Letter concludes that it is legally permissible for national banks to become members of the Government Securities Division of the Fixed Income Clearing Corporation and participate in its loss allocation system.

O

Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219

January 10, 2005 Interpretive Letter #1014

February 2005

12 USC 24(7)

Subject: National Bank Participation in the Loss Allocation System of the Government

Securities Division (“GSD”) of the Fixed Income Clearing Corporation (“FICC”)

Dear [ ]:

This letter responds to your request on behalf of the GSD of the FICC, a New York based

clearing corporation, concerning the ability of national banks to participate as netting members in

its current loss allocation system (“LAS”). FICC’s GSD provides services to its financial

institution members with respect to the clearing, netting and settlement of U.S. Government

securities transactions. For the reasons discussed below, we believe that it is legally permissible

for national banks to be members of the GSD and participate in its current LAS.

I. Background

FICC

The FICC is a clearing agency registered with, and supervised and regulated by, the Securities

and Exchange Commission (“SEC”). The FICC was formed by the merger of the Government

Securities Clearing Corporation (“GSCC”)1 and the MSB Clearing Corporation. FICC is divided

into the GSD and the Mortgage-Backed Securities Division. These two divisions offer their own

product specific services to their own members, with each maintaining separate rules and a

separate collateral margin pool.

The GSD clears, nets, settles and manages the risks for its member firms (brokers, dealers, banks

and other financial institutions) arising from a broad range of U.S. Government securities

transactions. In addition, the GSD offers its services to correspondent firms that clear U.S.

Government securities transactions through its members

separate rules and a

separate collateral margin pool.

The GSD clears, nets, settles and manages the risks for its member firms (brokers, dealers, banks

and other financial institutions) arising from a broad range of U.S. Government securities

transactions. In addition, the GSD offers its services to correspondent firms that clear U.S.

Government securities transactions through its members. The transactions processed by the

GSD include original authorizing purchases of Treasury and Freddie Mac securities, buy/sell and

repo transactions in Treasury and Government Agency securities, and General Collateral Finance

Repo transactions in U.S. Government and U.S. Government Agency securities as well as certain

1 The GSCC was the predecessor to the FICC’s GSD. “GSD” in this letter refers to both the GSCC and the GSD.

mortgage-backed securities.2 The GSD has offered these services to market participants,

including national banks, since 1989.

The GSD is part of the core infrastructure of the U.S. Government securities marketplace. By

providing sophisticated, automated trade comparison, netting and settlement services, the GSD

ensures the timely, accurate and cost-efficient completion of transactions for its netting

members.3 The GSD’s risk management process helps minimize the risks arising from the

process of clearing and settling U.S. Government securities transactions.

FICC represents that the GSD’s bank netting members are significant participants in the U.S.

Government securities market and important GSD members. For example, in June 2004 the

various bank members of GSD, in the aggregate, submitted transactions for processing with a par

value of approximately $1.6 trillion, most of which went into the GSD's netting system. FICC

asserts that it is important to the efficient functioning of this marketplace that key players, such

as the GSD’s bank netting members, continue to participate in the GSD

ers. For example, in June 2004 the

various bank members of GSD, in the aggregate, submitted transactions for processing with a par

value of approximately $1.6 trillion, most of which went into the GSD's netting system. FICC

asserts that it is important to the efficient functioning of this marketplace that key players, such

as the GSD’s bank netting members, continue to participate in the GSD.

GSD’s LAS

The GSD has several risk protection measures, which include the imposition of minimum

financial, and other admission standards,4 ongoing financial surveillance of members,5 the

maintenance of clearing fund margin (“Clearing Fund”),6 and the collection and pass-through of

2 The GSD must maintain a master file list of securities that the FICC has designated as eligible for netting. FICC

GSD Rulebook, Rule 30. As of October 19, 2004, there were 14,941 netting eligible securities identified on that list.

A predominant number of those securities would appear to qualify as Type I securities under 12 C.F.R. Part 1. 12

C.F.R. § 1.2(j). A national bank may deal in, underwrite, purchase and sell Type I securities in unlimited amounts.

12 C.F.R. § 1.3(a).

3 The FICC’s GSD has two basic types of members – netting members and comparison only members.

“Netting Members” are members of the comparison and netting systems. Netting members have their trades netted

and settled through GSD and, therefore, have securities and funds obligations to the GSD. “Comparison-only

members” do not have their trades netted and settled through GSD, but benefit from the GSD’s automated, binding

comparison of trades

etting members and comparison only members.

“Netting Members” are members of the comparison and netting systems. Netting members have their trades netted

and settled through GSD and, therefore, have securities and funds obligations to the GSD. “Comparison-only

members” do not have their trades netted and settled through GSD, but benefit from the GSD’s automated, binding

comparison of trades.

4 Bank netting member applicants must, for example, have a level of equity capital as of the end of the month prior

to the effective date of its membership, determined in accordance with generally accepted accounting principles, of

at least $100 million and its capital level and ratios must meet the applicable minimum levels required by the

appropriate regulatory agency. FICC GSD Rulebook, Rule 3, Section 2.

5 The FICC monitors members and may place them on a watch list based on ratings assigned according to the

FICC’s credit risk rating matrix or for failure to comply with certain operational standards and requirements. FICC

GSD Rulebook, Rule 4, Section 3. Members assigned a “weak” rating, or deemed to pose a relatively higher degree

of risk to the FICC will be placed on its internal watch list and monitored more closely by credit risk staff. A

member will continue to be included on the watch list until the condition that resulted in placement on the list has

sufficiently improved so that the FICC determines that close monitoring is no longer warranted. FICC GSD

Rulebook, Rule 4, Section 3; 69 Fed. Reg. 5624.

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6 FICC netting members are required to maintain deposits in a Clearing Fund account. Each member’s required

deposit is calculated daily to ensure enough funds are on hand to cover the risks associated with that member’s

activities. The purposes served by the Clearing Fund are to: [1] have on deposit from each netting member assets

book, Rule 4, Section 3; 69 Fed. Reg. 5624.

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6 FICC netting members are required to maintain deposits in a Clearing Fund account. Each member’s required

deposit is calculated daily to ensure enough funds are on hand to cover the risks associated with that member’s

activities. The purposes served by the Clearing Fund are to: [1] have on deposit from each netting member assets

mark-to market amounts. Moreover, the FICC has loss sharing arrangements (cross-margining7

and cross-guaranty8 arrangements) in place with other clearing corporations whereby a loss from

a common member on one clearing corporation might be covered by a profit at another clearing

corporation. FICC asserts that loss allocation (which would occur only if a member became

insolvent and the mark-to-market amount and margin it provided and the monies available from

these other loss sharing arrangements were not sufficient to cover liquidation losses) is a highly

unlikely event. The LAS provisions that govern the GSD netting member firms are generally

found in Rule 4 of the FICC GSD Rulebook. FICC represents that in the 15-year history of the

GSD’s netting system, not a single netting member has ever been declared insolvent, let alone

caused a loss that triggered the LAS.

FICC’s GSD Member Liability under the LAS

The FICC’s GSD Rulebook provides that a netting member is in default if insolvent and

describes the actions the FICC’s GSD may take in response.9 A defaulting member’s loss is first

covered by liquidating the defaulting member’s netted security positions and applying the

defaulting member’s Clearing Fund deposit.10 If the Clearing Fund deposit is insufficient to

satisfy the loss, and the defaulting member is a cross-margining participant or a common

member of a clearing corporation with which FICC has a cross-guaranty agreement, the FICC

will apply any amounts available under the applicable cross-margining guaranty or cross-

sufficient to sa

nd deposit.10 If the Clearing Fund deposit is insufficient to

satisfy the loss, and the defaulting member is a cross-margining participant or a common

member of a clearing corporation with which FICC has a cross-guaranty agreement, the FICC

will apply any amounts available under the applicable cross-margining guaranty or cross-

sufficient to satisfy any losses that may otherwise be incurred by the FICC (and ultimately its members) as a result

of the default by the member and the resultant close-out of that member’s settlement positions, [2] maintain a total

asset amount sufficient to satisfy potential losses to the FICC and its members resulting from the failure of more

than one member (and the failure of such member’s counterparties to pay their pro-rata allocation of loss), and [3]

ensure that the FICC has sufficient liquidity at all times to meet its payment and delivery obligations. Overview of

the GSD of the FICC. (Aug. 16, 2004), at p. 67 - 8.

7 FICC has established cross-margining arrangements with other clearing organizations (“Participating COs”). Each

FICC netting member signs an agreement under which it agrees to be bound by these cross-margining arrangements,

which allow the FICC or the Participating CO to apply the member’s margin collateral to satisfy any obligation of

the FICC to the Participating CO, or vice versa, that results from a default of the member. Overview of the GSD of

the FICC. (Aug. 16, 2004), at p. 74

ting COs”). Each

FICC netting member signs an agreement under which it agrees to be bound by these cross-margining arrangements,

which allow the FICC or the Participating CO to apply the member’s margin collateral to satisfy any obligation of

the FICC to the Participating CO, or vice versa, that results from a default of the member. Overview of the GSD of

the FICC. (Aug. 16, 2004), at p. 74.

8 FICC has entered into a multilateral netting contract and limited cross-guaranty agreement with the Depository

Trust Company (DTC), National Securities Clearing Corporation (NSCC), Emerging Markets Clearing Corporation

(EMCC) and the Options Clearing Corporation, under which these clearing agencies have agreed to make payment

to each other for any remaining unsatisfied obligations of a common defaulting participant to the extent that they

have excess resources of the defaulting participant. Overview of the GSD of the FICC. (Aug. 16, 2004), at p. 92;

2003 Fixed Income Clearing Corporation Annual Financial Statement. FICC is a wholly owned subsidiary of the

Depository Trust & Clearing Corporation (DTCC). DTC, NSCC and EMCC are also principal operating

subsidiaries of DTCC. 2003 Fixed Income Clearing Corporation Annual Financial Statement.

9 FICC GSD Rulebook, Rules 1, 4, 22, and 43.

10 FICC GSD Rulebook, Rule 4, Section 8.

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guaranty agreement to the loss.11 The GSD will allocate any remaining loss to the netting

members

the

Depository Trust & Clearing Corporation (DTCC). DTC, NSCC and EMCC are also principal operating

subsidiaries of DTCC. 2003 Fixed Income Clearing Corporation Annual Financial Statement.

9 FICC GSD Rulebook, Rules 1, 4, 22, and 43.

10 FICC GSD Rulebook, Rule 4, Section 8.

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guaranty agreement to the loss.11 The GSD will allocate any remaining loss to the netting

members.

In general, the GSD's loss allocation rules impose loss allocation obligations only on those

netting members that engaged in recent counterparty trading activity with the defaulting member

(“recent counterparties”).12 The GSD will mutualize loss, and thus impose loss allocation

obligations on netting members that are not recent counterparties, only if a recent counterparty

fails to pay its loss allocation obligation or if a loss allocation exceeds an applicable cap.13

Where the GSD mutualizes loss allocation obligations, a netting member can either pay the

amount of the loss or provide the GSD with notice of its election to terminate its membership.14

If a netting member elects to terminate its membership, its loss allocation liability is limited to its

Required Fund Deposit. 15 As a result, a member may cap its contingent liability for mutualized

loss at the member’s Required Fund Deposit.

GSD netting members may freely elect to terminate membership in the GSD. The FICC requests

that members provide it with written notice at least 10 business days prior to terminating

membership in the GSD.16 The termination is not effective until accepted by the FICC. Thus,

if the FICC proposed a rule change, for example, that provided that members were subject to

unlimited liability for a defaulting member’s losses, members could terminate membership in the

GSD. A member that terminates membership in the GSD is liable for the member’s obligations

that arose under GSD Rules prior to the termination of membership.17

II

ve until accepted by the FICC. Thus,

if the FICC proposed a rule change, for example, that provided that members were subject to

unlimited liability for a defaulting member’s losses, members could terminate membership in the

GSD. A member that terminates membership in the GSD is liable for the member’s obligations

that arose under GSD Rules prior to the termination of membership.17

II. Discussion

National banking law permits national banks, their operating subsidiaries, and their branches to

engage in clearing and execution activities as activities that are part of the business of banking

11 Id.

12 In general, “recent counterparty trading activity” includes the netting activity with a defaulting member that

occurred however many business days immediately prior to the day of default as are necessary to find at least five

times the dollar value amount of the defaulting member’s securities that are liquidated by the FICC. FICC GSD

Rulebook, Rule 4, Section 8(f); Overview of the GSD of the FICC. (Aug. 16, 2004), at pp. 90 – 92.

13 FICC GSD Rulebook, Rule 4, Section 8.

14 FICC GSD Rulebook, Rule 4, Section 8(e) and (h); Rule 2, Section 10.

15 Id; The “Required Fund Deposit” is the minimum level of deposit to the Clearing Fund that is required to be made

and maintained by a netting member. Each netting member must deposit a minimum cash contribution of $100,000

or 10% of the total amount of the Clearing Fund up to a maximum of $500,000. FICC GSD Rulebook, Rule 4,

Section 2(b)(ii).

16 FICC GSD Rulebook, Rule 2, Section 11.

17 Id.

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red Fund Deposit” is the minimum level of deposit to the Clearing Fund that is required to be made

and maintained by a netting member. Each netting member must deposit a minimum cash contribution of $100,000

or 10% of the total amount of the Clearing Fund up to a maximum of $500,000. FICC GSD Rulebook, Rule 4,

Section 2(b)(ii).

16 FICC GSD Rulebook, Rule 2, Section 11.

17 Id.

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because the activities are functionally equivalent to bank permissible credit and financial

intermediation activities.18

Clearing is a form of extending credit, one of the main functions of banking institutions.19 A

clearing agent substitutes its credit for that of its customers. A clearing agent is liable to a

clearinghouse for performance on all submitted contracts, and assumes, with respect to the

exchange, clearinghouse, and counterparties, the risk of default. The clearing function is akin to

two other traditional bank credit functions, providing bankers’ acceptances and letters of credit.

The credit function provided by a national bank in its clearing capacity is part of the business of

banking, because a principal business of a bank is to extend credit.20

National bank clearing and execution activities are functionally equivalent to the primary role of

banks as financial intermediaries. The role of a bank is to act as an intermediary, facilitating the

flow of money and credit among different parts of the economy.21 The role of a bank

intermediary takes many forms: providing payments transmission services, borrowing from

savers and lending to users and participating in the capital markets, as here. As the recognized

intermediaries between other, non-bank participants in the financial markets and the payment

systems, banks possess the expertise to effect transactions between parties and to manage their

own intermediation position

ediary takes many forms: providing payments transmission services, borrowing from

savers and lending to users and participating in the capital markets, as here. As the recognized

intermediaries between other, non-bank participants in the financial markets and the payment

systems, banks possess the expertise to effect transactions between parties and to manage their

own intermediation position. Hence, national bank clearing and execution activities are

permissible as part of bank authorized financial intermediary activities.22

The OCC has opined that national banks and their operating subsidiaries and branches may

engage in clearing and execution activities both domestically and abroad.23 In fact, the OCC

previously determined that it was permissible for national banks to invest in the GSD in order to

18 Courts have affirmed OCC interpretations that an activity is within the scope of the “business of banking” if it:

[1] is functionally equivalent to or a logical outgrowth of a traditional banking activity; [2] would respond to

customer needs or otherwise benefit the bank or its customers; and [3] involves risks similar to those already

assumed by banks. See, e.g., Merchant Bank v. State Bank, 77 U.S. 604 (1871); M & M Leasing Corp. v. Seattle

First Nat’l Bank, 563 F.2d 1377, 1382 (9th Cir. 1977), cert. denied, 436 U.S. 956 (1978); American Insurance

Ass’n. v. Clarke, 865 F.2d 278, 282 (2d Cir. 1988). In IAA v. Hawke, 211 F.3d 638 (D.C. Cir. 2000), the court

expressed the position that the “logical outgrowth” rationale needed to be kept within bounds, but endorsed the

“functional equivalent” component of the test.

19 See OCC Interpretive Letter No. 494 (Dec. 29, 1989).

20 Id.

21 See, e.g., OCC No-Objection Letter No. 90-1 (February 16, 1990); OCC No-Objection Letter No. 87-5 (July 20,

1977).

22 See OCC Interpretive Letter 892 (September 8, 2000).

23 See, e.g., OCC Interpretive Letter No. 929 (Feb

eded to be kept within bounds, but endorsed the

“functional equivalent” component of the test.

19 See OCC Interpretive Letter No. 494 (Dec. 29, 1989).

20 Id.

21 See, e.g., OCC No-Objection Letter No. 90-1 (February 16, 1990); OCC No-Objection Letter No. 87-5 (July 20,

1977).

22 See OCC Interpretive Letter 892 (September 8, 2000).

23 See, e.g., OCC Interpretive Letter No. 929 (Feb. 11, 2002); OCC Interpretive Letter No. 494, supra; OCC

Interpretive Letter No. 421, supra; OCC Interpretive Letter No. 384 (May 19, 1987); OCC Interpretive Letter No.

380, supra; OCC Interpretive Letter No. 372 (Nov. 7, 1986).

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take advantage of the services offered by the corporation.24 The permissibility of contributing to

a default fund was not addressed in OCC Interpretive Letter 421. However, a national bank’s

provision of a default fund contribution to cover potential defaults, as a necessary precondition to

engaging in bank permissible clearing and execution activities, is incidental to these activities.25

The OCC has determined that default fund contributions are, under these circumstances,

permissible guaranties.26

The National Bank Act is itself silent on the authority of national banks to provide guaranties.27

There is no express power, nor any express prohibition, concerning guaranties. And, the

Supreme Court has never held that guaranties are per se impermissible for national banks. 28

Instead, the Court has upheld a national bank’s power to make guaranties given the specific facts

under consideration.29 Lower courts have tended to generalize these cases, however, in stating

that national banks may not provide guaranties.30

OCC Interpretive Ruling 7.1017 clarifies that that a national bank may provide a guaranty if the

bank has a substantial interest in the transaction at issue. 31 A “substantial interest” exists if the

24 OCC Interpretive Letter No. 421 (March 14, 1988)

alize these cases, however, in stating

that national banks may not provide guaranties.30

OCC Interpretive Ruling 7.1017 clarifies that that a national bank may provide a guaranty if the

bank has a substantial interest in the transaction at issue. 31 A “substantial interest” exists if the

24 OCC Interpretive Letter No. 421 (March 14, 1988). In that letter, the OCC focused on the ability of a national

bank to hold stock in the corporation and discussed the corporation’s activities only to a very limited extent. The

current LAS was not in place at that time.

25 See e.g., OCC Interpretive Letter 929, supra

26 Id.

27 12 U.S.C. § 24 (Seventh).

28 See, e.g., Texas & Pacific Rwy. v. Potorff, 291 U.S. 245 (1934) (national bank has no authority to secure a private

deposit); First N.B. of Aiken v. Mott Iron Works, 258 U.S. 240 (1922) (declining to void a bank’s guarantee of

contract performance, and holding bank liable since it received the benefit of the guarantee); Citizens Central N.B. v.

Appleton, 216 U.S. 196 (1910)(declining to void one national bank’s guarantee to another bank, but deciding based

on a theory of implied contract); Merchants N.B. v. Wehrmann, 202 U.S. 295 (1906) (national bank may not assume

unlimited liability as a partner); Logan City N.B. v. Townsend, 139 U.S. 67 (1891) (declining to accept national bank

defense that it had no authority to guarantee a contract and holding bank liable since it benefited from the contract);

Cook County N.B. v. U.S., 107 U.S. 445 (1883) (not within implied or express powers of national bank to provide

the U.S. a priority of payment of claims arising from bank’s insolvency).

29 See Peoples Bank of Belleville v. Manufacturers N.B. of Chicago, 101 U.S. 181 (1880) (guarantee of notes held

within powers of a national bank when the transaction was in substance an “indorsement”); Cochran v. U.S., 157

U.S. 286 (1895) (contract of guarantee held within implied powers of a national bank)

o provide

the U.S. a priority of payment of claims arising from bank’s insolvency).

29 See Peoples Bank of Belleville v. Manufacturers N.B. of Chicago, 101 U.S. 181 (1880) (guarantee of notes held

within powers of a national bank when the transaction was in substance an “indorsement”); Cochran v. U.S., 157

U.S. 286 (1895) (contract of guarantee held within implied powers of a national bank).

30 See, e.g., Dunn v. McCoy, 113 F.2d 587 (9th Cir. 1940); Kimen v. Atlas Exchange N.B., 92 F.2d 615 (7th Cir.

1937) (invalidating bank sale of bonds to a customer and simultaneous guarantee to repurchase the bonds at any

time in the future at par); Border N.B. v. American N. B., 282 F. 73 (5th Cir. 1922 (upholding as letter of credit,

rather than an impermissible guarantee, an agreement covering the purchase and shipment of 200 tons of sugar);

Bowen v. Needles N.B., 94 F. 925 (9th Cir. 1899), cert. denied, 176 U.S. 682 (1900) (invalidating bank guarantee of

payment of customer’s checks, in full knowledge that the customer had no funds on deposit with the bank).

31 12 C.F.R. § 7.1017.

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guaranty provided by the bank is “incidental” 32 to another of its authorized activities.33 The

nexus between the bank permissible transaction and the guaranty provides the “substantial

interest” for the bank. The OCC has determined that a national bank’s provision of a default

fund contribution to cover potential defaults as a necessary precondition to engaging in bank

permissible clearing and execution activities, meets the substantial interest test and is incidental

to these activities. 34 A national bank has a substantial interest in providing such guaranties to

enable it to retain the ability to engage in bank permissible clearing and execution services, and

therefore the guaranty is incidental to banking. Thus, a national bank may contribute to a default

fund to guaranty its obligations and those of other exchange members consistent with the

requirements of OCC Interpretive Ruling 7.7010

nk has a substantial interest in providing such guaranties to

enable it to retain the ability to engage in bank permissible clearing and execution services, and

therefore the guaranty is incidental to banking. Thus, a national bank may contribute to a default

fund to guaranty its obligations and those of other exchange members consistent with the

requirements of OCC Interpretive Ruling 7.7010.

III. Conclusion

It is legally permissible for national banks to participate in the GSD’s LAS. OCC Interpretive

Letter 421 permits national banks to take advantage of the services offered by the GSD.

Moreover, OCC Interpretive Letter 929 concludes that clearing and exchange activities, and the

provision of funds to cover member defaults in connection with these activities, are permissible

activities for national banks. Accordingly, national banks may be netting members of the GSD

and participate in its LAS.

I trust the foregoing is responsive to your inquiry. If you have additional questions, please do

not hesitate to contact Tena M. Alexander, Special Counsel, Securities & Corporate Practices

Division at (202) 874-5210.

Sincerely,

/s/ Daniel P. Stipano

Daniel P. Stipano

Acting Chief Counsel

32 Incidental activities are activities that are permissible for national banks, not because they are part of the powers

expressly authorized for bank or the “business of banking,” but rather because they are “convenient” or “useful” to

those activities. See NationsBank v. Variable Annuity Life Insurance Co., 513 U.S. 2251 (1995); Arnold Tours, Inc.

v. Camp, 472 F.2d 427 (1st Cir. 1972); OCC Interpretive Letter No. 742 (Aug. 19, 1996); OCC Interpretive Letter

No. 737 (August 19, 1996); OCC Interpretive Letter No. 494, supra.

33 See, e.g., Dunn v. McCoy, 113 F.2d 587 (9th Cir. 1940); OCC Interpretive Letter No. 376, supra.

34 See e.g., OCC Interpretive Letter 929, supra

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