insufficient internal controls endangering broader financial stability?
Are there existing requirements under Section 17A of the Exchange Act,
such as the ``fair representation'' requirement in Section
17A(b)(3)(C), rules and regulations adopted by the Commission and
applicable to SROs, or relevant interpretations published by the
Commission that already provide a clear and sufficient basis for the
Commission to supervise covered clearing agencies in the manner
contemplated by proposed Rule 17Ad-22(e)(2) without adopting the
proposed rule? What are the possible benefits of adopting the rule as
proposed and what possible detriments may arise that the Commission
should consider?
     Are there disclosures that a covered clearing agency
should be required to make with respect to its governance arrangements?
Why or why not? If so, what should be the form and content of those
disclosures?
     Should the Commission require that the performance of the
board of directors and senior management--individually and as a group--
are reviewed on a regular basis? If so, how often should this review be
conducted? Should this review be conducted independently?
     Should the board of directors of covered clearing agencies
include individuals who are not executives, officers, or employees of
the covered clearing agency, or an affiliate of the covered clearing
agency? Should the board of directors of covered clearing agencies
include an independent audit committee?
     Should the Commission be involved in and/or set
requirements and standards with respect to board and management
governance at covered clearing agencies? Does the Commission have the
requisite statutory authority to adopt the rule proposals and matters
addressed in the related questions set forth in this release as to
governance arrangements, standards, composition, and qualifications of
covered clearing agencies' boards and management? Is the Commission's
oversight and establishment of corporate governance measures and
standards at clearing agencies a proper and good use of Commission
resources? What are the potential costs and benefits of these corporate
governance provisions?
3. Proposed Rule 17Ad-22(e)(3): Framework for the Comprehensive
Management of Risks
    Proposed Rule 17Ad-22(e)(3) would require a covered clearing agency
to establish, implement, maintain and enforce written policies and
procedures reasonably designed to maintain a sound risk management
framework for comprehensively managing legal, credit, liquidity,
operational, general business, investment, custody, and other risks
that arise in or are borne by the covered clearing agency.\133\
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    \133\ See proposed Rule 17Ad-22(e)(3), infra Part 0.
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    Existing Rules 17Ad-22(b) and (d) require registered clearing
agencies to establish, implement, maintain and enforce written policies
and procedures reasonably designed to meet several requirements that
address risk management practices by registered clearing agencies that
provide CCP services (Rules 17Ad-22(b)(1) through (4)), certain
requirements regarding

access to registered clearing agencies that provide CCP services (Rules
17Ad-22(b)(5) through (7)), and certain minimum standards for the
operations of registered clearing agencies providing CCP or CSD
services.\134\ Consistent with these requirements and the Exchange Act
requirements discussed above,\135\ the Commission preliminarily
believes that proposed Rule 17Ad-22(e)(3) is appropriate and would
require a covered clearing agency's policies and procedures to take a
broader, more comprehensive approach to risk management, which the
Commission believes is fundamental to a covered clearing agency's
functioning given its size, operation, and importance in the U.S.
securities markets. While existing rules under the Exchange Act already
target certain aspects of risk management, the Commission preliminarily
believes that comprehensive risk management policies and procedures
established pursuant to proposed Rule 17Ad-22(e)(3) would further
support the examination of risks, the assessment of their probability
and impact, and the identification of linkages to other entities that
in turn pose risks to the covered clearing agency. The Commission also
believes that comprehensive risk management policies and procedures
would facilitate the development of mechanisms to better prioritize,
manage, and monitor risks, and to measure the covered clearing agency's
risk tolerance and capacity. In proposing Rule 17Ad-22(e)(3), the
Commission is emphasizing a comprehensive approach to risk management
that would require risk management policies and procedures be designed
holistically, be consistent with each other, and work effectively
together in order to mitigate the risk of financial losses to covered
clearing agencies' members and participants in the markets they serve.
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    \134\ See 17 CFR 240.17Ad-22(b), (d); see also Clearing Agency
Standards Release, supra note 5, at 66230-43, 66244-58.
Specifically, as examples, Rule 17Ad-22(d)(4) requires a registered
clearing agency to have policies and procedures reasonably designed
to address certain aspects of operational risk, and Rule 17Ad-
22(d)(7) requires a registered clearing agency to have policies and
procedures reasonably designed to address certain aspects of risks
relating to linkages. See 17 CFR 240.17Ad-22(d)(4), (7).
    \135\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
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    In addition, policies and procedures for the comprehensive
management of risks have the potential to play an important role in
making sure that covered clearing agencies better fulfill the Exchange
Act requirements that the rules of a clearing agency be designed to
protect investors and the public interest.\136\ Similarly, these
requirements may promote the effectiveness of a covered clearing
agency's risk management procedures by fostering a focus on the
critical role that risk management plays in promoting prompt and
accurate clearance and settlement. Accordingly, the Commission
preliminarily believes that it is important that covered clearing
agencies have policies and procedures that enable them to identify,
monitor, and manage the range of risks that arise in or are borne by
all aspects of their clearance and settlement activities.
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    \136\ See 15 U.S.C. 78q-1(a)(2).
---------------------------------------------------------------------------

    In addition, the Commission is proposing the requirements described
below, which do not appear in existing Rules 17Ad-22(b) or (d). The
Commission preliminarily believes these requirements would be
appropriate for covered clearing agencies given the risks that their
size, operation, and importance pose to the U.S. securities markets.
a. Policies and Procedures Requirements, Periodic Review, and Annual
Board Approval
    Proposed Rule 17Ad-22(e)(3)(i) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to provide for risk management
policies, procedures, and systems designed to identify, measure,
monitor, and manage the range of risks that arise in or are borne by
the covered clearing agency, and subject them to review on a specified
periodic basis and approval by the board of directors annually.\137\
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    \137\ See id.
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    The Commission preliminarily believes periodic review of the risk
management policies and procedures would allow covered clearing
agencies to assess whether the risk management policies and procedures
should be updated to account for changing factors in the market and to
address and codify in a uniform way the approach to new risks taken
since the last periodic review. The Commission preliminarily believes
that the board of directors of a covered clearing agency should be
required to approve the risk management policies and procedures. The
Commission preliminarily believes that, in complying with this
requirement, a board of directors may want to subject all material
components of the covered clearing agency's risk management policies
and procedures to review pursuant to Rule 17Ad-22(e)(3)(i) due to the
critical role that risk management plays in promoting prompt and
accurate clearance and settlement.
b. Recovery and Orderly Wind-Down Plans
    Proposed Rule 17Ad-22(e)(3)(ii) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to ensure it establishes plans for
the recovery and orderly wind-down of the covered clearing agency
necessitated by credit losses, liquidity shortfalls, losses from
general business risk, or any other losses.\138\
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    \138\ See proposed Rule 17Ad-22(e)(3), infra Part 0.
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    Securities exchanges, market participants, and investors rely upon
the safe, sound, and efficient operations of covered clearing agencies,
and accordingly the Commission preliminarily believes that a disorderly
wind-down of a covered clearing agency would have systemic
consequences.\139\ The Commission preliminarily believes that a
recovery plan designed to deal with possible scenarios that may
threaten or potentially prevent a covered clearing agency from being
able to provide its critical operations and services as a going concern
and that assesses a full range of options for recovery could mitigate
the impact of a near failure of a covered clearing agency.
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    \139\ See generally Clearing Agency Standards Release, supra
note 5, at 66283 (noting, in discussing Rule 17Ad-22(d)(11), that
having policies and procedures ``allow[s] a clearing agency to wind
down positions in an orderly way and continue to perform its
obligations in the event of a participant default, assuring
continued functioning of the securities market in times of stress
and reducing systemic risk'').
---------------------------------------------------------------------------

    Based on its supervisory experience, the Commission recognizes that
covered clearing agencies operating in the market today each have
relevant standards and practices relating to recovery and orderly wind-
down with differing degrees of formality. The Commission therefore
preliminarily expects that Rule 17Ad-22(e)(3)(ii) would require covered
clearing agencies to review such standards and practices for
sufficiency with respect to the safe operation of the covered clearing
agency and revise such practices in a manner consistent with the
findings of such review consistent with the proposed rule, if adopted,
and the requirements of the Exchange Act.
c. Risk Management and Internal Audit
    Proposed Rule 17Ad-22(e)(3)(iii) would require a covered clearing
agency

to establish, implement, maintain and enforce written policies and
procedures reasonably designed to provide risk management and internal
audit personnel with sufficient authority, resources, independence from
management, and access to the board of directors. The Commission
preliminarily believes that a covered clearing agency could satisfy the
policies and procedures requirement for independence from management
by, for example, providing reporting lines for risk management
functions that are clear and separate from those for other operations
and providing for direct reporting to the board of directors or a
relevant committee of the board. In that regard, proposed Rule 17Ad-
22(e)(3)(iv) would require a covered clearing agency to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to provide risk management and internal audit
personnel with oversight by and a direct reporting line to a risk
management committee and an audit committee of the board of directors,
respectively. Furthermore, proposed Rule 17A-22(e)(3)(v) would require
a covered clearing agency to establish, implement, maintain and enforce
written policies and procedures reasonably designed to provide for an
independent audit committee.
    The Commission preliminarily believes that a covered clearing
agency should have an effective internal audit function in order to
provide, among other things, a rigorous and independent assessment of
the effectiveness of the clearing agency's risk management and control
processes, and should have an independent audit committee overseeing
the internal audit function in order to help promote the integrity and
efficiency of the audit process and strengthen internal controls. In
order to satisfy the independence requirement for an audit committee
under proposed Rule 17Ad-22(e)(2), a covered clearing agency could use
such independence criteria as are established by its board of
directors. The Commission further preliminarily believes that policies
and procedures for risk management are important to the effective
operation of a covered clearing agency.
d. Request for Comments
    The Commission generally requests comments on all aspects of
Proposed Rule 17Ad-22(e)(3). In addition, the Commission requests
comments on the following specific issues:
     Should the Commission require a covered clearing agency's
policies and procedures to maintain a sound risk management framework
for comprehensively managing legal, credit, liquidity, operational,
general business, investment, custody, and other risks that arise in or
are borne by the covered clearing agency? Why or why not?
     Should the Commission require a covered clearing agency's
policies and procedures include plans for the recovery and orderly
wind-down of the covered clearing agency necessitated by credit losses,
liquidity shortfalls, losses from general business risk, or any other
losses? Why or why not?
     How and to whom should the board of directors communicate
the results of its review of the risk management framework, if at all?
     Are there any other requirements that should be included
in the rule to facilitate policies and procedures that maintain a sound
risk management framework, including the proposed requirements for
policies and procedures regarding board review and approval of risk
management policies and policies and procedures with respect to
recovery and orderly wind-down plans? Why or why not? For example,
should the Commission require a covered clearing agency's policies and
procedures to identify, measure, monitor, and manage the material risks
that it poses to other entities, such as other financial market
utilities, settlement banks, liquidity providers, or service providers,
as a result of interdependencies? Why or why not?
     The Commission is not proposing at this time to require a
covered clearing agency's policies and procedures to, in its
comprehensive risk management framework, provide for criteria for the
independence of audit committee members. Should the Commission consider
requirements that specify such criteria? Why or why not? If so, should
those criteria be similar to the audit committee independence
requirements for listed companies in Rule 10A-3 under the Exchange Act?
\140\ In order to satisfy the policies and procedures requirement for
independence of the audit committee under proposed Rule 17Ad-22(e)(3),
should a covered clearing agency be allowed to use such independence
criteria as are established by its board of directors?
---------------------------------------------------------------------------

    \140\ See 17 CFR 240.10A-3.
---------------------------------------------------------------------------

4. Proposed Rules 17Ad-22(e)(4) Through (7): Financial Risk Management
a. Overview of Financial Risks Faced by Clearing Agencies
    Covered clearing agencies face a variety of financial risks from
their participants and service providers, including credit or
counterparty default risk, market risk, and liquidity risk. For
example, for clearing agencies that provide CSD services, credit risk
arises from the potential that a participant will not pay what it owes
for securities that it has purchased or will not deliver securities
that it has sold. For clearing agencies that clear and settle
derivatives contracts, credit risk arises from the potential that a
participant will not meet its margin or settlement obligations or pay
any other amounts owed to the covered clearing agency.\141\ Credit risk
also arises for clearing agencies of any type from commercial banks or
custodians that the covered clearing agency uses to effect money
transfers among participants, to hold overnight deposits, or to
safeguard cash or other collateral.
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    \141\ In this context, the clearing agency's credit risk is
closely related to the participant's market risk. A participant's
ability to meet its obligations to the clearing agency may be
affected by the participant's exposure to fluctuations in the market
value of the participant's open positions. In addition, fluctuations
in the market value of the collateral posted by the participant may
require the clearing agency to obtain additional margin from the
participant.
---------------------------------------------------------------------------

    Clearing agencies that provide CCP services take offsetting
positions as the substituted counterparty to a transaction and,
therefore, do not ordinarily face market risk except in the event of a
participant default. In such an event, market risk takes two forms.
First, the clearing agency may need to liquidate collateral posted by
the defaulting participant. The clearing agency is therefore exposed to
volatility in the market price of the defaulting participant's non-cash
collateral that could result in the clearing agency having insufficient
financial resources to cover the losses in the defaulting participant's
open positions. Second, a clearing agency providing CCP services is
subject to volatility in the market price of the defaulting
participant's open positions during the interval between the point at
which the clearing agency takes control of those positions and the
point at which the clearing agency is able to offset, transfer, or
liquidate those positions. A clearing agency faces the risk that its
exposure to a participant can change as a result of a change in prices,
positions, or both.
    A clearing agency must be able to measure the counterparty credit
exposures that it is expected to manage effectively. A clearing agency
can ascertain its current credit exposure to each participant by
marking each participant's outstanding positions to current market
prices and (to the extent permitted by a clearing agency's rules

and supported by law) netting any gains against any losses.
    In addition to credit risk and market risk, clearing agencies also
face liquidity or funding risk. Currently, to complete the settlement
process, clearing agencies generally rely on incoming payments from
participants in net debit positions in order to make payments to
participants in net credit positions. If a participant does not have
sufficient funds to make an incoming payment immediately when it is due
(even though it may be able to pay at some future time), or if a
settlement bank is unable to make an incoming payment on behalf of a
participant, the clearing agency faces a funding shortfall. A clearing
agency typically holds additional financial resources to cover
potential funding shortfalls such as margin collateral or lines of
credit. However, if collateral cannot be liquidated within a short
time, or if lines of credit are unavailable, liquidity risk would be
exacerbated.
b. Current Financial Risk Management Requirements for CCPs
    Rules 17Ad-22(b)(1) through (4) concern risk management
requirements for clearing agencies that perform CCP services
(hereinafter ``CCPs'' in this part). Rule 17Ad-22(b)(1) requires that
CCPs establish, implement, maintain and enforce written policies and
procedures reasonably designed to measure their credit exposures at
least once per day.\142\ Rule 17Ad-22(b)(2) requires that CCPs
establish, implement, maintain and enforce written policies and
procedures reasonably designed to use margin requirements to limit
their exposures to participants.\143\ This margin can also be used to
reduce a CCP's losses in the event of a participant default. Rule 17Ad-
22(b)(3) requires that CCPs establish, implement, maintain and enforce
written policies and procedures reasonably designed to maintain
sufficient financial resources to withstand, at a minimum, a default by
the participant family to which a CCP has the largest exposure in
extreme but plausible market conditions, except that CCPs clearing
security-based swap transactions must maintain additional financial
resources sufficient to withstand the simultaneous default by the two
participant families to which a CCP has the largest exposures.\144\
Finally, Rule 17Ad-22(b)(4) requires that CCPs establish, implement,
maintain and enforce written policies and procedures reasonably
designed to provide for an annual model validation that consists of
evaluating the performance of a clearing agency's margin models and the
related parameters and assumptions associated with such models and that
is performed by a qualified person who is free from influence from the
persons responsible for development or operation of the models being
validated.\145\
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    \142\ See 17 CFR 240.17Ad-22(b)(1).
    \143\ See 17 CFR 240.17Ad-22(b)(2).
    \144\ See 17 CFR 240.17Ad-22(b)(3).
    \145\ See 17 CFR 240.17Ad-22(b)(4).
---------------------------------------------------------------------------

c. Proposed Rule 17Ad-22(e)(4): Credit Risk
    Proposed Rule 17Ad-22(e)(4) would require a covered clearing agency
to establish, implement, maintain and enforce written policies and
procedures reasonably designed to effectively identify, measure,
monitor, and manage its credit exposures to participants and those
exposures arising from its payment, clearing, and settlement
processes.\146\ The Commission preliminarily believes the proposed rule
is consistent with the requirements of the Exchange Act discussed
above.\147\
---------------------------------------------------------------------------

    \146\ See proposed Rules 17Ad-22(e)(4), infra Part 0.
    \147\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
---------------------------------------------------------------------------

    Proposed Rule 17Ad-22(e)(4)(i) would require a covered clearing to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to maintain sufficient financial
resources to cover its credit exposure to each participant fully with a
high degree of confidence. The Commission's intention in proposing the
term ``high degree of confidence'' is to refer to the statistical
meaning of this term.\148\ The proposed rule would require a covered
clearing agency to use statistical methods to develop models in order
to estimate the financial resources required under proposed Rule 17Ad-
22(e)(4)(ii) and (iii),\149\ and to comply with the requirements of
proposed Rules 17Ad-22(e)(4)(ii) and (iii), while recognizing that such
an approach is necessarily imprecise to at least some degree.
---------------------------------------------------------------------------

    \148\ See, e.g., Arthur S. Goldberger, A Course in Econometrics
122-23 (Harvard Univ. Press, 2003) (defining confidence intervals
for parameter estimates).
    \149\ See supra Part 0 (noting that a clearing agency must be
able to measure the counterparty credit exposures in order to manage
risk effectively).
---------------------------------------------------------------------------

    Proposed Rule 17Ad-22(e)(4)(ii) would require a covered clearing
agency that provides CCP services, and that is ``systemically important
in multiple jurisdictions'' or ``a clearing agency involved in
activities with a more complex risk profile,'' to establish, implement,
maintain and enforce written policies and procedures reasonably
designed to maintain additional financial resources, to the extent not
already maintained pursuant to proposed Rule 17Ad-22(e)(4)(i), at a
minimum level necessary to enable it to cover a wide range of
foreseeable stress scenarios, including but not limited to the default
of the two participant families that would potentially cause the
largest aggregate credit exposure for the covered clearing agency in
extreme but plausible market conditions (hereinafter the ``cover two''
requirement).
    Proposed Rule 17Ad-22(e)(4)(iii) would require a covered clearing
agency that is not subject to proposed Rule 17Ad-22(e)(4)(ii) to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to maintain additional financial
resources, to the extent not already maintained pursuant to proposed
Rule 17Ad-22(e)(4)(i), at the minimum to enable it to cover a wide
range of foreseeable stress scenarios, including the default of the
participant family that would potentially cause the largest aggregate
credit exposure for the covered clearing agency in extreme but
plausible market conditions (hereinafter the ``cover one''
requirement).\150\ The Commission notes that the requirement in
proposed Rules 17Ad-22(e)(4)(ii) and (iii) to examine exposure under
foreseeable stress scenarios including extreme but plausible market
conditions means the covered clearing agency may need to use models to
determine how its estimated exposure under such conditions differs from
its actual exposure to positions of such participants, which it would
be required to measure under proposed Rule 17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

    \150\ The Commission notes that, with the exception of security-
based swap clearing agencies, all registered clearing agencies
providing CCP services are all currently required to meet a ``cover
one'' standard under Rule 17Ad-22(b)(3), and therefore the
Commission anticipates that covered clearing agencies may need to
make only limited changes to policies and procedures to satisfy the
proposed requirement, if adopted. See infra Parts 0 and 0
(discussing current practices at registered clearing agencies
relating to credit risk and the anticipated economic effect of the
proposed requirement, respectively).
---------------------------------------------------------------------------

    Also, as previously discussed, the Commission is proposing Rule
17Ad-22(a)(4) to define ``clearing agency involved in activities with a
more complex risk profile.'' \151\ The Commission is also proposing
Rule 17Ad-22(a)(19) to define ``systemically important in multiple
jurisdictions'' to

mean a covered clearing agency that has been determined by the
Commission to be systemically important in more than one jurisdiction
pursuant to Rule 17Ab2-2.\152\
---------------------------------------------------------------------------

    \151\ See supra Part 0 (discussing the scope of proposed Rule
17Ad-22(e)); supra notes 79-80 and accompanying text.
    \152\ See proposed Rule 17Ad-22(a)(19), infra Part 0; see also
infra Parts 0 and 0 (discussing the determinations process under
proposed Rule 17Ab2-2 and providing proposed rule text).
---------------------------------------------------------------------------

    Like the ``cover two'' requirement in Rule 17Ad-22(b)(3), which
applies to registered clearing agencies that provide CCP services for
security-based swaps,\153\ proposed Rule 17Ad-22(e)(4)(ii) would impose
a ``cover two'' requirement to address credit risk of certain covered
clearing agencies: Those systemically important in multiple
jurisdictions and those involved in activities with a more complex risk
profile. The Commission notes that the set of complex risk profile
clearing agencies subject to this requirement would include, as of the
date of this proposal, only registered clearing agencies that provide
CCP services for security-based swaps, which are already subject to the
``cover two'' requirement in Rule 17Ad-22(b)(3). In addition, the
Commission notes that no covered clearing agency would be systemically
important in multiple jurisdictions unless and until the Commission
made such a determination pursuant to proposed Rule 17Ab2-2.\154\ For
any covered clearing agency not currently subject to a ``cover two''
requirement that could be determined by the Commission in the future to
be either systemically important in multiple jurisdictions or involved
in activities with a more complex risk profile, the Commission believes
that requiring such entities to improve their resilience to offset
increased risk and to prepare for extreme but plausible market
conditions is appropriate because it could decrease the likelihood that
systemic events in other jurisdictions or extreme volatility in more
complex financial instruments would result in interruptions to the
provision of clearance and settlement services in the U.S. securities
markets.
---------------------------------------------------------------------------

    \153\ See 17 CFR 240.17Ad-22(b)(3); see also infra Part 0
(discussing the scope of proposed Rule 17Ad-22(e)); Clearing Agency
Standards Release, supra note 5, at 66233-36 (discussing proposed
Rule 17Ad-22(b)(3)).
    \154\ See infra Parts 0 and 0 (discussing the determinations
process under proposed Rule 17Ab2-2 and providing proposed rule
text).
---------------------------------------------------------------------------

    In addition, the Commission is proposing the requirements described
below. In discussing these requirements, the below sections describe
how they differ from existing requirements in Rules 17Ad-22(b)(1)
through (4) applicable to security-based swap clearing agencies,
previously discussed above.\155\
---------------------------------------------------------------------------

    \155\ See supra Part 0.
---------------------------------------------------------------------------

i. Prefunded Financial Resources
    Proposed Rule 17Ad-22(e)(4)(iv) would require a covered clearing
agency providing CCP services that is either systemically important in
multiple jurisdictions or a complex risk profile clearing agency to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to include prefunded financial
resources, excluding assessments for additional guaranty fund
contributions or other resources that are not prefunded, when
calculating the financial resources available to meet the standards
under proposed Rules 17Ad-22(e)(4)(i) through (iii), as
applicable.\156\ The Commission preliminarily believes that prefunding
default obligations is appropriate because of the importance of the
ability of a covered clearing agency to meet its default resource
obligations to the clearance and settlement system, given the risks
that its size, operation, and importance pose to the U.S. securities
markets.\157\ Immediately available financial resources are necessary
to ensure that a covered clearing agency can meet its financial
obligations on an ongoing basis. Without prefunded financial resources,
a covered clearing agency may be unable to meet its financial
obligations in stressed market conditions, when clearing members may be
unwilling or unable to contribute to the clearing agency's guaranty
fund in the event of a member default.
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    \156\ See proposed Rule 17Ad-22(e)(4)(iv), infra Part 0.
    \157\ See generally 12 U.S.C. 5461 (Congress finding, among
other things, that enhancements to the regulation and supervision of
systemically important FMUs and the conduct of systemically
important PCS activities by financial institutions are necessary,
under Title VIII, to provide consistency, to promote robust risk
management and safety and soundness, to reduce systemic risks, and
to support the stability of the broader financial system).
---------------------------------------------------------------------------

    The Commission notes that while the ability to assess participants
for contributions under applicable covered clearing agency governing
documents, rules, or agreements could not be included in this
calculation, previously paid-in participant contributions into a
covered clearing agency default fund could be counted to the extent the
clearing agency's rules, policies, or procedures permit such resources
to be used in a manner equivalent to other financial resources in the
default fund. Other sources of prefunded resources, such as margin
previously posted to the clearing agency by participants, could also be
treated in this manner. In addition, while the ability to draw down
under a revolving loan facility could not be counted towards prefunded
resources because funds from such loan facility would not be in the
covered clearing agency's immediate possession, the covered clearing
agency could count borrowed funds already drawn down, such as under a
term loan or other credit facility.
    Existing requirements under Rule 17Ad-22 do not include
requirements for prefunded financial resources at registered clearing
agencies. The proposed requirement reflects the Commission's
recognition of the importance of a covered clearing agency meeting its
default resource obligations, given the risks that its size, operation,
and importance pose to the U.S. securities markets.
ii. Combined or Separately Maintained Clearing or Guaranty Funds
    Proposed Rule 17Ad-22(e)(4)(v) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to maintain the financial resources
required under proposed Rules 17Ad-22(e)(4)(i) through (iii) in
combined or separately maintained clearing or guaranty funds.\158\ The
proposed rule makes clear that a covered clearing agency may choose to
maintain a separate default fund for purposes of complying with
proposed Rules 17Ad-22(e)(4)(i) through (iii).
---------------------------------------------------------------------------

    \158\ See proposed Rule 17Ad-22(e)(4)(v), infra Part 0.
---------------------------------------------------------------------------

    This requirement would be similar to the requirement in Rule 17Ad-
22(b)(3) requiring a security-based swap clearing agency to have
policies and procedures reasonably designed to maintain financial
resources generally or in separately maintained funds.\159\ The
Commission believes that this approach facilitates the operations of
clearing agencies. For example, clearing agencies may maintain separate
default funds for each product or asset type cleared, in order to more
appropriately tailor risk management requirements or contain losses
from a default to that fund.
---------------------------------------------------------------------------

    \159\ Rule 17Ad-22(b)(3) currently also permits a security-based
swap clearing agency to have policies and procedures reasonably
designed to maintain financial resources generally or in separately
maintained funds. See 17 CFR 240.17Ad-22(b)(3); see also Clearing
Agency Standards Release, supra note 5, at 66233-236.
---------------------------------------------------------------------------

iii. Testing the Sufficiency of Financial Resources
    Proposed Rule 17Ad-22(e)(4)(vi) would require a covered clearing
agency

to establish, implement, maintain and enforce written policies and
procedures reasonably designed to test the sufficiency of its total
financial resources available to meet the minimum financial resource
requirements under proposed Rules 17Ad-22(e)(4)(i) through (iii), as
applicable, by conducting a stress test of its total financial
resources at least once each day using standard predetermined
parameters and assumptions.\160\ Registered clearing agencies are not
subject to requirements for testing the sufficiency of their financial
resources under existing Rule 17Ad-22.
---------------------------------------------------------------------------

    \160\ See proposed Rule 17Ad-22(e)(4)(vi), infra Part 0.
---------------------------------------------------------------------------

    The proposed rule would also require a covered clearing agency to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to conduct a comprehensive analysis on
at least a monthly basis of the existing stress testing scenarios,
models, and underlying parameters and assumptions, and consider
modifications to ensure they are appropriate for determining the
covered clearing agency's required level of default protection in light
of current market conditions. When the products cleared or markets
served by a covered clearing agency display high volatility, become
less liquid, or when the size or concentration of positions held by the
entity's participants increases significantly, the proposed rule would
specifically require a covered clearing agency to have policies and
procedures for conducting comprehensive analyses of stress testing
scenarios, models, and underlying parameters and assumptions more
frequently than monthly. The Commission preliminarily believes that
what constitutes ``high volatility'' and ``low liquidity'' would vary
across asset classes that a covered clearing agency might clear.
Accordingly, the Commission preliminarily believes that a clearing
agency would need flexibility to address changing circumstances and is
therefore not proposing to prescribe triggers for any particular
circumstance.
    The proposed rule would also require a covered clearing agency to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to provide for the reporting of the
results of this analysis to the appropriate decision makers at the
covered clearing agency, including its risk management committee or
board of directors, and to require the use of the results to evaluate
the adequacy of and to adjust its margin methodology, model parameters,
and any other relevant aspects of its credit risk management policies
and procedures, in supporting compliance with the minimum financial
resources requirements discussed above.
    The Commission is also proposing to add Rule 17Ad-22(a)(18) to
define ``stress testing'' to mean the estimation of credit and
liquidity exposures that would result from the realization of extreme
but plausible price changes or changes in other valuation inputs and
assumptions.\161\ The Commission preliminarily believes that stress
testing is an important component of the proposed rules because stress
testing may enable a covered clearing agency to be prepared for an
extreme event that may not be anticipated or expected based solely on
current market conditions or from a sample of historical data.
---------------------------------------------------------------------------

    \161\ See proposed Rule 17Ad-22(a)(18), infra Part 0.
---------------------------------------------------------------------------

    The Commission preliminarily believes that the requirements in
proposed Rule 17Ad-22(e)(4)(vi) are appropriate for testing the
sufficiency of the financial resources of covered clearing agencies
because, in certain market conditions, such as periods of high
volatility or diminished liquidity, existing stress scenarios, models,
or underlying parameters may no longer be valid or appropriate. Based
on its supervisory experience, the Commission believes that certain,
but not all, covered clearing agencies adjusted their stress testing
scenarios following the 2008 financial crisis to incorporate larger
debt, equity, and credit market shocks similar to those experienced
during the crisis. Accordingly, the Commission preliminarily believes
that specific policies and procedures contemplating actions to be taken
by all covered clearing agencies in such circumstances are necessary to
ensure the safe functioning of the covered clearing agencies as
required by the Exchange Act,\162\ and that requiring periodic feedback
and analysis on the strength of credit risk management policies and
procedures would improve the reliability of those policies and
procedures. The Commission also preliminarily believes that the rule
would provide a covered clearing agency with the flexibility to use
stress scenarios that are appropriately tailored to current market
conditions and that can be revised over time as markets change and
believes that such flexibility is appropriate to achieve the objectives
of the Exchange Act.
---------------------------------------------------------------------------

    \162\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
---------------------------------------------------------------------------

iv. Annual Conforming Model Validation
    Proposed Rule 17Ad-22(e)(4)(vii) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to require a conforming model
validation for its credit risk models to be performed not less than
annually or more frequently as may be contemplated by the covered
clearing agency's risk management policies and procedures.\163\ The
Commission preliminary believes that an annual cycle is appropriate for
the reasons described in Part II.A.3. The Commission notes that other
important reviews such as auditing of the financial statements of
registered clearing agencies and their disclosure are required to occur
on an annual basis as well.\164\
---------------------------------------------------------------------------

    \163\ See proposed Rule 17Ad-22(e)(4)(vii), infra Part 0.
    \164\ See 17 CFR 240.17Ad-22(c)(2).
---------------------------------------------------------------------------

    The Commission is proposing to add Rule 17Ad-22(a)(5) to define
``conforming model validation'' to mean an evaluation of the
performance of each material risk management model used by a covered
clearing agency, along with the related parameters and assumptions
associated with such models.\165\ Such model validation would apply to
models that would include initial margin models, liquidity risk models,
and models used to generate clearing or guaranty fund requirements. A
conforming model validation would also require that the model
validation be performed by a qualified person who is free from
influence from the persons responsible for the development or operation
of the models or policies being validated so that credit risk models
can be candidly assessed.\166\ Generally, the Commission considers that
a person is free from influence when that person does not perform
functions associated with the clearing agency's models (except as part
of the annual model validation) and does not report to a person who
performs these functions. The Commission generally would not expect
that it would be necessary for policies and procedures adopted pursuant
to this proposed requirement to require the clearing agency to separate
organizationally model review from model development or to maintain two
separate quantitative teams.
---------------------------------------------------------------------------

    \165\ See proposed Rule 17Ad-22(a)(5), infra Part 0.
    \166\ See Clearing Agency Standards Release, supra note 5, at
66238.
---------------------------------------------------------------------------

    The proposed rule differs from the existing requirement for
security-based swap clearing agencies in Rule 17Ad-

22(b)(4) by defining in explicit terms the requirements for a
conforming model validation and by requiring it for credit risk
models.\167\ The proposed rule would also apply to any covered clearing
agency, and not only security-based swap clearing agencies. The
Commission preliminarily believes, because credit risk models play an
important role in limiting systemic risk, that it is important to
create a consistent, clear, and uniformly applied minimum standard for
model validation across all covered clearing agencies.\168\ The
Commission also preliminarily believes that annual conforming model
validation would provide unbiased feedback on the performance of such
models and policies, and therefore could improve their reliability.
---------------------------------------------------------------------------

    \167\ Rule 17Ad-22(b)(4) requires a security-based swap clearing
agency to establish, implement, maintain and enforce written
policies and procedures reasonably designed to provide for an annual
model validation consisting of evaluating the performance of the
clearing agency's margin models and the related parameters and
assumptions associated with such models by a qualified person who is
free from influence from the persons responsible for the development
or operation of the models being validated. See 17 CFR 240.17Ad-
22(b)(4); see also Clearing Agency Standards Release, supra note 5,
at 66236-238.
    In contrast to proposed Rules 17Ad-22(a)(5) and (e)(4)(vii),
Rule 17Ad-22(b)(4) requires only a model validation for margin
models and does not specify the general elements of a model
validation.
    \168\ See generally Clearing Agency Standards Release, supra
note 5, at 66238.
---------------------------------------------------------------------------

d. Proposed Rule 17Ad-22(e)(5): Collateral
    Proposed Rule 17Ad-22(e)(5) would require a covered clearing agency
to establish, implement, maintain and enforce written policies and
procedures reasonably designed to limit the assets it accepts as
collateral to those with low credit, liquidity, and market risks, and
also require policies that set and enforce appropriately conservative
haircuts and concentration limits if the covered clearing agency
requires collateral to manage its own or its participants' credit
exposures.\169\ The proposed rule includes requirements similar to
those applicable to registered clearing agencies under Rule 17Ad-
22(d)(3) but would, in addition, require a covered clearing agency's
policies and procedures to set and enforce appropriately conservative
haircuts and concentration limits if the covered clearing agency
requires collateral to manage its own or its participants' credit
exposures.\170\
---------------------------------------------------------------------------

    \169\ See proposed Rule 17Ad-22(e)(5), infra Part 0.
    \170\ Registered clearing agencies are currently subject to
requirements under Rule 17Ad-22(d)(3), which requires registered
clearing agencies to hold assets in a manner that minimizes risk of
loss or risk of delay in access to them and invest assets in
instruments with minimal credit, market, and liquidity risk. See 17
CFR 240.17Ad-22(d)(3); see also Clearing Agency Standards Release,
supra note 5, at 66247-48; infra Part 0 (discussing proposed Rule
17Ad-22(e)(16)).
     Similarly, the Commission preliminarily believes that
appropriately conservative haircuts and concentration limits would
require a covered clearing agency to value assets in a manner that
minimizes risk of loss or risk of delay in access to them.
---------------------------------------------------------------------------

    The Commission is proposing Rule 17Ad-22(e)(5) to require policies
and procedures with respect to specific practices to be followed by a
covered clearing agency when managing collateral to ensure the
safeguarding of funds, consistent with the requirements under the
Exchange Act discussed above.\171\ In doing so, proposed Rule 17Ad-
22(e)(5) would promote confidence that covered clearing agencies are
able to meet their settlement obligations by reducing the likelihood
that assets securing participant obligations to the covered clearing
agency would be unavailable or insufficient when the covered clearing
agency needs to draw on them. Specifically, such requirements recognize
the role played by system-wide asset price deterioration in generating
systemic risk and the vulnerability a covered clearing agency could
face if posted collateral were concentrated in assets that subsequently
experience such deterioration in price.\172\ The Commission
preliminarily believes the proposed rule is appropriate given the risks
that its size, operation, and importance pose to the U.S. securities
markets, thereby promoting stability in the national system for
clearance and settlement by increasing the likelihood collateral
holdings will function as designed when faced with stressed market
conditions.
---------------------------------------------------------------------------

    \171\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
    \172\ See, e.g., Mark Roe, Clearinghouse Overconfidence (Aug.
11, 2013), available at http:[sol][sol]ssrn.com/abstract=2224305
(discussing the risks posed to clearing agencies by asset price
deterioration).
---------------------------------------------------------------------------

    In addition, the Commission is proposing that a covered clearing
agency establish, implement, maintain and enforce written policies and
procedures reasonably designed to include a not-less-than-annual review
of the sufficiency of a covered clearing agency's collateral haircuts
and concentration limits.\173\ Rule 17Ad-22(d) does not impose a
similar requirement on registered clearing agencies. The Commission
preliminarily believes that the proposed approach is appropriate
because of the importance of collateral haircuts and concentration
limits to a covered clearing agency's risk management policies and
procedures. Because of the role collateral plays in a default, a
covered clearing agency needs assurance of its value in the event of
liquidation, as well as the capacity to draw upon that collateral
promptly. The Commission preliminarily believes, given the risks that a
covered clearing agency's size, operation, and importance pose to the
U.S. securities markets, that it is important to require policies and
procedures for a not-less-than-annual review of the sufficiency of its
collateral haircuts and concentration limits.\174\
---------------------------------------------------------------------------

    \173\ See proposed Rule 17Ad-22(e)(5), infra Part 0.
    \174\ See supra Part 0 (discussing the Commission's rationale
for imposing varying frequencies of review under certain policies
and procedures requirements of the proposed rules).
---------------------------------------------------------------------------

e. Proposed Rule 17Ad-22(e)(6): Margin
    Generally, proposed Rule 17Ad-22(e)(6) would require a covered
clearing agency that provides CCP services to establish, implement,
maintain and enforce written policies and procedures reasonably
designed to cover its credit exposures to its participants by
establishing a risk-based margin system that is monitored by management
on an ongoing basis and regularly reviewed, tested, and verified.\175\
---------------------------------------------------------------------------

    \175\ See proposed Rule 17Ad-22(e)(6), infra Part 0.
---------------------------------------------------------------------------

    Rule 17Ad-22(b)(2) currently requires registered clearing agencies
that provide CCP services to use risk-based models and parameters to
set margin requirements, and to review such margin requirements and the
risk-based models and parameters at least monthly,\176\ and the
proposed rule would impose substantially the same requirements.\177\
Rule 17Ad-22(b)(4) also currently requires a registered clearing agency
that provides CCP services to establish, implement, maintain and
enforce written policies and procedures reasonably designed to provide
for an annual model validation consisting of evaluating the performance
of the clearing agency's margin models and the related parameters and
assumptions associated with such models by a qualified person who is
free from influence from the persons responsible for the development or
operation of the models being validated.
---------------------------------------------------------------------------

    \176\ See 17 CFR 240.17Ad-22(b)(2).
    \177\ Similar to Rule 17Ad-22(b)(2), proposed Rule 17Ad-
22(e)(6)(vi) would require a covered clearing agency to conduct on
at least a monthly basis a conforming sensitivity analysis of its
margin resources and its parameters and assumptions for backtesting.
See infra Parts 0 and 0.
---------------------------------------------------------------------------

    The Commission notes that proposed Rule 17Ad-22(e)(6) is different
from these existing requirements under Rule

17Ad-22, as discussed below. The proposed requirements reflect more
specific recognition by the Commission of the importance margin plays
in risk management by covered clearing agencies. The Commission
preliminarily believes that these requirements for a covered clearing
agency to periodically verify and modify margin requirements in light
of changing market conditions would be appropriate to mitigate the
risks posed by a covered clearing agency to financial markets in
periods of financial stress considering the risks that its size,
operation, and importance pose to the U.S. securities markets.
i. Active Management of Model Risk
    Proposed Rule 17Ad-22(e)(6)(i) would require a covered clearing
agency that provides CCP services to establish, implement, maintain and
enforce written policies and procedures reasonably designed to result
in a margin system that at a minimum considers, and produces margin
levels commensurate with, the risks and particular attributes of each
relevant product, portfolio, and market.\178\ The complexity and
product risk characteristics of the cleared product and underlying
instrument can influence the margin requirements necessary to manage
the credit exposures posed by a covered clearing agency's participants.
Additionally, the volume of trading may also influence the margin
requirements necessary to manage the credit exposures proposed by a
covered clearing agency's participants. The Commission preliminarily
believes that expressly requiring policies and procedures regarding the
active management of a covered clearing agency's margin system to
account for those factors and differences would help ensure the
effectiveness of a covered clearing agency's risk management practices.
---------------------------------------------------------------------------

    \178\ See proposed Rule 17Ad-22(e)(6)(i), infra Part 0.
---------------------------------------------------------------------------

ii. Collection of Margin
    Proposed Rule 17Ad-22(e)(6)(ii) would require a covered clearing
agency that provides CCP services to establish implement, maintain and
enforce written policies and procedures reasonably designed to ensure
that the margin system would mark participant positions to market and
collect margin, including variation margin or equivalent charges if
relevant, at least daily, and include the authority and operational
capacity to make intraday margin calls in defined circumstances.\179\
The Commission preliminarily believes that marking each participant's
outstanding positions to current market prices is an important feature
of an effective margin system because adverse price movements can
rapidly increase a covered clearing agency's exposures to its
participants. Rule 17Ad-22(b)(2) requires registered clearing agencies
that provide CCP services to calculate margin requirements daily. The
Commission preliminarily believes that requiring a covered clearing
agency to have the authority and operational capacity to make intraday
margin calls in defined circumstances will benefit covered clearing
agencies by covering settlement risk created by intraday price
movements. By being more specific with respect to its expectations for
collecting sufficient margin and having other liquid resources at its
disposal, the Commission expects that a covered clearing agency will be
better able to organize its practices accordingly, to limit its
exposures to potential losses from defaults by clearing members in
normal market conditions considering the risks that its size,
operation, and importance pose to the U.S. securities markets.\180\
---------------------------------------------------------------------------

    \179\ See proposed Rule 17Ad-22(e)(6)(ii), infra Part 0.
    \180\ See Clearing Agency Standards Release, supra note 5, at
66231.
---------------------------------------------------------------------------

iii. Ninety-Nine Percent Confidence Level
    Proposed Rule 17Ad-22(e)(6)(iii) would require a covered clearing
agency that provides CCP services to establish, implement, maintain and
enforce written policies and procedures reasonably designed to
calculate margin sufficient to cover its potential future exposure to
participants in the interval between the last margin collection and the
close out of positions following a participant default.\181\ The
Commission is proposing to add Rule 17Ad-22(a)(14) to define
``potential future exposure'' to mean the maximum exposure estimated to
occur at a future point in time with an established single-tailed
confidence level of at least 99% with respect to the estimated
distribution of future exposure.\182\ The Commission preliminarily
believes that a 99% confidence level is an appropriately conservative
setting that is also consistent with the international standard for
bank capital requirements, which requires banks to measure market risks
at a 99% confidence interval when determining regulatory capital
requirements.\183\
---------------------------------------------------------------------------

    \181\ See proposed Rule 17Ad-22(e)(6)(iii), infra Part 0.
    \182\ See proposed Rule 17Ad-22(a)(14), infra Part 0.
    \183\ See Clearing Agency Standards Release, supra note 5, at
66226 (describing the history of usage for a 99% confidence
interval). A 99% confidence level would represent one day of actual
trading losses that exceeded the results predicted by the model (as
revealed by backtesting) for every 100 days that trading occurred.
See id. Requiring a covered clearing agency to have policies and
procedures with a higher or lower confidence level than that
currently used by its clearing members could potentially create
incentives or disincentives for clearing members to clear based on
the statistical confidence level alone.
---------------------------------------------------------------------------

    The Commission preliminarily believes that, rather than establish
specific criteria in advance, it is more appropriate to address
liquidation periods separately with respect to each covered clearing
agency through the Commission's supervisory process under Sections 17A
and 19 of the Exchange Act,\184\ so that the length of the liquidation
period can be appropriately tailored to the characteristics of the
products cleared by the covered clearing agency as financial markets
evolve.
---------------------------------------------------------------------------

    \184\ See supra Part 0 (discussing the regulatory framework
under Section 17A of the Exchange Act); supra note 96 (describing
the requirements in Section 19(b) of the Exchange Act).
---------------------------------------------------------------------------

iv. Price Data Source
    Proposed Rule 17Ad-22(e)(6)(iv) would require a covered clearing
agency that provides CCP services to establish, implement, maintain and
enforce written policies and procedures reasonably designed to ensure
that it uses reliable sources of timely price data and procedures and
sound valuation models for addressing circumstances in which pricing
data are not readily available or reliable.\185\ The Commission
preliminarily believes that a covered clearing agency should use
reliable sources of timely price data because its margin system needs
such data to operate with a high degree of accuracy and reliability,
given the risks that the covered clearing agency's size, operation, and
importance pose to the U.S. securities markets.\186\ Based on its
supervisory experience, the Commission preliminarily believes that
reliable data sources may include the following features, among other
things: (i) Provision of data by the data source that is accurate,
complete, and timely; (ii) capability of the data source to provide
broad data sets to the covered clearing agency; and (iii) limited need
for manual intervention by the clearing agency. In some situations,
price data may not be available or reliable, such as in instances where
third party data

providers experience lapses in service or where limited liquidity
otherwise makes price discovery difficult. Establishing appropriate
procedures and sound valuation models is a useful step a covered
clearing agency can take to help protect itself in such situations. The
Commission preliminarily believes, in selecting price data sources, a
covered clearing agency should consider the likelihood of the data
being provided under a variety of market conditions and not select
price data sources based on their cost alone.
---------------------------------------------------------------------------

    \185\ See proposed Rule 17Ad-22(e)(6)(iv), infra Part 0.
    \186\ Cf. PFMI Report, supra note 1, at 51 (discussing Principle
6, margin).
---------------------------------------------------------------------------

v. Method for Measuring Credit Exposure
    Proposed Rule 17Ad-22(e)(6)(v) would require a covered clearing
agency that provides CCP services to establish, implement, maintain and
enforce written policies and procedures reasonably designed to ensure
the use of an appropriate method for measuring credit exposure that
accounts for relevant product risk factors and portfolio effects across
products. Measuring such portfolio effects means a covered clearing
agency may take into account certain netting procedures or offsets
through which credit exposure may be reduced in measuring credit
exposure, including the use of portfolio margining procedures across
products where applicable.\187\ The Commission preliminarily believes
that this proposed requirement that covered clearing agencies
contemplate both product level and portfolio level effects when
considering and measuring their credit exposure is appropriate, given
that the method for measuring credit exposure will determine the
accuracy of a covered clearing agency's measurements in practice.
---------------------------------------------------------------------------

    \187\ See proposed Rule 17Ad-22(e)(6)(v), infra Part 0.
---------------------------------------------------------------------------

vi. Backtesting and Sensitivity Analysis
    Under proposed Rule 17Ad-22(e)(6)(vi), in addition to the
requirement discussed above in relation to monitoring by management on
an ongoing basis, a covered clearing agency that provides CCP services
would be required to establish, implement, maintain and enforce written
policies and procedures reasonably designed to regularly review, test,
and verify its risk-based margin system by conducting backtests at
least once each day and conducting a conforming sensitivity analysis of
its margin resources and its parameters and assumptions for backtesting
at least monthly, and consider modifications to ensure the backtesting
practices are appropriate for determining the adequacy of its margin
resources.\188\ The Commission preliminarily believes that, since
margin positions must be calculated at least daily, policies and
procedures should also provide for daily backtesting. The Commission
preliminarily believes that requiring, on at least a monthly basis, a
conforming sensitivity analysis of margin resources and parameters and
assumptions for backtesting would appropriately balance cost concerns
with the interest of assuring that risk margin methodologies continue
to reflect current conditions. The Commission notes that, based on its
supervisory experience, risk management committees of the board and
similar management committees of registered clearing agencies commonly
meet on a monthly basis, and therefore the proposed requirement of a
monthly sensitivity analysis would be consistent with such meeting
frequency.
---------------------------------------------------------------------------

    \188\ See proposed Rule 17Ad-22(e)(6)(vi), infra Part 0.
---------------------------------------------------------------------------

    Backtesting is a technique used to compare the potential losses
forecasted by a model with the actual losses that participants
incurred, and is intended to reveal the accuracy of models.
Misspecified or miscalibrated models may lead to errors in decision
making. The Commission is proposing to require policies and procedures
that provide for backtesting the margin models used by covered clearing
agencies to help uncover and address possible errors in model design,
misapplication of models, or errors in the inputs to, and assumptions
underlying, margin models. The Commission is also proposing to add Rule
17Ad-22(a)(1) to define ``backtesting'' to mean an ex-post comparison
of actual outcomes with expected outcomes derived from the use of
margin models.\189\ Additionally, the Commission is proposing to add
Rule 17Ad-22(a)(17) to define ``sensitivity analysis'' to mean an
analysis that involves analyzing the sensitivity of a model to its
assumptions, parameters, and inputs.\190\ The Commission preliminarily
understands that these terms and definitions are commonly accepted
among, and employed by, market participants.\191\
---------------------------------------------------------------------------

    \189\ See proposed Rule 17Ad-22(a)(1), infra Part 0.
    \190\ See proposed Rule 17Ad-22(a)(17), infra Part 0.
    \191\ See, e.g., Alexander J. McNeil, R[uuml]diger Frey & Paul
Embrechts, Quantitative Risk Management: Concepts, Techniques, and
Tools, at 35 (Princeton Univ. Press, 2005) (defining ``factor-
sensitivity measures'' as a change in portfolio value given a
predetermined change in one of the underlying risk factors).
---------------------------------------------------------------------------

    The Commission is also proposing to add Rule 17Ad-22(a)(6) to
define ``conforming sensitivity analysis'' to mean a sensitivity
analysis that considers the impact on the model of both moderate and
extreme changes in a wide range of inputs, parameters, and assumptions,
including correlations of price movements or returns if relevant, which
reflect a variety of historical and hypothetical market conditions and
actual and hypothetical portfolios of proprietary positions and, where
applicable, customer positions. The Commission notes that ``sensitivity
analysis'' is a commonly understood term among industry
participants,\192\ and the Commission intends for the proposed
definition to ensure that the specified minimum requirements are met in
performing sensitivity analyses. Under the proposed definition, a
conforming sensitivity analysis, when performed by or on behalf of a
covered clearing agency involved in activities with a more complex risk
profile, would consider the most volatile relevant periods, where
practical, that have been experienced by the markets served by the
clearing agency. Under the proposed definition, a conforming
sensitivity analysis would also test the sensitivity of the model to
stressed market conditions, including the market conditions that may
ensue after the default of a member and other extreme but plausible
conditions as defined in a covered clearing agency's risk
policies.\193\
---------------------------------------------------------------------------

    \192\ See id.
    \193\ See proposed Rule 17Ad-22(a)(6), infra Part 0.
---------------------------------------------------------------------------

    Under proposed Rule 17Ad-22(e)(6)(vi), the policies and procedures
for model review, testing, and verification requirements would include
policies and procedures for conducting a conforming sensitivity
analysis more frequently than monthly when the products cleared or
markets served display high volatility, become less liquid, or when the
size or concentration of positions held by participants increases or
decreases significantly.\194\ The proposed rule would also require a
covered clearing agency to establish, implement, maintain and enforce
written policies and procedures reasonably designed to report the
results of such conforming sensitivity analysis to appropriate decision
makers at the covered clearing agency, including its risk management
committee or board of directors, and use these results to evaluate the
adequacy of and adjust its margin methodology, model parameters, and
any other relevant aspects of its credit risk management policies and
procedures. The Commission preliminary believes that the requirement to
report to

appropriate decision makers at the covered clearing agency, including
its risk management committee or board of directors, is important to
ensure that such risk management requirements and compliance therewith
are addressed at the most senior levels of the governance framework of
the covered clearing agency, commensurate with the importance of said
requirements.
---------------------------------------------------------------------------

    \194\ See proposed Rule 17Ad-22(e)(6)(vi), infra Part 0.
---------------------------------------------------------------------------

    By proposing the requirement for conducting a conforming
sensitivity analysis, the Commission expects that feedback generated by
these analyses would improve the performance of risk-based margin
systems used by covered clearing agencies and therefore better ensure
the safe functioning of covered clearing agencies. Additionally, the
Commission preliminarily believes that conforming sensitivity analysis
may help a covered clearing agency discover and address shortcomings in
its margin models that would not otherwise be revealed through
backtesting and is accordingly appropriate given the risks that its
size, operation, and importance pose to the U.S. securities
markets.\195\
---------------------------------------------------------------------------

    \195\ Cf. PFMI Report, supra note 1, at 56 (discussing Principle
6, margin).
---------------------------------------------------------------------------

vii. Annual Conforming Model Validation
    Rule 17Ad-22(b)(4) currently requires a registered clearing agency
that provides CCP services to establish, implement, maintain and
enforce written policies and procedures reasonably designed to provide
for an annual model validation consisting of evaluating the performance
of the clearing agency's margin models and the related parameters and
assumptions associated with such models by a qualified person who is
free from influence from the persons responsible for the development or
operation of the models being validated. Under proposed Rule 17Ad-
22(e)(6)(vii), a covered clearing agency that provides CCP services
would be required to establish, implement, maintain and enforce written
policies and procedures reasonably designed to require not less than
annually a conforming model validation of the covered clearing agency's
margin system and related models.\196\ As previously discussed, the
model validation would be required to include initial margin models,
liquidity risk models, and models used to generate clearing or guaranty
fund requirements. Also, for a model validation to be considered a
conforming model validation under the proposed rule, it would have to
be performed by a qualified person who is free from influence from the
persons responsible for the development or operation of the models or
policies being validated.\197\
---------------------------------------------------------------------------

    \196\ See proposed Rule 17Ad-22(e)(6)(vii), infra Part 0; see
also supra Part 0 and infra Part 0 (defining ``conforming model
validation'' under proposed Rule 17Ad-22(a)(5) and providing the
definition text, respectively).
    \197\ See supra Part 0 (describing a person who is free from
influence in the context of the policy and procedure requirement for
an annual conforming model validation addressing credit risk).
---------------------------------------------------------------------------

    The Commission preliminarily believes the proposed approach of
requiring policies and procedures that subject a covered clearing
agency's models to review by such parties would be relevant to ensuring
the safe operation of covered clearing agencies and will help to ensure
that covered clearing agencies have the opportunity to benefit from the
views of a qualified person free from influence and incorporate
alternative risk management methodologies into their models as
appropriate. The Commission preliminarily believes this is important
for covered clearing agencies given the risks that a covered clearing
agency's size, operation, and importance pose to the U.S. securities
markets.
f. Proposed Rule 17Ad-22(e)(7): Liquidity Risk
    Proposed Rule 17Ad-22(e)(7) would require a covered clearing agency
to establish, implement, maintain and enforce written policies and
procedures reasonably designed to effectively measure, monitor, and
manage the liquidity risk that arises in or is borne by it, by meeting,
at a minimum, the ten requirements specified below.\198\
---------------------------------------------------------------------------

    \198\ See proposed Rule 17Ad-22(e)(7), infra Part 0; see also
infra Parts 0-0.
---------------------------------------------------------------------------

    Liquidity risk describes the risk that an entity will be unable to
meet financial obligations on time due to an inability to deliver funds
or securities in the form required though it may possess sufficient
financial resources in other forms. Although Rule 17Ad-22(d)(11)
currently requires, among other things, that a registered clearing
agency establish, implement, maintain and enforce written policies and
procedures reasonably designed to take timely action to contain
liquidity pressures and to continue to meet obligations in the event of
a participant default, the Commission does not currently have
requirements for policies and procedures of registered clearing
agencies regarding the management of liquidity risk with the level of
specificity proposed in Rule 17Ad-22(e)(7). Given the risks that a
covered clearing agency's size, operation, and importance pose to the
U.S. securities markets, the proposed requirements would require a
covered clearing agency to maintain sufficient liquidity resources to
ensure they are prepared to meet their payment obligations in order to
facilitate the prompt and accurate clearance and settlement of
securities transactions.
i. Sufficient Liquid Resources
    Proposed Rule 17Ad-22(e)(7)(i) would require that a covered
clearing agency's policies and procedures be reasonably designed to
ensure that it maintains sufficient liquid resources in all relevant
currencies to effect same-day and, where appropriate, intraday and
multiday settlement of payment obligations with a high degree of
confidence under a wide range of potential stress scenarios that
includes the default of the participant family that would generate the
largest aggregate payment obligation for it in extreme but plausible
market conditions. As noted above, maintaining sufficient liquidity
resources helps ensure that a covered clearing agency is prepared to
meet its payment obligations in order to facilitate the prompt and
accurate clearance and settlement of securities transactions
ii. Qualifying Liquid Resources
    Proposed Rule 17Ad-22(e)(7)(ii) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to ensure it holds qualifying liquid
resources sufficient to meet the minimum liquidity resource requirement
in each relevant currency for which the covered clearing agency has
payment obligations owed to clearing members.\199\ The Commission is
also proposing to add Rule 17Ad-22(a)(15) to define ``qualifying liquid
resources.'' \200\ For any covered clearing agency, in each relevant
currency, qualifying liquid resources would include three types of
assets:
---------------------------------------------------------------------------

    \199\ See proposed Rule 17Ad-22(e)(7)(ii), infra Part 0. In
other words, if payment obligations were denominated in U.S.
dollars, the minimum liquidity resource requirement would refer to a
U.S. dollar amount.
    \200\ See proposed Rule 17Ad-22(a)(15), infra Part 0.
---------------------------------------------------------------------------

     Cash held either at the central bank of issue or at
creditworthy commercial banks; \201\
---------------------------------------------------------------------------

    \201\ The Commission preliminarily believes that the
creditworthiness of commercial banks should be considered by a
covered clearing agency after considering its particular
circumstances and those of its members and the markets which it
services. Accordingly, in complying with the requirements of
proposed Rule 17Ad-22(e)(7) and proposed Rule 17Ad-22(a)(15), a
covered clearing agency's policies and procedures for determining
whether a commercial bank is creditworthy may reflect such
circumstances.

---------------------------------------------------------------------------

     Assets that are readily available and convertible into
cash through either:
    [cir] Prearranged funding arrangements without material adverse
change limitations, such as committed lines of credit, foreign exchange
swaps, and repurchase agreements, or
    [cir] Other prearranged funding arrangements determined to be
highly reliable even in extreme but plausible market conditions by the
board of directors of the covered clearing agency following a review
conducted for this purpose not less than annually; and
     Other assets that are readily available and eligible for
pledging to (or conducting other appropriate forms of transactions
with) a relevant central bank, if the covered clearing agency has
access to routine credit at such central bank.\202\
---------------------------------------------------------------------------

    \202\ See id. The Commission notes that such access to routine
credit at a relevant central bank and the collateral required by
such central bank to be posted to secure a loan may be determined at
the discretion of the central bank, and accordingly the practical
application of the definition of qualifying liquid resources would
be subject to variation based on those decisions. The Commission
preliminarily believes that inclusion of assets eligible for
pledging to any central bank, as opposed to only to a Federal
Reserve Bank, is appropriate because, in practice, a covered
clearing agency may need access to liquid resources in currencies
other than U.S. dollars.
---------------------------------------------------------------------------

    The Commission preliminarily believes that this requirement is
appropriate, given the risks that its size, operation, and importance
pose to the U.S. securities markets, and will help ensure that a
covered clearing agency has sufficient liquid resources, as determined
by stress testing, to effect settlement of payment obligations with a
high degree of confidence under a wide range of potential stress
scenarios.\203\ Furthermore, the Commission preliminarily believes this
requirement is appropriate given the specific circumstances of the U.S.
securities markets. U.S. securities markets are among the largest and
most liquid in the world, and CCPs operating in the United States are
also among the largest in the world.\204\ The resulting peak liquidity
demands of CCPs are therefore proportionately large on both an
individual and an aggregate basis, and the ability of CCPs to satisfy a
requirement limiting qualifying liquid resources to committed
facilities could be constrained by the capacity of traditional
liquidity sources in the U.S. banking sector in certain circumstances.
Therefore, the Commission is proposing to include in the definition of
qualifying liquid resources other prearranged funding arrangements
determined to be highly reliable even in extreme but plausible market
conditions.
---------------------------------------------------------------------------

    \203\ Cf. PFMI Report, supra note 1, at 60 (discussing Principle
7, liquidity risk).
    \204\ See infra notes 561-562 and accompanying text (discussing
the volume of transactions processed by U.S. clearing agencies).
---------------------------------------------------------------------------

    For similar reasons, the Commission preliminarily believes it is
appropriate to include in the definition of qualifying liquid resources
assets that a central bank would permit a covered clearing agency to
use as collateral, to the extent such covered clearing agency has
access to routine credit at such central bank.\205\ The Commission
preliminarily notes that, although covered clearing agencies do not
currently have access to routine credit at Federal Reserve Banks,
potential registrants that could be determined to be covered clearing
agencies in the future may be operating in a jurisdiction where access
to routine credit is provided to the potential registrant by that
jurisdiction's central bank.\206\
---------------------------------------------------------------------------

    \205\ See ICMA Eur. Repo Council, The Interconnectivity of
Central and Commercial Bank Money in the Clearing and Settlement of
the European Repo Market, at 10-11 (Sept. 2011) (indicating that
access to central bank credit is important and may cause banks to
use either central bank settlement services or cash settlement
banking services of a commercial bank, depending on availability of,
and the terms of, central bank credit).
    \206\ See Peter Allsopp, Bruce Summers & John Veale, The
Evolution of Real-Time Gross Settlement: Access, Liquidity and
Credit, and Pricing, at 15 (World Bank, Feb. 2009) (indicating that
CCPs in the Eurozone have access to central bank settlement account
services and routine credit).
---------------------------------------------------------------------------

    With regard to assets convertible into cash, the Commission
preliminarily notes that the mere ownership of assets that a covered
clearing agency may consider readily available and also may consider
readily convertible into cash, based on factors such as the historical
volume of trading in a particular market for such asset, may not be
sufficient alone to make the assets count towards qualifying liquid
resources unless one of the above-referenced prearranged funding
arrangements is in place under which the covered clearing agency would
receive cash in a timely manner. The prearranged funding arrangements
would be in place to cover any shortfall. The Commission, however,
preliminarily considers committed funding arrangements to be reasonably
capable of being established by covered clearing agencies in the
relevant commercial lending markets and other funding arrangements to
be reasonably capable of being assessed for reliability by the boards
of directors of covered clearing agencies following consideration of
the relevant circumstances, and therefore preliminarily believes the
standard to be sufficiently clear to allow for it to be interpreted and
applied in practice by covered clearing agencies. Further, the
Commission preliminarily notes that, in complying with proposed Rule
17Ad-22(e)(7), covered clearing agencies should consider the lower of
the value of the assets capable of being pledged and the amount of the
commitment (or the equivalent availability under a highly reliable
prearranged facility) as the amount that counts towards qualifying
liquid resources in the event there is any expected difference between
the two.\207\ This may occur, for example, where the terms of the
arrangement provide for over-collateralization or where the covered
clearing agency lacks sufficient qualifying assets to make full use of
an otherwise qualifying liquidity facility.
---------------------------------------------------------------------------

    \207\ The Commission notes that, based on the types of assets
that may be considered qualifying liquid resources, for purposes of
complying with proposed Rule 17Ad-22(e)(7)(ii), factors that may be
relevant for a covered clearing agency to take into account include
(i) the portion of its default fund that is held as cash, (ii) the
portion of its default fund that is held as securities, (iii) the
portion of any excess default fund contributions held as cash that
could be used by the covered clearing agency to meet liquidity
needs, (iv) the portion of any excess default fund contributions
held as securities that could be used by the covered clearing agency
to meet liquidity needs, (v) the amount at any given time of
securities or cash delivered by members that a covered clearing
agency may be able to use to meet liquidity needs upon the default
of a member, and (vi) the borrowing limits under any committed
funding arrangement.
---------------------------------------------------------------------------

    In defining the proposed requirements for qualifying liquid
resources, the Commission preliminarily believes that it would be
appropriate to provide covered clearing agencies with the flexibility
to use highly reliable funding arrangements in addition to committed
arrangements for purposes of using assets other than cash to meet the
proposed requirements of Rule 17Ad-22(e)(7).\208\ The Commission
preliminarily believes that limiting the funding arrangements that are
included within the definition of qualifying liquid resources to
committed funding arrangements may not be necessary or appropriate in
determining liquidity requirements for a covered clearing agency
operating in the U.S. securities markets and expanding the concept of
qualifying liquid resources to include other highly reliable funding
arrangements is necessary and appropriate to ensure the proper
functioning of covered clearing agencies as required by the Exchange
Act.
---------------------------------------------------------------------------

    \208\ Cf. PFMI Report, supra note 1, at 57 (discussing Principle
7, liquidity risk, at Key Consideration 5).
---------------------------------------------------------------------------

    For similar reasons, the Commission preliminarily believes it is
appropriate to include in the definition of qualifying liquid resources
assets that a central

bank would permit a covered clearing agency to use as collateral.\209\
The Commission notes that, although routine discount window borrowing
at a Federal Reserve Bank is currently not available to covered
clearing agencies, this provision will provide covered clearing
agencies with additional flexibility in meeting the liquidity
requirements of proposed Rule 17Ad-22(e)(7), should routine credit at a
Federal Reserve Bank become available in the future.\210\
---------------------------------------------------------------------------

    \209\ The Commission also preliminarily notes that the term
``central bank'' in the proposed definition of ``qualifying liquid
resources'' is not limited to a Federal Reserve Bank, and
accordingly covered clearing agencies based in or operating outside
of the United States that have access to routine credit at other
central banks would be able to take that into consideration when
assessing the amount of their qualifying liquid resources.
    \210\ See infra Part 0 (discussing the relative cost of central
bank credit). Section 806(b) of the Clearing Supervision Act states
that the Board may authorize a Federal Reserve Bank to provide to a
designated FMU discount and borrowing privileges only in unusual and
exigent circumstances, subject to certain conditions. See 12 U.S.C.
5465(b).
---------------------------------------------------------------------------

iii. Access to Account Services at a Federal Reserve Bank or Other
Relevant Central Bank
    Proposed Rule 17Ad-22(e)(7)(iii) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to ensure it uses accounts and
services at a Federal Reserve Bank, pursuant to Section 806(a) of the
Clearing Supervision Act,\211\ or other relevant central bank, when
available and where determined to be practical by the board of
directors of the covered clearing agency, in order to enhance its
management of liquidity risk.\212\ The Commission notes that the
proposed rule would not require using Federal Reserve Bank or other
relevant central bank account services; it would only require a covered
clearing agency to establish, implement, maintain and enforce written
policies and procedures reasonably designed to consider and determine
when and in what circumstances it chooses to do so, when the services
are available and when considered to be practical. The Commission
preliminarily believes that covered clearing agencies should be
encouraged to actively consider using Federal Reserve Bank or other
central bank accounts and services, as this is a valuable new tool made
available under the Clearing Supervision Act.\213\ The Commission
preliminarily believes, however, that it should also permit the use of
commercial banks by covered clearing agencies holding cash as
collateral or for other services related to clearance and settlement
activity, even when comparable services are available from a central
bank.
---------------------------------------------------------------------------

    \211\ See 12 U.S.C. 5465(a).
    \212\ See proposed Rule 17Ad-22(e)(7)(iii), infra Part 0.
    \213\ See Clearing Agency Standards Release, supra note 5, at
66268-69 & n.535.
---------------------------------------------------------------------------

iv. Liquidity Providers
    Proposed Rule 17Ad-22(e)(7)(iv) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to ensure it undertakes due
diligence to confirm that it has a reasonable basis to believe each of
its liquidity providers, whether or not such liquidity provider is a
clearing member, has sufficient information to understand and manage
the liquidity provider's liquidity risks, and the capacity to perform
as required under its commitments to provide liquidity.\214\
---------------------------------------------------------------------------

    \214\ See proposed Rule 17Ad-22(e)(7)(iv), infra Part 0.
---------------------------------------------------------------------------

    The Commission preliminarily intends for the term ``due diligence''
to have the same meaning as what this term is commonly understood to
mean by market participants. Consequently, in order to comply with the
requirements of proposed Rule 17Ad-22(e)(7) and to form a reasonable
basis regarding a liquidity provider's understanding and management of
liquidity risks and operational capacity, the Commission expects a
covered clearing agency would ordinarily not rely on representations of
the liquidity provider to this effect and instead conduct its own
investigation into the liquidity provider's business. A covered
clearing agency should consider implementing due diligence procedures
that provide a sufficient basis for its belief, given its business and
the nature of its liquidity providers. Procedures for purposes of
forming a reasonable basis could include, for example, interviewing the
liquidity provider's staff and reviewing both public and non-public
documents that would allow the covered clearing agency to gather
information about relevant factors, including but not limited to the
strength of the liquidity provider's financial condition, its risk
management capabilities, and its internal controls.
    The Commission preliminarily believes that proposed Rule 17Ad-
22(e)(7)(iv) is appropriate because a covered clearing agency needs to
soundly manage its relationships with liquidity providers given the
risks posed to the U.S. securities markets by its size, operation, and
importance. In addition, Proposed Rule 17Ad-22(e)(7)(iv) would
reinforce proposed Rule 17Ad-22(e)(7)(ii) and the definition of
qualifying liquid resources in proposed Rule 17Ad-22(a)(15), which
contemplate potential reliance on liquidity providers where a covered
clearing agency would seek to use assets other than cash for purposes
of complying with proposed Rule 17Ad-22(e)(7)(ii) and would need to
transact with a liquidity provider to convert such assets into cash.
Should a committed or prearranged funding arrangement prove to be
unreliable at the time a covered clearing agency needs to utilize it
because of liquidity problems at the lender itself, this failure may
trigger a liquidity problem at the covered clearing agency, which would
raise systemic risk concerns for the U.S. securities markets. These
types of problems at a liquidity provider, by indirectly affecting a
covered clearing agency, could undermine the national system for the
prompt and accurate clearance and settlement of securities
transactions.
v. Maintenance and Annual Testing of Liquidity Provider Procedures and
Operational Capacity
    Proposed Rule 17Ad-22(e)(7)(v) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to ensure that the covered clearing
agency maintains and, on at least an annual basis,\215\ tests with each
liquidity provider, to the extent practicable, its procedures and
operational capacity for accessing each type of relevant liquidity
resource.\216\
---------------------------------------------------------------------------

    \215\ The Commission preliminary believes that an annual cycle
is appropriate for the reasons described in Part 0.
    \216\ See proposed Rule 17Ad-22(e)(7)(v), infra Part 0.
---------------------------------------------------------------------------

    In addition, proposed Rule 17Ad-22(e)(7)(v) would reinforce
proposed Rule 17Ad-22(e)(7)(ii) and the definition of qualifying liquid
resources in proposed Rule 17Ad-22(a)(15), which contemplate potential
reliance on liquidity providers where a covered clearing agency would
seek to use assets other than cash for purposes of complying with
proposed Rule 17Ad-22(e)(7)(ii) and would need to transact with a
liquidity provider to convert such assets into cash. If procedures or
operational capacity for accessing liquidity under committed or
prearranged funding arrangements fail to function as planned and in a
timely manner, the covered clearing agency may fail to meet its payment
obligation, which would raise systemic risk concerns for the U.S.
markets and could undermine the national system for the prompt and
accurate clearance and

settlement of securities transactions. Proper preparation for a
liquidity shortfall scenario could also promote members' confidence in
the ability of a covered clearing agency to perform its obligations,
which can mitigate the risk of contagion during stressed market
conditions. The Commission preliminarily believes this is important for
covered clearing agencies given the risks that a covered clearing
agency's size, operation, and importance pose to the U.S. securities
markets.
    The Commission preliminarily believes that testing of access to
liquidity resources could include efforts by a covered clearing agency
to verify that a liquidity provider is able to provide the relevant
liquidity resource in the manner intended under the terms of the
funding arrangement and without undue delay, such as, for example,
promptly funding a draw on the covered clearing agency's credit
facility. Testing procedures could include, for example, test draws
funded by the liquidity provider or tests of electronic connectivity
between the covered clearing agency and the liquidity provider. The
Commission recognizes that testing with liquidity providers may not
always be practicable in the absence of committed liquidity
arrangements.
    The Commission preliminarily believes the proposed requirement that
testing of a covered clearing agency's access to liquidity be conducted
at least annually with each liquidity provider to be a reasonable step
to ensure the objectives of the Exchange Act are achieved in practice.
The Commission understands such tests are routinely performed currently
by certain registered clearing agencies but are subject to variation
due, in part, to the absence of a regulatory requirement and the
incremental time and attention needed to conduct the tests. The
Commission preliminarily anticipates the effect of the proposed rule
will be to require the development of more uniform liquidity testing
practices by covered clearing agencies, and has accordingly proposed to
allow covered clearing agencies to assess the practicability of such
testing to provide them with reasonable flexibility to design the tests
to suit the circumstances of the covered clearing agency and its
particular liquidity arrangements.
vi. Testing the Sufficiency of Liquid Resources
    Proposed Rule 17Ad-22(e)(7)(vi)(A) through (C) would require a
covered clearing agency to establish, implement, maintain and enforce
written policies and procedures reasonably designed to determine the
amount and regularly test the sufficiency of the liquid resources held
for purposes of meeting the minimum liquid resource requirement of
proposed Rule 17Ad-22(e)(7)(i) by (A) conducting a stress test of its
liquidity resources at least once each day using standard and
predetermined parameters and assumptions; \217\ (B) conducting a
comprehensive analysis of the existing stress testing scenarios,
models, and underlying parameters and assumptions used in evaluating
liquidity needs and resources, and considering modifications to ensure
they are appropriate for determining the covered clearing agency's
identified liquidity needs and resources in light of current and
evolving market conditions at least once each month; \218\ and (C)
conducting a comprehensive analysis of the existing stress testing
scenarios, models, and underlying parameters and assumptions used in
evaluating liquidity needs and resources more frequently when products
cleared or markets served display high volatility or become less
liquid, when the size or concentration of positions held by
participants increases significantly, or in other circumstances
described in the covered clearing agency's policies and
procedures.\219\ Proposed Rule 17Ad-22(e)(7)(vi)(D) would also require
a covered clearing agency to establish, implement, maintain and enforce
written policies and procedures reasonably designed to result in
reporting the results of the analyses performed under proposed Rule
17Ad-22(e)(7)(vi)(B) and (C) to appropriate decision makers, including
the risk management committee or board of directors, at the covered
clearing agency for use in evaluating the adequacy of and adjusting its
liquidity risk management framework.
---------------------------------------------------------------------------

    \217\ The Commission preliminary believes that a daily cycle is
appropriate for the reasons described in Part 0.
    \218\ The Commission preliminary believes that a monthly cycle
is appropriate for the reasons described in Part 0.
    \219\ See proposed Rule 17Ad-22(e)(7)(vi), infra Part 0.
---------------------------------------------------------------------------

    The Commission preliminarily believes that proposed Rules 17Ad-
22(e)(7)(vi)(A) through (D) would require a covered clearing agency to
take reasonable steps to ensure the adequacy of liquid resources in
practice. Given the risks that a covered clearing agency's size,
operation, and importance pose to the U.S. securities markets, in
addition to the potential consequences to the U.S. financial system of
a failure of a covered clearing agency, the Commission preliminarily
believes that requiring a covered clearing agency to devote additional
time and attention to testing the sufficiency of its liquid resources,
relative to a registered clearing agency generally, is appropriate. The
Commission preliminarily believes that the requirements in proposed
Rule 17Ad-22(e)(7)(vi) are appropriate for testing the sufficiency of
liquid resources of covered clearing agencies because, in certain
market conditions, such as periods of high volatility or diminished
liquidity, existing stress scenarios, models, or underlying parameters
may no longer be valid or appropriate. For example, covered clearing
agencies may have adjusted their financial resources models following
the 2008 financial crisis to account for larger debt, equity, and
credit market shocks than would have been contemplated by those models
prior to the crisis. Accordingly, the Commission preliminarily believes
that specific policies and procedures specifying actions to be taken by
covered clearing agencies to maintain sufficient liquid resources would
contribute to the safe functioning of the covered clearing agency as
required by the Exchange Act,\220\ and that requiring periodic feedback
and analysis on the strength of liquidity risk management policies and
procedures would improve the reliability of those policies and
procedures. The Commission also preliminarily believes that covered
clearing agencies should have the flexibility to use stress scenarios
that are appropriately calibrated to the markets in which they operate
and that they can be revised over time as those markets change. Proper
preparation for a liquidity shortfall scenario could also promote a
participant's confidence in the ability of a covered clearing agency to
perform its obligations, which can mitigate the risk of undue
disruption during stressed market conditions.
---------------------------------------------------------------------------

    \220\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
---------------------------------------------------------------------------

    One of the appropriate methods of preparation by a covered clearing
agency would be, in the Commission's preliminary view, the testing of
the sufficiency of liquidity that it might need under certain extreme
but plausible parameters and assumptions. The Commission preliminarily
believes that conducting stress testing of liquidity would allow a
covered clearing agency to understand its level of resilience and
adjust its operations accordingly to address areas of inadequacy. The
Commission preliminarily believes that by testing under extreme but
plausible scenarios,

covered clearing agencies, and in particular those designated
systemically important, would be better prepared in the event that
equivalent or similar scenarios actually occurred.
vii. Annual Conforming Model Validation
    Proposed Rule 17Ad-22(e)(7)(vii) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to result in performing an annual or
more frequent conforming model validation of its liquidity risk
models.\221\
---------------------------------------------------------------------------

    \221\ See proposed Rules 17Ad-22(a)(5) and (e)(7)(vii), infra
Part 0. The Commission notes that, in contrast to proposed Rules
17Ad-22(a)(5) and (e)(7)(vii), Rule 17Ad-22(b)(4) requires only a
model validation for margin models and does not specify the general
elements of a model validation. See supra note 167 and accompanying
text.
     In addition, the Commission preliminary believes that an annual
cycle is appropriate for the reasons described in Part 0.
---------------------------------------------------------------------------

    The Commission preliminarily believes that such annual conforming
model validation would provide feedback on the performance of such
liquidity risk models conducted by a qualified person who is free from
influence from the persons responsible for the development or operation
of the liquidity risk model, as contemplated by the definition of
``conforming model validation'' in proposed Rule 17Ad-22(a)(5), and
incorporate alternative liquidity risk management methodologies into
their models as appropriate. Generally, the Commission preliminarily
considers that a person is free from influence when that person does
not perform functions associated with the clearing agency's models
(except as part of the annual model validation) and does not report to
a person who performs these functions. Preliminarily, the Commission
would not expect policies and procedures adopted pursuant to this
proposed requirement to require the clearing agency to detach model
review from model development or to maintain two separate quantitative
teams. By reacting to such feedback, a covered clearing agency may
improve the functioning of its liquidity risk model. The Commission
notes that misspecified or miscalibrated liquidity risk models may lead
to errors in decision making. The Commission preliminarily believes
that the proposed rule is appropriate following consideration of the
Exchange Act requirements discussed above \222\ and the risks that a
covered clearing agency's size, operation, and importance pose to the
U.S. securities markets.
---------------------------------------------------------------------------

    \222\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
---------------------------------------------------------------------------

viii. Address Liquidity Shortfalls and Seek To Avoid Unwinding
Settlement
    Proposed Rule 17Ad-22(e)(7)(viii) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to address foreseeable liquidity
shortfalls that would not be covered by its liquid resources and seek
to avoid unwinding, revoking, or delaying the same-day settlement of
payment obligations.\223\ The Commission preliminarily believes advance
planning by a covered clearing agency with regard to liquidity
shortfalls could further enhance the covered clearing agency's ability
to perform its payment obligations without delay and therefore support
the ability of the clearing agency's participants to function without
disruption. Foreseeable liquidity shortfalls could include, for
example, potential shortfalls that can be identified through testing a
covered clearing agency's financial resources in a manner consistent
with the policies and procedures requirements in proposed Rule 17Ad-
22(e)(7)(vi). The Commission recognizes that foreseeable liquidity
shortfalls could occur even when a covered clearing agency is in
compliance with the proposed requirements of Rule 17Ad-22(e)(7), such
as when, for example, the covered clearing agency is unable to obtain
liquidity pursuant to a prearranged funding arrangements that are
uncommitted. The Commission preliminarily believes the proposed
requirement is appropriate for covered clearing agencies given the
risks that a covered clearing agency's size, operation, and importance
pose to the U.S. securities markets and are consistent with the
Exchange Act requirements discussed above.\224\
---------------------------------------------------------------------------

    \223\ See proposed Rule 17Ad-22(e)(7)(viii), infra Part 0.
    \224\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
---------------------------------------------------------------------------

ix. Replenishment of Liquid Resources
    Proposed Rule 17Ad-22(e)(7)(ix) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to describe its process for
replenishing any liquid resources that it may employ during a stress
event.\225\ The Commission preliminarily believes a covered clearing
agency should specifically contemplate and memorialize its expectations
for replenishing its financial resources when they are depleted so that
its ability to withstand repeated stress events, such as multiple
market shocks or sequential defaults of multiple participants is
clearly understood and reflected in its planning for such events. The
Commission preliminarily believes that the proposed requirement is
appropriate given the risks that a covered clearing agency's size,
operation, and importance pose to the U.S. securities markets and is
consistent with the Exchange Act requirements discussed above.\226\
---------------------------------------------------------------------------

    \225\ See proposed Rule 17Ad-22(e)(7)(ix), infra Part 0.
    \226\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
---------------------------------------------------------------------------

x. Feasibility Analysis for ``Cover Two''
    Proposed Rule 17Ad-22(e)(7)(x) would require a covered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to ensure it, at least once a year,
evaluates the feasibility of maintaining sufficient liquid resources at
a minimum in all relevant currencies to effect same-day and, where
appropriate, intraday and multiday settlement of payment obligations
with a high degree of confidence under a wide range of foreseeable
stress scenarios that includes, but is not limited to, the default of
the two participant families that would potentially cause the largest
aggregate credit exposure for the covered clearing agency in extreme
but plausible market conditions if the covered clearing agency provides
CCP services and is either systemically important in multiple
jurisdictions or a clearing agency involved in activities with a more
complex risk profile.\227\
---------------------------------------------------------------------------

    \227\ See proposed Rule 17Ad-22(e)(7)(x), infra Part 0.
---------------------------------------------------------------------------

    Rule 17Ad-22 does not currently provide specific requirements
regarding the sizing and testing of liquid resources or what types of
financial resources would qualify as liquid. However, the financial
crisis of 2008 demonstrated the plausibility of the default of two
large participants in a clearing agency over a brief period.\228\
Accordingly, the Commission preliminarily believes that its proposed
approach is appropriate, given the need for more stringent financial
resource requirements for a covered clearing agency due to the risks
that its size, operation, and importance

pose to the U.S. securities markets, and is consistent with the
Exchange Act requirements discussed above.\229\ The Commission also
believes that such financial resources must be robust enough to
accommodate the risks that are particular to each market served and
accordingly believes that a covered clearing agency should have the
flexibility to determine that different standards are appropriate in
different markets, given the variable nature and risks associated with
the products cleared.\230\
---------------------------------------------------------------------------

    \228\ See Clearing Agency Standards Release, supra note 5, at
66235-36 (noting that the financial crisis of 2008 demonstrated the
plausibility of the default of two large participants in a clearing
agency over a brief period).
    \229\ See notes 54-56 and accompanying text; see also Parts 0
and 0 (generally discussing the regulatory framework under Section
17A of the Exchange Act, as amended by the Dodd-Frank Act).
    \230\ See generally Clearing Agency Standards Release, supra
note 5, at 66234-36 (describing a ``cover two'' requirement for
credit risk).
---------------------------------------------------------------------------

    The Commission also preliminarily believes that, with greater
emphasis being placed on the role of CCPs in the financial system, the
requirement in proposed Rule 17Ad-22(e)(7)(x) for CCPs to review and
consider the feasibility of meeting a higher liquidity risk management
standard is appropriate. While Rule 17Ad-22(e)(7)(x) would impose on
certain covered clearing agencies' policies and procedures requirements
to conduct an annual analysis of the feasibility of maintaining ``cover
two'' for liquidity, such covered clearing agencies would not be
mandated to adopt a ``cover two'' approach regarding liquidity risk
management. The responsibility for such a determination would remain
with the boards of directors of covered clearing agencies following a
review of the information produced pursuant to proposed Rule 17Ad-
22(e)(7)(x).
    The Commission preliminarily believes that it may be appropriate
for a covered clearing agency that provides CCP services to maintain
liquidity coverage at levels higher than other clearing agencies due to
the heightened need to ensure the safe operation of covered clearing
agencies given their importance to the U.S. financial markets and the
risks attributable to the products they clear, but also that covered
clearing agencies not subject to a ``cover two'' requirement should
have flexibility to evaluate the results of an annual feasibility study
and to make their own determinations as to whether a ``cover two''
approach to liquidity risk management is necessary or appropriate.
Furthermore, the Commission notes that if, following completion of a
feasibility study as contemplated in proposed Rule 17Ad-22(e)(7)(x), a
covered clearing agency makes a determination to move beyond ``cover
one'' for liquidity that would be required under proposed Rule 17Ad-
22(e)(7)(i), such covered clearing agency would not be limited to
sizing its qualifying liquid resources to cover the default of its two
largest participant families. In such case, the covered clearing agency
could select a level of liquid resources exceeding ``cover one'' that
it deems most appropriate to the management of liquidity risk, which
could be either less than, equal to, or more than ``cover two.''
    Based on its supervisory experience, the Commission also
preliminarily believes that, in sizing its liquid resources to exceed
``cover one,'' a covered clearing agency may take into account a
variety of factors, including, but not limited to, (i) the business
model of the covered clearing agency, such as a utility model (which
may be also referred to as an ``at cost'' model) versus a for-profit
model; (ii) diversification of its members' business models as they
impact the members' ability to supply liquidity to the covered clearing
agency; (iii) concentration of membership of the covered clearing
agency, as the breadth of the membership may affect the ability to draw
liquidity from members; (iv) levels of usage of the covered clearing
agency's services by members, as the concentration of demand on the
covered clearing agency's services may bear upon potential liquidity
needs; (v) the relative concentration of members' market share in the
cleared products; (vi) the degree of alignment of interest between
member ownership of the covered clearing agency and the provision of
funding to the covered clearing agency; and (vii) the nature of, and
risks associated with, the products cleared by the covered clearing
agency.
g. Request for Comments
    The Commission generally requests comments on all aspects of
proposed Rules 17Ad-22(e)(4), (5), (6), and (7) and proposed Rules
17Ad-22(a)(5), (6), (14), (15), (17), (18), and (19). In particular,
the Commission requests comments on the following issues:
     Has the Commission provided sufficient guidance for Rule
17Ad-22(e)(4) regarding the meaning of the requirement to cover credit
exposures to each participant ``fully with a high degree of
confidence''? Has the Commission provided sufficient guidance regarding
the meaning of the requirement to maintain the financial resources
required under proposed Rules 17Ad-22(e)(4)(i) through (iii), as
applicable, ``in combined or separately maintained clearing or guaranty
funds''? Has the Commission provided sufficient guidance regarding the
use of ``high volatility'' and ``become less liquid''? Why or why not?
     Is the Commission's proposed requirement to cover credit
exposures to each participant ``fully with a high degree of
confidence'' in proposed Rule 17Ad-22(e)(4) appropriate? Why or why
not?
     Should a covered clearing agency's policies and procedures
provide for the measurement of credit exposures more frequently than
once per day? Why or why not? If so, how frequently? What factors
should be considered in determining the minimum frequency?
     Should the Commission require a covered clearing agency's
policies and procedures to limit the assets it accepts as collateral to
those with low credit, liquidity, and market risks? Why or why not? Has
the Commission provided sufficient guidance regarding what constitutes
``low credit, liquidity, and market risks''? Why or why not? If not,
what additional guidance should the Commission consider providing?
     Should the Commission require a covered clearing agency's
policies and procedures to set and enforce appropriately conservative
haircuts and concentration limits if the covered clearing agency
requires collateral to manage its or its participants' credit exposure?
Why or why not? Has the Commission provided sufficient guidance on what
would constitute ``appropriately conservative haircuts and
concentration limits''? Why or why not? Should the Commission adopt
different standards? If so, what should those standards be? Please
explain in detail.
     Are there any other requirements that should be included
in proposed Rule 17Ad-22(e)(5) to facilitate policies and procedures
that address collateral? Why or why not? Are there any requirements
that should be removed? Why or why not? For instance, should the
Commission require policies and procedures that avoid concentrated
holdings of any particular kind of asset, such as those that would
significantly impair the covered clearing agency's ability to liquidate
such assets quickly without significant adverse price effects? Should
the Commission require policies and procedures that avoid concentrated
holdings under certain conditions?
     Has the Commission provided sufficient guidance for Rule
17Ad-22(e)(6) regarding ``margin levels commensurate with, the risks
and particular attributes of each relevant product, portfolio, and
market''? Has the Commission provided sufficient guidance regarding
what a ``reliable'' source of timely price data is? Why or

why not? Should the Commission use a different standard? If so, what
should that standard be? Please explain in detail.
     Is the requirement in proposed Rule 17Ad-22(e)(6)(i)
regarding policies and procedures reasonably designed to result in a
margin system that at a minimum considers, and produces margin levels
commensurate with, the risks and particular attributes of each relevant
product, portfolio, and market appropriate? Why or why not?
     Is the Commission's approach in proposed Rule 17Ad-
22(e)(6)(iii), requiring a covered clearing agency's policies and
procedures to calculate margin sufficient to cover its potential future
exposure to participants, and the definition of ``potential future
exposure'' in proposed Rule 17Ad-22(a)(14) to mean the ``maximum
exposure estimated to occur at a future point in time with an
established single-tailed confidence interval of at least 99% with
respect to the estimated distribution of future exposure'' appropriate
and sufficiently clear? Why or why not?
     Are there any other requirements that should be included
in proposed Rule 17Ad-22(e)(6) to facilitate policies and procedures
that address margin? Why or why not? For instance, should the
Commission require policies and procedures that address minimum
liquidation periods for products cleared by covered clearing agencies?
Why or why not?
     Has the Commission provided sufficient guidance for Rule
17Ad-22(e)(7) regarding what constitutes the ``relevant currency'' in
holding qualifying liquid resources? Has the Commission provided
sufficient guidance regarding the ``due diligence'' with respect to
liquidity providers? Has the Commission provided sufficient guidance
regarding what constitutes ``foreseeable'' liquidity shortfalls? Why or
why not?
     Has the Commission provided sufficient guidance regarding
what constitutes ``regularly'' testing the sufficiency of liquid
resources under proposed Rule 17Ad-22(e)(7)(vi)? Why or why not? How
frequently should a covered clearing agency test the sufficiency of its
liquid resources? Please explain.
     Does the set of minimum requirements for policies and
procedures under proposed Rule 17Ad-22(e)(7) sufficiently address
liquidity risks? Why or why not? Should the Commission adopt other
requirements for addressing liquidity risk?
     Is the proposed definition of ``qualifying liquid
resources'' under Rule 17Ad-22(a)(15) accurate, appropriate, and
sufficiently clear given the requirements proposed? Why or why not?
Should all types of assets be subject to prearranged funding
arrangements? Should the proposed definition distinguish among them by
asset, product type, or liquidity? Are there alternative definitions
the Commission should consider?
     Is the meaning of the term ``due diligence'' under Rule
17Ad-22(7)(iv) sufficiently clear? Why or why not?
     Is the proposed definition of ``systemically important in
multiple jurisdictions'' under Rule 17Ad-22(a)(19) accurate,
appropriate, and sufficiently clear given the requirements proposed?
Why or why not? Are there alternative definitions the Commission should
consider? How should the Commission assess another regulator or
jurisdiction's determination that a covered clearing agency is
systemically important in multiple jurisdictions? Please explain.\231\
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    \231\ For additional requests for comments relating to proposed
Commission determinations under Rule 17Ab2-2, see Part 0.
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     Is the Commission's proposed approach to ``cover one'' and
``cover two'' with respect to credit risk appropriate? Should the
Commission expand or contract the scope of covered clearing agencies
subject to a ``cover two'' requirement beyond those systemically
important in multiple jurisdictions or those involved in activities
with a more complex risk profile? Why or why not? Is the ``cover two''
approach, in which the covered clearing agency must have policies and
procedures requiring financial resources sufficient to cover the
default of the two participant families that would potentially cause
the largest aggregate credit exposure for the covered clearing agency
in extreme but plausible market conditions, appropriate? Should the
Commission require policies and procedures that provide for financial
resources in excess of ``cover two''? Why or why not? If so, what would
be the potential costs and benefits?
     Is the Commission's proposed approach to ``cover one'' and
``cover two'' with respect to liquidity risk appropriate? Should the
Commission require policies and procedures that would provide for
maintaining qualifying liquid resources equal to ``cover two,'' rather
than policies and procedures for a feasibility analysis with regard to
``cover two''? Why or why not?
     Should the Commission include more specific requirements
for policies and procedures regarding stress testing that take into
account, for example, relevant peak historic price volatilities, shifts
in other market factors such as price determinants and yield curves,
multiple defaults over various time horizons, simultaneous pressures in
funding and asset markets, or a spectrum of forward-looking stress
scenarios in a variety of extreme but plausible market conditions? Why
or why not?
     Is the requirement to require policies and procedures for
reporting the results of a conforming sensitivity analysis to the
appropriate decision makers at the covered clearing agency appropriate?
Why or why not? Has the Commission sufficiently described who the
appropriate decision makers are? Please explain.
     Do any of the proposed rules for financial risk management