 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 20 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. 21 In addition, the G-30 Report estimated that “roughly 20 percent of commitments to settle U.S. Treasury security trades are cleared through FICC.” 22 19 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. 20 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. 21 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. 22 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. 23 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.” 24 23 TMPG White Paper, supra note 21, at 3. 24 Id. D. Proposal The Commission believes that a covered clearing agency, including one that provides CCP services, 25 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. 26 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.” 27 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, 28 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. 29 25 Hereafter covered clearing agencies are referred to as “CCAs.” 26 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. 27 CCA Standards Proposing Release, supra note 7, 79 FR at 29552; see also CCA Standards Adopting Release, supra note 25, 81 FR at 70839. 28 17 CFR 240.17Ad-22(e)(18). 29 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. 30 30 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. 31 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. 31 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. 32 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. 32 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. 33 The Commission believes that these benefits arising from central clearing should help improve the functioning of the U.S. Treasury market. 33 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. 34 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. 35 34 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. 35 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. 36 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. 37 U.S. Treasury securities are typically issued a few days after the auction and trade on the secondary market. 38 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. 39 This proposal applies to the secondary market for U.S. Treasury securities. 36 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. 37 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. 38 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/. 39 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”). 40 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. 41 40 Joint Staff Report, supra note 4, at 11, 35-36. 41 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. 42 42 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. 43 43 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. 44 44 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. 45 However, in recent years, much of the trading on IDBs, in terms of number of trades and overall volume, has been conducted by PTFs. 46 45 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 supra note 37 (setting forth conditions for being a primary dealer). 46 G-30 Report, supra note 5, at 1. Most IDBs are FICC direct participants, and the trades between an IDB, that is a FICC direct participant, and another FICC direct participant are submitted for central clearing to FICC, which, as noted above, is currently the only U.S. Treasury securities CCA. Various types of market participants are direct participants of FICC, including dealers (both bank-affiliated and independent), banks, and IDBs. FICC's current rules generally require that FICC direct participants submit for clearing all trades with other FICC direct participants. 47 However, FICC's rules do not require that a trade between a FICC direct participant and a party that is not a FICC direct participant be submitted for clearing. Therefore, for trades on IDBs between a party that is not a FICC direct participant (which, on an IDB, is generally a PTF) and a dealer which is a FICC direct participant—which results in two separate transactions, between the IDB and the dealer, on the one hand, and between the IDB and the PTF, on the other hand—the transaction between the dealer and the IDB would be centrally cleared. But the transaction between a PTF which is not a FICC member and the IDB, on the other side, would not be centrally cleared and instead would be settled bilaterally with the IDB, often through a clearing agent acting on behalf of the non-FICC direct participant. 48 47 FICC Rule 2A section 7(e) (requirement that FICC Netting Members submit to FICC all of its eligible trades with other Netting Members); FICC Rule 18 section 2 (similar requirement with regard to Repo transactions). The Rules for FICC's GSD are available at https://www.dtcc.com/~/media/Files/Downloads/legal/rules/ficc_gov_rules.pdf. Unless otherwise indicated, all references to “FICC Rule” in this release refer to the GSD Rulebook. 48 See TMPG White Paper, supra note 21, at Figures 5A and 5B (providing graphical description of this type of clearing). A 2015 inter-agency staff publication found that PTFs account for more than half of the trading activity in the futures and electronic IDB markets for U.S. Treasury securities, providing the vast majority of market depth, and questioned whether trades cleared by such firms outside of a CCP are subject to the same level of risk mitigation. 49 In 2018, the TMPG determined that “a majority of trades in the secondary [cash] Treasury market now clear bilaterally, a trend that is contrary to the direction of recent regulatory requirements in other markets ( i.e., swaps) that for some products mandate clearing and for others encourage it through higher margin requirements on bilaterally cleared transactions.” 50 The trading volume of non-FICC members, at least in the cash U.S. Treasury market, is now estimated to exceed that of FICC members. 51 Whether or not a trade is centrally cleared impacts the risk management requirements applicable to the trade. Specifically, trades cleared and settled outside of a CCP may not be subject to the same extent of risk management associated with central clearing, which includes requirements for margin determined by a publicly disclosed method that applies objectively and uniformly to all members of the CCP, loss mutualization, and liquidity risk management. 52 49 Joint Staff Report, supra note 4, at 2, 55. 50 TMPG White Paper, supra note 21, at 2. 51 IAWG Report, supra note 4, at 30; TMPG White Paper, supra note 21, at 12. 52 IAWG Report, supra note 4, at 30; G-30 Report, supra note 5. Dealer-to-customer trading generally involves “off-the-run” issues more often than the interdealer market and typically is conducted via voice or electronically ( i.e., electronic “request for quote” systems referred to section IV infra as non-ATS IDBs). 53 Trading in the dealer-to-customer cash market is generally—and has historically been—conducted through bilateral transactions. Customers have not traditionally traded directly with other end users. 54 Rather, non-dealers primarily trade with dealers, and dealers use the interdealer market as a source of orders and trading interest to help facilitate their trading with customers in the dealer-to-customer market. Generally, trades in the dealer-to-customer market are not centrally cleared. 55 53 G-30 Report, supra note 5, at 1; TMPG White Paper, supra note 21, at 1-2. 54 See Exchange Act Release No. 90019 (Sep. 28, 2020), 85 FR 87106, 87108 (Dec. 30, 2020). 55 G-30 Report, supra note 5, at 1; IAWG Report, supra note 4, at 3; TMPG White Paper, supra note 21, at 6. 2. U.S. Treasury Repo Market In a U.S. Treasury repo transaction, one party sells a U.S. Treasury security to another party, along with a commitment to repurchase the security at a specified price on a specified later date. A reverse repo transaction is the same transaction from the buyer's perspective. 56 The effect of such a repo transaction is similar to a cash loan, using the U.S. Treasury securities as collateral. The difference in price between the purchase and repurchase is typically converted to an interest rate, and represents the “cost” of the loan. U.S. Treasury repos can use a particular security as collateral (known in the industry as “specific collateral”) or can designate a broad class of securities as collateral (known as “general collateral”). Most U.S. Treasury repos are overnight, though the parties can set the term for longer (generally no longer than one year). 56 For purposes of this release, we generally refer to both repos and reverse repos collectively as “repos.” 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 low cost secured 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. 57 The Federal Reserve also engages in U.S. Treasury repos to bring about liquidity in the financial system, implement monetary policy, and promote financial stability. As of March 31, 2022, total repo assets were approximately $6 trillion, while repo liabilities were approximately $5.6 trillion, with over half collateralized by U.S. Treasury securities. 58 Of that amount, 38 percent is attributable to the Federal Reserve's reverse repo programs, 27 percent to securities dealers, 20 percent to what is referred to as “rest of world” and includes, among other entities, foreign hedge funds, and the rest to banks, mortgage real estate investment trusts, and insurance companies. 59 57 Viktoria Baklanova, Isaac Kuznits, Trevor Tatum, Primer: Money Market Funds and the Repo Market (Feb. 18, 2021), available at https://www.sec.gov/files/mmfs-and-the-repo-market-021721.pdf (“MMF Primer”). 58 The Financial Accounts of the United States (Q1 2022), available at https://www.federalreserve.gov/releases/z1/20220609/html/l207.htm. The difference between repo assets and repo liabilities in the Financial Accounts is largely attributed to incomplete repo data collections and is calculated as instrument discrepancies. 59 See id. Depending on clearing and settlement practices, the U.S. Treasury repo market consists of four main components: (1) non-centrally cleared, settled bilaterally, (2) centrally cleared, settled bilaterally, (3) non-centrally cleared, settled on a triparty platform, and (4) centrally cleared, settled on a triparty platform. For non-centrally cleared bilateral U.S. Treasury repos, the parties agree to the terms and settle the trades between themselves, without involving a CCP or other third-party. As mentioned above, FICC's rules require its direct participants to submit for central clearing all eligible trades with other direct participants. Therefore, non-centrally cleared bilateral U.S. Treasury repos involve at least one party that is not a FICC direct participant ( e.g., a hedge fund); such repos may also involve a repo structure that FICC does not accept for clearing. For centrally cleared bilateral U.S. Treasury repos, the parties are FICC direct participants that submit agreed-upon trade details to FICC for central clearing, and those trades are settled delivery versus payment using the members' clearing banks and/or Fedwire Securities Service. 60 Additionally, some institutional participants ( e.g., money market funds and hedge funds) that are not FICC direct participants also centrally clear repos through FICC's sponsored service. In 2005, FICC established this service (the “Sponsored Service”), allowing eligible direct participants (Sponsoring Members) to sponsor their clients into a limited form of FICC membership and then to submit certain eligible securities transactions of their clients (Sponsored Members) to FICC for central clearing. 61 FICC interacts solely with the Sponsoring Member/direct participant as agent for purposes of the Sponsoring Member's clients/Sponsored Members' obligations to and from FICC. Sponsoring Members also guarantee to FICC the payment and performance obligations of their Sponsored Members. 62 Sponsoring Members can be either bank direct participants of FICC which meet certain capital and other requirements or any other FICC direct participant which meets what FICC determines to be the appropriate financial resource requirements; in practice, Sponsoring Members include both banks and broker-dealers. 63 Sponsored Members have to be “qualified institutional buyers” as defined by Rule 144A under the Securities Act of 1933, as amended, or otherwise meet the financial standards necessary to be a “qualified institutional buyer,” and currently, Sponsored Members generally consist of hedge funds, money market funds, other asset managers, and smaller banks. 64 60 See note 249 infra. 61 See Self-Regulatory Organizations; Fixed Income Clearing Corporation; Order Approving a Proposed Rule Change Establishing a Sponsored Membership Program, Exchange Act Release No. 51896 (June 21, 2005), 70 FR 36981 (June 27, 2005). 62 See Exchange Act Release No. 51896 (June 21, 2005), 70 FR 36981 (June 27, 2005); 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. 63 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). 64 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. 65 65 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. 66 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. 67 Each type of eligible collateral for the Sponsored GC Service is assigned its own generic CUSIP number, and security types are not mixed. 68 66 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. 67 See generally DTCC Sponsored General Collateral Service, available at https://www.dtcc.com/-/media/Files/Downloads/Clearing-Services/FICC/GOV/SponsoredGC-FS-INTL.pdf. 68 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, 69 and the Government Securities Act of 1986 specifically included government securities within the scope of section 17A. 70 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. 71 The Commission's ability to achieve these goals is based upon the regulation of clearing agencies registered with the Commission. 72 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. 73 69 See supra note 1. 70 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). 71 See 15 U.S.C. 78q-1(a)(2)(A). 72 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). 73 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. 74 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. 74 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.” 75 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.” 76 75 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.”). 76 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. 77 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. 78 77 17 CFR 240.17Ad-22(e)(18). 78 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.” 79 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. 80 79 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). 80 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. 81 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. 82 Permissible locations include a clearing corporation and a bank, as defined in section 3(a)(6) of the Exchange Act. 83 81 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). 82 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. 83 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. 84 The account must be titled “Special Reserve Bank Account for the Exclusive Benefit of Customers” (“customer reserve account”). 85 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”). 86 Under the formula, the broker-dealer adds up customer credit items and then subtracts from that amount customer debit items. 87 The credit items include credit balances in customer accounts and funds obtained through the use of customer securities. 88 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. 89 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. 90 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. 91 The broker-dealer must make a deposit into the customer reserve account if the computation shows an increase in the reserve requirement. 84 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). 85 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. 86 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). 87 See id. 88 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. 89 See 17 CFR 240.15c3-3a, Items 10-14. 90 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. 91 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. 92 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. 93 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. 94 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). 95 92 See 17 CFR 240.15c3-3a. 93 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. 94 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. 95 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. 96 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 97 or a derivatives clearing organization (“DCO”) registered with the Commodities Futures Trading Commission under section 5b of the Commodity Exchange Act. 98 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. 99 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. 96 See 17 CFR 240.15c3-3a, Item 13. 97 15 U.S.C. 78q-1. 98 7 U.S.C. 78q-1. 99 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. 108 108 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. 143 143 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 Di [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2022-20288. Public record. Not legal advice.