[Federal Register Volume 85, Number 231 (Tuesday, December 1, 2020)]
[Notices]
[Pages 77281-77295]
[FR Doc No: 2020-26401]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-90502; File No. SR-NSCC-2020-003]

Self-Regulatory Organizations; National Securities Clearing
Corporation; Order Approving a Proposed Rule Change 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 24, 2020.
    On March 16, 2020, National Securities Clearing Corporation
(``NSCC'') filed with the Securities and Exchange Commission
(``Commission'') proposed rule change SR-NSCC-2020-003 (``Proposed Rule
Change'') pursuant to Section 19(b)(1) of the Securities Exchange Act
of 1934 (``Act'') \1\ and Rule 19b-4 thereunder.\2\ The Proposed Rule
Change was published for comment in the Federal Register on March 31,
2020.\3\ The Commission received comment letters on the Proposed Rule
Change.\4\ On May 15, 2020, pursuant to Section 19(b)(2) of the Act,\5\
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.\6\ On June 24, 2020, the
Commission instituted proceedings to determine whether to approve or
disapprove the Proposed Rule Change.\7\ 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.\8\ For the reasons discussed below, the Commission is
approving the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 88474 (March 25, 2020),
85 FR 17910 (March 31, 2020) (SR-NSCC-2020-003) (``Notice''). NSCC
also filed the proposal contained in the Proposed Rule Change as
advance notice SR-FICC-2020-802 (``Advance Notice'') with the
Commission pursuant to Section 806(e)(1) of the Dodd-Frank Wall
Street Reform and Consumer Protection Act entitled the Payment,
Clearing, and Settlement Supervision Act of 2010 (``Clearing
Supervision Act''). 12 U.S.C. 5465(e)(1); 17 CFR 240.19b-4(n)(1)(i).
Notice of filing of the Advance Notice was published for comment in
the Federal Register on April 15, 2020. Securities Exchange Act
Release No. 88615 (April 9, 2020), 85 FR 21037 (April 15, 2020) (SR-
NSCC-2020-802). On May 15, 2020, the Commission issued a request for
information regarding the Advance Notice. See Commission's Request
for Additional Information, available at https://www.sec.gov/rules/sro/nscc-an/2020/34-88615-request-for-info.pdf. On September 9,
2020, NSCC submitted its response thereto, which it then amended on
October 16, 2020. See Response to Commission's Request for
Additional Information, available at https://www.sec.gov/rules/sro/nscc-an/2020/34-88615-response-to-request-for-info.pdf; Letters from
James Nygard, Director and Assistant General Counsel, NSCC
(September 9 and October 16, 2020), available at https://www.sec.gov/comments/sr-nscc-2020-802/srnscc2020802-7753722-223190.pdf and https://www.sec.gov/comments/sr-nscc-2020-802/srnscc2020802-7915013-224474.pdf. On November 6, 2020, the
Commission published a notice of no objection to the Advance Notice.
Securities Exchange Act Release No. 90367 (November 6, 2020), 85 FR
73099 (November 16, 2020). The proposal contained in the Proposed
Rule Change and the Advance Notice shall not take effect until all
regulatory actions required with respect to the proposal are
completed.
    \4\ Comments are available at https://www.sec.gov/comments/sr-nscc-2020-003/srnscc2020003-7108527-215929.pdf.
    \5\ 15 U.S.C. 78s(b)(2).
    \6\ Securities Exchange Act Release No. 88885 (May 15, 2020), 85
FR 31007 (May 21, 2020) (SR-NSCC-2020-003).
    \7\ Securities Exchange Act Release No. 89145 (June 24, 2020),
85 FR 39244 (June 30, 2020) (SR-NSCC-2020-003).
    \8\ Securities Exchange Act Release No. 89949 (September 22,
2020), 85 FR 60854 (September 28, 2020) (SR-NSCC-2020-003).
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I. Description of The Proposed Rule Change

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.\9\ 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.\10\ 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.\11\
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    \9\ 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.
    \10\ 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 9.
    \11\ See Rule 46 (Restrictions on Access to Services), supra,
note 9.

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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.\12\ 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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    \12\ See Procedure XV, supra note 9.
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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 robustly estimate the volatility component using statistical
techniques. 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.'' \13\ 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 generate sufficient price
observations to allow the VaR model to provide a precise estimate 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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    \13\ 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 9.
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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 \14\ or OTC Link issue.\15\
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.\16\ 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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    \14\ 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.
    \15\ 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.
    \16\ 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, supra note 3, 85 FR at 17912. 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.'' \17\ 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.\18\ 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,\19\
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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    \17\ 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.
    \18\ Because the VaR model generally relies on predictability,
this model may be less reliable for measuring market risk of
securities that exhibit illiquid characteristics.
    \19\ 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, supra
note 3, 85 FR at 17915.
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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.\20\ 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.\21\
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    \20\ 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 9.
    \21\ See Notice, supra note 3, 85 FR at 17912. 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.\22\ 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.\23\
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    \22\ See Notice, supra note 3, 85 FR at 17912.
    \23\ 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 9.
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C. Proposed Revision to the Definition of Illiquid Security

    Under the Proposed Rule Change, 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.\24\ 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.\25\
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    \24\ NSCC has stated that the exchanges that would initially be
specified securities exchanges are those listed in note 16. See
supra note 16.
    \25\ See Notice, supra note 3, 85 FR at 17913. 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'').\26\ 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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    \26\ 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.\27\ 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.\28\
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    \27\ 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, supra note 3, 85 FR at 17914.
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.
    \28\ See Notice, supra note 3, 85 FR at 17914.
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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.\29\ 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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    \29\ See Notice, supra note 3, 85 FR at 17912.
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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 \30\ 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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    \30\ 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.\31\
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    \31\ See Notice, supra note 3, 85 FR at 17914.
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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 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.\32\ 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.\33\
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    \32\ 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, supra note 3, 85 FR at 17915; see
also Model Risk Management Framework, supra note 27.
    \33\ 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, supra note 3, at 85 FR at 17915;
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.\34\ 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.\35\
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    \34\ See Notice, supra note 3, 85 FR at 17915; see also Model
Risk Management Framework, supra note 27.
    \35\ 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.\36\ 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.\37\
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    \36\ 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.
    \37\ 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, supra note 3, 85 FR at 17915; see
also Model Risk Management Framework, supra note 27.
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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.\38\
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    \38\ See id.
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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.\39\ Because
Illiquid Securities and UITs would each have specific haircut-based
volatility charges pursuant to the Proposed Rule Change, 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.\40\ 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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    \39\ 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, supra
note 3, 85 FR at 17912.
    \40\ See Notice, supra note 3, 85 FR at 17916.
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    Further, NSCC represents that certain fixed income securities, such
as preferred stocks,\41\ 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.\42\
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    \41\ See id.
    \42\ See id.; see also Model Risk Management Framework, supra
note 27.
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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.\43\
---------------------------------------------------------------------------

    \43\ See Notice, supra note 3, 85 FR at 17917.
---------------------------------------------------------------------------

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.\44\ 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 \45\ 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.
---------------------------------------------------------------------------

    \44\ Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure
XV, supra note 9.
    \45\ Section I.(A)(1)(a)(iii) of Procedure XV, supra note 9.
---------------------------------------------------------------------------

    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.'' \46\ Based on the current drafting of the Rules,
NSCC believes that it is unclear how positions in Family-Issued
Securities would be treated.\47\ 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.\48\
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.
---------------------------------------------------------------------------

    \46\ 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.
    \47\ See Notice, supra note 3, 85 FR at 17917.
    \48\ See Notice, supra note 3, 85 FR at 17913 and 17917 n. 52.
---------------------------------------------------------------------------

II. Discussion and Commission Findings

    Section 19(b)(2)(C) of the Act \49\ directs the Commission to
approve a proposed rule change of a self-regulatory organization if it
finds that such proposed rule change is consistent with the
requirements of the Act and rules and regulations thereunder applicable
to such organization. After carefully considering the proposed rule
change, the Commission finds that the proposed rule change is
consistent with the requirements of the Act and the rules and
regulations thereunder applicable to NSCC. In particular, the
Commission finds that the proposed rule change is consistent with
Sections 17A(b)(3)(F) \50\ and (b)(3)(I) \51\ of the Act and Rules
17Ad-22(e)(4)(i), (e)(6)(i), and (e)(23)(ii) thereunder.\52\
---------------------------------------------------------------------------

    \49\ 15 U.S.C. 78s(b)(2)(C).
    \50\ 15 U.S.C. 78q-1(b)(3)(F).
    \51\ 15 U.S.C. 78q-1(b)(3)(I).
    \52\ 17 CFR 240.17Ad-22(e)(4)(i), (e)(6)(i), and (e)(23)(ii).
---------------------------------------------------------------------------

A. Consistency With Section 17A(b)(3)(F) of the Act

    Section 17A(b)(3)(F) of the Act \53\ requires that the rules of a
clearing agency, such as NSCC, be designed to: (i) Promote the prompt
and accurate clearance and settlement of securities transactions; (ii)
assure the safeguarding of securities and funds which are in the
custody or control of the clearing agency or for which it is
responsible; (iii) foster cooperation and coordination with persons
engaged in the clearance and settlement of securities transactions;
(iv) remove impediments to and perfect the mechanism of a national
system for the prompt and accurate clearance and settlement of
securities transactions; and (v) protect investors and the public
interest.
---------------------------------------------------------------------------

    \53\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------

    The Commission believes that the proposal is consistent with
Section 17A(b)(3)(F) of the Act for the reasons stated below.
(i) Prompt and Accurate Clearance and Settlement and Safeguarding of
Securities and Funds
    As described above in Section I.C, NSCC proposes to revise the
definition of ``Illiquid Securities'' to provide additional specific
objective criteria that would lead to a security being considered as an
Illiquid Security, which would, in turn, broaden the scope of
securities that would be considered as Illiquid Securities for
assessing margin requirements. For example, NSCC would consider
additional factors such as an issuer's market capitalization and a
defined illiquidity ratio to determine whether a security is illiquid,
which would capture certain exchange-listed securities that the current
rules do not include as Illiquid Securities. Therefore, the Commission
believes that NSCC's proposed new definition of Illiquid Securities is
designed to more precisely identify securities with illiquid
characteristics than the current methodology.
    Moreover, as described above in Section I.D, NSCC proposes to
specifically exclude Illiquid Securities and UITs when calculating the
volatility component of a Required Fund Deposit using the VaR model,
and to 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. In addition,
instead of using the current fixed haircut percentages for Illiquid
Securities, 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). The proposal would also require NSCC to
regularly assess appropriate haircut percentages to cover its credit
risks. The Commission believes that by providing that the volatility
component of margin for Illiquid Securities and UITs should be
determined by applying haircuts tailored to specific groups of Illiquid
Securities and to 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.
    NSCC provided information regarding the impact of the proposed rule
change on its backtesting coverage.\54\ Specifically, a recent impact
study shows that the proposal 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).\55\ The Commission has reviewed NSCC's analysis and agrees
that its results indicate that NSCC's proposal results in margin levels
that better reflect the risks and particular attributes of the Member's
portfolio.
---------------------------------------------------------------------------

    \54\ Backtesting is an ex-post comparison of actual outcomes
with expected outcomes derived from the use of margin models. See 17
CFR 240.17Ad-22(a)(1).
    \55\ See Notice, supra note 3, 85 FR at 17915. As part of the
Proposed Rule Change, NSCC filed Exhibit 3--NSCC Impact Studies,
comparing the current and proposed methodologies. Pursuant to 17 CFR
240.24b-2, NSCC requested confidential treatment of Exhibit 3. NSCC
also filed the proposal contained in the Proposed Rule Change as
Advance Notice. See supra note 3. Because the proposals contained in
the Advance Notice and the Proposed Rule Change are the same, all
information provided by NSCC regarding the improvements in
backtesting coverage for other asset groups was considered
regardless of whether the information submitted with respect to the
Advance Notice or the Proposed Rule Change.
---------------------------------------------------------------------------

    In addition, as described in Section I.E, NSCC proposes to
eliminate the existing Illiquid Charge. This existing charge would no
longer be needed in light of the revised definition and haircut-based
margin methodology described in Sections I.C and I.D, which would more
precisely address the risk that the Illiquid Charge purported to cover.
As described in Section I.F, NSCC proposes to make conforming changes
to harmonize the Rules in light of the changes described in Sections
I.C and I.D. The Commission believes that these changes are designed to
provide clear and coherent Rules regarding the haircut-based volatility
charge for Illiquid Securities and UITs.
    Taken together, the Commission believes that the Proposed Rule
Change is designed to allow NSCC to collect margin more precisely
tailored to the nature of the risks presented by positions in
securities with illiquid characteristics than the current methodology,
and in a manner that fully addresses NSCC's applicable credit
exposures. In turn, the proposal should help ensure that, in the event
of a Member default, NSCC's operation of its critical clearance and
settlement services would not be disrupted because of insufficient
financial resources. Accordingly, the Commission finds that NSCC's
proposal should help NSCC to continue providing prompt and accurate
clearance and settlement of securities transactions in the event of a
Member default, consistent with Section 17A(b)(3)(F) of the Act.
    Moreover, by better limiting NSCC's exposure to Members, the
proposal is designed to help ensure that NSCC has collected sufficient
margin from Members, so that non-defaulting Members would not be
exposed to mutualized losses resulting from the default of a Member
holding positions in Illiquid Securities and/or UITs. Accordingly, the
Commission believes that by helping to limit non-defaulting Members'
exposure to mutualized losses, the proposal is designed to help assure
the safeguarding of securities and funds which are in NSCC's custody or
control, consistent with Section 17A(b)(3)(F) of the Act.
    One commenter asserts that the proposal does not promote the prompt
and accurate clearance and settlement of securities transactions, and
also does not assure the safeguarding of securities and funds which are
in the custody or control of NSCC or for which it is responsible
because (1) the haircut-based volatility charge fails to bring clarity
and transparency, (2) NSCC failed to explain how the current formula
leaves members exposed to default, and (3) NSCC failed to explain how
the proposed methodology would limit exposure in the event of a Member
default.\56\
---------------------------------------------------------------------------

    \56\ See Letter from Daniel Zinn, General Counsel and Cass
Sanford, Associate General Counsel, OTC Markets Group Inc. (July 21,
2020) (``OTC II Letter'') at 2-3.
---------------------------------------------------------------------------

    The Commission disagrees with this comment. First, and as discussed
further in Section II.E, the Commission believes that the Proposed Rule
Change identifies what would constitute an Illiquid Security and
describes how the haircut-based charge for Illiquid Securities and UITs
would apply. Second, and as discussed further above, NSCC provided
backtesting results to show that NSCC has a backtest coverage of 96.2%
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), as compared to a
backtest coverage of 99.5% under the Proposed Rule Change. As
demonstrated by the backtesting analysis, 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 Notice and the materials filed as part of the Proposed Rule Change,
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. Finally, the Commission believes that
the proposed changes would enable NSCC to collect margin that more
accurately reflects the risk characteristics of Illiquid Securities and
UITs by applying a haircut more precisely tailored to Illiquid
Securities (grouped by price level and a long or short positions) and
UITs, and therefore allow NSCC to be in a better position to absorb
losses in connection with a Member default and manage its credit
exposure to such Member.

(ii) Protection of Investors and the Public Interest
    The Commission believes that the proposal should help protect
investors and the public interest by mitigating some of the risks
presented by NSCC as a central counterparty. Because a defaulting
member could place stresses on NSCC with respect to NSCC's ability to
meet its clearance and settlement obligations upon which the broader
financial system relies, it is important that NSCC has a robust margin
methodology to limit NSCC's credit risk exposure in the event of a
Member default. As described above, the Proposed Rule Change would
revise the definition of an ``Illiquid Security,'' and the haircut-
based methods for determining volatility components for positions in
Illiquid Securities and UITs. These changes should help improve NSCC's
ability to calculate margin accurately to better produce margin that is
more commensurate with the risks associated with its Members' Illiquid
Securities and UITs, and thus more effectively cover its credit
exposures to its Members. By collecting margin that more accurately
reflects the risk characteristics of such securities, NSCC would be in
a better position to absorb and contain the spread of any losses that
might arise from a Member default. Therefore, the proposal is designed
to reduce the possibility that NSCC would need to call for additional
resources from non-defaulting Members due to a Member default, which
could inhibit the ability of these non-defaulting Members to facilitate
securities transactions. Accordingly, the Commission believes that the
proposal is designed to protect investors and the public interest by
mitigating some of the systemic risks presented by NSCC as a central
counterparty.
    One commenter states that the proposal does not protect investors
because the increased costs will likely be passed on to retail
shareholders of small firms.\57\ The Commission is not persuaded that
the proposal will not protect investors solely because of the potential
for increased costs that could be passed on to retail shareholders of
small firms. While the proposal may result in an increase in the
Required Fund Deposit for a Member who transacts in Illiquid Securities
and UITs, such an increase is designed to allow NSCC to reduce the
risks it faces associated with Illiquid Securities and UITs in the
event of a Member default.\58\ As a result, NSCC should be more
resilient so that it can satisfy its obligations as a central
counterparty while reducing the possibility that NSCC would need to
mutualize among non-defaulting Members any losses arising out of a
Member default, which facilitates the protection of investors by
helping to ensure that investors receive the proceeds from their
securities transactions.
---------------------------------------------------------------------------

    \57\ See OTC II Letter at 3.
    \58\ This benefit may be particularly important since, as the
Commission discussed elsewhere, small firms, which tend to be most
financially constrained, may be disproportionately affected by
downturns or tightening credit conditions. See Temporary Amendments
to Regulation Crowdfunding, Securities Act Release No. 10781 (May 4,
2020), 85 FR 27116, 27123 n. 40 (May 7, 2020) (citing to Gabriel
Perez[hyphen]Quiros and Allan Timmermann, Firm Size and Cyclical
Variations in Stock Returns, 55(3) Journal of Finance 1229-1262
(2000) (showing that ``small firms display the highest degree of
asymmetry in their risk across recession and expansion states, which
translates into a higher sensitivity of their expected stock returns
with respect to variables that measure credit market conditions'');
Murillo Campello and Long Chen, Are Financial Constraints Priced?
Evidence from Firm Fundamentals and Stock Returns, 42(6) Journal of
Money, Credit, and Banking 1185-1198 (2010) (finding that
financially constrained firms' business fundamentals are
significantly more sensitive to macroeconomic movements than
unconstrained firms' fundamentals); Eugene Fama and Kenneth French,
Common Risk Factors in the Returns on Stocks and Bonds, 3 Journal of
Financial Economics 3-56 (1993)).
---------------------------------------------------------------------------

    Several commenters expressed concerns that the proposal would
discourage entry to the public market by small and growing companies,
hinder small business capital formation, negatively impact small
company liquidity, and dissuade investors from trading in Illiquid
Securities.\59\ Several commenters stated that the proposal will hurt
small broker-dealers, which in turn will hurt small businesses, and is
detrimental to small business capital formation needs.\60\ Several
commenters stated that the proposal would negate the objectives of
Regulations D, A+, and Crowdfunding, and negatively affect small
business capital formation.\61\
---------------------------------------------------------------------------

    \59\ Letter from John Busacca, Founder, The Securities Industry
Professional Association (April 23, 2020) (``SIPA Letter'') at 3;
Letter from James Snow, President, Wilson-Davis & Co., Inc.
(November 20, 2020) (``Wilson III Letter'') at 5. The SIPA Letter
also expresses concern regarding increased costs arising from
regulatory and DTC requirements generally, as well as the results of
SEC and FINRA trading suspensions. Id. at 3. Other commenters
expressed similar concern regarding general increases in costs not
related to this proposal. See also Letter from Kimberly Unger, The
Security Traders Association of New York, Inc. (June 30, 2020)
(``STANY Letter'') at 2-3; and Letter from James C. Snow, Chief
Compliance Officer, Wilson-Davis & Co., Inc. (July 29, 2020)
(``Wilson II Letter'') at 5. Such issue is not directed to the
Proposed Rule Change and, accordingly, is beyond the scope of the
Commission's consideration.
    \60\ See Letter from Charles F. Lek, Lek Securities Corporation
(April 30, 2020) (``Lek Letter'') at 3; Letter from Daniel Zinn,
General Counsel and Cass Sanford, Associate General Counsel, OTC
Markets Group Inc. (June 26, 2020) (``OTC I Letter'') at 4; STANY
Letter at 2.
    \61\ See SIPA Letter at 3; Wilson II Letter at 2; Wilson III
Letter at 4; OTC I Letter at 4.
---------------------------------------------------------------------------

    In response, NSCC states that the Proposed Rule Change is not
designed to advantage or disadvantage capital formation in any
particular market segment.\62\ NSCC further states that the Proposed
Rule Change focuses entirely on managing the clearance and settlement
risk associated with secondary transactions in securities with illiquid
characteristics as required by Section 17A of the Exchange Act, which
is unaffected by those initiatives.\63\
---------------------------------------------------------------------------

    \62\ See NSCC Letter at 10.
    \63\ See id.
---------------------------------------------------------------------------

    First, with respect to the commenters who raised concerns regarding
liquidity and capital formation, the Commission believes that limiting
NSCC's exposure to its Members by allowing NSCC to collect more
accurate margin to manage its exposure to Illiquid Securities and UITs
would benefit Members due to NSCC's decreased exposure to losses
resulting from a Member default. Effectively mitigating such risks
would, in turn, reduce the likelihood that NSCC would have to call on
its Members to contribute additional resources, which would otherwise
could be used by its Members to facilitate securities transactions
thereby providing liquidity to the securities markets. Thus, the
Commission believes that NSCC's proposal, by helping non-defaulting
members preserve their financial resources, could promote liquidity
provision in such circumstances because these resources would be
available to facilitate securities transactions.
    The Commission acknowledges that the proposal could increase the
margin required to be collected from a Member who transacts in Illiquid
Securities and UITs, which, in turn, may cause such a Member to incur
additional costs to access needed liquidity for meeting margin
requirements. Despite these potential impacts, the Commission is not
persuaded that the Proposed Rule Change would have a negative effect on
small business capital formation such that it would be inconsistent
with the public interest. To the extent that Members incur funding
costs associated with additional margin, they may choose to distribute
these costs across transactions in all securities for which they make
markets rather than allocate those costs only to transactions in
securities that require additional margin. Thus, the fact that Members
have flexibility in how they allocate

costs could mitigate negative impacts, if any, on the liquidity and
capital formation of a particular subset of issuers.
    The Commission recognizes the possibility that, as a result of the
proposed change, some Members may pass along some of the costs related
to margin requirements such that they ultimately are borne, to some
degree, by investors in Illiquid Securities. However, non-defaulting
Members' exposure to mutualized losses resulting from a Member's
default and any resulting disruptions to clearance and settlement
absent the Proposed Rule Change may also increase costs to investors
and potentially adversely impact market participation, liquidity, and
access to capital by issuers, including issuers of Illiquid Securities.
As a result, and as the Commission previously acknowledged, this
proposed rule change may help reduce transaction costs in the markets
NSCC clears, and reductions in counterparty default risk allow the
corresponding portion of transaction costs to be allocated to more
productive uses by market participants who otherwise would bear those
costs.\64\ Moreover, as discussed in Section II.A(i) above, by helping
to limit non-defaulting Members' exposure to mutualized losses, the
proposed rule change is designed to help assure the safeguarding of
securities and funds of its Members that are in NSCC's custody or
control, consistent with Section 17A(b)(3)(F).
---------------------------------------------------------------------------

    \64\ See Securities Exchange Act Release No. 78961 (September
28, 2016), 81 FR 70786, 70866-67 (October 13, 2016) (S7-03-14)
(``CCA Standards Adopting Release'').
---------------------------------------------------------------------------

    Further, the Commission is not persuaded by the commenters'
generalized statements on the potential impact on small business
capital formation that could result from implementation of the Proposed
Rule Change. The Commission acknowledges the possibility that, as the
commenter asserted, issuers of securities in smaller companies may
experience a reduction in liquidity because of the increased margin
requirements applicable to transactions in Illiquid Securities.
Nevertheless, the Commission believes that investors would not be
discouraged from holding Illiquid Securities. The Commission
understands that, in general, stock prices fall in response to a
reduction in liquidity until such securities provide an adequate
desired return for investors,\65\ and some studies indicate illiquid
stocks pay investors a higher expected stock excess return to
compensate for greater illiquidity.\66\ Thus, as long as stock prices
can adjust to reflect the reduced liquidity, affected small issuers may
still be able to attract capital from investors, albeit at a higher
cost that appropriately reflects the risks inherent in the clearance
and settlement of the securities they issue. Moreover, to the extent
that investment decisions are driven by other factors, such as the
future prospects of specific companies, there might be no decrease in
access to capital or little change in cost.
---------------------------------------------------------------------------

    \65\ See, e.g., Viral Acharya and Lasse H. Pedersen, 2005, Asset
pricing with liquidity risk, 77 Journal of Financial Economics 375-
410 (2005).
    \66\ See, e.g., Yakov Amihud, Illiquidity and stock returns:
Cross-section and time series effects, 5(1) Journal of Financial
Markets 31-56 (2002); Joel Hasbrouck, Trading costs and returns for
US equities: Estimating effective costs from daily data, 64(3) The
Journal of Finance 1445-1477 (2009); Robert. A. Korajczyk and Ronnie
Sadka, Pricing the commonality across alternative measures of
liquidity, 87(1) Journal of Financial Economics 45-72 (2008); and
Michael J. Brennan, Tarun Chordia, Avanidhar Subrahmanyam and Qing
Tong, Sell-order liquidity and the cross-section of expected stock
returns, 105(3) Journal of Financial Economics 523-541 (2012).
However, some studies do not find that more illiquid stocks have
higher expected returns. See, e.g., Michael J. Brennan and Avanidhar
Subrahmanyam, Market microstructure and asset pricing: On the
compensation for illiquidity in stock returns, 41(3) Journal of
Financial Economics 441-464 (1996); Matthew I. Spiegel and Xiaotong
Wang, Cross-sectional variation in stock returns: Liquidity and
idiosyncratic risk, Yale ICF Working Paper No. 05-13 (2005).
---------------------------------------------------------------------------

    In addition, the commenters' arguments ignore the potential
benefits to small businesses when their securities are eligible for
central clearing by NSCC. As do other clearing agencies, NSCC provides
a number of services that mitigate risk, reduce costs, and enhance
processing efficiencies for the securities markets, market
participants, issuers (including small issuers), and investors. By
reducing NSCC's risk exposure to its members and thus the likelihood of
its failure, the proposal helps ensure that NSCC would continue to
provide such services, which would benefit securities markets, market
participants, issuers (including small issuers), and investors. Thus,
the commenters do not take into account any potential positive impacts
on small business capital formation that may arise as a result of the
Proposed Rule Change.
    Therefore, notwithstanding the potential unspecified impact on
capital formation in smaller and less liquid markets, as described
above, the Commission believes that, in light of the potential benefits
to investors arising from the Proposed Rule Change and the resulting
overall improved risk management at NSCC, i.e., the prompt and accurate
clearance and settlement of securities transactions and the
safeguarding of securities and funds based on the collection of margin
commensurate with the risks presented by these securities, the Proposed
Rule Change is designed to protect investors and the public interest,
consistent with Section 17A(b)(3)(F) of the Act.
(iii) Fostering Cooperation and Removing Impediments
    Several commenters asserted that the Proposed Rule Change is
inconsistent with Section 17A(b)(3)(F) of the Act because the proposal
neither addresses nor meets all of the elements prescribed in Section
17A(b)(3)(F).\67\ In response to these comments, the Commission
acknowledges that Section 17A(b)(3)(F) of the Act requires a clearing
agency's rules to be designed to meet a number of objectives, as listed
above. However, certain proposals may not necessarily directly
implicate every aspect of Section 17A(b)(3)(F). Nevertheless, for the
reasons discussed below, the Commission disagrees with the commenters
that the Proposed Rule Change does not meet with the requirements of
Section 17A(b)(3)(F) related to whether a clearing agency's rules are
designed to foster cooperation and coordination with persons engaged in
the clearance and settlement of securities transactions, and to remove
impediments to and perfect the mechanism of a national system for the
prompt and accurate clearance and settlement of securities
transactions.
---------------------------------------------------------------------------

    \67\ See OTC I Letter at 4; OTC II Letter at 2-3; Wilson II
Letter at 6; Wilson III Letter at 1.
---------------------------------------------------------------------------

    One commenter argues that the proposal will not foster cooperation
and coordination between the various market participants engaged in
processing transactions in Illiquid Securities because increased margin
requirements will disadvantage smaller firms, exacerbating the trend of
firms ceasing to provide liquidity in thinly traded stocks due to
overly burdensome regulatory costs.\68\ As an initial matter, Section
17A(b)(3)(F) has a narrower scope than the issue raised by the
commenter, in that it addresses cooperation and coordination with
persons engaged in the clearance and settlement of securities
transactions and not among market participants more broadly.
Nevertheless, even when considering Section 17A(b)(3)(F) as it could
apply to market participants more broadly, the Commission does not
agree with the commenter's argument that increased margin requirements
could disadvantage smaller firms and is inconsistent with fostering
cooperation and coordination with persons engaged in the clearance and
settlement of

securities transactions. This proposal would establish a clear and
transparent methodology for determining the volatility component of
margin for a particular class of securities that would apply to all
NSCC Members in a uniform manner.\69\ The use of such a uniform
methodology is essential to fostering and ensuring cooperation and
coordination with persons engaged in the clearance and settlement of
securities transactions because it provides a generally applicable and
understood methodology established ex ante for determining margin for
this particular class of securities. The collection of appropriately
tailored margin pursuant to this methodology would, in turn, help
decrease the likelihood that losses arising out of a Member default
would exceed NSCC's prefunded resources and threaten NSCC's ability to
continue providing clearance and settlement of securities transactions
and to serve market participants as a central counterparty and,
therefore, to provide an infrastructure for cooperation in the
continued clearance and settlement of securities transactions.
Therefore, the Commission believes that the Proposed Rule Change is
consistent with fostering cooperation and coordination, as provided
under Section 17A(b)(3)(F).
---------------------------------------------------------------------------

    \68\ See OTC II Letter at 3.
    \69\ See Section II.E infra.
---------------------------------------------------------------------------

    The commenters further state that the proposal would not remove
impediments to the national system for prompt and accurate clearance
and settlement but would impose additional requirements and increase
the already prohibitive transactional costs involved in clearing and
settling OTC and small company stocks, making already thinly traded
securities more illiquid.\70\ The Proposed Rule Change is designed to
allow NSCC to better identify securities that present illiquid
characteristics based on additional objective criteria and to impose
tailored haircuts to determine the appropriate margin for such
securities and UITs. These changes will, in turn, enable NSCC to
collect margin more precisely tailored to the different levels of risk
that Members pose to NSCC as a result of their particular trading
activity in Illiquid Securities and UITs, resulting in more accurate
clearance and settlement of securities transactions. The Commission
believes that these improvements to the clearance and settlement of
securities transactions are consistent with removing impediments to the
national system for clearance and settlement, in that less precise
margin determinations could constitute an impediment to NSCC's
continued ability to clear and settle securities transactions if losses
arising out of a Member default were to exceed NSCC's prefunded
resources and threaten NSCC's continued operation as a central
counterparty for securities transactions. For these reasons, the
Commission believes that this change is consistent with removing
impediments to the national system of clearance and settlement, as
provided under Section 17A(b)(3)(F).
---------------------------------------------------------------------------

    \70\ See OTC II Letter at 3; Wilson III Letter at 1.
---------------------------------------------------------------------------

    For the reasons discussed above, the Commission believes that the
Proposed Rule Change is consistent with the requirements of Section
17A(b)(3)(F) of the Act.\71\
---------------------------------------------------------------------------

    \71\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------

B. Consistency With Section 17A(b)(3)(I) of the Act

    Section 17A(b)(3)(I) of the Act requires that the rules of a
clearing agency do not impose any burden on competition not necessary
or appropriate in furtherance of the Act.\72\ This provision does not
require the Commission to find that a proposed rule change represents
the least anticompetitive means of achieving the goal. Rather, it
requires the Commission to balance the competitive considerations
against other relevant policy goals of the Act.\73\
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    \72\ 15 U.S.C. 78q-1(b)(3)(I).
    \73\ See Bradford National Clearing Corp., 590 F.2d 1085, 1105
(D.C. Cir. 1978).
---------------------------------------------------------------------------

    The Commission received various comments regarding the proposal's
impact on competition. Several commenters argued that the proposal
would disproportionately affect smaller broker-dealer Members and small
companies.\74\ One commenter acknowledged that the proposal would apply
to all Members equally, but was concerned that the proposal is likely
to disproportionately impact smaller Members and harm competition.\75\
Multiple commenters asserted that the proposal would discriminate
against small Members because the proposal would demand higher margin,
which would in turn raise the cost for liquidity.\76\ One commenter
further contended that, while large bank-affiliated broker-dealer
Members will not have a liquidity issue resulting from the proposal,
other Members will have a liquidity issue under the proposal.\77\
---------------------------------------------------------------------------

    \74\ See Letter from Christopher R. Doubek, CEO, Alpine
Securities Corporation (April 21, 2020) (``Alpine Letter'') at 2 and
3; SIPA Letter at 3; and Lek Letter at 2 and 3.
    \75\ See OTC I Letter at 5.
    \76\ See Alpine Letter at 2; STANY Letter at 2; OTC I Letter at
5; and Lek Letter at 2.
    \77\ See Lek Letter at 2. Lek Letter and SIPA Letter also argue
that the unfair burden on competition is due to the fact that DTCC's
board is almost entirely made up of representatives from large banks
and other big-businesses. See Lek Letter at 3 and SIPA Letter at 2.
This proposal does not change the composition of DTCC's board, and
the commenter does not provide specifics information regarding the
composition of DTCC's board and how it relates to this proposal. As
discussed below, the impact of the proposed changes are determined
by a Member's portfolio composition and trading activity rather than
a Member's size or type. As addressed throughout, the Commission has
concluded that the proposal does not impose any burden on
competition not necessary or appropriate in furtherance of the Act.
---------------------------------------------------------------------------

    In response, NSCC acknowledges that the proposal may result in an
increase in the Required Fund Deposit for a Member effecting
transactions in Illiquid Securities, and that it may also result in
higher margin costs overall for Members whose business is concentrated
in Illiquid Securities, relative to other Members with more diversified
portfolios. However, NSCC states that the methodology for computing the
margin requirement for a Member's Required Fund Deposit under the
proposal does not take into consideration the Member's size or overall
mix of business in liquid or illiquid securities, including micro-cap
securities, relative to other Members. Any effect the proposal would
have on a particular Member's margin requirement is solely a function
of the default risk posed to NSCC by the Member's activity at NSCC--
firm size or business model is not pertinent to the assessment of that
risk.\78\ Accordingly, NSCC believes that the proposal does not
discriminate against Members or affect them differently on either of
those bases.
---------------------------------------------------------------------------

    \78\ See NSCC Letter at 4.
---------------------------------------------------------------------------

    NSCC states that it is required to manage clearance and settlement
risk presented by each Member with respect to the particular securities
products each Member transacts through the system by, among other
things, collecting margin sufficient to cover the risk of default with
respect to those trades with a high degree of confidence. Accordingly,
each Member is primarily responsible for mitigating the risk associated
with its own business.\79\ NSCC represents that the proposal is
intended to provide a more robust assessment and coverage of the risk
associated with volatility exhibited by Illiquid Securities that NSCC
has identified through backtesting to the statutorily prescribed
level.\80\ As contemplated by the Act and Rule 17Ad-22, each Member
would be responsible to provide margin commensurate with the default
risk

posed by its business to NSCC under the proposal.
---------------------------------------------------------------------------

    \79\ See NSCC Letter at 5.
    \80\ Id.
---------------------------------------------------------------------------

    The Commission acknowledges that the Proposed Rule Change could
entail increased margin charges to some Members that would be borne by
those Members. In considering the costs and benefits of the
requirements of Rule 17Ad-22(e)(6), the Commission expressly
acknowledged in the CCA Standards Adopting Release that risk-based
initial margin requirements may cause market participants to
internalize some of the costs borne by the central counterparty as a
result of large or risky positions and stated that confirming that
margin models are well-specified and correctly calibrated with respect
to economic conditions will help ensure that the margin requirements
continue to align the incentives of a central counterparty's members
with the goal of financial stability.\81\ Nevertheless, in response to
the comments that the proposal would disproportionately affect smaller
broker-dealer Members or those broker-dealer Members that are not
affiliated with large banks, the Commission believes that the impact of
the proposed changes would be entirely determined by a Member's
portfolio composition and trading activity rather than a Member's size
or type. The Proposed Rule Change would calculate the volatility
component of a Member's Required Fund Deposit based on the risks
presented by positions in Illiquid Securities, as described in Section
I.C. To the extent a Member's volatility component would increase under
the Proposed Rule Change, that increase would be based on the
securities held by the Member and NSCC's requirement to collect margin
to appropriately address the risk.
---------------------------------------------------------------------------

    \81\ See CCA Standards Adopting Release, supra note 64, 81 FR at
70870. In addition, when considering the benefits, costs, and
effects on competition, efficiency, and capital formation, the
Commission recognized that a covered clearing agency, such as NSCC,
might pass incremental costs associated with compliance on to its
members, and that such members may seek to terminate their
membership with that CCA. See id., 81 FR at 70865. Moreover, when
considering similar comments related to a proposed rule change
designed to address a covered clearing agency's liquidity risk, the
Commission concluded that the imposition of additional costs did not
render the proposal inconsistent with the Exchange Act. See
Securities Exchange Act Release No. 82090 (November 15, 2017), 82 FR
55427, 55438 n. 209 (November 21, 2017) (SR-FICC-2017-002).
---------------------------------------------------------------------------

    In addition, as noted above, the Commission acknowledges that the
impact of a higher margin requirement may present higher costs on some
Members relative to others due to a number of factors, such as access
to liquidity resources, cost of capital, business model, and applicable
regulatory requirements. These higher relative burdens may weaken
certain Members' competitive positions relative to other Members.\82\
However, the Commission believes that such burden on competition
stemming from a higher impact on some members than on others is
necessary and appropriate. The Commission believes that NSCC is
required 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, considers, and produces margin levels commensurate with, the
risks and particular attributes of each relevant product, portfolio,
and market. NSCC's members include a large and diverse population of
entities. By participating in NSCC, each Member is subject to the same
margin requirements, which are designed to satisfy NSCC's regulatory
obligation to manage the risk presented by its Members. As discussed in
more detail in Section II.D below, this Proposed Rule Change is
designed to ensure that NSCC collects margin that is commensurate with
the risks presented by Illiquid Securities and UITs.
---------------------------------------------------------------------------

    \82\ These potential burdens are not fixed, and affected Members
may choose to restructure their liquidity sources, costs of capital,
or business model, thereby moderating the potential impact of the
Proposed Rule Change.
---------------------------------------------------------------------------

    Furthermore, NSCC has provided an impact study demonstrating that
the proposal would raise the current lowest average backtesting
coverage from 96.2% to 99.5%.\83\ As noted above, the Commission has
reviewed NSCC's analysis and agrees that its results indicate that
NSCC's proposal results in margin levels that better reflect the risks
and particular attributes of the Member's portfolio and help NSCC
achieve backtesting coverage that meets its targeted confidence level.
In turn, the Commission believes that the Proposed Rule Change would
help NSCC better maintain sufficient financial resources to cover its
credit exposures to each Member in full with a high degree of
confidence. By helping NSCC to better manage its credit exposure, the
proposal would help NSCC better mitigate the potential losses to NSCC
and its Members associated with liquidating a Member's portfolio in the
event of a Member default, in furtherance of NSCC's obligations under
Section 17A(b)(3)(F) of the Act as shown in Section II.A.
---------------------------------------------------------------------------

    \83\ See note 55.
---------------------------------------------------------------------------

    Therefore, for the reasons stated above, the Commission believes
that the Proposed Rule Change is consistent with the requirements of
Section 17A(b)(3)(I) of the Act \84\ because any competitive burden
imposed by the proposal is necessary and appropriate in furtherance of
the Act.
---------------------------------------------------------------------------

    \84\ 15 U.S.C. 78q-1(b)(3)(I).
---------------------------------------------------------------------------

C. 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.\85\
---------------------------------------------------------------------------

    \85\ 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.\86\
Two commenters state that NSCC has not demonstrated that its current
margin requirements are insufficient to cover credit risks to its
Members.\87\
---------------------------------------------------------------------------

    \86\ See Lek Letter at 1; STANY Letter at 1; OTC I Letter at 2.
    \87\ 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.\88\ 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).\89\

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.\90\
---------------------------------------------------------------------------

    \88\ See NSCC Letter at 6.
    \89\ 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 9.
    \90\ 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.\91\ 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.\92\
---------------------------------------------------------------------------

    \91\ See NSCC Letter at 5-6.
    \92\ See NSCC Letter at 6.
---------------------------------------------------------------------------

    The Commission believes that the proposal is consistent with Rule
17Ad-22(e)(4)(i) under the Exchange Act.\93\ 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.
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 and precisely calibrated 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, and agrees that the analysis
demonstrates that the proposal would result in better backtesting
coverage and, therefore, less credit exposure to its Members. Finally,
the proposal appropriately 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.
---------------------------------------------------------------------------

    \93\ 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 Proposed Rule
Change, 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 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.\94\
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.
---------------------------------------------------------------------------

    \94\ In addition, because the proposals contained in the Advance
Notice and the Proposed Rule Change are the same, all information
submitted by NSCC was considered regardless of whether the
information submitted with respect to the Advance Notice or the
Proposed Rule Change. See supra notes 3 and 55.
---------------------------------------------------------------------------

    Therefore, for the reasons discussed above, the Commission believes
that the changes proposed in the Proposed Rule Change 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).\95\
---------------------------------------------------------------------------

    \95\ 17 CFR 240.17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

D. 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.\96\
---------------------------------------------------------------------------

    \96\ 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.\97\
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.\98\ Two commenters state 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.\99\ 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.\100\
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.\101\ In addition, one commenter states that
the proposal bears no relationship to a Member's actual credit
rating.\102\
---------------------------------------------------------------------------

    \97\ 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'').
    \98\ See OTC II Letter at 5; STANY Letter at 3.
    \99\ See Lek Letter at 1; Wilson III Letter at 3. 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. Further, one commenter argues that the
Proposed Rule Change is also unwarranted because NSCC could address
NSCC's market risk exposure by modifying the settlement timeline.
See Wilson III Letter at 4. According to the commenter, if the NSCC
proposed rules that would eliminate the two-day settlement cycle in
favor of immediate, same-day electronic settlement, the market risk
exposure would be eliminated. See id. The Commission disagrees with
the argument. The securities industry transitioned to the current
two-day settlement cycle on September 5, 2017, only after a multi-
year, industry-wide initiative and the Commission's amendment of
Rule 15c6-1. See Securities Exchange Act Release No. 78962
(September 28, 2016), 81 FR 69240, 69254 (October 5, 2016)
(``Discussion of Current Efforts To Shorten the Settlement Cycle in
the U.S.''); See Securities Exchange Act Release No. 80295 (March
22, 2017), 82 FR 15564 (March 29, 2017). Therefore, the commenter's
suggestion that NSCC could unilaterally shorten the current two-day
settlement to a same-day settlement cycle is not a feasible
alternative to the Proposed Rule Change.
    \100\ See STANY Letter at 3.
    \101\ See SIPA Letter.
    \102\ 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.\103\ 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.\104\
---------------------------------------------------------------------------

    \103\ See NSCC Letter at 8.
    \104\ See NSCC Letter at 8-9.
---------------------------------------------------------------------------

    In addition, NSCC explains that it included the second element of
the 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.\105\ 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.\106\ 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.\107\
---------------------------------------------------------------------------

    \105\ See id.
    \106\ See id.
    \107\ 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.\108\ 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.\109\ 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.\110\
---------------------------------------------------------------------------

    \108\ See id.
    \109\ See id.
    \110\ 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 precisely and 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 comments questioning whether the proposal is
necessary because ``the existing margin has always been enough to
cover'' \111\ 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 Proposed Rule Change. 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.\112\ 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.\113\ 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 Proposed Rule Change, 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.
---------------------------------------------------------------------------

    \111\ See Lek Letter at 1; see also Wilson III at 3-4.
    \112\ 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).
    \113\ 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,\114\ and a micro-cap security would then be subject to the
illiquidity ratio test described in Section I.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.
---------------------------------------------------------------------------

    \114\ 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, supra note 3, 85 FR at 17912 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 categorization as Illiquid
Securities 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.\115\ In particular, the
average OTC security issuer is smaller, and their securities trade
less, on average, than securities traded on a national securities
exchange.\116\ Moreover, issuers of quoted OTC securities tend to have
a lower market capitalization than those with securities listed on a
national securities exchange,\117\ and many quoted OTC securities are
illiquid.\118\ 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.\119\
---------------------------------------------------------------------------

    \115\ Securities Act Release No. 68124 (September 16, 2020), 85
FR 68124, 68185 (October 27, 2020) (S7-14-19) (``Publication or
Submission of Quotations Without Specified Information'').
    \116\ See id.
    \117\ See id.
    \118\ See id.
    \119\ See id.
---------------------------------------------------------------------------

    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.\120\
---------------------------------------------------------------------------

    \120\ 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).
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    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.\121\
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    \121\ 17 CFR 240.17Ad-22(e)(6)(i).
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E. 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.\122\
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    \122\ 17 CFR 240.17Ad-22(e)(23)(ii).
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    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.\123\

Other commenters state that the proposal is overly complicated and does
not allow Members to predict the financial consequences and operating
impacts of their activities, and the impact on their liquidity
needs.\124\
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    \123\ 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.
    \124\ 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; Wilson III Letter at 2. Wilson III also states that NSCC
failed to meet the requirements of Rule 17Ad-22(e)(23)(ii) and
(iii), which requires a clearing agency 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 and to publicly disclose relevant basic
data on transaction volume and values, because NSCC has not
undertaken the requisite studies or gathered sufficient data to
fully understand the impact of the Proposed Rule Change. See Wilson
III Letter at 3. The Commission disagrees with this comment. First,
as described in more detail below, NSCC provides methods for Members
to understand their respective margin requirements. See infra note
127 and accompanying text. Second, as stated above, NSCC submitted
to the Commission impact studies comparing the impact of the current
and proposed methodologies on its Members, and provided additional
information regarding the improvements in backtesting coverage for
other asset groups in confidential exhibits. See supra notes 55 and
94.
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    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.\125\ NSCC states that the proposed
parameters are definitive and non-discretionary to enable application
on an algorithmic basis.\126\ 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.\127\
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    \125\ See NSCC Letter at 6.
    \126\ See id.
    \127\ See id.
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    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.\128\ 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.\129\ 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.\130\ 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.\131\
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    \128\ See id.
    \129\ See id.
    \130\ See id.
    \131\ See id.
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    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.\132\
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    \132\ See NSCC Letter at 7.
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    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.\133\ 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.\134\ 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.\135\
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    \133\ See id.
    \134\ See id.
    \135\ See id.
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    Finally, NSCC states that it conducted member outreach in
connection with the proposal described in the Proposed Rule Change.
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.\136\ 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.\137\
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    \136\ See id. Wilson III states that unlike NSCC's
representation, only one impact study was received. See Wilson III
Letter at 3. The Commission does not believe that NSCC's purported
failure to provide particular impact studies to all of its Members
is a dispositive factor in determining whether the Proposed Rule
Change is designed to be consistent with Rule 17Ad-22(e)(23)(ii).
Rule 17Ad-22(e)(23)(ii) requires NSCC to provide sufficient
information to enable participants to identify and evaluate the
risks, fees, and other material costs they may incur. NSCC has (1)
acknowledged that that the proposal may result in an increase in the
Required Fund Deposit for a Member effecting transactions in
Illiquid Securities, and that it may also result in higher margin
costs overall for Members whose business is concentrated in Illiquid
Securities, relative to other Members with more diversified
portfolios, and (2) provided Members with a Portal that enables them
to identify and evaluate their costs.
    \137\ See NSCC Letter at 7.
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    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.\138\ NSCC represents that the Guide will be updated to reflect
the changes in methodology set forth in the proposal.\139\
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    \138\ See id.
    \139\ See id.
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    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 I.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 I.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 Commission 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,\140\ 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).'' \141\ 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.
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    \140\ 17 CFR 240.17Ad-22(e).
    \141\ See CCA Standards Adopting Release, supra note 64, 81 FR
at 70845.
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    For the reasons discussed above, the Commission believes that the
proposals in the Proposed Rule Change 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).\142\
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    \142\ 17 CFR 240.17Ad-22(e)(23)(ii).
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III. Conclusion

    On the basis of the foregoing, the Commission finds that the
proposed rule change is consistent with the requirements of the Act and
in particular with the requirements of Section 17A of the Act \143\ and
the rules and regulations promulgated thereunder.
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    \143\ 15 U.S.C. 78q-1.
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    It is therefore ordered, pursuant to Section 19(b)(2) of the Act
\144\ that proposed rule change SR-NSCC-2020-003, be, and hereby is,
approved.\145\
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    \144\ 15 U.S.C. 78s(b)(2).
    \145\ In approving the proposed rule change, the Commission
considered the proposals' impact on efficiency, competition, and
capital formation. 15 U.S.C. 78c(f). See also Section II.B.