[Federal Register Volume 85, Number 221 (Monday, November 16, 2020)]
[Notices]
[Pages 73099-73109]
[FR Doc No: 2020-25202]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-90367; File No. SR-NSCC-2020-802]

Self-Regulatory Organizations; National Securities Clearing
Corporation; Notice of No Objection to Advance Notice To Enhance
National Securities Clearing Corporation's Haircut-Based Volatility
Charge Applicable to Illiquid Securities and UITs and Make Certain
Other Changes to Procedure XV

November 6, 2020.

I. Introduction

    On March 16, 2020, National Securities Clearing Corporation
(``NSCC'') filed with the Securities and Exchange Commission
(``Commission'') advance notice SR-NSCC-2020-802 (``Advance Notice'')
pursuant to Section 806(e)(1) of Title VIII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act, entitled Payment, Clearing
and Settlement Supervision Act of 2010 (``Clearing Supervision Act'')
\1\ and Rule 19b-4(n)(1)(i) \2\ under the Securities Exchange Act of
1934 (``Exchange Act'') \3\ to enhance the calculation of certain
components of the Clearing Fund formula.\4\ The Advance Notice was
published for comment in the Federal Register on April 15, 2020.\5\ The
Commission received comments on the proposal.\6\ On May 15, 2020, the
Commission requested further information for consideration of the
Advance Notices, pursuant to Section 806(e)(1)(D) of the Clearing
Supervision Act (``RFI''),\7\ which tolled the Commission's period of
review of the Advance Notices until 60 days from the date the
information required by the Commission was received by the
Commission.\8\ On September 9, 2020, the Commission received responses
to the RFI from NSCC.\9\ This publication serves as notice of no
objection to the Advance Notice.
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    \1\ 12 U.S.C. 5465(e)(1).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ 15 U.S.C. 78a et seq.
    \4\ NSCC also filed related proposed rule change with the
Commission pursuant to Section 19(b)(1) of the Act and Rule 19b-4
thereunder, seeking approval of proposed changes to their rules
necessary to implement the Advance Notices (``Proposed Rule
Change''). 15 U.S.C. 78s(b)(1) and 17 CFR 240.19b-4, respectively.
The Proposed Rule Change was published in the Federal Register on
March 21, 2020. Securities Exchange Act Release No. 88474 (March 25,
2020), 85 FR 17910 (March 31, 2020) (SR-NSCC-2020-003). On May 15,
2020, the Commission designated a longer period within which to
approve, disapprove, or institute proceedings to determine whether
to approve or disapprove the Proposed Rule Change. Securities
Exchange Act Release No. 88885 (May 15, 2020), 85 FR 31007 (May 21,
2020) (SR-NSCC-2020-003). On June 24, 2020, the Commission issued an
order instituting proceedings to determine whether to approve or
disapprove the Proposed Rule Changes. Securities Exchange Act
Release No. 89145 (June 24, 2020), 85 FR 39244 (June 30, 2020) (SR-
NSCC-2020-003). On September 22, 2020, the Commission designated a
longer period for Commission action on the proceedings to determine
whether to approve or disapprove the Proposed Rule Change.
Securities Exchange Act Release No. 89949 (September 22, 2020), 85
FR 60854 (September 28, 2020) (SR-NSCC-2020-003).
    \5\ Securities Exchange Act Release No. 88615 (April 9, 2020),
85 FR 21037 (April 15, 2020) (SR-NSCC-2020-802) (``Notice of
Filing'').
    \6\ Comments are available at https://www.sec.gov/comments/sr-nscc-2020-003/srnscc2020003-7108527-215929.pdf. All but one of the
comments were submitted with respect to the Proposed Rule Change.
Supra note 4. Because the proposals contained in the Advance Notice
and the Proposed Rule Change are the same, all public comments
received on the proposal were considered regardless of whether the
comments were submitted with respect to the Advance Notice or the
Proposed Rule Change.
    \7\ 12 U.S.C. 5465(e)(1)(D).
    \8\ See 12 U.S.C. 5465(e)(1)(E)(ii) and (G)(ii); see Memorandum
from the Office of Clearance and Settlement Supervision, Division of
Trading and Markets, titled ``Commission's Request for Additional
Information,'' available at https://www.sec.gov/rules/sro/nscc-an/2020/34-88615-request-for-info.pdf.
    \9\ See 12 U.S.C. 5465(e)(1)(E)(ii) and (G)(ii); see Memorandum
from the Office of Clearance and Settlement Supervision, Division of
Trading and Markets, titled ``Response to the Commission's Request
for Additional Information,'' available at https://www.sec.gov/rules/sro.shtml.
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II. The Advance Notice

A. Background

    NSCC provides clearing, settlement, risk management, central
counterparty services, and a guarantee of completion for virtually all
broker-to-broker trades involving equity securities, corporate and
municipal debt securities, and unit investment trust transactions in
the U.S. markets. A key tool that NSCC uses to manage its credit
exposure to its Members is collecting an appropriate Required Fund
Deposit (i.e., margin) from each Member.\10\ A Member's Required Fund
Deposit is designed to mitigate potential losses to NSCC associated
with liquidation of the Member's portfolio in the event of a Member
default.\11\ The aggregate of all NSCC Members' Required Fund Deposits
(together with certain other deposits required under the Rules)
constitutes NSCC's Clearing Fund, which NSCC would access should a
Member default and that Member's Required Fund Deposit, upon
liquidation, be insufficient to satisfy NSCC's losses.\12\
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    \10\ Terms not defined herein are defined in NSCC's Rules and
Procedures (``Rules''), available at http://www.dtcc.com/~/media/
Files/Downloads/legal/rules/nscc_rules.pdf. See Rule 4 (Clearing
Fund) and Procedure XV (Clearing Fund Formula and Other Matters) of
the Rules.
    \11\ Under NSCC's Rules, a default would generally be referred
to as a ``cease to act'' and could encompass a number of
circumstances, such as a member's failure to make a Required Fund
Deposit in a timely fashion. See Rule 46 (Restrictions on Access to
Services), supra note 10.
    \12\ See Rule 46 (Restrictions on Access to Services), supra
note 10.
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    Each Member's Required Fund Deposit consists of a number of
applicable components, each of which is calculated to address specific
risks faced by NSCC, as identified within NSCC's Rules.\13\ Generally,
the largest component of Members' Required Fund Deposits is the
volatility component. The volatility component is designed to reflect
the amount of money that could be lost on a portfolio over a given
period within a 99% confidence level. This component represents the
amount assumed necessary to absorb losses while liquidating the
portfolio.
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    \13\ See Procedure XV, supra note 10.
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    NSCC's methodology for calculating the volatility component of a
Member's Required Fund Deposit depends on the type of security and
whether the security has sufficient pricing or trading history for NSCC
to perform statistical analysis. Generally, for most securities (e.g.,
equity securities), NSCC calculates the volatility component using,
among other things, a parametric Value at Risk (``VaR'') model, which
results in a ``VaR Charge.'' \14\ However, the VaR model generally
relies on predictability, and this model may be less reliable for
measuring market risk of securities that exhibit illiquid
characteristics. More specifically, the VaR model relies on assumptions
that are based on historical observations of security prices.
Securities that exhibit illiquid characteristics, which generally have
low trading volumes or are not traded frequently may not present
sufficient instances of price observations to allow

the VaR model to provide a precise measure of market risk for such
securities. Accordingly, for securities that do not have sufficient
pricing or trading history to perform statistical analysis, NSCC
applies a haircut to calculate the volatility component, in lieu of the
VaR-based calculation.
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    \14\ Specifically, NSCC calculates the VaR Charge as the
greatest of (1) the larger of two separate calculations that utilize
the VaR model, (2) a gap risk measure calculation based on the
largest non-index position in a portfolio that exceeds a
concentration threshold, which addresses concentration risk that can
be present in a member's portfolio, and (3) a portfolio margin floor
calculation based on the market values of the long and short
positions in the portfolio, which addresses risks that might not be
adequately addressed with the other volatility component
calculations. See Sections I.(A)(1)(a)(i) and I.(A)(2)(a)(i) of
Procedure XV, supra note 10.
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B. Current Practice for Determining Volatility Component for Illiquid
Securities and UITs

    Two types of securities for which NSCC uses a haircut to calculate
the volatility component are securities that NSCC deems to be
``Illiquid Securities'' and UITs. NSCC's Rules currently define an
Illiquid Security as a security that is (i) not traded on or subject to
the rules of a national securities exchange registered under the
Exchange Act, or (ii) an OTC Bulletin Board \15\ or OTC Link issue.\16\
Based on its interpretation of that definition, NSCC considers
securities that are not listed on the national securities exchanges,
i.e., those exchanges which are covered by certain third party data/
pricing vendors, to be Illiquid Securities.\17\ UITs are redeemable
securities, or units, issued by investment companies that offer fixed
security portfolios for a defined period of time.
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    \15\ The OTC Bulletin Board is an inter-dealer quotation system
that is used by subscribing members of the Financial Industry
Regulatory Authority (``FINRA'') to reflect market making interest
in eligible securities (as defined in FINRA's Rules). See http://www.finra.org/industry/otcbb/otc-bulletin-board-otcbb.
    \16\ OTC Link is an electronic inter-dealer quotation system
that displays quotes from broker-dealers for many over-the-counter
securities. See https://www.otcmarkets.com.
    \17\ NSCC represents that it utilizes multiple third-party
vendors to price its eligible securities. NSCC believes that
national securities exchanges covered by these third party vendors
tend to list securities that exhibit liquid characteristics such as
having more available public information, larger trading volumes and
higher capitalization. See Notice of Filing, supra note 5, 85 FR at
21040. The exchanges that have established listing services that the
vendors cover for this purpose are: New York Stock Exchange LLC,
NYSE American LLC, NYSE Arca, Inc., The Nasdaq Stock Market and Cboe
BZX Exchange, Inc. NSCC represents that Members' Clearing Fund
Summary reports, available through the DTCC Risk Portal, identify
securities within their portfolio by the ticker symbol and indicate
whether those securities are considered Illiquid Securities for
purposes of the calculation of the Illiquid Charge. See id.
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    Under NSCC's current rules, Illiquid Securities and UITs are
subject to haircut-based charges to calculate the volatility component
of a Member's Required Fund Deposit based upon two distinct but related
rationales. Specifically, Illiquid Securities are considered
``securities that are less amenable to statistical analysis, such as
OTC Bulletin Board or Pink Sheet issues or issues trading below a
designated dollar threshold (e.g., five dollars),'' and UITs are
considered ``securities that are amenable to generally accepted
statistical analysis only in a complex manner.'' \18\ Based on these
determinations, NSCC considers Illiquid Securities and UITs as
categories of securities that tend to exhibit illiquid characteristics,
such as low trading volumes or infrequent trading.\19\ NSCC therefore
calculates the volatility component for these two categories of
securities by multiplying the absolute value of a given position by a
percentage that is (1) not less than 10% for securities that are less
amenable to statistical analysis, including Illiquid Securities,\20\
and (2) not less than 2% for securities that are amenable to generally
accepted statistical analysis only in a complex manner, including UITs.
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    \18\ A security that is less amenable to statistical analysis
generally lacks pricing or trading history upon which to perform
statistical analysis. A security that is amenable to generally
accepted statistical analysis only in a complex manner generally may
have pricing or trading history, but further calculations upon the
pricing or trading history would be required to perform statistical
analysis.
    \19\ Because the VaR model generally relies on predictability,
this model may be less reliable for measuring market risk of
securities that exhibit illiquid characteristics.
    \20\ NSCC currently calculates the volatility charge for IPOs,
which have fewer than 31 business days of trading history over the
past 153 business days, by applying a haircut of 15% and all other
Illiquid Securities by applying a haircut of 20%. See Notice of
Filing, supra note 5, 85 FR at 21042.
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    In addition to using the haircut-based volatility charge for
Illiquid Securities, NSCC currently can also apply an additional charge
(an ``Illiquid Charge'') for certain positions in Illiquid Securities
that exceed volume thresholds set forth in the Rules.\21\ NSCC
represents that the Illiquid Charge was designed to address a situation
where the defaulting Member may have a relatively large position in an
Illiquid Security, which would increase the risk that NSCC might face
losses when liquidating the Member's position in these securities due
to the securities' lack of marketability and other characteristics.\22\
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    \21\ Specifically, the Illiquid Charge applies to Illiquid
Positions as defined under NSCC's Rules. The Rules specify the
applicable thresholds that result in an Illiquid Position
determination. For example, where a Member's net buy position in an
Illiquid Security exceeds a threshold no greater than 100 million
shares, that position may become subject to the Illiquid Charge.
However, NSCC's rules also provide for certain offsets and credit
risk considerations that will be considered when determining whether
a position in an Illiquid Security should be considered an Illiquid
Position and, thus, subject to the additional Illiquid Charge. See
Rule 1 and Sections I.(A)(1)(h) and I.(A)(2)(f) of Procedure XV,
supra note 10.
    \22\ See Notice of Filing, supra note 5, 85 FR at 21038. See
also Securities Exchange Act Release No. 80597 (May 4, 2017), 82 FR
21863 (May 10, 2017) (SR-NSCC-2017-001) (order approving proposed
rule change to describe the illiquid charge that may be imposed on
Members).
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    NSCC states that it regularly assesses its market and credit risks,
as such risks are related to its margin methodologies, to evaluate
whether margin levels are commensurate with the particular risk
attributes of each relevant product, portfolio, and market.\23\ Based
on such assessments, NSCC seeks to refine its current approach to risk
managing Member positions in Illiquid Securities and UITs. More
specifically, NSCC proposes to (1) revise the definition of Illiquid
Security, (2) adopt specific exclusions from the VaR model, and
corresponding haircut-based methods for determining volatility
components for positions in Illiquid Securities and UITs, (3) eliminate
the existing Illiquid Charge, and (4) make certain conforming changes
regarding municipal and corporate bonds and Family-Issued
Securities.\24\
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    \23\ See Notice of Filing, supra note 5, 85 FR at 21039.
    \24\ The term ``Family-Issued Security'' means a security that
was issued by a Member or an affiliate of that Member. See Rule 1,
supra note 10.
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C. Proposed Revision to the Definition of Illiquid Security

    Under the Advance Notice, NSCC proposes a new definition of
Illiquid Security that would consist of three particular categories of
securities. As noted further below, application of the new definition
of Illiquid Security would capture a broader set of securities than the
current definition.
(i) Securities Not Listed on a Specified Securities Exchange
    The first category of the new definition of Illiquid Securities
would include any security that is not listed on a ``specified
securities exchange.'' For purposes of this definition, NSCC's Rules
would define a ``specified securities exchange'' as a national
securities exchange that has established listing services and is
covered by industry pricing and data vendors.\25\ NSCC would make the
determination of whether a security falls in this category on a daily
basis. NSCC represents that this new definition would reflect the
process that it currently employs to determine whether a security is
not traded on or subject to the rules of a national securities exchange
registered under the Securities Exchange Act of 1934, as amended.\26\
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    \25\ NSCC has stated that the exchanges that would initially be
specified securities exchanges are those listed in note 17. See
supra note 17.
    \26\ See Notice of Filing, supra note 5, 85 FR at 21040. Based
on historic performances, NSCC believes the national securities
exchanges that the vendors cover are appropriate for determining if
a security exhibits characteristics of liquidity because such
exchanges tend to list securities that exhibit liquid
characteristics such as having more available public information,
larger trading volumes, and higher capitalization. See id.

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(ii) Micro-Capitalization Securities and ADRs Subject to an Illiquidity
Ratio
    The second category of the new definition of Illiquid Securities
would apply to certain securities that are listed on a specified
securities exchange. Specifically, the types of securities that would
potentially be considered as Illiquid Securities under this second
category either (i) have a market capitalization that is considered by
NSCC to be a micro-capitalization (``micro-capitalization'' or ``micro-
cap'') as of the last business day of the prior month, or (ii) are
American depositary receipts (``ADRs'').\27\ To determine whether these
securities qualify as Illiquid Securities, NSCC would apply, on a
monthly basis, an illiquidity ratio test to these two sets of
securities.
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    \27\ ADRs are securities that represent shares of non-U.S.
companies that are held by a U.S. depository bank outside of the
United States. Each ADR represents one or more shares of foreign
stock or a fraction of a share.
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1. Micro-Capitalization Definition
    Initially, NSCC would define ``micro-capitalization'' as market
capitalization of less than $300 million. Changes to this threshold
amount of $300 million would not be subject to any particular period of
review, but would occur when NSCC determines changes may be
appropriate.\28\ NSCC believes that using market capitalization to
consider whether a security is illiquid, in conjunction with the
illiquidity ratio test, is appropriate because securities with a market
capitalization below a certain threshold tend to exhibit illiquid
characteristics such as limited trading volumes and a lack of public
information.\29\
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    \28\ Any changes to the micro-cap threshold would be subject to
NSCC's model risk management governance procedures as set forth in
the Clearing Agency Model Risk Management Framework (``Model Risk
Management Framework''). See Notice of Filing, supra note 5, 85 FR
at 21040. See Securities Exchange Act Release No. 81485 (August 25,
2017), 82 FR 41433 (August 31, 2017) (File No. SR-NSCC-2017-008)
(describes the adoption of the Model Risk Management Framework of
NSCC which sets forth the model risk management practices of NSCC)
and Securities Exchange Act Release No. 84458 (October 19, 2018), 83
FR 53925 (October 25, 2018) (File No. SR-NSCC-2018-009) (amends the
Model Risk Management Framework). NSCC would notify Members of any
changes to the micro-capitalization threshold by Important Notice.
    \29\ See Notice of Filing, supra note 5, 85 FR at 21040.
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2. ADRs
    With respect to ADRs, NSCC believes that subjecting these
securities to the illiquidity ratio test to determine whether a
particular ADR is an Illiquid Security is appropriate because the
market capitalization of an ADR may be difficult to calculate. This is
because of challenges associated with the day-to-day fluctuation of the
conversion rate of an ADR into the relevant local security, which in
turn makes it difficult to price the ADR.\30\ Without knowing the
market capitalization of the ADR, it is therefore difficult to
determine whether an ADR represents a non-micro-cap issuer.
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    \30\ See id.
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3. Application of the Illiquidity Ratio and the Illiquidity Ratio Test
to Micro-Cap Securities and ADRs
    The proposal would define the illiquidity ratio for a security as
the ratio of the security's daily price return divided by the average
daily trading amount \31\ of such security over the prior 20 business
days. In addition, if NSCC is unable to retrieve data to calculate the
illiquidity ratio for a security on any day, NSCC would use a default
value for that day for the security (i.e., the security would be
treated as illiquid for that day).
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    \31\ The daily trading amount equals the daily trading volume
multiplied by the end-of-day price. See id.
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    In order to classify a micro-cap security or ADR as ``illiquid,''
NSCC then takes the illiquidity ratio calculated for these securities
and applies an illiquidity ratio test. The test functions as follows:
NSCC determines whether the security's median illiquidity ratio of the
prior six months exceeds a threshold that is set to the 99th percentile
of the illiquidity ratio of all non-micro-cap common stock using the
prior six months of data. Where such a threshold is exceeded, NSCC will
designate the relevant security as an Illiquid Security. NSCC performs
this exercise, and thereby determines the set of micro-cap securities
and ADRs to be considered Illiquid Securities, on a monthly basis.
    The illiquidity ratio test is designed to measure the level of a
security's price movement relative to its level of trading activity.
For example, given the same dollar amount of trading activity, a larger
price movement typically indicates less liquidity. Conversely, for
price movement of a given magnitude, a smaller dollar amount of trading
activity would indicate less liquidity.
    Securities that are exchange-traded products (``ETPs'') with market
capitalization of less than $300 million could be classified as
illiquid upon application of the illiquidity test. However, ETPs and
ADRs would be excluded when calculating the illiquidity ratio
threshold. ETPs are excluded because the underlying common stocks that
make up the ETPs are already included in the calculation. ADRs are
excluded because it is difficult to determine whether an ADR represents
a non-micro-cap issuer. An ADR's market capitalization may be difficult
to calculate due to the fact that, as noted above, each ADR often
converts to a different number of shares of a local security. The
threshold used in the illiquidity ratio test will be determined by NSCC
on a monthly basis using the prior six months of data.
(iii) Securities With Limited Trading History
    The third category of the new definition of Illiquid Security would
include securities that are listed on a specified securities exchange
and, as determined by NSCC on a monthly basis, have fewer than 31
business days of trading history over the past 153 business days on
such exchange. NSCC represents that it has historically used such time
period to identify initial public offerings (``IPOs'') which tend to
exhibit illiquid characteristics due to their limited trading history,
thereby making it an appropriate time period to use for the purposes of
determining a security's liquidity, and IPOs would likely constitute
most of the securities that would fall into this category.\32\
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    \32\ See Notice of Filing, supra note 5, 85 FR at 21042.
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D. Proposed Haircut-Based Volatility Charge Specifically Applicable to
Illiquid Securities and UITs

(i) Haircut-Based Volatility Charge Applicable to Illiquid Securities
    As proposed in the Advance Notice, NSCC would expressly exclude
Illiquid Securities when calculating the volatility component of a
Required Fund Deposit using the VaR model and instead would apply a
haircut-based volatility charge specifically to Illiquid Securities. To
determine the appropriate volatility charge, NSCC would group Illiquid
Securities by price level.\33\ NSCC generally would calculate one
haircut-based volatility charge for short and long positions together.
However, with respect to an Illiquid Security that is a sub-penny
security, NSCC would calculate the haircut-based volatility

charge for short positions and long positions separately.\34\
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    \33\ The price level groupings would be subject to NSCC's model
risk management governance procedures set forth in the Model Risk
Management Framework. See Notice of Filing, supra note 5, 85 FR at
21043; see also Model Risk Management Framework, supra note 28.
    \34\ NSCC states that the different treatment for Illiquid
Securities that are sub-penny securities is appropriate because
short positions in sub-penny securities have unlimited upside market
price risk, as the price of a security may increase and could
potentially subject NSCC to losses under its trade guaranty. NSCC
further states the proposal would allow NSCC to calculate a haircut-
based volatility charge that accounts for this risk of such price
movements. Further, NSCC states that sub-penny securities are
typically issued by companies with low market capitalization, and
may be susceptible to market manipulation, enforcement actions, or
private litigation. See Notice of Filing, supra note 5, at 85 FR at
21043; Letter from Timothy J. Cuddihy, Managing Director, DTCC
Financial Risk Management (September 3, 2020) (``NSCC Letter'') at
10.
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    The haircut percentage applicable to each group of Illiquid
Securities would be determined at least annually. The applicable
percentage, and the decision of how often the applicable percentage is
determined, would be subject to NSCC's model risk management governance
procedures set forth in the Model Risk Management Framework.\35\ NSCC
states that a number of important considerations consistent with the
model risk management practices adopted by NSCC could prompt more
frequent haircut review, such as material deterioration of a Member's
backtesting performance, market events, market structure changes, and
model validation findings.\36\
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    \35\ See Notice of Filing, supra note 5, 85 FR at 21042; see
also Model Risk Management Framework, supra note 28.
    \36\ See id.
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    The haircut percentage would be the highest of the following
percentages: (1) 10%, (2) a percent benchmarked to be sufficient to
cover the 99.5th percentile of the historical 3-day returns of each
group of Illiquid Securities in each Member's portfolio, and (3) a
percent benchmarked to be sufficient to cover the 99th percentile of
the historical 3-day returns of each group of Illiquid Securities in
each Member's portfolio after incorporating a fixed transaction cost
equal to one-half of the estimated bid-ask spread.\37\ The look-back
period for purposes of calibrating the applicable percentage would be
no less than five years and would initially be five years to be
consistent with the historical data set used in model development. The
look-back period may be adjusted by NSCC as necessary consistent with
the model risk management practices adopted by NSCC to respond to, for
example, market events that impact liquidity in the market and Member
backtesting deficiencies.\38\
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    \37\ If NSCC needs to liquidate a defaulting Member's portfolio,
it may incur a transaction cost which represents bid-ask spreads.
Bid-ask spreads account for the difference between the observed
market price that a buyer is willing to pay for a security and the
observed market price for which a seller is willing to sell that
security.
    \38\ Adjustments to the look-back period would be subject to
NSCC's model risk governance procedures set forth in the Model Risk
Management Framework. See Notice of Filing, supra note 5, 85 FR at
21042-43; see also Model Risk Management Framework, supra note 28.
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(ii) Haircut-Based Volatility Charge Applicable to UITs
    Similar to its proposed approach to risk managing Illiquid
Securities, NSCC would exclude UITs from calculating the volatility
component of the Required Fund Deposit using the VaR model, and instead
would assign a percentage to be used in the calculation of a haircut-
based volatility charge. UITs are less suited to application of the VaR
model because they generally have a limited trading history, which does
not provide the type of pricing data that allows for application of the
VaR model. NSCC would review the percentage used in this calculation at
least annually.
    The haircut percentage applicable to UITs would be the highest of
(1) 2%, and (2) the 99.5th percentile of the historical 3-day returns
for the group of UITs within each Member's portfolio using a look-back
period of no less than 5 years. The applicable percentage, and the
decision of how often the applicable percentage is determined, would be
subject to NSCC's model risk management governance procedures set forth
in the Model Risk Management Framework.\39\
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    \39\ See Notice of Filing, supra note 5, 85 FR at 21043; see
also Model Risk Management Framework, supra note 28.
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(iii) Revisions to Description of Securities Not Amenable to Generally
Accepted Statistical Analysis or Amenable to Statistical Analysis Only
in a Complex Manner
    NSCC proposes to revise the existing language in its Rules relating
to securities that are either less amenable to statistical analysis or
amenable to statistical analysis only in a complex manner.\40\ Because
Illiquid Securities and UITs would each have specific haircut-based
volatility charges pursuant to the Advance Notice, these sections would
no longer apply to Illiquid Securities or UITs. Furthermore, NSCC
represents that the proposed definition of Illiquid Security would
effectively encompass all securities that are currently considered as
securities that are less amenable to statistical analysis.\41\ However,
NSCC believes that it should preserve this category of securities
within its Rules because NSCC may find it necessary to calculate margin
charges for certain securities that do not constitute Illiquid
Securities or UITs and instead would continue to fall under this
category.
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    \40\ NSCC represents that it also would remove the phrase ``such
as OTC Bulletin Board or Pink Sheet issues or issues trading below a
designated dollar threshold (e.g., five dollars)'' from the existing
language relating to securities that are less amenable to
statistical analysis. While this language was intended as an example
of these types of securities, NSCC now believes that the example
inadequately describes all of the securities that are less amenable
to statistical analysis and may be misleading. See Notice of Filing,
supra note 5, 85 FR at 21043.
    \41\ See Notice of Filing, supra note 5, 85 FR at 21043.
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    Further, NSCC represents that certain fixed income securities, such
as preferred stocks,\42\ would continue to fall into the category of
securities that are amenable to statistical analysis only in a complex
manner. Thus, these types of securities would still be subject to a
haircut-based charge. The application of a haircut percentage to any
new security, using these categories, would be subject to NSCC's model
risk management governance procedures set forth in the Model Risk
Management Framework.\43\
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    \42\ See Notice of Filing, supra note 5, 85 FR at 21044.
    \43\ See id.; see also Model Risk Management Framework, supra
note 28.
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E. Proposed Elimination of the Illiquid Charge

    NSCC proposes to eliminate the existing Illiquid Charge (and the
corresponding definition of Illiquid Position), which may be imposed as
an additional charge in the volatility component that is applied to
Illiquid Securities as securities that are less amenable to statistical
analysis. NSCC represents that because the current haircut-based
volatility charge that is applied to Illiquid Securities uses fixed
percentages for all such securities (15% for IPOs and 20% for the rest
of Illiquid Securities), the Illiquid Charge was added to cover some of
the risks that the current volatility charge did not cover. NSCC also
represents that the proposal would address the risks presented by
positions in Illiquid Securities more adequately than the Illiquid
Charge, and that therefore the Illiquid Charge would no longer be
needed.\44\
---------------------------------------------------------------------------

    \44\ See Notice of Filing, supra note 5, 85 FR at 21044.
---------------------------------------------------------------------------

F. Proposed Conforming Changes

    NSCC proposes to make two conforming changes to harmonize the Rules
in light of the proposed amendments discussed above. First, the current
Rules state that securities less amenable to statistical analysis or
amenable to statistical analysis only in

a complex manner ``other than municipal and corporate bonds'' shall be
excluded from the VaR Charge.\45\ NSCC believes that this drafting is
unclear regarding whether municipal and corporate bonds are excluded
from this section of the Rules. Moreover, the reference to municipal
and corporate bonds is not necessary in this portion of the Rules
because a different subsection of the Rules \46\ provides separately
for haircut-based volatility charges for municipal and corporate bonds.
The proposal would therefore remove this reference to municipal and
corporate bonds from this section of the Rules.
---------------------------------------------------------------------------

    \45\ Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure
XV, supra note 10.
    \46\ Section I.(A)(1)(a)(iii) of Procedure XV, supra note 10.
---------------------------------------------------------------------------

    Second, the Rules currently provide that Family-Issued Securities
are excluded from calculation of the volatility component using the VaR
model because the specific haircut-based volatility charge for such
securities is provided in a separate subsection. However, the separate
subsection only refers to ``long Net Unsettled Positions in Family-
Issued Securities.'' \47\ Based on the current drafting of the Rules,
NSCC believes that it is unclear how positions in Family-Issued
Securities would be treated.\48\ In practice, NSCC states that
currently, short positions in Family-Issued Securities whose volatility
is less amenable to statistical analysis are subject to the haircut set
forth in Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure XV,
and those short positions in Family-Issued Securities that meet
particular volume thresholds are subject to the Illiquid Charge.\49\
NSCC proposes to revise the Rules to expressly reference its current
practice that long positions in Family-Issued Securities would be
excluded from the VaR Charge but subject to the haircut-based
volatility charge exclusively applicable to such securities in a
separate provision of the Rules. In addition, determination of the
appropriate margin for short positions in Family-Issued Securities
would continue to be covered by the haircut-based volatility charge in
Sections I.(A)(1)(a)(ii) and I.(A)(2)(A)(ii) as securities that are
less amenable to statistical analysis.
---------------------------------------------------------------------------

    \47\ Id. In addition, the current Rules exclude ``family issued
security'' from the current definition of Illiquid Security, which
is subject to Illiquid Charge, providing that the term is provided
in Procedure XV, although Procedure XV does not provide such
definition.
    \48\ See Notice of Filing, supra note 5, 85 FR at 21041.
    \49\ See Notice of Filing, supra note 5, 85 FR at 21042 and
21044 n. 52.
---------------------------------------------------------------------------

III. Discussion and Commission Findings

    Although the Clearing Supervision Act does not specify a standard
of review for an advance notice, the stated purpose of the Clearing
Supervision Act is instructive: To mitigate systemic risk in the
financial system and promote financial stability by, among other
things, promoting uniform risk management standards for SIFMUs and
strengthening the liquidity of SIFMUs.\50\
---------------------------------------------------------------------------

    \50\ See 12 U.S.C. 5461(b).
---------------------------------------------------------------------------

    Section 805(a)(2) of the Clearing Supervision Act authorizes the
Commission to prescribe regulations containing risk management
standards for the payment, clearing, and settlement activities of
designated clearing entities engaged in designated activities for which
the Commission is the supervisory agency.\51\ Section 805(b) of the
Clearing Supervision Act provides the following objectives and
principles for the Commission's risk management standards prescribed
under Section 805(a): \52\
---------------------------------------------------------------------------

    \51\ 12 U.S.C. 5464(a)(2).
    \52\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------

     To promote robust risk management;
     To promote safety and soundness;
     To reduce systemic risks; and
     To support the stability of the broader financial system.
    Section 805(c) provides, in addition, that the Commission's risk
management standards may address such areas as risk management and
default policies and procedures, among others areas.\53\
---------------------------------------------------------------------------

    \53\ 12 U.S.C. 5464(c).
---------------------------------------------------------------------------

    The Commission has adopted risk management standards under Section
805(a)(2) of the Clearing Supervision Act and Section 17A of the
Exchange Act (the ``Clearing Agency Rules'').\54\ The Clearing Agency
Rules require, among other things, each covered clearing agency to
establish, implement, maintain, and enforce written policies and
procedures that are reasonably designed to meet certain minimum
requirements for its operations and risk management practices on an
ongoing basis.\55\ As such, it is appropriate for the Commission to
review advance notices against the Clearing Agency Rules and the
objectives and principles of these risk management standards as
described in Section 805(b) of the Clearing Supervision Act. As
discussed below, the Commission believes the proposal in the Advance
Notice is consistent with the objectives and principles described in
Section 805(b) of the Clearing Supervision Act,\56\ and in the Clearing
Agency Rules, in particular Rule 17Ad-22(e)(4)(i), (e)(6)(i), and
(e)(23)(ii).\57\
---------------------------------------------------------------------------

    \54\ 17 CFR 240.17Ad-22. See Securities Exchange Act Release No.
68080 (October 22, 2012), 77 FR 66220 (November 2, 2012) (S7-08-11).
See also Securities Exchange Act Release No. 78961 (September 28,
2016), 81 FR 70786 (October 13, 2016) (S7-03-14) (``Standards for
Covered Clearing Agencies''). NSCC is a ``covered clearing agency''
as defined in Rule 17Ad-22(a)(5).
    \55\ Id.
    \56\ 12 U.S.C. 5464(b).
    \57\ 17 CFR 240.17Ad-22(e)(4)(i), (e)(6)(i), and (e)(23)(ii).
---------------------------------------------------------------------------

A. Consistency With Section 805(b) of the Clearing Supervision Act

    The Commission believes that the Advance Notice is consistent with
the stated objectives and principles of Section 805(b) of the Clearing
Supervision Act.\58\ Specifically, the Commission believes that the
changes proposed in the Advance Notice are consistent with promoting
robust risk management, promoting safety and soundness, reducing
systemic risks, and supporting the broader financial system.\59\
---------------------------------------------------------------------------

    \58\ 12 U.S.C. 5464(b).
    \59\ Several of the issues raised by the commenters are directed
at the Proposed Rule Change and will be addressed in that context.
These comments generally relate to the proposal's impact on
competition, its consistency with the Exchange Act, and its effect
on capital formation. See Letter from Christopher R. Doubek, CEO,
Alpine Securities Corporation (April 21, 2020) (``Alpine Letter'')
at 3; Letter from John Busacca, Founder, The Securities Industry
Professional Association (April 23, 2020) (``SIPA Letter'') at 5-6;
Letter from Charles F. Lek, Lek Securities Corporation (April 30,
2020) (``Lek Letter'') at 1; Letter from Kimberly Unger, The
Security Traders Association of New York, Inc. (June 30, 2020)
(``STANY Letter'') at 1 (commenting on impact on competition). See
Letter from James C. Snow, Chief Compliance Officer, Wilson-Davis &
Co., Inc. (July 29, 2020) (``Wilson II Letter'') at 2-7; Letter from
Daniel Zinn, General Counsel and Cass Sanford, Associate General
Counsel, OTC Markets Group Inc. (June 26, 2020) (``OTC I Letter'')
at 4-5 (commenting on the application of Section 17A(b)(3)(F) of the
Exchange Act). See Alpine Letter at 3; Wilson II Letter at 2-7;
STANY Letter at 1 (commenting on capital formation). The
Commission's evaluation of the Advance Notice is conducted under the
Clearing Supervision Act and, as noted above, generally considers
whether the proposal will mitigate systemic risk and promote
financial stability.
---------------------------------------------------------------------------

    The Commission believes that the proposal is consistent with
promoting robust risk management. First, as described in Section II.C
above, NSCC proposes to revise the definition of ``Illiquid
Securities'' to broaden the scope of securities that will be considered
as Illiquid Securities for assessing margin requirements, including by
providing specific objective criteria that would lead to a security
being considered an ``Illiquid Security.'' Revising the definition of
Illiquid Securities to specifically include a broader set of these
types of

securities within the definition of Illiquid Securities would allow
NSCC to apply a haircut to determine the volatility component for such
securities, thereby avoiding reliance on assumptions employed by the
VaR model. As described above in Section II.A., the method that NSCC
currently uses to calculate the volatility component of the margin for
most securities (i.e., the VaR model) yields a less accurate measure of
market risk for securities with illiquid characteristics because the
VaR model is a model-based calculation, which generally relies on
predictability. More specifically, the VaR model relies on assumptions
that are based on historical observations of security prices.
Securities that exhibit illiquid characteristics, which generally have
low trading volumes or are not traded frequently, may not provide
sufficient price observations for the VaR model to provide an
appropriate measure of market risk.
    In addition, as described in Section II.D above, NSCC proposes to
specifically exclude Illiquid Securities and UITs from application of
the VaR model and change the haircut-based volatility component of the
Clearing Fund formula that is applicable to positions in Illiquid
Securities and UITs. Currently, in order to calculate the volatility
component, fixed percentages are applied to two general categories of
securities that encompass Illiquid Securities and UITs, i.e., (1)
securities that are less amenable to statistical analysis, and (2)
securities that are amenable to generally accepted statistical analysis
only in a complex manner. The proposal would apply a specific
percentage developed for Illiquid Securities and UITs. Moreover, for
Illiquid Securities, instead of using the current fixed haircut
percentages, the proposal would group such securities by price level
and apply a different haircut percentage based on the specific price
group. Illiquid Securities that are sub-penny securities would be
separately grouped by long or short position to more accurately reflect
different levels of risk presented by long and short positions of such
securities (i.e., a higher level of risk is associated with the short
positions in sub-penny securities). By allowing for the application of
a haircut more precisely tailored to Illiquid Securities (grouped by
price level and as long or short positions) and UITs, this change
should result in margin amounts that are more commensurate with the
risk attributes of these types of securities, thereby limiting NSCC's
credit exposure to Members holding positions in such securities in a
more precise manner.\60\ Also, the proposal's provision that NSCC
regularly assess appropriate haircut percentages to cover its credit
risks would require NSCC to take account of changing circumstances and
allow NSCC to respond more effectively to such changing circumstances.
---------------------------------------------------------------------------

    \60\ In addition, the proposal would eliminate the existing
Illiquid Charge, which would be replaced by the haircut-based
charges on Illiquid Securities as described in Section II.E. Because
the proposal would address the risks presented by positions in
Illiquid Securities more adequately than the Illiquid Charge, the
Illiquid Charge would no longer be needed.
---------------------------------------------------------------------------

    NSCC's backtesting results and Member impact studies indicate that
Illiquid Securities, particularly low-priced Illiquid Securities, are
more likely to have reduced backtesting coverage, which indicates that
NSCC does not collect sufficient margin to cover additional risk
present in those securities.\61\ Specifically, the Commission has
considered NSCC's analyses and understands that the proposal's revised
definition of Illiquid Securities and the corresponding new haircut
methodology for determining the margin for Illiquid Securities would
improve its backtesting coverage from 96.2% to 99.5% for the asset
group that exhibited the lowest average backtesting coverage
percentages (i.e., short positions in sub-penny securities and
securities priced between one cent and one dollar), consistent with the
high degree of confidence required by the Commission's rules for
coverage of exposures to participants.\62\ The Commission believes that
this improved backtesting coverage demonstrates that NSCC's proposal
would result in margin levels that better reflect the risks and
particular attributes of the Member's portfolio.
---------------------------------------------------------------------------

    \61\ Backtesting refers to an ex-post comparison of actual
outcomes, i.e., the actual margin collected, with expected outcomes
derived from the use of margin models.
    \62\ NSCC also provided additional information regarding the
improvements in backtesting coverage for other asset groups in
confidential exhibits.
---------------------------------------------------------------------------

    Accordingly, the Commission believes that these proposed changes
for determining what constitutes an Illiquid Security and the adoption
of a specific haircut methodology for Illiquid Securities and UITs
would be consistent with promoting robust risk management because the
proposed methodology would enable NSCC to more precisely manage the
relevant risks than the current methodology.
    The Commission also believes that the proposal is consistent with
the promotion of safety and soundness at NSCC. As summarized above, the
proposed changes are designed to allow NSCC to collect sufficient
margin amounts that are more precisely tailored to the nature of the
risks presented by positions in securities with illiquid
characteristics. By doing so, the proposed methodology would help
provide NSCC with a more precisely determined level of resources to
limit its exposure in the event of a Member default. Such an increase
in NSCC's available financial resources would decrease the likelihood
that losses arising out of a member default would exceed NSCC's
prefunded resources and threaten the safety and soundness of NSCC's
ongoing operations. Accordingly, the Commission believes that the
proposal would be consistent with promoting safety and soundness at
NSCC.\63\
---------------------------------------------------------------------------

    \63\ The Commission believes that NSCC's proposal to make
certain clarifying changes regarding the applicability of particular
sections to municipal and corporate bonds and Family-Issued
Securities is also consistent with promoting safety and soundness at
NSCC because these changes would eliminate potential uncertainty
within NSCC's Rules. Such changes should result in clear and
coherent Rules, which should help enhance the ability of NSCC and
its Members to more effectively plan for and manage their risks.
---------------------------------------------------------------------------

    Finally, the Commission believes that the proposal is consistent
with reducing systemic risk and supporting the broader financial
system. As discussed above, in a Member default scenario, NSCC would
access its Clearing Fund should the defaulted Member's own Required
Fund Deposit be insufficient to satisfy losses caused by the
liquidation of that Member's portfolio. With the proposed changes, NSCC
seeks to collect margin at levels that better reflect the risks
presented by positions in securities that exhibit illiquid
characteristics. By collecting margin that more accurately reflects the
risk characteristics of such securities, NSCC would be in a better
position to absorb losses in connection with a Member default, and
could thereby reduce the possibility that NSCC would need to mutualize
among the non-defaulting Members losses arising out of a Member
default. Reducing the potential for loss mutualization could, in turn,
reduce the potential knock-on effects to non-defaulting Members, their
customers, and the broader market arising out of a Member default. The
Commission believes, therefore, that the proposal would be consistent
with reducing systemic risk and supporting the stability of the broader
financial system.
    For the reasons stated above, the Commission believes the changes
proposed in the Advance Notice are consistent with Section 805(b) of
the Clearing Supervision Act.

B. Consistency With Rule 17Ad-22(e)(4)(i)

    Rule 17Ad-22(e)(4)(i) under the Exchange Act requires that each
covered clearing agency establish, implement, maintain and enforce
written policies and procedures reasonably designed to effectively
identify, measure, monitor, and manage its credit exposures to
participants and those arising from its payment, clearing, and
settlement processes, including by maintaining sufficient financial
resources to cover its credit exposure to each participant fully with a
high degree of confidence.\64\
---------------------------------------------------------------------------

    \64\ 17 CFR 240.17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

    Several commenters question whether NSCC has adequately
demonstrated that its proposal is consistent with Rule 17Ad-22(e)(4)(i)
under the Exchange Act by showing the insufficiency of NSCC's current
margin methodology and whether the increase in margin is necessary.\65\
Two commenters state that NSCC has not demonstrated that its current
margin requirements are insufficient to cover credit risks to its
Members.\66\
---------------------------------------------------------------------------

    \65\ See Lek Letter at 1; STANY Letter at 1; OTC I Letter at 2.
    \66\ See STANY Letter at 1; OTC I Letter at 2.
---------------------------------------------------------------------------

    In response, NSCC states that the proposal is designed to provide a
more accurate measure of the risks associated with Illiquid Securities
and to cover in full the risks presented by Members to NSCC.\67\ To
demonstrate why the proposed revision to its methodology for assessing
margin on Illiquid Securities is necessary to address the risk
presented by such securities, NSCC relies upon the results of recent
backtesting analyses. Specifically, NSCC examines the backtesting
coverage for a historical time period under both the current and
proposed margin methodologies. Based on this analysis, NSCC represents
that the proposal would help NSCC to address the risk presented by
Illiquid Securities and that it would improve the lowest average
backtesting coverage with respect to Illiquid Securities from 96.2% to
99.5% for the asset group that exhibited the lowest average backtesting
coverage percentages (i.e., short positions in sub-penny securities and
securities priced between one cent and one dollar).\68\ NSCC further
states that its backtesting results and Member impact studies indicate
that Illiquid Securities, particularly low-priced Illiquid Securities,
are more likely to present additional risk.\69\
---------------------------------------------------------------------------

    \67\ See NSCC Letter at 6.
    \68\ Id. at 5; 17 CFR 240.17Ad-22(e)(4)(i). NSCC also notes that
this improvement in coverage level would allow it to meet the high
degree of confidence referenced in Rule 17Ad-22(e)(4)(i). Id. As
stated above, the volatility component of the margin collected by
NSCC is designed to reflect the amount of money that could be lost
on a portfolio over a given period within a 99% confidence level,
and NSCC has established a 99% target backtesting confidence level.
See, e.g., Procedure XV, Section I.B(3), supra note 10.
    \69\ See NSCC Letter at 5.
---------------------------------------------------------------------------

    NSCC notes that the proposed changes to its methodology produce a
more accurate haircut calculation by factoring in price levels,
resulting in margin levels that better reflect the risks and particular
attributes of Member portfolios.\70\ NSCC represents that the enhanced
methodology for identifying Illiquid Securities and the calculation of
the haircut-based volatility component applicable to these securities
and UITs improve the risk-based methodology, which in turn, better
manage its credit exposures to Members.\71\
---------------------------------------------------------------------------

    \70\ See NSCC Letter at 5-6.
    \71\ See NSCC Letter at 6.
---------------------------------------------------------------------------

    The Commission believes that the proposal is consistent with Rule
17Ad-22(e)(4)(i) under the Exchange Act.\72\ Specifically, the proposal
to revise the definition of Illiquid Securities would help NSCC to
better identify securities that may present credit exposures unique to
such securities for purposes of applying an appropriate margin charge.
Additionally, the proposal would provide additional criteria that use
more objective factors to determine what constitutes an Illiquid
Security. These factors consider a security's listing status, trading
history, and market capitalization, and would result in a more accurate
classification of securities with illiquid characteristics being
considered as Illiquid Securities. In addition, the proposal to base
the calculation of the haircut-based volatility charge applied to
positions in Illiquid Securities and UITs on those securities' price
level and risk profile would enable NSCC to collect and maintain
sufficient resources to cover its credit exposures to each participant
whose portfolio contains positions in Illiquid Securities and/or UITs
with a high degree of confidence. The Commission has reviewed and
analyzed NSCC's analysis of the improvements in its backtesting
coverage, which demonstrate that the proposal would result in better
backtesting coverage and, therefore, less credit exposure to its
Members. Finally, the proposal requires NSCC to review and determine
the haircut percentages at least annually. Accordingly, the Commission
believes that the proposal would enable NSCC to better manage its
credit risks by allowing it to respond regularly and more effectively
to any material deterioration of backtesting performances, market
events, market structure changes, or model validation findings.
---------------------------------------------------------------------------

    \72\ 17 CFR 240.17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

    In response to comments that NSCC has not demonstrated that current
margin requirements are insufficient to cover credit risks to its
Members, the Commission disagrees. In considering these comments, the
Commission thoroughly reviewed and considered (i) the Advance Notice,
including the supporting exhibits that provided confidential
information on the performance of the proposed revision to the
definition of an Illiquid Security and the use of a revised haircut-
based methodology applicable to both Illiquid Securities and UITs,
three rounds of impact analysis, and backtesting coverage results; (ii)
the comments received; and (iii) the Commission's own understanding of
the performance of the current margin methodology, with which the
Commission has experience from its general supervision of NSCC,
compared to the proposed margin methodology. Based on its review of
these materials, the Commission believes that the proposal would, in
fact, better enable NSCC to cover its credit exposure to Members and
meet the applicable Commission regulatory requirements. Specifically,
the Commission has considered the results of NSCC's backtesting
coverage analyses, which indicate that the current margin methodology
results in backtesting coverage that does not meet NSCC's targeted
confidence level. The analyses also indicate that the proposal would
result in improved backtesting coverage that meets NSCC's targeted
coverage level. Therefore, the Commission believes that the proposal
would provide NSCC with a more precise margin calculation designed to
meet the applicable regulatory requirements for margin coverage.
    Therefore, for the reasons discussed above, the Commission believes
that the changes proposed in the Advance Notice are reasonably designed
to enable NSCC to effectively identify, measure, monitor, and manage
its credit exposure to Members, consistent with Rule 17Ad-
22(e)(4)(i).\73\
---------------------------------------------------------------------------

    \73\ 17 CFR 240.17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

C. Consistency With Rule 17Ad-22(e)(6)(i)

    Rule 17Ad-22(e)(6)(i) under the Exchange Act requires that each
covered clearing agency that provides central counterparty services
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, at a minimum, considers, and produces margin levels
commensurate with, the risks and particular attributes of each relevant
product, portfolio, and market.\74\
---------------------------------------------------------------------------

    \74\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------

    Several commenters suggest that the proposal does not reflect the
actual risk attributes of the securities to which it would apply.\75\
For example, two commenters state that treating as Illiquid Securities
all securities that are not listed on a ``specified securities
exchange,'' which would be defined as a national securities exchange
that has established listing services and is covered by industry
pricing and data vendors, is not tailored to accurately capture
securities that present the defined liquidation and marketability
risks, noting that many large international companies' securities are
traded in the OTC marketplace.\76\ One commenter states that the
proposal is unwarranted because the existing margin has always been
enough to cover a defaulting Member's losses, and accordingly, the
current margin should be enough to cover the risks presented by
Members' portfolios.\77\ One commenter states that NSCC has not
justified a $300 million market capitalization requirement for all
exchange-listed stocks, and that this threshold does not consider the
actual risks facing NSCC.\78\ Another commenter states that ETPs and
ADRs, which are products typically offered by large banks and
brokerages, are excluded from the definition of an Illiquid Security,
and that such exclusion shows a bias against small Members.\79\ In
addition, one commenter states that the proposal bears no relationship
to a Member's actual credit rating.\80\
---------------------------------------------------------------------------

    \75\ See Alpine Letter; OTC I Letter; STANY Letter; and Letter
from Daniel Zinn, General Counsel and Cass Sanford, Associate
General Counsel, OTC Markets Group Inc. (July 21, 2020) (``OTC II
Letter'').
    \76\ See OTC II Letter at 5; STANY Letter at 3.
    \77\ See Lek Letter at 1. Lek also states that net capital
should be considered solely as additional insurance for agency
firms, and that NSCC should include the margin that Lek collects
from its customers when computing Lek's capital. Id. However, this
issue is beyond the scope of this proposal and is not addressed
herein.
    \78\ See STANY Letter at 3.
    \79\ See SIPA Letter.
    \80\ See Alpine Letter at 4.
---------------------------------------------------------------------------

    In response to comments regarding treating as Illiquid Securities
all securities that are not listed on a national securities exchange
that has established listing services and is covered by industry
pricing and data vendors, NSCC states that securities that trade on a
national securities exchange tend to trade with greater frequency in
higher volumes than other venues, and national securities exchanges are
subject to price and volume reporting regimes that assure greater
accuracy of price and volume information.\81\ NSCC further states that
securities that are not listed on a national securities exchange may
trade without being registered with the Commission and have less
reliable price and volume information.\82\
---------------------------------------------------------------------------

    \81\ See NSCC Letter at 8.
    \82\ See NSCC Letter at 8-9.
---------------------------------------------------------------------------

    In addition, NSCC explains that it included the second element of
the proposed definition's criteria, ``covered by industry pricing and
data vendors,'' to ensure that NSCC is able to access and utilize
quality third party pricing data to derive returns in order to
calculate the appropriate margin.\83\ NSCC further explains that the
commercial availability of reliable information from independent, third
party sources is critical to ensuring that NSCC can rely on end of day
and intraday pricing in order to accurately manage risk positions
consistent with its Rules.\84\ Accordingly, NSCC believes that the use
of ``specified securities exchange'' as defined in the proposal is an
appropriate basis for determining whether a security is an Illiquid
Security.\85\
---------------------------------------------------------------------------

    \83\ See id.
    \84\ See id.
    \85\ See id.
---------------------------------------------------------------------------

    Regarding the comments that many large international companies'
securities are traded in the OTC marketplace, NSCC acknowledges that
the proposed definition of Illiquid Securities would cover the
securities of some large, well-capitalized issuers not listed on a
specified securities exchange.\86\ However, NSCC states that the
proposal is designed to appropriately address risk in part by grouping
Illiquid Securities by price level, and sub-penny securities by long or
short position.\87\ Accordingly, not all Illiquid Securities would be
given the same haircut or have the same margin requirements or result
in a higher deposit than would be required under the current Rules.\88\
---------------------------------------------------------------------------

    \86\ See id.
    \87\ See id.
    \88\ See id.
---------------------------------------------------------------------------

    The Commission understands that, as described above, the proposal
as a whole is designed to enable NSCC to more effectively address the
risks presented by Members' positions in securities with illiquid
characteristics, including Illiquid Securities and UITs. As such, NSCC
seeks to produce margin levels that are more commensurate with the
particular risk attributes of these securities, including the risk of
increased transaction and market costs to NSCC to liquidate or hedge
due to lack of liquidity or marketability of such positions. The
Commission believes that the proposal would improve NSCC's ability to
consider, and produce margin levels commensurate with, the risks and
particular attributes of Illiquid Securities and UITs.
    First, by expanding and refining the definition of Illiquid
Securities, the Commission believes that NSCC should be able to better
identify those securities that may exhibit illiquid characteristics.
Specifically, the proposal would ensure that three separate categories
of securities are included in the definition of an Illiquid Security,
and all three categories are calibrated to take into account specific
and objective factors that are indicative of a security's liquidity.
For example, the second category of the proposed definition of an
Illiquid Security would apply an illiquidity ratio to micro-cap
securities and ADRs to get a more precise measure of their liquidity.
Moreover, consistent with NSCC's current practice for determining the
margin for securities in an initial public offering, the third category
of the proposed definition would consider the frequency of a security's
trading, to take into account that infrequent trading reduces the
amount of price and volume information available to measure market
risk.
    In addition, the Commission believes that the proposed changes to
the haircut-based volatility charges to base the calculation on the
price level and risk profile of the applicable security would help NSCC
to more effectively measure the risks that are particular to Illiquid
Securities and UITs. Based on its analysis of the backtesting and
impact analyses and its understanding of the proposed definition of an
Illiquid Security, the Commission believes that the differentiated
haircut percentages are reasonably designed to cover NSCC's exposures
to Members more appropriately than the current fixed percentage
approach because NSCC designed the variable haircut percentages to
reflect specific risks presented by Illiquid Securities by price level
and by UITs. The Commission also believes that it is reasonable to
separate long and short positions of sub-penny securities in order to
reflect the different risk levels presented by such positions.
    Taken together, the Commission believes that the proposal should
permit NSCC to calculate a haircut-based volatility charge that is more

appropriately designed to address the risks presented by the positions
in Illiquid Securities and UITs.
    In response to the comment questioning whether the proposal is
necessary because ``the existing margin has always been enough to
cover'' \89\ a defaulting Member's losses, the Commission does not
agree that the fact that margin has historically been sufficient to
cover a defaulting Member's losses obviates the need for the changes
proposed in the Advance Notice. As an initial matter, credit exposures
are not measured only by those events that have actually happened, but
also include events that could potentially occur in the future. For
this reason, a risk-based margin system is required to cover potential
future exposure to participants.\90\ Potential future exposure is, in
turn, defined as 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.\91\ Thus, to be consistent with its regulatory requirements,
NSCC must consider potential future exposure, which includes, among
other things, losses associated with the liquidation of a defaulted
member's portfolio. As demonstrated by the backtesting analysis
discussed above, under its current margin methodology, NSCC is not
achieving its 99% targeted confidence level for asset groups that are
Illiquid Securities. Based on its review of the Advance Notice, in
conjunction with the Commission's supervisory observations, the
Commission believes that the proposed changes would better enable NSCC
to collect margin commensurate with the different levels of risk that
Members pose to NSCC as a result of their particular trading activity
in Illiquid Securities and UITs. Further, the Commission believes the
amount of margin NSCC would collect under the proposed changes would
help NSCC better manage its credit exposures to its Members and those
exposures arising from its payment, clearing, and settlement processes.
---------------------------------------------------------------------------

    \89\ See Lek Letter at 1.
    \90\ 17 CFR 240.17Ad-22(e)(6)(iii) (requiring a covered clearing
agency 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, at a minimum, calculates 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).
    \91\ 17 CFR 240.17Ad-22(a)(13).
---------------------------------------------------------------------------

    In response to the comment asserting that a $300 million market
capitalization requirement for all exchange-listed stocks is not
justifiable, the Commission disagrees with this interpretation of the
proposal. Not all securities that fall under the market capitalization
threshold under the proposal would be deemed to be Illiquid Securities
or require a higher margin compared to the current Rules. As set forth
in the proposal, the determination of whether a micro-cap security is
an Illiquid Security does not rely solely on capitalization. By
contrast, under the proposal, the initial determination of whether a
security is a micro-cap security would employ a $300 million
threshold,\92\ and a micro-cap security would then be subject to the
illiquidity ratio test described in Section II.C(ii)3 above to take
into account the security's liquidity and determine whether it is an
Illiquid Security. Therefore, depending on the liquidity of the issuer,
there could be instances where a security with less than $300 million
in market capitalization would not constitute an Illiquid Security.
---------------------------------------------------------------------------

    \92\ NSCC represents that the initial threshold is set at $300
million because it is based on prevailing thresholds for market
capitalization categories in the industry. See NSCC Letter at 9;
Notice of Filing, supra note 5, 85 FR at 21040 n. 24 (citing, as an
example of the prevailing views, https://www.sec.gov/reportspubs/investor-publications/investorpubs/microcapstockhtm.html).
---------------------------------------------------------------------------

    In response to the comments stating that treating all securities
that are not listed on a specified exchange as Illiquid Securities is
not tailored to accurately capture securities that present the defined
liquidation and marketability risks, the Commission disagrees. This
proposal does not change the current treatment of securities that are
not listed on a specified securities exchange, because the current
Rules define Illiquid Securities to include securities that are not
traded on a national securities exchange. Further, the Commission
believes that this distinction is appropriate. Securities that are
quoted on the OTC market differ from those listed on national
securities exchanges.\93\ In particular, the average OTC security
issuer is smaller, and their securities trade less, on average, than
securities traded on a national securities exchange.\94\ Moreover,
issuers of quoted OTC securities tend to have a lower market
capitalization than those with securities listed on a national
securities exchange,\95\ and many quoted OTC securities are
illiquid.\96\ Quoted OTC securities are characterized by significantly
lower dollar trading volumes than listed stocks, even for securities of
similar size as measured by market capitalization.\97\
---------------------------------------------------------------------------

    \93\ Publication or Submission of Quotations Without Specified
Information, Final Rule; Exchange Act Release No. 89891, at 218
(September 16, 2020), available at https://www.sec.gov/rules/final/2020/33-10842.pdf.
    \94\ See id.
    \95\ See id.
    \96\ See id. at 220.
    \97\ See id. at 218-19.
---------------------------------------------------------------------------

    In response to the comment that ETPs and ADRs are exempt from the
definition of Illiquid Securities, the Commission disagrees. The
Proposed Rule Change would not exclude all ETPs and ADRs by category
from the definition of Illiquid Securities. Instead, the proposal would
only exclude ETPs and ADRs when calculating the illiquidity ratio
threshold for purposes of the second test under the definition of an
Illiquid Security (i.e., the median of the illiquidity ratio threshold
based on non-micro-cap common stocks). An ETP or an ADR could be
determined to be an Illiquid Security, and NSCC would apply a haircut
to ETPs and ADRs in the same manner as other Illiquid Securities.
    Finally, in response to the comment that the proposal bears no
relationship to a Member's actual credit rating, the Commission
disagrees that such a relationship is necessary in order to design an
accurate and appropriate margin methodology for the securities that a
Member holds. Neither the proposal, nor NSCC's margin methodology more
broadly, is designed to calculate the volatility component based on a
Member's credit rating but rather on the risks presented by each
security. Therefore, the Member's credit rating is not relevant to the
determination of the appropriate volatility component of the margin for
a particular security.\98\
---------------------------------------------------------------------------

    \98\ The Alpine Letter also questions whether the Credit Risk
Rating Matrix (``CRRM'') will continue to be used in the margin
calculation for Illiquid Securities. See Alpine Letter at 3. NSCC
responds that the calculation of the appropriate haircuts for
Illiquid Securities, including calculation of the appropriate volume
thresholds, does not consider the Member's CRRM rating. The CRRM
rating currently is used in determining the Illiquid Position
subject to NSCC's Illiquid Charge, which will be eliminated upon
implementation of the proposal. See NSCC Letter at 7-8. Going
forward, the CRRM would continue to be used in general credit risk
monitoring of members, but would not be used for the determination
of the volatility component of the margin for a particular security.
See Securities Exchange Act Release No. 80734 (May 19, 2017), 82 FR
24177 (May 25, 2017) (order approving proposed rule changes to
enhance the CRRM).
---------------------------------------------------------------------------

    Accordingly, the Commission believes the proposal is consistent
with Rule 17Ad-22(e)(6)(i) under the Exchange Act because it is
designed to assist NSCC in maintaining a risk-based

margin system that considers, and produces margin levels commensurate
with, the risks and particular attributes of portfolios that exhibit
illiquid risk attributes.\99\
---------------------------------------------------------------------------

    \99\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------

D. Consistency With Rule 17Ad-22(e)(23)(ii)

    Rule 17Ad-22(e)(23)(ii) under the Exchange Act requires each
covered clearing agency to establish, implement, maintain, and enforce
written policies and procedures reasonably designed to provide
sufficient information to enable participants to identify and evaluate
the risks, fees, and other material costs they incur by participating
in the covered clearing agency.\100\
---------------------------------------------------------------------------

    \100\ 17 CFR 240.17Ad-22(e)(23)(ii).
---------------------------------------------------------------------------

    The majority of commenters express concerns regarding the method
for determining the proposed volatility component for Illiquid
Securities being confidential. Several commenters express concern that
the proposal does not explain how the haircut-based volatility charge
will be calculated and that the proposal does not allow Members to
review the proposed margin equations, models, and calculations.\101\
Other commenters state that the proposal does not allow Members to
predict the financial consequences and operating impacts of their
activities, and the impact on their liquidity needs.\102\
---------------------------------------------------------------------------

    \101\ See Alpine Letter at 2; SIPA Letter at 4-5; OTC I Letter
at 2-3; OTC II Letter at 3-4; Wilson II Letter at 7. Wilson II also
asserts that NSCC has failed to meet the requirements of Rule 17Ad-
22(e)(23)(iii) for failing to quantify the current inadequate market
capitalization, median illiquidity ratios, and how those factors
would be improved under the proposal. However, Rule 17Ad-
22(e)(23)(iii) requires each covered clearing agency to establish,
implement, maintain, and enforce written policies and procedures
reasonably designed to publicly disclose relevant basic data on
transaction volume and values. This rule does not require a covered
clearing agency to disclose the specific information that the
commenter seeks because the information described by the commenter
is not the basic data on transaction volumes and values required by
the rule. Moreover, NSCC publicly provides data on transaction
volumes and values in its quantitative disclosures, which are
available at https://www.dtcc.com/legal/policy-and-compliance.
    \102\ See Letter from James C. Snow, President/CCO, Wilson-Davis
& Co., Inc. (May 1, 2020) (``Wilson I Letter'') at 2-3; STANY Letter
at 2.
---------------------------------------------------------------------------

    In response, NSCC states that the language of the proposal is
reasonably transparent and clear enough to enable Members to determine
the Member's Required Fund Deposit.\103\ NSCC states that the proposed
parameters are definitive and non-discretionary to enable application
on an algorithmic basis.\104\ For example, a security that is an ADR or
has a micro-capitalization of less than $300 million would be subject
to the illiquidity ratio test, which would be provided in the Rules, to
determine whether it is an Illiquid Security. In addition, NSCC states
that, because haircuts would be applied according to the price level of
the Illiquid Securities, Members should be able to more easily
determine the applied margin impact per the current market price of the
security.\105\
---------------------------------------------------------------------------

    \103\ See NSCC Letter at 6.
    \104\ See id.
    \105\ See id.
---------------------------------------------------------------------------

    NSCC also represents that it maintains the NSCC Risk Management
Reporting application on the Participant Browser Service (``PBS'') and
the NSCC Risk Client Portal (``Portal'') to improve transparency of
Members' Clearing Fund requirements.\106\ NSCC states that the PBS is a
member-accessible website portal for accessing reports and other
disclosures. NSCC further states that the Risk Management Reporting
application enables a Member to view and download Clearing Fund
requirement information and component details, including issue-level
Clearing Fund information related to start of day volatility charges
and mark-to-market, intraday exposure, and other components.\107\ NSCC
represents that the application enables a Member to view, for example,
a portfolio breakdown by asset type, including the amounts attributable
to the parametric VaR model and the amounts associated with Illiquid
Securities.\108\ NSCC also represents that Members are able to view and
download spreadsheets that contain market amounts for current clearing
positions and the associated volatility charges.\109\
---------------------------------------------------------------------------

    \106\ See id.
    \107\ See id.
    \108\ See id.
    \109\ See id.
---------------------------------------------------------------------------

    In addition, NSCC represents that the Portal provides members the
ability, for information purposes, to view and analyze certain risks
relating to their portfolio, including calculators to assess the risk
and clearing fund impact of certain activities and to compare their
portfolio to historical and average values. For example, it allows
Members to review both hourly and 15-minute intra-day snapshots to
monitor fluctuations in the volatility and exposure in their portfolios
to help Members to anticipate potential intra-day margin calls. The
intervals are available through 7:00 p.m. to provide additional reports
that may help Members to forecast next-day margin requirements.\110\
---------------------------------------------------------------------------

    \110\ See NSCC Letter at 7.
---------------------------------------------------------------------------

    NSCC further represents that it maintains the NSCC Client
Calculator on the Portal that provides functionality to Members to
enter `what-if' position data and to recalculate their volatility
charges to determine margin impact pre-trade.\111\ NSCC specifically
states that this calculator allows Members to see the impact to the
volatility charge if specific transactions are executed, or to
anticipate the impact of an increase or decrease to a current clearing
position.\112\ NSCC represents that the Client Calculator portfolio
detail can be downloaded to modify a current margin portfolio, and then
allow Members to upload the portfolio to run a margin calculation, and
permit Members to view position level outputs in order to make informed
risk management and execution decisions.\113\
---------------------------------------------------------------------------

    \111\ See id.
    \112\ See id.
    \113\ See id.
---------------------------------------------------------------------------

    Finally, NSCC states that it conducted member outreach in
connection with the proposal described in the Advance Notice. NSCC
represents that, in 2019 and 2020, NSCC distributed three rounds of
impact studies to Members impacted by the change to communicate
revisions to the methodology and discuss specific portfolio impacts by
reviewing charts and quantitative results.\114\ NSCC further represents
that it has performed outreach to Members with details for this
proposal for the past two years, which allowed Members to understand
and ask questions about the proposal.\115\
---------------------------------------------------------------------------

    \114\ See id.
    \115\ See id.
---------------------------------------------------------------------------

    NSCC states that it has also posted an NSCC Risk Margin Component
Guide (``Guide'') on the Portal which provides descriptions of some of
the components used in NSCC's current risk-based methodology, including
the volatility charges, mark-to-market charges, fail charges for CNS
transactions, a charge for Family-Issued Securities to mitigate wrong
way risk, a charge for Illiquid Positions, a charge to mitigate day
over day margin differentials, a coverage component and a backtesting
charge.\116\ NSCC represents that the Guide will be updated to reflect
the changes in methodology set forth in the proposal.\117\
---------------------------------------------------------------------------

    \116\ See id.
    \117\ See id.
---------------------------------------------------------------------------

    The Commission believes that the proposal is consistent with Rule
17Ad-22(e)(23)(ii) and is designed to provide sufficient information to
enable Members to identify and evaluate the risks and other material
costs they incur by participating in NSCC. The changes described in the
proposal would be reflected in NSCC's Rules and therefore publicly
available to NSCC's Members

and prospective members for application to their own portfolios.
Specifically, the proposed rule text would reflect the two sets of
changes in the proposal. First, the proposed rule text would define the
types of securities that would constitute ``Illiquid Securities'' as
three particular categories of securities, as described in Section
II.C(i), (ii), and (iii). By reviewing the definitions of an Illiquid
Security, NSCC's members should be able to understand the types of
factors that would cause a security to be considered an Illiquid
Security, all of which are ascertainable, such as its trading history
(including whether it is traded on an exchange or not and, if so, on
which exchange), its market capitalization, and the type of security
(i.e., whether it is an ADR). The specific parameters of the
illiquidity ratio test would also be reflected in NSCC's Rules, thereby
enabling a Member to determine whether a security that is an ADR or has
a micro-capitalization of less than $300 million would be an Illiquid
Security.
    Second, the proposed rule text would provide that NSCC would apply
a haircut to Illiquid Securities to determine the appropriate
volatility component, with Illiquid Securities grouped by price level
to determine the appropriate haircut to apply to a particular security.
The proposed rule text would further specify that the haircut
percentage would be the highest of the three percentages as provided in
Section II.D(i), and would be determined at least annually.
Additionally, if a Member had questions with respect to a particular
security, it could use the various client-facing tools described above
to determine whether a security would be considered an Illiquid
Security. Taken together, the Division believes that the proposal,
which would be reflected in NSCC's Rules, in conjunction with the
various client-facing tools, provides sufficient information to Members
to understand the operation of the haircut-based volatility charges and
how such charges would apply to particular transactions. The Commission
further believes that NSCC provided sufficient information to Members
to identify and evaluate the risks and other material costs they would
incur due to securities with illiquid characteristics under the
proposal.
    For these reasons, the Commission disagrees with the comments
stating that the proposal lacks details and does not explain how the
haircut-based volatility charge will be calculated, and that the
proposal does not allow Members to predict the impact on their
activities. The Commission acknowledges that, as some commenters have
noted, the proposal does not provide or specify the actual models or
calculations that NSCC would use to determine the appropriate haircut
or what constitutes an Illiquid Security. However, when adopting the
CCA Standards, the Commission declined to adopt a commenter's view that
a covered clearing agency should be required to provide, at least
quarterly, its methodology for determining initial margin requirements
at a level of detail adequate to enable participants to replicate the
covered clearing agency's calculations, or, in the alternative, that
the covered clearing agency should be required to provide a
computational method with the ability to determine the initial margin
associated with changes to each respective participant's portfolio or
hypothetical portfolio, participant defaults and other relevant
information. The Commission stated that ``[m]andating disclosure of
this frequency and granularity would be inconsistent with the
principles-based approach the Commission is taking in Rule 17Ad-
22(e).'' \118\ Consistent with that approach, the Commission does not
believe that Rule 17Ad-22(e)(23)(ii) would require NSCC to disclose its
actual margin methodology, so long as NSCC has provided sufficient
information for its Members to understand the potential costs and risks
associated with participating in NSCC for clearing Illiquid Securities.
---------------------------------------------------------------------------

    \118\ See Standards for Covered Clearing Agencies, supra note
54, 81 FR at 70845.
---------------------------------------------------------------------------

    For the reasons discussed above, the Commission believes that the
proposals in the Advance Notice would enable NSCC to establish,
implement, maintain, and enforce written policies and procedures
reasonably designed to provide sufficient information to enable Members
to identify and evaluate the risks, fees, and other material costs they
incur as NSCC's Members, consistent with Rule 17Ad-22(e)(23)(ii).\119\
---------------------------------------------------------------------------

    \119\ 17 CFR 240.17Ad-22(e)(23)(ii).
---------------------------------------------------------------------------

IV. Conclusion

    It is therefore noticed, pursuant to Section 806(e)(1)(I) of the
Clearing Supervision Act, that the Commission DOES NOT OBJECT to
Advance Notice (SR-NSCC-2020-802) and that NSCC is AUTHORIZED to
implement the proposal as of the date of this notice or the date of an
order by the Commission approving proposed rule change SR-NSCC-2020-
003, whichever is later.

    By the Commission.
J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2020-25202 Filed 11-13-20; 8:45 am]
BILLING CODE 8011-01-P


Steven Silverman/DC/USEPA/US

09/21/2006 12:56 PM

To

<EMAIL_ADDRESS> cc

Subject

citation on p. 4 now included, in bold type

also, my folks in North Carolina advise me that for style reasons, we would have internal subparagraphs denominated by letters (a,b,c,d,etc) rather than numbers as now appears, and that we would refer to EPA as 'EPA' or 'the agency', rather than 'our'.