the participant family to which it has the largest exposure in extreme
but plausible market conditions.\621\ It further requires CCPs for
security-based swaps to establish, implement, maintain and enforce
written policies and procedures reasonably designed to maintain
additional financial resources sufficient to withstand, at a minimum, a
default by the two participant families to which it has the largest
exposures in extreme but plausible market conditions, in its capacity
as a CCP for security-based swaps.\622\ Accordingly, the Commission
notes that Rule 17Ad-22(b)(3) imposes a ``cover two'' requirement on
CCPs for security-based swaps in order to protect such CCPs from the
extreme jump-to-default risk and nonlinear payoffs associated with the
nature of the financial products they clear and the participants in the
markets they serve. Meanwhile, CCPs that clear products other than
security-based swaps are subject to a ``cover one'' requirement.\623\
Rule 17Ad-22(b)(3) also states that such policies and procedures may
provide that additional financial resources be maintained by the CCP in
combined or separately maintained funds.\624\
---------------------------------------------------------------------------

    \621\ See 17 CFR 240.17Ad-22(b)(2).
    \622\ See id.
    \623\ See supra Part 0 and infra Part 0 (discussing the related
``cover one'' and ``cover two'' requirements in proposed Rule 17Ad-
22(e)(4)).
    \624\ See id.
---------------------------------------------------------------------------

    Under existing rules, CCPs collect contributions from their members
for the purpose of establishing guaranty or clearing funds to mutualize
losses under extreme but plausible market conditions. Currently, the
guaranty funds or clearing funds consist of liquid assets and their
sizes vary depending on a number of factors, including the products the
CCP clears and the characteristics of CCP members. In particular, the
guaranty funds for CCPs that clear security-based swaps are relatively
larger, as measured by the size of the fund as a percentage of the
total and largest exposures, than the guaranty or clearing funds
maintained by CCPs for other financial instruments. CCPs generally take
the liquidity of collateral into account when determining member
obligations. Applying haircuts to assets posted as margin, among other
things, mitigates the liquidity risk associated with selling margin
assets in the event of a participant default.
ii. Collateral and Margin
    Rule 17Ad-22(b)(2) requires a registered clearing agency that
provides CCP services to establish, implement, maintain and enforce
written policies and procedures reasonably designed to use margin
requirements to limit their exposures to participants.\625\ This margin
can also be used to reduce a CCP's losses in the event of a participant
default.
---------------------------------------------------------------------------

    \625\ See 17 CFR 240.17Ad-22(b)(2).
---------------------------------------------------------------------------

    Registered clearing agencies that provide CCP services take
positions as substituted counterparties once their trade guarantee goes
into effect. Therefore, if a counterparty whose obligations the
registered clearing agency has guaranteed defaults, the covered
clearing agency may face market risk, which can take one of two forms.
First, a covered clearing agency is subject to the risk of movement in
the market prices of the defaulting member's open positions. Where a
seller defaults and fails to deliver a security, the covered clearing
agency may need to step into the market to buy the security in order to
complete settlement and deliver the security to the buyer. Similarly,
where a buyer defaults, the covered clearing agency may need to meet
payment obligations to the seller. Thus, in the interval between when a
member defaults and when the covered clearing agency must meet its
obligations as a substituted counterparty in order to complete
settlement, market price movements expose the covered clearing agency
to market risk. Second, the covered clearing agency may need to
liquidate non-cash margin collateral posted by the defaulting member.
The covered clearing agency is therefore exposed to the risk that
erosion in market prices of the collateral posted by the defaulting
member could result in the covered clearing agency having insufficient
financial resources to cover the losses in the defaulting member's open
positions.
    To manage their exposure to market risk resulting from fulfilling a
defaulting member's obligations, registered clearing agencies compute
margin requirements using inputs such as portfolio size, volatility,
and sensitivity to various risk factors that are likely to influence
security prices. Moreover, since the size of price movements is, in
part, a function of time, registered clearing agencies may limit their
exposure to market risk by marking participant positions to market
daily and, in some cases, more frequently. CCPs also use similar
factors to determine haircuts applied to assets posted by members in
satisfaction of margin requirements. To manage market risk associated
with collateral liquidation, CCPs consider the current prices of assets
posted as collateral and price volatility, asset liquidity, and the
correlation of collateral assets and a member's portfolio of open
positions. Further, because CCPs need to value their margin assets in
times of financial stress, their rulebooks may include features such as
market-maker domination charges that increase clearing fund obligations
regarding open positions of members in securities in which the member
serves as a dominant market maker. The reasoning behind this charge is
that, should a member default, liquidity in products in which the
member makes markets may fall, leaving these positions more difficult
to liquidate for non-defaulting participants.
    Rule 17Ab-22(b)(2) also requires a registered clearing agency that
provides CCP services to establish, implement, maintain and enforce
written policies and procedures reasonably designed to provide for
risk-based models and parameters to set margin requirements.\626\ The
generally recognized standard for such models and parameters is, under
normal market conditions, price movements that produce changes in
exposures that are expected to breach margin requirements

or other risk controls only 1% of the time (i.e., at a 99% confidence
interval) over a designated time horizon.\627\ Currently, CCPs use
margin models to ensure coverage at a single-tailed 99% confidence
interval. Losses beyond this level are typically covered by the CCP's
guaranty fund. This standard comports with existing international
standards for bank capital requirements, which require banks to measure
market risks at a 99% confidence interval when determining regulatory
capital requirements.\628\
---------------------------------------------------------------------------

    \626\ See id.
    \627\ See 17 CFR 240.17Ad-22(a)(4). The Commission notes that
because it is proposing to add new definitions to Rule 17Ad-22(a),
``normal market conditions'' would appear in Rule 17Ad-22(a)(12) in
the event the proposed rules are adopted. The Commission is not
proposing to alter the definition of ``normal market conditions.''
    \628\ See BCBS, International Convergence of Capital Measurement
and Capital Standards: A Revised Framework (June 2004), available at
http://www.bis.org/publ/bcbs107.pdf; see also Darryll Hendricks &
Beverly Hirtle, New Capital Rule Signals Supervisory Shift
(Secondary Mortgage Mkts, Sept. 1998), available at http://www.freddiemac.com/finance/smm/july98/pdfs/hen_hirt.pdf.
    Prior to this standard, banks measured value-at-risk using a
range of confidence intervals from 90-99%. See BCBS, An Internal
Model-Based Approach to Market Risk Capital Requirements, at 12
(Apr. 1995), available at http://www.bis.org/publ/bcbs17.pdf. When
determining the minimum quantitative standards for calculating risk
measurements, the BCBS noted then the importance of specifying ``a
common and relatively conservative confidence level,'' choosing the
99% confidence interval over other less conservative measures. See
id.
    Since its adoption in 1998, the standard has become a generally
recognized practice of banks to quantify credit risk as the worst
expected loss that a portfolio might incur over an appropriate time
horizon at a 99% confidence interval. See Kenji Nishiguchi, Hiroshi
Kawai & Takanori Sazaki, Capital Allocation and Bank Management
Based on the Quantification of Credit Risk, at 83 (FRBNY Econ.
Policy Rev., Oct. 1998), available at http://www.newyorkfed.org/research/epr/98v04n3/9810nish.pdf; Jeff Aziz & Narat Charupat,
Calculating Credit Exposure and Credit Loss: A Case Study, at 34
(Sept. 1998), available at http://www.bis.org/bcbs/ca/alrequse98.pdf.
---------------------------------------------------------------------------

    Rule 17Ad-22(b)(2) also requires a registered clearing agency that
provides CCP services to establish, implement, maintain and enforce
written policies and procedures reasonably designed to review such
margin requirements and the related risk-based models and parameters at
least monthly.\629\ CCPs are accordingly required to establish a model
validation process that evaluates the adequacy of margin models,
parameters, and assumptions. Additionally, CCPs are required to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to provide for an annual model
validation consisting of evaluating the performance of the CCPs' margin
models and the related parameters and assumptions associated with such
models by a qualified person who is free from influence from the
persons responsible for the development or operation of the models
being validated.\630\
---------------------------------------------------------------------------

    \629\ See 17 CFR 240.17Ad-22(b)(2).
    \630\ See 17 CFR 240.17Ad-22(b)(4).
---------------------------------------------------------------------------

iii. Liquidity Risk
    In addition to credit risk and the aforementioned market risk,
registered clearing agencies also face liquidity or funding risk.
Currently, to complete the settlement process, registered clearing
agencies that employ netting rely on incoming payments from
participants in net debit positions in order to make payments to
participants in net credit positions. If a participant does not have
sufficient funds or securities in the form required to fulfill a
payment obligation immediately when due (even though it may be able to
pay at some future time), or if a settlement bank is unable to make an
incoming payment on behalf of a participant, a registered clearing
agency may face a funding shortfall. Such funding shortfalls may occur
due to a lack of financial resources necessary to meet delivery or
payment obligations, however even registered clearing agencies that do
hold sufficient financial resources to meet their obligations may not
carry those in the form required for delivery or payments to
participants.
    A registered clearing agency that provides CCP services may hold
additional financial resources to cover potential funding shortfalls in
the form of collateral. As noted above, CCPs may take the liquidity of
collateral into account when determining member obligations. Applying
haircuts to illiquid assets posted as margin mitigates the liquidity
risk associated with selling margin assets in the event of participant
default. Some registered CCPs also arrange for liquidity provision from
other financial institutions using lines of credit. Additionally, some
registered clearing agencies enter into prearranged funding agreements
with their members pursuant to their rules. For example, members of one
registered clearing agency are obligated to enter into repurchase
agreements against securities that would have been delivered to a
defaulting member.
    No rule under the Exchange Act currently requires a registered
clearing agency through its written policies and procedures to address
liquidity risk.
c. Settlement
    Rule 17Ad-22(d)(5) requires a registered clearing agency to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to employ money settlement arrangements
that eliminate or strictly limit the clearing agency's settlement bank
risks and require funds transfers to the clearing agency to be final
when effected.\631\ Rule 17Ad-22(d)(12) further requires a registered
clearing agency to establish, implement, maintain and enforce written
policies and procedures reasonably designed to ensure that final
settlement occurs no later than the end of the settlement day.\632\
Accordingly, for example, certain registered clearing agencies provide
for final settlement of securities transfers no later than the end of
the day of the transaction. Rule 17Ad-22(d)(15) also requires a
registered clearing agency to establish, implement, maintain and
enforce written policies and procedures reasonably designed to state to
its participants the clearing agency's obligations with respect to
physical deliveries and identify and manage the risks from these
obligations.\633\
---------------------------------------------------------------------------

    \631\ See 17 CFR 240.17Ad-22(d)(5).
    \632\ See 17 CFR 240.17Ad-22(d)(12).
    \633\ See 17 CFR 240.17Ad-22(d)(15).
---------------------------------------------------------------------------

d. CSDs and Exchange-of-Value Settlement Systems
i. CSDs
    Rule 17Ad-22(d)(10) requires a registered clearing agency that
provides CSD services to establish, implement, maintain and enforce
written policies and procedures reasonably designed to maintain
securities in an immobilized or dematerialized form for transfer by
book entry to the greatest extent possible. Currently, some securities,
such as mutual fund securities and government securities, are issued
primarily or solely on a dematerialized basis. Dematerialized shares do
not exist as physical certificates but are held in book entry form in
the name of the owner (which, where the master security holder file is
not maintained on paper due to the use of technology, is also referred
to as electronic custody). Other types of securities may be issued in
the form of one or more physical security certificates, which could be
held by the CSD to facilitate immobilization. Alternatively, securities
may be held by the beneficial owner in record name, in the form of
book-entry positions, where the issuer offers the ability for a
security holder to hold through the direct registration system. Whether
immobilization occurs at the CSD or through direct registration depends
on what is provided for by the issuer.

    When a trade occurs, the depository's accounting system credits one
participant account and debits another participant account.
Transactions between counterparties in dematerialized shares are
recorded by the registrar responsible for maintaining the paper or
electronic register of security holders, such as by a transfer agent,
and reflected in customer accounts.
    Registered CSDs currently reconcile ownership positions in
securities against CSD ownership positions on the security holders list
daily, mitigating the risk of unauthorized creation or deletion of
shares.
ii. Exchange-of-Value Settlement Systems
    Rule 17Ad-22(d)(13) requires a registered clearing agency to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to eliminate principal risk by linking
securities transfers to funds transfers in a way that achieves delivery
versus payment,\634\ which serves to link obligations by conditioning
the final settlement of one upon the final settlement of the other. One
registered clearing agency, for example, operates a Model 2 DVP system
that provides for gross securities transfers during the day followed by
an end-of-day net funds settlement. Under the rules governing the
clearing agency's system, the delivering party in a DVP transaction is
assured that it will be paid for the securities once they are credited
to the receiving party's securities account. DVP eliminates the risk
that a buyer would lose the purchase price of a security purchased from
a defaulting seller or that a seller would lose the sold security
without receiving payment for a security acquired by a defaulting
buyer.
---------------------------------------------------------------------------

    \634\ See 17 CFR 240.17Ad-22(d)(13); see also Clearing Agency
Standards Release, supra note 5, at 66256.
---------------------------------------------------------------------------

    For example, one registered clearing agency has rules governing its
continuous net settlement (``CNS'') system, under which it becomes the
counterparty for settlement purposes at the point its trade guarantee
attaches, thereby assuming the obligation of its members that are
receiving securities to receive and pay for those securities, and the
obligation of members that are delivering securities to make the
delivery. Unless the clearing agency has invoked its default rules, it
is not obligated to make those deliveries until it receives from
members with delivery obligations deliveries of such securities;
rather, deliveries that come into CNS ordinarily are promptly
redelivered to parties that are entitled to receive them through an
allocation algorithm. Members are obligated to take and pay for
securities allocated to them in the CNS process. These rules also
provide mechanisms to allow receiving members a right to receive high
priority in the allocation of deliveries, and also permit a member to
buy-in long positions that have not been delivered to it by the close
of business on the scheduled settlement date.
e. Default Management
i. Participant-Default Rules and Procedures
    Rule 17Ad-22(d)(11) requires a registered clearing agency to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to make key aspects of its default
procedures publicly available and establish default procedures that
ensure it can take timely action to contain losses and liquidity
pressures and to continue meeting its obligations in the event of a
participant default. The rules of registered clearing agencies
typically state what constitutes a default, identify whether the board
or a committee of the board may make that determination, and describe
what steps the clearing agency may take to protect itself and its
members. In this regard, registered clearing agencies typically
attempt, among other things, to hedge and liquidate a defaulting
member's positions. Rules of registered clearing agencies also include
information about the allocation of losses across available financial
resources.
ii. Segregation and Portability
    No rule under the Exchange Act currently requires a registered
clearing agency through its written policies and procedures to enable
the portability of positions of a member's customers and the collateral
provided in connection therewith. Additionally, no rule under the
Exchange Act currently requires a registered clearing agency through
its written policies and procedures to protect the positions of a
member's customers from the default or insolvency of the member.\635\
---------------------------------------------------------------------------

    \635\ See supra note 293 (discussing existing rules applicable
to registered broker-dealers that address customer security
positions and funds in cash securities and listed option markets,
thereby promoting segregation and portability at the broker-dealer
level).
---------------------------------------------------------------------------

f. General Business and Operational Risk Management
i. General Business Risk
    Business risk refers to the risks and potential losses arising from
a registered clearing agency's administration and operation as a
business enterprise that are neither related to member default nor
separately covered by financial resources designated to mitigate credit
or liquidity risk. While Rule 17Ad-22 sets forth requirements for
registered clearing agencies to identify, monitor, and mitigate or
eliminate a broad array of risks through written policies and
procedures, no rule under the Exchange Act expressly requires a
registered clearing agency through its written policies and procedures
to identify, monitor, and manage general business risk or to meet a
capital requirement. Nonetheless, registered clearing agencies
currently have certain internal controls in place to mitigate business
risk. Some clearing agencies, for instance, have policies and
procedures that identify an auditor who is responsible for examining
accounts, records, and transactions, as well as other duties prescribed
in the audit program. Other registered clearing agencies allow members
to collectively audit the books of the clearing agency on an annual
basis, at their own expense.
ii. Custody and Investment Risks
    Registered clearing agencies face default risk from commercial
banks that they use to effect money transfers among participants, to
hold overnight deposits, and to safeguard collateral. Rule 17Ad-
22(d)(3) requires a registered clearing agency to establish, implement,
maintain and enforce written policies and procedures reasonably
designed to (i) hold assets in a manner that minimizes risk of loss or
delay in its access to them; and (ii) invest assets in instruments with
minimal credit, market, and liquidity risks.\636\ Registered clearing
agencies currently seek to minimize the risk of loss or delay in access
by holding assets that are highly liquid (e.g., cash, U.S. Treasury
securities, or securities issued by a U.S. government agency) and by
engaging banks to custody the assets and facilitate settlement.
Typically, registered clearing agencies take steps to ensure that
assets held in custody are protected from claims from the custodian's
creditors using trust accounts or equivalent arrangements.
Additionally, designated clearing agencies may gain access to account

services at a Federal Reserve Bank, to the extent such services are not
already available as the result of other laws and regulations.\637\
---------------------------------------------------------------------------

    \636\ See 17 CFR 240.17Ad-22(d)(3).
    \637\ See supra Part 0 (discussing the requirement under
proposed Rule 17Ad-22(e)(7)(iii) for a covered clearing agency to
have policies and procedures reasonably designed to ensure it has
access to account services at a Federal Reserve Bank or other
relevant central bank).
---------------------------------------------------------------------------

iii. Operational Risk
    Operational risk refers to a broad category of potential losses
arising from deficiencies in internal processes, personnel, and
information technology. Registered clearing agencies face operational
risk from both internal and external sources, including human error,
system failures, security breaches, and natural or man-made disasters.
Rule 17Ad-22(d)(4) requires a registered clearing agency to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to identify sources of operational risk and to
minimize those risks through the development of appropriate systems,
controls and procedures.\638\ It also requires a registered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to (i) implement systems that are
reliable and secure, and have adequate, scalable capacity; and (ii)
have business continuity plans that allow for timely recovery of
operations and fulfillment of a clearing agency's obligations.\639\
---------------------------------------------------------------------------

    \638\ See 17 CFR 240.17Ad-22(d)(4).
    \639\ See id.
---------------------------------------------------------------------------

    As a result, registered clearing agencies have developed and
currently maintain plans to assure the safeguarding of securities and
funds, the integrity of automated data processing systems, and the
recovery of securities, funds, or data under a variety of loss or
destruction scenarios.\640\ These plans may include turning operations
over to a secondary site that is located a sufficient distance from the
primary location to ensure a distinct geographic risk profile. In
addition, registered clearing agencies generally maintain an internal
audit department to review the adequacy of their internal controls,
procedures, and records with respect to operational risks. Some
registered clearing agencies also engage independent accountants to
perform an annual study and evaluation of the internal controls
relating to their operations.\641\
---------------------------------------------------------------------------

    \640\ Many of these practices had been previously developed
pursuant to prior Commission guidelines. See ARP I and II, supra
note 324; see also supra note 326 (discussing related requirements
under proposed Regulation SCI).
    \641\ See, e.g., NSCC, Assessment of Compliance with the CPSS/
IOSCO Recommendations for Central Counterparties (Nov. 2011),
available at http://www.dtcc.com/legal/policy-and-compliance.aspx.
---------------------------------------------------------------------------

g. Access
i. Access and Participation Requirements
    Rule 17Ad-22(b)(5) requires a registered clearing agency that
provides CCP services to establish, implement, maintain and enforce
written policies and procedures reasonably designed to provide the
opportunity for a person that does not perform any dealer or security-
based swap dealer services to obtain membership on fair and reasonable
terms at the clearing agency to clear securities for itself or on
behalf of other persons.\642\ Rule 17Ad-22(b)(6) requires a registered
clearing agency that provides CCP services to establish, implement,
maintain and enforce written policies and procedures reasonably
designed to have membership standards that do not require participants
to maintain a portfolio of any minimum size or a minimum transaction
volume.\643\ Rule 17Ad-22(b)(7) requires a registered clearing agency
that provides CCP services to establish, implement, maintain and
enforce written policies and procedures reasonably designed to provide
a person that maintains net capital equal or greater than $50 million
with the ability to obtain membership at the clearing agency, provided
such persons are able to comply with reasonable membership standards,
with higher net capital requirements permissible subject to Commission
approval.\644\
---------------------------------------------------------------------------

    \642\ See 17 CFR 240.17Ad-22(b)(5).
    \643\ See 17 CFR 240.17Ad-22(b)(6).
    \644\ See 17 CFR 240.17Ad-22(b)(7).
---------------------------------------------------------------------------

    In addition, Rule 17Ad-22(d)(2) requires a registered clearing
agency to establish, implement, maintain and enforce written policies
and procedures reasonably designed to require participants to have
sufficient financial resources and robust operational capacity to meet
obligations arising from participation in the clearing agency, have
procedures in place to monitor that participation requirements are met
on an ongoing basis, and have participation requirements that are
objective and publicly disclosed, and permit fair and open access.\645\
Typically, a registered clearing agency's rulebook requires applicants
for membership to provide certain financial and operational information
prior to being admitted as a member and on an ongoing basis as a
condition of continuing membership. Registered clearing agencies review
this information to ensure that the applicant has the operational
capability to meet the other demands of interfacing with the clearing
agency. In particular, registered clearing agencies typically require
that an applicant demonstrate that it has adequate personnel capable of
handling transactions with the clearing agency and adequate physical
facilities, books and records, and procedures to fulfill its
anticipated commitments to, and to meet the operational requirements
of, the clearing agency and other members with necessary promptness and
accuracy. As a result, an applicant needs to demonstrate that it has
adequate personnel capable of handling transactions with the clearing
agency and adequate physical facilities, books and records, and
procedures to conform to conditions or requirements in these areas that
the clearing agency reasonably may deem necessary for its protection.
Registered clearing agencies have published these requirements on their
Web sites.
---------------------------------------------------------------------------

    \645\ See 17 CFR 240.17Ad-22(d)(2).
---------------------------------------------------------------------------

    Registered clearing agencies use an ongoing monitoring process to
help them understand relevant changes in the financial condition of
their members and to mitigate credit risk exposure of the clearing
agency to its members. The risk management staff analyzes financial
statements filed with regulators, as well as information obtained from
other SROs and gathered from various financial publications, so that
the clearing agency may evaluate, for instance, whether members
maintain sufficient financial resources and robust operational capacity
to meet their obligations as participants in the clearing agency
pursuant to existing Rule 17Ad-22(d)(2)(i).
    Table 1 contains membership statistics for registered clearing
agencies.\646\ Current membership generally reflects features of
cleared markets. The decision to become a clearing member depends on
the products being cleared, the structure of these asset markets as
well as the current state of regulation for cleared markets. For
example, the structure of security-based swap markets and the payoffs
to security-based swap contracts differs markedly from that of equity
markets and common stock, which may explain some of the differences
between the concentrated membership of certain clearing agencies and
the relatively broader membership of others.
---------------------------------------------------------------------------

    \646\ See supra Part 0.

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

ii. Tiered Participation Arrangements
    Tiered participation arrangements occur when clearing members
(direct participants) provide access to clearing services to third
parties (indirect participants). No rule under the Exchange Act
currently requires a registered clearing agency through its written
policies and procedures to identify, monitor, and manage material risks
arising from tiered participation arrangements. The Commission
understands, however, that certain registered clearing agencies have
policies and procedures currently in place in order to identify,
monitor, or manage such arrangements. Specifically, such clearing
agencies rely on information gathered from, and distributed by, direct
participants in order to manage these tiered participation
arrangements. For example, under some covered clearing agencies' rules,
direct participants generally have the responsibility to indicate to
the clearing agency whether a transaction submitted for clearing
represents a proprietary or customer position. Such rules further
require direct participants to calculate, and notify the clearing
agency of the value of, each customer's collateral. Direct participants
also communicate with indirect participants regarding the clearing
agency's margin and other requirements.
iii. Links
    Rule 17Ad-22(d)(7) requires a registered clearing agency to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to evaluate the potential sources of
risks that can arise when the clearing agency establishes links either
cross-border or domestically to clear or settle trades, and ensure that
the risks are managed prudently on an ongoing basis.\647\
---------------------------------------------------------------------------

    \647\ See 17 CFR 240.17Ad-22(d)(7).
---------------------------------------------------------------------------

    Each registered clearing agency is linked to other clearing
organizations, trading platforms, and service providers. For instance,
a link between U.S. and Canadian clearing agencies allows U.S. members
to clear and settle valued securities transactions with participants of
a Canadian securities depository. The link is designed to facilitate
cross-border transactions by allowing members to use a single
depository interface for U.S. and Canadian dollar transactions and
eliminate the need for split inventories.\648\ Registered clearing
agencies that provide CCP services currently establish links to allow
members to realize collateral and other operational efficiencies.
---------------------------------------------------------------------------

    \648\ See Exchange Act Release No. 52784 (Nov. 16, 2005), 71 FR
70902 (Nov. 23, 2005); Exchange Act Release No. 55239 (Feb. 5,
2007), 72 FR 6797 (Feb. 13, 2007).
---------------------------------------------------------------------------

h. Efficiency
i. Efficiency and Effectiveness
    Rule 17Ad-22(d)(6) requires a registered clearing agency to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to require the clearing agency to be
cost-effective in meeting the requirements of participants while
maintaining safe and secure operations.\649\ Registered clearing
agencies have procedures to control costs and to regularly review
pricing levels against operating costs. These clearing agencies may use
a formal budgeting process to control expenditures, and may review
pricing levels against their costs of operation during the annual
budget process. Registered clearing agencies also analyze workflows in
order to make recommendations to improve their operating efficiency.
---------------------------------------------------------------------------

    \649\ See 17 CFR 240.17Ad-22(d)(6).
---------------------------------------------------------------------------

ii. Communication Procedures and Standards
    Although no rule under the Exchange Act expressly requires a
registered clearing agency through its written policies and procedures
to use or accommodate relevant internationally accepted communication
procedures and standards, the Commission believes that registered
clearing agencies already use these standards. Registered clearing
agencies typically rely on electronic communication with market
participants, including members. For example, some registered clearing
agencies have rules in place stating that clearing members must
retrieve instructions, notices, reports, data, and other items and
information from the clearing agency through electronic data retrieval
systems. Some registered clearing agencies have the ability to rely on
signatures transmitted, recorded, or stored through electronic,
optical, or similar means. Other clearing agencies have policies and
procedures that provide for certain emergency meetings using telephonic
or other electronic notice.
i. Transparency
    Transparency requirements and disclosures by registered clearing
agencies serve to limit the size of potential information asymmetries
between registered clearing agencies, their members, and market
participants. Rule 17Ad-22(d)(9) requires a registered clearing agency
to establish, implement, maintain and enforce written policies and
procedures reasonably designed to provide market participants with
sufficient information for them to identify and evaluate risks and
costs associated with using the clearing agency's services.\650\
Information regarding the operations and services of each registered
clearing agency can be viewed publicly either on the clearing agency's
Web site or a Web site maintained by an affiliate of the clearing
agency. Because registered clearing agencies are SROs,\651\ changes to
their rules are published by the Commission and are available for
public viewing on each clearing agency's Web site.\652\
---------------------------------------------------------------------------

    \650\ See 17 CFR 240.17Ad-22(d)(9).
    \651\ See supra Part 0 and note 95 (describing the Commission's
framework for regulation of SROs and the SRO rule filing process).
    \652\ See supra note 362 (discussing requirements under Rule
19b-4(i)).
---------------------------------------------------------------------------

    Besides providing market participants with information on the risks
and costs associated with their services, registered clearing agencies
regularly provide information to their members to assist them in
managing their risk exposures and potential funding obligations. Some
of these disclosures may be common to all members--such as information
about the composition of clearing fund assets--while other disclosures
that concern particular positions or obligations may only be made to
individual members.
4. Determinations by the Commission
    Currently, although Rule 17Ad-22(d) applies to registered clearing
agencies, no mechanism exists for the Commission to make determinations
with regard to covered clearing agencies of the type that would occur
under proposed Rule 17Ab2-2.\653\
---------------------------------------------------------------------------

    \653\ See proposed Rule 17Ab2-2, infra Part 0.
---------------------------------------------------------------------------

C. Consideration of Benefits, Costs, and the Effect on Competition,
Efficiency, and Capital Formation

    The discussion below sets forth the potential economic effects
stemming from the proposed rules. The section begins by framing more
general economic issues related to the proposed amendments to Rule
17Ad-22 and proposed Rule 17Ab2-2. The discussion that follows
considers the effects of the proposed rules on efficiency, competition,
and capital formation. The section ends with a discussion of the
benefits and costs flowing from specific provisions of the proposed
amendments to Rule 17Ad-22 and proposed Rule 17Ab2-2.

1. General Economic Considerations
    The proposed amendments to Rule 17Ad-22, taken as a whole, would
likely produce economic effects that are either conditioned on multiple
provisions of proposed Rule 17Ad-22(e) being implemented as a set or
are simply common to multiple provisions of the proposal. Since these
economic effects are attributable in some way to each of the individual
subsections of proposed Rule 17Ad-22(e), this section considers
potential impacts of the proposed amendments, as a whole, through their
effects on systemic risk, the discretion with which covered clearing
agencies operate, market integrity, concentration in the market for
clearing services and among clearing members, and QCCP status.
a. Systemic Risk
    A large portion of financial activity in the United States
ultimately flows through one or more registered clearing agencies that
would become covered clearing agencies under the proposed rules. These
clearing agencies have direct links to members and indirect links to
the customers of members. They are also linked to each other through
common members, operational processes, and in some cases cross-
margining and cross-guaranty agreements. These linkages allow covered
clearing agencies to provide opportunities for risk-sharing but also
allow them to serve as potential conduits for risk transmission.
Covered clearing agencies play an important role in fostering the
proper functioning of financial markets. If they are not effectively
managed, however, they may transmit financial shocks, particularly on
days of market stress.
    The centralization of clearance and settlement activities at
covered clearing agencies allows market participants to reduce costs,
increase operational efficiency, and manage risks more
effectively.\654\ While providing benefits to market participants, the
concentration of these activities at a covered clearing agency
implicitly exposes market participants to the risks faced by covered
clearing agencies themselves, making risk management at covered
clearing agencies a key element of systemic risk mitigation.
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    \654\ Cf. PFMI Report, supra note 1, at 9.
---------------------------------------------------------------------------

b. Discretion
    The Commission recognizes that the degree of discretion permitted
by the proposed rules partially determines their economic effect. Even
where current practices at covered clearing agencies would not need to
change significantly to comply with the proposed rules, covered
clearing agencies could still potentially face costs associated with
the limitations on discretion that will result from the proposed rules,
including costs related to limiting a clearing agency's flexibility to
respond to changing economic environments. For example, to the extent
that covered clearing agencies currently in compliance with the
proposed rules value the ability to periodically allow net liquid
assets to drop below the minimum level specified by the proposed rules,
they may incur additional costs because under the proposed rules they
lose the option to do so.
    Although there may be costs to limiting the degree of discretion
covered clearing agencies have over risk management policies and
procedures, the Commission preliminarily believes there are also
potential benefits. As discussed above, clearing agencies may not fully
internalize the social costs of poor internal controls and thus, given
additional discretion, may not craft appropriate risk management
policies and procedures. For example, even if existing regulation
provides clearing agencies with the incentives necessary to manage
risks appropriately in a static sense, they may not provide clearing
agencies with incentives to update their risk management programs in
response to dynamic market conditions. Additionally, efforts at cost
reduction or profit maximization could encourage clearing agencies to
reduce the quality of risk management by, for example, choosing to
update parameters and assumptions rapidly in periods of low volatility
while maintaining stale parameters and assumptions in periods of high
volatility. By reducing covered clearing agencies' discretion over
their policies and procedures, the proposed amendments to Rule 17Ad-22
may reduce the likelihood that risk management practices lag behind
changing market conditions by requiring periodic analysis of model
performance while paying particular attention to periods of high
volatility or low liquidity.
    Subjecting covered clearing agencies to more specific requirements
may have other benefits for cleared markets as well. Recent academic
research has explored the ways in which regulation affects liquidity in
financial markets when participants are ``ambiguity averse,'' where
ambiguity is defined as uncertainty over the set of payoff
distributions for an asset.\655\ Such investors may heavily weigh
worst-case scenarios when they decide whether to hold the asset. The
Commission preliminarily believes that regulation aimed at enhancing
standards for covered clearing agencies while reducing their discretion
may reduce the ambiguity associated with holding cleared assets in the
presence of credit risk and settlement risk \656\ and thus may allow
investors to rule out worst-case states of the world. In this regard,
more specific rules may encourage participation in cleared markets by
investors that benefit from resulting risk-sharing opportunities.\657\
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    \655\ See e.g., Itzhak Gilboa & David Schmeidler, Maxmin
Expected Utility with Non-Unique Prior, 18 J. Mathematical Econ. 141
(1989) (proposing an axiomatic foundation of a decision rule based
on maximizing expected minimum payoff of a strategy).
    \656\ Specifically, by performing key roles in the transaction
process, clearing agencies serve to maintain higher minimum payoffs
in poor states of the world, by, for example, immobilizing
securities or adopting DVP systems.
    \657\ See e.g., David Easley & Maureen O'Hara, Microstructure
and Ambiguity, 65 J. Fin. 1817 (2010) (using a theoretical model of
trade on venues that differ in rules, the authors show how rules
that reduce market-related ambiguity may induce a participatory
equilibrium).
---------------------------------------------------------------------------

c. Market Integrity
    The Commission preliminarily believes that the proposed amendments
to Rule 17Ad-22 could provide the benefit of reduced potential for
market fragmentation that may arise from different requirements across
regulatory regimes. These benefits would flow to markets that are also
supervised by the Board and the CFTC, and internationally, since
cleared markets are global in nature and linked to one another through
common participants.
    Based on its consultation and coordination with other regulators,
the Commission preliminarily believes its proposal is consistent and
comparable, where possible and appropriate, with the rules and policy
statement proposed by the Board and the rules adopted by the CFTC. The
Board's proposed revisions to its PSR Policy incorporate only the
headline principles contained in the PFMI Report and are consistent
with the Commission's approach in proposed Rule 17Ad-22(e).\658\
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    \658\ The Commission preliminarily notes that the Commission's
proposal provides a greater level detail than the proposed PSR
Policy and is tailored to take into account considerations
particular to covered clearing agencies, consistent with the
Commission's role as the supervisory agency under the Clearing
Supervision Act. The Commission further notes that, in contrast to
the Board's PSR Policy, proposed Rule 17Ad-22(e) would constitute an
enforceable federal regulation if adopted. See proposed PSR Policy,
supra note 53, at 2841 (distinguishing the legal effect of proposed
Reg. HH from the proposed PSR Policy).
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    With respect to the rules proposed by the Board and adopted by the
CFTC, in

many instances the rules proposed by the Commission are consistent with
these regulatory provisions, as each of the three rule sets are
intended to be consistent with the headline principles contained in the
PFMI Report,\659\ but the Commission's proposals differ from those
requirements proposed by the Board and adopted by the CFTC in terms of
the specific portions of the key considerations and explanatory text
contained in the PFMI Report that are, or are not, referenced or
emphasized. In some cases, the Commission is proposing more specific
requirements than those proposed by the Board or adopted the CFTC, and,
in others, it is proposing rules with fewer additional specific
requirements.
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    \659\ For example, the Commission preliminarily believes that
proposed Rule 17Ad-22(e)(23), requiring disclosure of rules, key
procedures, and market data, contains the same substantive
requirements as rules proposed by the Board and adopted by the CFTC.
See proposed Reg. HH, supra note 53, at 3686-88, 3693 (the Board
proposing Sec. 234.3(a)(23)); DCO Int'l Standards Release, supra
note 53, at 72493-94, 72521 (CFTC adopting Sec. 39.37).
    In this case, the Commission notes that regulators have taken
slightly different approaches to achieving disclosure of rules, key
procedures, and market data. The CFTC requires disclosure through
the CPSS-IOSCO Disclosure Framework. See DCO Int'l Standards
Release, supra note 53, at 72493-94, 72521 (CFTC adopting Sec.
39.37(a)); see also CPSS-IOSCO, Disclosure Framework for Financial
Market Infrastructures (Apr. 2012), available at http://www.bis.org/publ/cpss101c.pdf. The Commission and the Board have proposed to
require disclosure through a comprehensive public disclosure set
forth in their proposed rules. The Commission preliminarily
believes, however, that the three disclosure regimes impose the same
substantive requirements.
---------------------------------------------------------------------------

    The following discussion provides examples of proposed rule
provisions that are representative of the differences between the
Commission's proposal and the Board's proposal and the CFTC's final
rules, where the Commission is proposing more detailed requirements
than those proposed by the Board or adopted by the CFTC:
     In proposing Rule 17Ad-22(e)(4), the Commission would
explicitly permit a covered clearing agency's policies and procedures
to be reasonably designed to maintain financial resources either in
combined or separately maintained clearing or default funds. Rules
proposed by the Board and adopted by the CFTC do not include a
comparable provision. The Commission preliminarily believes this
requirement is appropriate because permitting a covered clearing agency
to maintain a separate default fund for purposes of complying with
proposed Rules 17Ad-22(e)(4)(ii) and (iii) increases the range of
options available to covered clearing agencies when complying with this
requirement and, when used appropriately, will allow a covered clearing
agency to distribute the costs and responsibilities of clearing
membership more equitably among clearing members.
     In proposing Rule 17Ad-22(e)(7), the Commission would
permit a covered clearing agency's policies and procedures to include
as qualifying liquid resources (i) assets that are readily available
and convertible into cash through prearranged funding arrangements
determined to be highly reliable even in extreme but plausible market
conditions by the board of directors of the covered clearing agency,
following a review conducted for this purpose not less than annually,
and (ii) other assets that are readily available and eligible for
pledging to a relevant central bank, if the covered clearing agency has
access to routine credit at such central bank that permits said pledges
or other transactions by the covered clearing agency. Rules proposed by
the Board do not include a provision comparable to either of these two
proposed requirements, and rules adopted by the CFTC do not include a
provision including as qualifying liquid resources assets readily
available and eligible for pledging to a central bank.\660\
---------------------------------------------------------------------------

    \660\ See proposed Reg. HH, supra note 53, at 3677-78, 3691 (the
Board proposing Sec. 234.3(a)(7)); DCO Int'l Standards Release,
supra note 53, at 72487-91, 72518 (CFTC adopting Sec. 39.33(c)).
---------------------------------------------------------------------------

    The Commission preliminarily believes this requirement is
appropriate given the specific circumstances of the U.S. securities
markets. U.S. securities markets are among the largest and most liquid
in the world, and CCPs operating in the United States are also among
the largest in the world. The resulting peak liquidity demands of CCPs
are therefore proportionately large on both an individual and an
aggregate basis, and the ability of CCPs to satisfy a requirement
limiting qualifying liquid resources to committed facilities could be
constrained by the capacity of traditional liquidity sources in the
U.S. banking sector in certain circumstances. The Commission
preliminarily believes that limiting the funding arrangements that are
included within the definition of qualifying liquid resources to
committed funding arrangements is not appropriate in the case of the
U.S. securities markets and expanding the concept of qualifying liquid
resources to include other highly reliable funding arrangements is
necessary and appropriate to ensure the proper functioning of covered
clearing agencies under the Exchange Act. For similar reasons, the
Commission preliminarily believes it is appropriate to include in the
definition of qualifying liquid resources assets that a central bank
would permit a covered clearing agency to use as collateral, to the
extent such covered clearing agency has access to routine credit at
such central bank.
     In proposing Rule 17Ad-22(e)(13), the Commission would
explicitly require a covered clearing agency's policies and procedures
to be reasonably designed to ensure that the covered clearing agency
has the authority and operational capacity to contain losses and
liquidity demands in a timely manner and to continue to meet its
obligations by, among other things, addressing the allocation of credit
losses the covered clearing agency may face. Rules proposed by the
Board and adopted by the CFTC do not include a comparable provision to
address the allocation of credit losses.\661\ The Commission
preliminarily believes this requirement is appropriate to help ensure
that credit losses a covered clearing agency may reasonably be expected
to experience are capable of allocation through pre-established
practices of the covered clearing agency. The proposed rule would also
facilitate the orderly handling of member defaults and provide
certainty and transparency by enabling members to understand their
obligations to the covered clearing agency in extreme circumstances ex
ante.
---------------------------------------------------------------------------

    \661\ See 17 CFR 39.16; proposed Reg. HH, supra note 53, at
3680-81, 3692 (the Board proposing Sec. 234.3(a)(13)); see also DCO
Principles Release, supra note 53, at 69395-97, 69442 (CFTC adopting
Sec. 39.16).
---------------------------------------------------------------------------

     In proposing Rule 17Ad-22(e)(18), the Commission would
explicitly require a covered clearing agency's policies and procedures
to be reasonably designed to require monitoring of compliance with
access and participation requirements. Rules proposed by the Board and
adopted by the CFTC do not include a comparable provision. The
Commission preliminarily believes this requirement is consistent with
Exchange Act provisions requiring registered clearing agencies to have
rules designed to not permit unfair discrimination in the admission of
participants because it helps ensure that a covered clearing agency
complies with its own membership requirements.
     In proposing Rule 17Ad-22(e)(19), the Commission would
explicitly require a covered clearing agency's policies and procedures
to be reasonably designed to require regular review of its tiered
participation arrangements. Rules proposed by the Board and adopted by
the CFTC do not include a comparable provision. The

Commission preliminarily believes this requirement is consistent with
Exchange Act provisions requiring registered clearing agencies to have
rules designed to not permit unfair discrimination in the admission of
participants because it helps ensure that a covered clearing agency
periodically reconsiders whether in practice its membership
requirements may result in either an inappropriately broad or narrow
membership.
    The following discussion provides examples of proposed rule
provisions that are representative of the differences between the
Commission's proposal and the Board's proposal and the CFTC's final
rules, where the Commission is proposing requirements that are more
general than those proposed by the Board or adopted by the CFTC:
     In proposing Rule 17Ad-22(e)(2), the Commission would not
require a covered clearing agency's policies and procedures to be
reasonably designed to include requirements for disclosure of board
decisions, review of the performance of the board of directors and
individual directors, documentation and disclosure of governance
arrangements, procedures for managing conflicts of interests involving
board members, and oversight of the risk function. Rules adopted by the
CFTC include such requirements.\662\ The Commission preliminarily
believes that such requirements would in part be duplicative of
existing Exchange Act requirements applicable to covered clearing
agencies grounded in the broad definition of the term ``rules of a
clearing agency'' in Section 3(a)(27) of the Exchange Act,\663\ and
otherwise have been contemplated by the Commission's proposed
Regulation MC.\664\ Accordingly any further requirements in this
respect would be considered by the Commission separately.
---------------------------------------------------------------------------

    \662\ See DCO Int'l Standards Release, supra note 53, at 72480-
81, 72515 (CFTC adopting Sec. 39.30).
    \663\ See 15 U.S.C. 78c(a)(27).
    \664\ See supra note 111 (discussing rules for governance
arrangements proposed by the Commission to, among other things,
mitigate conflicts of interest at registered clearing agencies that
provide CCP services for security-based swaps).
---------------------------------------------------------------------------

     In proposing Rules 17Ad-22(e)(4) and (e)(7), the
Commission would not require a covered clearing agency's policies and
procedures for stress testing its financial resources and liquid
resources, respectively, to cover specific stress scenarios, as rules
adopted by the CFTC do.\665\ The Commission preliminarily believes it
is appropriate to provide discretion to the covered clearing agencies
to identify the stress scenarios most appropriate for their needs given
their status as SROs subject to the Commission's oversight, and to rely
upon other tools available to the Commission through its supervisory
and examination programs to ensure the responsibilities of covered
clearing agencies in this regard are fulfilled.
---------------------------------------------------------------------------

    \665\ See DCO Int'l Standards Release, supra note 53, at 72492-
93, 72520 (CFTC adopting Sec. 39.36(c)).
---------------------------------------------------------------------------

     In proposing Rule 17Ad-22(e)(5), the Commission would not
specifically require, as the CFTC does in its rules, a covered clearing
agency's policies and procedures to be reasonably designed to (i)
establish prudent valuation practices and develop haircuts that are
tested regularly and take into account stressed market conditions
(including to reduce the need for procyclical adjustments); (ii) avoid
concentrated holdings of certain assets where it could significantly
impair the ability to liquidate such assets quickly without significant
adverse price effects; and (iii) use a collateral management system
that is well designed and operationally flexible, such that it, among
other things, accommodates changes in the ongoing monitoring and
management of collateral; and (iv) allow for the timely valuation of
collateral and execution of any collateral or margin calls.\666\ While
the Commission preliminarily agrees that these requirements may
facilitate prudent practices, the Commission preliminarily observes
that consideration of these practices would fall within the general
responsibilities of a covered clearing agency and its board of
directors. The Commission therefore preliminarily believes that
proposed Rule 17Ad-22(e)(5) strikes the appropriate balance in
establishing policies and procedures requirements with respect to
collateral management.
---------------------------------------------------------------------------

    \666\ See 17 CFR 39.11, 39.13; see also DCO Principles Release,
supra note 53 (CFTC adopting Secs. 39.11 and 39.13).
---------------------------------------------------------------------------

     In proposing Rule 17Ad-22(e)(6), the Commission also would
not require a covered clearing agency's policies and procedures to be
reasonably designed to determine the appropriate historic time period
for the margin methodology based on the characteristics of each
product, spread, account, or portfolio or to require specifying minimum
liquidation periods for different types of derivatives. Rules adopted
by the CFTC include such requirements.\667\ While the Commission
preliminarily agrees that these requirements may facilitate prudent
practices, the Commission preliminarily observes that consideration of
these practices would fall within the general responsibilities of a
covered clearing agency and its board of directors. The Commission
therefore preliminarily believes that proposed Rule 17Ad-22(e)(6)
strikes the appropriate balance in establishing policies and procedures
requirements with respect to risk management.
---------------------------------------------------------------------------

    \667\ See 17 CFR 39.13(g)(2); see also DCO Principles Release,
supra note 53, at 69364-79, 69438 (CFTC adopting Sec. 39.13(g)(2)).
---------------------------------------------------------------------------

    These differences between the Commission's proposal and the Board's
proposed rules and the CFTC's final rules are provided here as examples
of the differences observed between the respective rule sets and do not
constitute an exhaustive list. In preliminarily formulating the
specific requirements of the proposed rules in furtherance of Section
17A of the Exchange Act, the Commission was guided by its experience in
supervising registered clearing agencies, including through the SRO
rule filing process under Section 19(b) of the Exchange Act and Rule
19b-4, periodic inspections and examinations, and other monitoring of
the activities of registered clearing agencies.\668\ The Commission
also took into account the particular circumstances of the U.S.
securities markets, including but not limited to business models of and
current practices at covered clearing agencies, characteristics of the
products cleared, the nature of the covered clearing agencies'
participant base, and other factors. The Commission preliminarily
believes the differences between its proposal and the Board's proposed
rules and the CFTC's final rules are appropriate for the reasons noted
above. The Commission further preliminarily notes that some of the
differences between the Commission's proposal and the CFTC's final
rules is attributable to differences between the scope of the
Commission's and the CFTC's regulatory authority.\669\
---------------------------------------------------------------------------

    \668\ See supra Part 0 and note 96 (describing the Commission's
framework for regulation of SROs and the SRO rule filing process).
    \669\ For example, the Commission is proposing Rules 17Ad-
22(e)(11) and (12) to establish requirements for covered clearing
agencies that provide CSD services and for exchange-of-value
settlement systems. See supra Parts 0-0 and infra Part 0 (discussing
the proposed rules and providing rule text, respectively). The CFTC
has not proposed comparable rules because CSDs and securities
settlement systems do not fall within the scope of its regulatory
authority.
---------------------------------------------------------------------------

    Further, CPSS-IOSCO members are also in various stages of
implementing the standards set forth in the PFMI Report into their own
regulatory regimes, and the Commission preliminarily believes that
proposing a set of requirements generally consistent with the relevant
international standards would result in diminished likelihood that
participants in cleared markets would restructure and operate

in less-regulated markets.\670\ Additionally, international standards
such as the Basel III framework could create complications for U.S.
clearing agencies not subject to regulations based on the standards set
in the PFMI Report as a result of the Basel III framework's treatment
of QCCPs. In particular, if U.S. clearing agencies do not obtain QCCP
status from foreign banking regulators who have adopted rules
conforming to the Basel III framework because, for instance, the
regulatory framework is not consistent with the standards set forth in
the PFMI Report, foreign bank members of U.S. clearing agencies may
have incentives to move their clearing business to clearing agencies in
jurisdictions where they might obtain lower capital requirements under
the Basel III framework.\671\
---------------------------------------------------------------------------

    \670\ See supra note 53 (citing the Board's proposal and the
CFTC's final rules).
    \671\ See supra note 48 and infra Part 0 (discussing the Basel
III capital requirements and the economic effect of QCCP status
under the Basel III capital requirements, respectively).
---------------------------------------------------------------------------

    Failure to maintain consistency with other regulators may disrupt
cleared markets in a number of ways. Significant differences across
regulatory regimes may encourage participants to restructure their
operations in order to avoid a particular regulatory regime.\672\ Such
differences may reduce the liquidity of cleared products in certain
markets if they result in an undersupply of clearing services. Further,
inconsistency in regulation across jurisdictions may increase the
likelihood that restructuring by market participants in response such
inconsistency results in concentrating clearing activity in regimes
with a weaker commitment to policies and procedures for sound risk
management.
---------------------------------------------------------------------------

    \672\ See, e.g., Arnoud W.A. Boot, Silva Dez[otilde]elan, & Todd
T. Milbourn, Regulatory Distortions in a Competitive Financial
Services Industry, 16 J. Fin. Serv. Res. 249 (2000) (showing that,
in a simple industrial organization model of bank lending, a change
in the cost of capital resulting from regulation results in a
greater loss of profits when regulated banks face competition from
non-regulated banks than when regulations apply equally to all
competitors); Victor Fleischer, Regulatory Arbitrage, 89 Tex. L.
Rev. 227 (2010) (discussing how, when certain firms are able to
choose their regulatory structure, regulatory costs are shifted onto
those entities that cannot engage in regulatory arbitrage).
---------------------------------------------------------------------------

    In the case of clearing agency standards, there are additional
motivations for consistency with other regulatory requirements. The
Commission preliminarily believes that such consistency would prevent
the application of inconsistent regulatory burdens and thereby reduce
the likelihood that participants in cleared markets would restructure
and operate in less-regulated markets. Additionally, such consistency
would allow foreign bank clearing members and foreign bank customers of
clearing members of covered clearing agencies to be subject to lower
capital requirements under the Basel III framework.\673\
---------------------------------------------------------------------------

    \673\ See Basel III capital requirements, supra note 48.
---------------------------------------------------------------------------

d. Concentration
    The economic effects associated with the proposed rules may also be
partially determined by the economic characteristics of clearing
agencies. Generally, the economic characteristics of FMIs, including
clearing agencies, include specialization, economies of scale, barriers
to entry, and a limited number of competitors.\674\ Such
characteristics, coupled with the particulars of an FMI's legal
mandate, could result in market power, leading to lower levels of
service, higher prices, and under-investment in risk management
systems.\675\
---------------------------------------------------------------------------

    \674\ See supra note 49 (defining ``financial market
infrastructure'').
    \675\ Cf. PFMI Report, supra note 1, at 11.
---------------------------------------------------------------------------

    The centralization of clearing activities in a relatively small
number of clearing agencies somewhat insulated from market forces may
result in a reduction in their incentives to innovate and to invest in
the development of appropriate risk management practices on an ongoing
basis, particularly when combined with the cost reduction pressures
noted above in Part IV.A.\676\ However, the Commission notes that the
inverse may not necessarily hold. In other words, additional
competition in the market for clearing services may not necessarily
result in improved risk management. For instance, aggressive price-
cutting in a ``race to the bottom'' may result in clearing agencies
accepting lower-quality collateral, requiring lower margin and default
fund contributions, lowering access requirements, or holding lower
reserves, potentially undermining their risk management efforts.\677\
---------------------------------------------------------------------------

    \676\ Kenneth J. Arrow, Economic Welfare and the Allocation of
Resources for Invention 609-626, in The Rate and Direction of
Inventive Activity: Economic and Social Factors (NBER, 1962),
available at http://www.nber.org/chapters/c2144.pdf.
    \677\ See CPSS, Market Structure Development in the Clearing
Industry: Implications for Financial Stability, at sec. 5 (Nov.
2010), available at http://www.bis.org/publ/cpss92.pdf; see also
Siyi Zhu, Is There a `Race to the Bottom' in Central Counterparties
Competition?--Evidence from LCH.Clearnet SA, EMCF and EuroCCP, DNB
Occasional Studies, Vol. 9, No. 6 (2011); John Kiff et al., Credit
Derivatives: Systemic Risks and Policy Options (IMF Working Paper
No. 254, Nov. 2009), available at http://www.imf.org/external/pubs/ft/wp/2009/wp09254.pdf.
---------------------------------------------------------------------------

    Market power may raise particular issues with respect to the
allocation of benefits and costs flowing from these proposed rules and
precipitate changes in the structure of the financial networks that are
served by covered clearing agencies. For example, as a result of
limited competition,\678\ existing covered clearing agencies may easily
pass the incremental costs associated with enhanced standards on to
their members, who may share these costs with their customers,
potentially resulting in increased transaction costs in cleared
securities.
---------------------------------------------------------------------------

    \678\ See generally Nadia Linciano, Giovanni Siciliano &
Gianfranco Trovatore, The Clearing and Settlement Industry:
Structure Competition and Regulatory Issues (Italian Secs. & Exch.
Comm'n Research Paper 58, May 2005), available at http://www.ssrn.com/abstract=777508 (concluding in part that the core
services offered by the clearance and settlement industry tend
toward natural monopolies because the industry can be characterized
as a network industry, where consumers buy systems rather than
single goods, consumption externalities exist, costs lock-in
consumers once they choose a system, and production improves with
economies of scale); Heiko Schmiedel, Markku Malkam[auml]ki & Juha
Tarkka, Economies of Scale and Technological Development in
Securities Depository and Settlement Systems, at 10 (Bank of Fin.
Discussion Paper 26, Oct. 2002), available at http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0226.pdf (``The overall results of this study reveal the
existence of substantial economies of scale among depository and
settlement institutions. On average, the centralized U.S. system is
found to be the most cost effective settlement system and may act as
the cost saving benchmark.'').
---------------------------------------------------------------------------

    If incremental increases in costs lead clearing agencies to charge
higher prices for their services, then certain clearing members may
choose to terminate membership and cease to clear transactions for
their customers. Should this occur the result may be further
concentration among clearing members, where each remaining member
clears a higher volume of transactions. In this case, clearing agencies
and the financial markets they serve would be more exposed to these
larger clearing members. These remaining clearing members may, however,
each internalize more of the costs their activity in cleared markets
imposes on the financial system.
    The increased importance of a small set of clearing members, in
turn, may result in firms not previously systemically important
increasing in systemic importance. This is particularly true for
clearing members that participate in multiple markets, both cleared and
not cleared.\679\ However, adequate regulation of capital levels and
margin amounts at surviving clearing members could mean that, though
shocks to these members may be

larger, the propagation of shocks may be limited to a smaller set of
entities and their equity holders.
---------------------------------------------------------------------------

    \679\ See, e.g., Roe, supra note 172 (arguing that counterparty
risk concentrated within CCPs may be transferred to the broader
financial system through links between clearing members and their
clients).
---------------------------------------------------------------------------

e. Qualifying CCP Status and Externalities on Clearing Members
    An effect of the proposed amendments to Rule 17Ad-22 is that
covered clearing agencies required to comply with the proposed rules
may be more likely to qualify as QCCPs in non-U.S. jurisdictions that
have adopted the Basel III framework's QCCP definition. Under the Basel
III framework, a QCCP is defined as an entity operating as a CCP that
is prudentially supervised in a jurisdiction where the relevant
regulator has established, and publicly indicated that it applies to
the CCP on an ongoing basis, domestic rules and regulations that are
consistent with the standards set forth in the PFMI Report.\680\
Because the proposed amendments to Rule 17Ad-22 are intended to be in
line with the standards set forth in the PFMI Report, the Commission
preliminarily believes that foreign bank clearing members of certain
covered clearing agencies and foreign banks clearing indirectly through
clearing members of covered clearing agencies may benefit from covered
clearing agencies obtaining QCCP status. In particular, bank clearing
members and bank indirect participants of covered clearing agencies
that could attain QCCP status would face lower capital requirements
with respect to cleared derivatives and repurchase agreement
transactions because, under the Basel III framework, capital
requirements for bank exposures to QCCPs are lower than capital
requirements for bank exposures to non-qualifying CCPs for these
products. Although the Board and the Office of the Comptroller of the
Currency have already adopted rules implementing the Basel III capital
requirements that would identify all covered clearing agencies (with
the exception of ICEEU) as QCCPs for the purposes of applying risk
weights to assets at U.S. banks,\681\ the proposed amendments to Rule
17Ad-22 may result in non-U.S. bank clearing members experiencing lower
capital requirements related to exposures against covered clearing
agencies relative to a baseline scenario in which foreign banking
regulators do not determine that a covered clearing agency is a
QCCP.\682\
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    \680\ See supra note 48 (discussing the Basel III capital
requirements).
    \681\ See infra Part 0.
    \682\ The Commission notes that benefits to banks that may arise
as a result of the proposed rules may be contingent upon regulators
in other jurisdictions taking action to recognize the QCCP status of
covered clearing agencies.
---------------------------------------------------------------------------

    The Basel III framework affects capital requirements for bank
exposures to central counterparties in two important ways. The first
relates to trade exposures, defined under the Basel III capital
requirements as the current and potential future exposure of a clearing
member or indirect participant in a CCP arising from OTC derivatives,
exchange-traded derivatives transactions, and securities financing
transactions. If these exposures are held against a QCCP, they will be
assigned a risk weight of 2%. In contrast, exposures against non-
qualifying CCPs do not receive lower capital requirements relative to
bilateral exposures and are assigned risk weights between 20% and 100%,
depending on counterparty credit risk. Second, the Basel III capital
requirements impose a cap on risk weights applied to default fund
contributions, limiting risk-weighted assets (subject to a 1250% risk
weight) to a cap of 20% of a clearing member's trade exposures against
a QCCP. This is in contrast to treatment of exposures against non-
qualifying CCPs, which are uncapped and subject to a 1250% risk weight.
Because QCCP status generally impacts capital treatment, any benefits
of attaining QCCP status will likely accrue, at least in part, to
foreign clearing members or foreign indirect participants subject to
the Basel III capital requirements.\683\ As a result of lower risk
weights applied to exposures and a cap on capital requirements against
default fund obligations, clearing members of QCCPs subject to Basel
III capital requirements may experience an improved capital position
relative to bank members of non-QCCPs. This may lower the costs of debt
capital for bank members of QCCPs.\684\
---------------------------------------------------------------------------

    \683\ For a discussion of the effects of QCCP status on
competition between bank and non-bank clearing members, see Part 0.
    \684\ See supra note 593 (noting that the Commission currently
expects the lower capital treatment under the Basel III framework to
affect registered clearing agencies FICC, ICEEU, and OCC, each of
which would meet the definition of a ``covered clearing agency''
under the proposed rules).
---------------------------------------------------------------------------

    Non-U.S. banks that are constrained by Basel III tier one capital
requirements would face a shock to risk-weighted assets once capital
rules come into force.\685\ The size of the shock depends on
regulators' determinations with regard to QCCP status. Regardless of
the size of the shock and in order to come into compliance with capital
rules, however, affected banks will have to raise capital or reduce
leverage. In the absence of perfect markets, these banks may incur
ongoing costs as a result.
---------------------------------------------------------------------------

    \685\ As discussed above, the Board and Office of Comptroller of
the Currency have adopted rules implementing capital requirements
under Basel III that make capital treatment for exposures to CCPs
independent of the proposed rules for U.S. banks regulated by these
two agencies, and therefore the Commission preliminarily believes no
benefits would accrue to U.S. bank clearing members of FICC and OCC.
---------------------------------------------------------------------------

    In quantifying the benefits of achieving QCCP status, the
Commission based its estimate on publicly available information with
regard to OCC.\686\ To estimate the upper bound for the potential
benefits accruing to bank clearing members at OCC as a result of QCCP
status, the Commission identified a sample of 20 bank clearing members
at OCC and, for each bank, collected information about total assets,
risk weighted assets, net income and tier one capital ratio at the
holding company level for 2012.\687\ The Commission then allocated
trade exposures and default fund exposures across the sample of bank
clearing members based on the level of risk-weighted assets.\688\ The
Commission measured the impact on risk-weighted assets for non-U.S.
bank clearing members under two different capital treatment regimes.
The first regime is in the absence of QCCP status, assuming a 100% risk
weight applied to trade exposures and 1250% risk weight applied to
default fund exposures for non-U.S. members. In the second regime, OCC
obtains QCCP status, and banks are allowed to apply a 2% risk

weight applied to trade exposures and a 1250% risk weight to default
fund exposures up to a total exposure cap of 20% of trade
exposures.\689\ If OCC is determined to be a QCCP, then the increase in
risk weighted assets will be smaller in magnitude, implying a smaller
adjustment at lower cost. The Commission preliminarily estimates that
benefits associated with OCC obtaining QCCP status stemming from lower
capital requirements against trade exposures to QCCPs as a result of
the proposed rules to have an upper bound of $600 million per year, or
approximately 0.60% of the total 2012 net income reported by bank
clearing members at OCC.
---------------------------------------------------------------------------

    \686\ Under the Basel III framework ICCEU and FICC's repurchase
agreement segment would also be eligible for QCCP status. However,
FICC does not report counterparties to repo agreements, and ICEEU
does not separately report exposures related to security-based swap
clearing, so we are currently unable to quantify potential benefits
related to QCCP status for these entities.
    \687\ The Commission used the set of entities it identified as
banks on OCC's member list, available at http://www.optionsclearing.com/membership/member-information/. For U.S.
bank holding companies, 2012 total assets, risk weighted assets, net
income, and tier 1 capital ratios were collected from Y-9C reports
available at the National Information Center, http://www.ffiec.gov/nicpubweb/nicweb/nichome.aspx. For non-U.S. bank holding companies,
Commission staff obtained corresponding data from financial
statements and supplementary financial materials posted to bank Web
sites. Where necessary, values were converted back to U.S. dollars
at appropriate exchange rates obtained from Thomson Reuters
Datastream and the Federal Reserve, http://www.federalreserve.gov/releases/h10/hist/.
    \688\ For example, one bank in the sample, with 6.25% of total
risk-weighted assets, was assigned 6.25% of the total trade and
default fund exposures while another bank in the sample, with 3.43%
of total risk weighted assets, was assigned 3.43% of these
exposures. Because trade exposures of OCC members against OCC are
nonpublic, the Commission used the balance of OCC margin deposits
and deposits in lieu of margin held at OCC, $57.48 billion, as a
proxy for trade exposures. OCC's 2012 clearing fund deposits were
valued at $2.66 billion. See OCC, 2012 Annual Report, available at
http://www.optionsclearing.com/components/docs/about/annual-reports/occ_2012_annual_report.pdf.
    \689\ The Basel III framework allows banks to compute default
fund exposures in two ways. Method 1 involves computing capital
requirements for each member proportional to its share of an
aggregate capital requirement for all clearing members in a scenario
where to average clearing members default. The Commission currently
lacks data necessary to compute default fund exposures under this
approach, instead we use Method 2, which caps overall exposure to a
QCCP at 20% of trade exposures. See Basel III framework, supra note
48, Annex 4, paras. 121-25 (outlining two methods for computing
default fund exposures).
---------------------------------------------------------------------------

    The Commission's analysis is limited in several respects and relies
on several assumptions. First, a limitation of our proxy for trade
exposures and our use of OCC's clearing fund is that the account
balances include deposits by bank clearing members, who would
experience lower capital requirements under the Basel III framework,
and non-bank clearing members who would not. The Commission
preliminarily assumes, for the purposes of establishing an upper bound
for the benefits to market participants that are associated with QCCP
status for OCC under the proposed rules, that the balance of both OCC's
margin account and OCC's default fund are attributable only to bank
clearing members. Additionally, we assume an extreme case where, in the
absence of QCCP status, trade exposures against a CCP would be assigned
a 100% risk weight, causing the largest possible shock to risk-weighted
assets for affected banks.
    Concluding that lower capital requirements on trade exposures to
OCC would produce effects in the real economy also requires that
certain conditions exist. Agency problems, taxes, or other capital
market imperfections could result in banks targeting a particular
capital structure. Further, capital constraints on bank clearing
members subject to the Basel III framework should bind so that higher
capital requirements on bank clearing members subject to the Basel III
framework in the absence of QCCP status would cause these banks to
exceed capital constraints if they chose to redistribute capital to
shareholders or invest capital in projects with returns that exceed
their cost of capital. Using publically available data, however, it is
not currently possible to determine whether capital constraints will
bind for bank clearing members when rules applying Basel III capital
requirements come into force, so to estimate an upper bound for the
effects of QCCP status on bank clearing members we assume that tier one
capital constraints for all bank clearing members of OCC would bind in
an environment with zero weight placed on bank exposures to CCPs.\690\
---------------------------------------------------------------------------

    \690\ The Commission notes that, at present, no bank in its
sample of bank clearing members of OCC is bound by capital
requirements under the Basel III framework. Bank holding company
risk-weighted assets, adjusted total assets, and capital ratio data
have been taken from http://www2.fdic.gov/SDI/. The Commission used
data from 2009-2012 for its sample of bank clearing members and
assumed no bank-specific countercyclical capital buffers for these
banks. This suggests a minimum tier 1 capital ratio of 9.6%,
exceeding the Basel III minimum by 1.1%. The same analysis suggests
a minimum total capital ratio of 12.3%, exceeding the Basel III
minimum by 1.8%.
---------------------------------------------------------------------------

    For the purposes of quantifying potential benefits from QCCP
status, the Commission has also assumed that banks choose to adjust to
new capital requirements by deleveraging. In particular, the Commission
assumed that banks would respond by reducing risk-weighted assets
equally across all risk classes until they reach the minimum tier one
capital ratio under the Basel framework of 8.5%. We measure the ongoing
costs to each non-U.S. bank by multiplying the implied change in total
assets by each bank's return on assets, estimated using up to 12 years
of annual financial statement data.\691\
---------------------------------------------------------------------------

    \691\ This data has been taken from Compustat. Due to data
limitations, for certain banks a shorter window was used for this
calculation. The minimum sample window was nine years.
---------------------------------------------------------------------------

    The Basel III capital requirements for exposures to CCPs yield
additional benefits for QCCPs that the Commission is currently unable
to quantify due to lack of data concerning client clearing arrangements
by banks. For client exposures to clearing members, the Basel III
capital requirements allow participants to reflect the shorter close-
out period of cleared transactions in their capitalized exposures. The
Basel III framework's treatment of exposures to CCPs also applies to
client exposures to CCPs through clearing members. This may increase
the likelihood that bank clients of bank clearing members that are
subject to the Basel III capital requirements share some of the
benefits of QCCP status.
    Furthermore, the fact that the Basel III capital requirements apply
to bank clearing members may have important implications for
competition and concentration. While the proposed rules may extend
lower capital requirements against exposures to CCPs to non-U.S. bank
clearing members of covered clearing agencies,\692\ the benefits of
QCCP status will still be limited to bank clearing members. However,
the costs associated with compliance with the proposed rules may be
borne by all clearing members, regardless of whether or not they are
supervised as banks. A potential consequence of this allocation of
costs and benefits may be ``crowding out'' of members of QCCPs that are
not banks and will not experience benefits with respect to the Basel
III framework. This may result in an unintended consequence of
increased concentration of clearing activity among bank clearing
members. As noted in Part IV.C.1.d, this increased concentration could
mean that each remaining clearing member becomes more important from
the standpoint of systemic risk transmission.
---------------------------------------------------------------------------

    \692\ See supra note 599 and accompanying text (noting that
banks supervised by the Board and the Office of the Comptroller of
the Currency would treat covered clearing agencies as QCCPs for the
purposes of calculating regulatory capital ratios).
---------------------------------------------------------------------------

    In addition to benefits for bank clearing members, certain benefits
resulting from QCCP status may also accrue to covered clearing
agencies. If banks value lower capital requirements attributable to
QCCP status, bank clearing members may prefer membership at QCCPs to
membership at CCPs that are not QCCPs. A flight of clearing members
from covered clearing agencies in the absence of QCCP status would
result in default-related losses being mutualized across a narrower
member base. If the flight from covered clearing agencies results in
lower transactional volume at these clearing agencies, then economies
of scale may be lost, resulting in higher clearing fees and higher
transaction costs in cleared products.
2. Effect on Competition, Efficiency, and Capital Formation
    The proposed amendments to Rule 17Ad-22 and proposed Rule 17Ab2-2
have the potential to affect competition, efficiency, and capital
formation. As with the rest of the benefits and costs associated with
the proposed amendments to Rule 17Ad-22, the Commission preliminarily
believes that several of the effects described below only occur to the
extent that covered clearing agencies do not already have operations
and governance mechanisms

that conform to the requirements in proposed Rule 17Ad-22(e).
Additionally, the Commission preliminarily believes that consistency
with international regulatory frameworks, as embodied by the standards
set forth in the PFMI Report, which may promote the integrity of
cleared markets, could have substantial effects on competition,
efficiency, and capital formation.
a. Competition
    Two important characteristics of the market for clearance and
settlement services are high fixed costs and economies of scale. Large
investments in risk management and information technology
infrastructure costs, such as financial data database and network
maintenance expenses, are components of high fixed costs for clearing
agencies. Consequently, the clearance and settlement industry exhibits
economies of scale in that the average total cost per transaction,
which includes fixed costs, diminishes with the increase in transaction
volume as high fixed costs are spread over a larger number of
transactions.
    Furthermore, high fixed costs translate into barriers to entry that
preclude competition. Lower competition is an important source of
market power for clearing agencies. As a result, clearing agencies
possess the ability to exert market power and influence the fees
charged for clearance and settlement services in the markets they
serve.\693\ Any costs resulting from the proposed amendments may have
the effect of raising already high barriers to entry. As the potential
entry of new clearing agencies becomes more remote, existing clearing
agencies may be able to reduce service quality, restrict the supply of
services, or increase fees above marginal cost in an effort to earn
economic rents from participants in cleared markets.\694\
---------------------------------------------------------------------------

    \693\ See, e.g., Clearing Agency Standards Release, supra note
5, at 66263.
    \694\ See, e.g., Clearing Agency Standards Release, supra note
5, at 66263 n.481.
---------------------------------------------------------------------------

    Even if they could not take advantage of a marginal increase in
market power, clearing agencies may use their market power to pass any
increases in costs that flow from the proposed amendments to their
members. This may be especially true in the cases of member-owned
clearing agencies, such as DTC, FICC, NSCC, and OCC, where members lack
the opportunity to pass costs through to outside equity holders.
Allowing clearing members to serve on the board of directors of a
covered clearing agency may align a covered clearing agency's
incentives with its membership. Certain complications may also arise,
however, when clearing members sit on boards of covered clearing
agencies as members of the board and may choose to allocate the costs
of enhanced risk management inefficiently across potential competitors,
in an effort to reduce their own share of these costs.
    Members who are forced to internalize the costs of additional
requirements under the proposed rules may seek to terminate their
membership. Additionally, prospective clearing members may find it
difficult to join clearing agencies, given the additional costs they
must internalize.\695\ Remaining clearing members may gain market power
as a result, enabling them to extract economic rents from their
customers. Rent extraction could take the form of higher transaction
costs in cleared markets, thereby reducing efficiency, as discussed
below.
---------------------------------------------------------------------------

    \695\ See supra Part 0 (discussing concentration both in the
market for clearing services and among clearing members).
---------------------------------------------------------------------------

    The Commission also acknowledges that proposed Rule 17Ad-22(e)(19)
may affect competition among firms that choose to become clearing
members, and those who provide clearing services indirectly, through a
clearing member. Monitoring and managing the risks associated with
indirect participation in clearing may be costly. If monitoring and
managing the risks associated with indirect participation in clearing
proves costly for clearing agencies and if clearing agencies are able
to pass the additional costs related to monitoring and managing risks
to clearing members, it may cause marginal clearing members unable to
absorb these additional costs to exit. While these exits may be
socially efficient, since they reflect the internalization of costs
otherwise imposed upon other participants in cleared markets through
increased probability of clearing agency default, they may nevertheless
result in lower competition among clearing members for market share,
potentially providing additional market power to the clearing members
that remain.
    The Commission preliminarily believes, however, that management of
risks from indirect participation is important in mitigating the risks
that clearing agencies pose to financial stability. The tiered
participation risk exposures, including credit, liquidity, and
operational risks inherent in indirect participation arrangements, may
present risks to clearing agencies, their members, and to the broader
financial markets. For instance, if the size of an indirect
participant's positions is large relative to a clearing member's
capacity to absorb risks, this may increase the clearing member's
default risk. Consequently, a clearing agency with indirect
participation arrangements may be exposed to the credit risk of an
indirect participant through its clearing members. Similarly, a margin
call on, or a default by, an indirect participant could constrain
liquidity of its associated clearing members, making it more difficult
for these members to manage their positions at the clearing agency.
    The consistency across regulatory frameworks contemplated by the
proposed rules may also affect competition. Financial markets in
cleared products are global, encompassing many countries and regulatory
jurisdictions. Consistency with international regulatory frameworks may
facilitate entry of clearing agencies into new markets. By contrast,
conflicting or duplicative regulation across jurisdictions, or even
within jurisdictions, may cause competitive friction that inhibits
entry and helps clearing agencies behave like local monopolists.
Consistency in regulation can facilitate competition among clearing
agencies so long as regulation is not so costly as to discourage
participation in any market. Additionally, the Commission preliminarily
believes that proposed Rule 17Ad-22(e)(23) may facilitate competition
among clearing agencies across jurisdictions by requiring public
disclosures that enable market participants to compare clearing
agencies more easily.
    The consistency across regulatory requirements contemplated by the
proposed rules may affect competition among banks in particular.
Clearing derivative and repurchase agreement transactions through QCCPs
will result in lower capital requirements for banks under the Basel III
capital requirements. Therefore, consistency with the standards set
forth in the PFMI Report may allow banks that clear these products
through covered clearing agencies to compete on equal terms with banks
that clear through other clearing agencies accorded QCCP status. This
effect potentially countervails higher barriers to entry that enhanced
risk management standards may impose on clearing members by lowering
the marginal cost of clearing these transactions. Furthermore, covered
clearing agencies potentially compete with one another for volume from
clearing members. Since clearing members receive better treatment for
exposures against QCCPs, clearing

members will find it less costly to deal with QCCPs. Failure to
establish requirements consistent with the standards set forth in the
PFMI Report may place U.S. covered clearing agencies at a competitive
disadvantage globally.
    The ability of covered clearing agencies to obtain QCCP status may
also affect competition among clearing agencies. Under the Basel III
framework, QCCP status would have practical relevance only for covered
clearing agencies providing CCP services for derivatives, security-
based swaps, and securities financing transactions. To the extent that
the proposed rules increase the likelihood that banking regulators that
have implemented the Basel III framework in their jurisdiction
recognize covered clearing agencies as QCCPs, banks that clear at
covered clearing agencies will experience lower capital requirements.
Since clearing agencies may compete for volume from clearing members
that are also banks, the proposed rules may remove a competitive
friction between covered clearing agencies and other clearing agencies
that enjoy recognition as QCCPs by banking regulators. As a corollary,
the proposed rules could potentially disadvantage any registered
clearing agencies that are not covered clearing agencies.\696\ The
Commission also preliminarily notes that the ability of registered
clearing agencies to voluntarily apply for covered clearing agency
status under proposed Rule 17Ab2-2(a) may potentially allow entrants to
achieve QCCP status if the Commission determines they should receive
covered clearing agency status and they otherwise meet the requirements
of the Basel III framework.
---------------------------------------------------------------------------

    \696\ See supra note 593 (noting that the Commission currently
expects the lower capital treatment under the Basel III framework to
affect registered clearing agencies FICC, ICEEU, and OCC, each of
which would meet the definition of a ``covered clearing agency''
under the proposed rules).
---------------------------------------------------------------------------

    Further competitive effects may flow from the proposal as a result
of the determinations under proposed Rule 17Ab2-2 for clearing agencies
engaged in activities with a more complex risk profile and clearing
agencies that are systemically important in multiple jurisdictions.
These entities will be responsible for maintaining additional financial
resources sufficient to cover the default of the two participant
families that would potentially cause the largest aggregate credit
exposures in extreme but plausible market conditions as well as
undertake an annual feasibility analysis for extending liquidity risk
management from ``cover one'' to ``cover two.'' These clearing agencies
will have to collect these resources from participants, either through
higher margin requirements or guaranty fund contributions, or
indirectly through third-party borrowing arrangements secured by member
resources. Regardless of how clearing agencies obtain these additional
resources, the requirement to do so potentially raises the costs to use
services provided by covered clearing agencies which could, at the
margin, shift transactional volume to clearing agencies that fall
outside the scope determined by proposed Rule 17Ab2-2, where competing
clearing agencies exist, or opt out of clearing altogether.
b. Efficiency
    The proposed amendments to Rule 17Ad-22 may affect efficiency in a
number of ways, though as discussed previously, most of these effects
will only flow to the extent that covered clearing agencies do not
already comply with the proposed amendments. First, because the
proposed amendments result in general consistency with the standards
set forth in the PFMI Report and requirements proposed by the Board and
adopted by the CFTC, consistency likely fosters efficiency by reducing
the risk that covered clearing agencies will be faced with conflicting
or duplicative regulation when clearing financial products across
multiple regulatory jurisdictions.
    Consistency across regulatory regimes in multiple markets may also
result in efficiency improvements. Fully integrated markets would allow
clearing agencies to more easily exploit economies of scale because
clearing agencies tend to have low marginal costs and, thus, could
provide clearance and settlement services over a larger volume of
transactions at a lower average cost. Differences in regulation, on the
other hand, may result in market fragmentation, allowing clearing
agencies to operate as local monopolists. The resulting potential for
segmentation of clearing and settlement businesses along jurisdictional
lines may lead to overinvestment in the provision of clearing services
and reductions in efficiency as clearing agencies open and operate
solely within jurisdictional boundaries. If market segmentation
precludes covered clearing agencies from clearing transactions for
customers located in another jurisdiction with a market too small to
support a local clearing agency, fragmentation may result in under-
provisioning of clearing and settlement services in these areas, in
turn reducing the efficiency with which market participants share risk.
    The proposed amendments may also affect efficiency directly if they
mitigate covered clearing agencies' incentives to underinvest in risk
management and recovery and wind-down procedures. CCP default and
liquidation is likely a costly event, so to the extent that the
proposed rules mitigate the risk of CCP default and prescribe rules for
orderly recovery and wind-down, they will produce efficiency benefits.
Another direct effect on efficiency may come if registered clearing
agencies attempt to restructure their operations in ways that would
allow them to fall outside of the scope of proposed Rule 17Ad-22(e).
    Finally, price efficiency and the efficiency of risk sharing among
market participants may be affected by the proposed amendments. On one
hand, the cost of a transaction includes costs related to counterparty
default that are typically unrelated to fundamental asset payoffs.
Academic research using credit default swap transaction data has
revealed a statistically significant, though economically small,
relationship between the credit risk of a counterparty and the spreads
implicit in transaction prices.\697\ Enhanced risk management by
clearing agencies may reduce this component of transaction costs. By
reducing deviations of prices from fundamental value, the proposed
amendments may increase price efficiency. If lower transaction costs or
reduced ambiguity facilitates participation in cleared markets by
investors who would benefit from opportunities for risk-sharing in
these markets,\698\ then this transmission channel may result in more
efficient allocation of risk. On the other hand, the proposed
amendments may have adverse implications for price efficiency in
cleared markets if they drive up transaction costs as higher costs of
risk management enter asset prices. An increase in transaction costs
could cause certain market participants to avoid trading altogether,
reducing liquidity in

cleared products and opportunities for risk sharing among investors in
these markets.
---------------------------------------------------------------------------

    \697\ See e.g., Navneet Arora, Priyank Gandhi & Francis
Longstaff, Counterparty Credit Risk and the Credit Default Swap
Market, 103 J. Fin. Econ. 280 (2012). Using transaction prices and
quotes by 14 different CDS dealers, the authors identified how
dealers' credit risk affects transaction prices. They observed a
relationship between spreads and credit risk implying that a 645-
basis-point increase in a dealer's credit spread would produce a
one-basis-point increase in transaction prices. They explain the
magnitude of this relationship by noting that their sample included
transactions that were mostly collateralized, which would diminish
the sensitivity of transaction prices to counterparty credit risk.
    \698\ If investors who might benefit from risk-sharing in
cleared markets are ambiguity-averse, then regulation that addresses
payoffs in times of financial strain may induce their participation.
See supra note 655 and accompanying text.
---------------------------------------------------------------------------

c. Capital Formation
    The implications for capital formation that flow from these
proposed rules stem mainly from incremental costs that result from
compliance with more specific standards and benefits in the form of
more efficient risk sharing.
    In cases where current practice falls short of the proposed
amendments, covered clearing agencies may have to invest in
infrastructure or make other expenditures to come into compliance,
which may divert capital from other uses. In line with our previous
discussion of cost allocation in the market for clearing services,
these resources may come from clearing members and their
customers.\699\
---------------------------------------------------------------------------

    \699\ See supra Part 0 (discussing the economic effects of the
proposed rules on the market for clearing services generally).
---------------------------------------------------------------------------

    At the same time, the Commission preliminarily believes that the
standards contemplated under the proposed rules may foster capital
formation. As mentioned earlier, clearing agencies that are less prone
to failure may help reduce transaction costs in the markets they
clear.\700\ Conceptually, the component of transaction costs that
reflects counterparty credit risk insures one counterparty against the
default of another.\701\ 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 these
costs.
---------------------------------------------------------------------------

    \700\ See supra Part 0 (discussing the general economic effects
of the proposed rules on systemic risk).
    \701\ See supra note 697.
---------------------------------------------------------------------------

    If, on balance, the proposed amendments cause transaction costs to
decrease in cleared markets, then the expected value of trade may
increase. Counterparties that are better able to diversify risk through
participation in cleared markets may be more willing to invest in the
real economy rather than choosing to engage in precautionary savings.
3. Effect of Proposed Amendments to Rule 17Ad-22 and Proposed Rule
17Ab2-2
    The discussion below outlines the costs and benefits preliminarily
considered by the Commission as they relate to the rules being proposed
today. These specific costs and benefits are in addition to the more
general costs and benefits anticipated under the Commission's proposal
discussed in Part IV.C.1 and include, in particular, the costs and
benefits stemming from the availability of QCCP status under the Basel
III capital requirements. Many of the costs and benefits discussed
below are difficult to quantify. This is particularly true where
clearing agency practices are anticipated to evolve and adapt to
changes in technology and other market developments. The difficulty in
quantifying costs and benefits of the proposed rules is further
exacerbated by the fact that in some cases the Commission lacks
information regarding the specific practices of clearing agencies that
could assist in quantifying certain costs. For example, as noted in
Part IV.C.3.a.iv(4), without detailed information about the composition
of illiquid assets held by clearing agencies and their members, the
Commission cannot provide reasonable estimates of costs associated with
satisfying substantive requirements under proposed Rules 17Ad-
22(e)(7)(i) and (ii). Another example, discussed in Part
IV.C.3.a.iv(5), is testing and validation of financial risk models,
where the Commission is only able to estimate that costs will fall
within a range. In this case, the costs associated with substantive
requirements under the proposed rules may depend on the types of risk
models employed by clearing agencies, which are, in turn, dictated by
the markets they serve. As a result, much of the discussion is
qualitative in nature, though where possible, the costs and benefits
have been quantified.
a. Proposed Rule 17Ad-22(e)
    The Commission recognizes that the scope of the proposed rules is
an important determinant of their economic effect. Having considered
the anticipated costs associated with the proposed rules, the
Commission preliminarily believes that it is appropriate to limit the
application of proposed Rule 17Ad-22(e) to covered clearing agencies,
as these are the registered clearing agencies for which the benefits of
the proposed rules are the greatest. In particular, as discussed below,
the Commission preliminarily believes that an important benefit
resulting from the enhanced risk management requirements in the
proposed rules is a reduction in the risk of a failure of a covered
clearing agency. For example, for designated clearing agencies these
benefits may be significant due to their size, exposure to, and
interconnectedness with market participants, and the effect their
failure may have on markets, market participants, and the broader
financial system. For complex risk profile clearing agencies,
significant benefits may flow as a result of their higher baseline
default risk.
    As an alternative, the Commission could have proposed to extend the
scope of proposed Rule 17Ad-22(e) to cover all registered clearing
agencies. The Commission preliminarily acknowledges, however, that
costs of compliance with the proposed rules may represent barriers to
entry for clearing agencies. By continuing to apply Rule 17Ad-22(d) to
registered clearing agencies that are not covered clearing agencies,
the Commission preliminary believes that the proposed scope Rule 17Ad-
22(e) appropriately preserves the potential for innovation in the
establishment and operation of registered clearing agencies.\702\
Moreover, including CME and ICE in the set of covered clearing agencies
would potentially subject them to requirements that would be
duplicative of CFTC requirements.
---------------------------------------------------------------------------

    \702\ The Commission notes that under proposed Rule 17Ab2-2(a),
a registered clearing agency that is not involved in activities with
a more complex risk profile and is not a designated clearing agency
may apply for covered clearing agency status, which would subject
them to the requirements of Rule 17Ad-22(e). The Commission
preliminarily believes that this may occur if the registered
clearing agency believes such status may credibly signal the quality
of the services it provides or if it is seeking to obtain QCCP
status under the Basel III framework.
---------------------------------------------------------------------------

i. Proposed Rule 17Ad-22(e)(1): Legal Risk
    Because, as noted above, proposed Rule 17Ad-22(e)(1) would require
substantially the same set of policies and procedures as Rule 17Ad-
22(d)(1),\703\ the Commission preliminarily believes that proposed Rule
17Ad-22(e)(1) would likely impose limited material additional costs on
covered clearing agencies and produce limited benefits, in line with
the general economic considerations discussed in Part IV.C.1.
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    \703\ See supra note 107; supra Part 0 (discussing the full set
of requirements under proposed Rule 17Ad-22(e)(1)); supra Part 0
(discussing current practices among registered clearing agencies
regarding legal risk); see also 17 CFR 240.17Ad-22(d)(1).
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ii. Proposed Rule 17Ad-22(e)(2): Governance
    Each covered clearing agency has a board of directors that governs
its operations and oversees its senior management. Proposed Rule 17Ad-
22(e)(2) would establish more detailed requirements for governance
arrangements at covered clearing agencies relative to those imposed on

registered clearing agencies under Rule 17Ad-22(d)(8).\704\
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    \704\ See supra Part 0 (discussing the full set of requirements
under proposed Rule 17Ad-22(e)(2) and its relationship to Rule 17Ad-
22(d)(8)); see also supra note 119 (discussing how the proposed rule
would complement other proposed requirements concerning governance
at clearing agencies that may apply separately).
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    The Commission understands that any covered clearing agency subject
to the proposed rule has policies and procedures in place that clearly
prioritize the risk management and efficiency of the clearing agency.
However, the Commission preliminarily believes that covered clearing
agencies do not already have in place policies and procedures with
respect to other requirements under proposed Rule 17Ad-22(e)(2). Based
its supervisory experience, the Commission preliminarily believes that
some covered clearing agencies may need to update their policies and
procedures to comply with proposed Rule 17Ad-22(e)(2)(iv). These
updates will entail certain basic compliance costs, and covered
clearing agencies may also incur assessment costs related to analyzing
current governance arrangements in order to determine the extent to
determine which they do not meet the requirements of the proposed
amendments. The estimated costs in terms of paperwork are discussed in
Part III.D.1. If, as a result of new policies and procedures, a covered
clearing agency is required to recruit new directors, the Commission
preliminarily estimates a cost per director of $73,000.\705\
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    \705\ The Commission estimated a cost per director of $68,000 in
proposing Regulation MC. See Exchange Act Release No. 34-63107 (Oct.
14, 2010), 75 FR 65881, 65921 & n.215 (Oct. 26, 2010). The $73,000
estimate reflects this amount in 2013 dollars, using consumer price
inflation data provided by the Bureau of Labor Statistics.
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    While there are potential costs associated with compliance, the
Commission preliminarily believes that benefits would potentially
accrue from these requirements. Specifically, the Commission
preliminarily believes that enhanced governance arrangements would
further promote safety and efficiency at the clearing agency--motives
that may not be part of a clearing agency's governance arrangements in
the absence of regulation. Policies and procedures required under the
proposed rules would also reinforce governance arrangements at covered
clearing agencies by requiring board members and senior management to
have appropriate experience and skills to discharge their duties and
responsibilities.
    Compliance with these proposed requirements could reduce the risk
that insufficient internal controls within a covered clearing agency
endanger broader financial stability. While the benefits of compliance
are difficult to quantify, the Commission preliminarily believes that
they flow predominantly from a reduced probability of covered clearing
agency default.
iii. Proposed Rule 17Ad-22(e)(3): Comprehensive Framework for the
Management of Risks
    The Commission preliminarily believes that proposed Rule 17Ad-
22(e)(3) would aid covered clearing agencies in implementing a
systematic process to examine risks and assess the probability and
impact of those risks.\706\ Proposed Rule 17Ad-22(e)(3)(i) specifies
that a risk management framework include policies and procedures
reasonably designed to identify, measure, monitor, and manage the range
of risks that arise in or are borne by the covered clearing agency.
Critically, these policies and procedures would be subject to review on
a specified basis and approval by the board of directors annually. A
sound framework for comprehensive risk management under regular review
would have the benefits of providing covered clearing agencies with a
better awareness of the totality of risks they face in the dynamic
markets they serve. In addition, the requirement to have policies and
procedures that provide for an independent audit committee of the board
and that provide internal audit and risk management functions with
sufficient resources, authority, and independence from management, as
well as access to risk and audit committees of the board, would
reinforce governance arrangements directly related to risk management
at covered clearing agencies. A holistic approach to risk management
could help ensure that policies and procedures that covered clearing
agencies adopt pursuant to the proposed rules work in tandem with one
another. For example, such an approach could result in risk-based
membership standards under proposed Rule 17Ad-22(e)(18) that are
consistent with policies and procedures related to the allocation of
credit losses under proposed Rule 17Ad-22(e)(13)(i). The Commission
preliminarily believes ensuring that a covered clearing agency's risk
management activities fit within a unified framework could mitigate the
risk of financial losses to covered clearing agencies' members and
participants in the markets they serve.
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    \706\ See supra Part 0 (discussing the full set of requirements
under proposed Rule 17Ad-22(e)(3)).
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    Additionally, the proposed rule extends requirements under Rules
17Ad-22(d)(4) and 17Ad-22(d)(11) by requiring plans for recovery and
wind-down.\707\ To the extent that covered clearing agencies do not
already have such plans in place, they may incur additional incremental
costs. Plans for recovery and wind-down benefit both clearing members
and, more generally, participants in markets where products are
cleared. Many of the costs and benefits of such plans depend critically
on the specific recovery and wind-down tools that covered clearing
agencies choose to include in their rules. The presence of such plans
could reduce uncertainty over the allocation of financial losses to
clearing members in the event that a covered clearing agency faces
losses due to member default or for other reasons that exceed its
prefunded default resources. Further, recovery and wind-down plans that
detail the circumstances under which clearing services may be suspended
or terminated may mitigate the risk of market disruption in periods of
financial stress. Market participants who face the possibility that the
assets they trade may no longer be cleared and settled by a CCP may be
unwilling to trade such assets at times when risk sharing is most
valuable. While the effects are difficulty to quantify, the Commission
preliminarily believes that recovery and wind-down plans may support
liquidity in times of financial stress.
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    \707\ See supra Part 0 (discussing the requirements for recovery
and orderly wind-down plans under proposed Rule 17Ad-22(e)(3)(ii)).
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    Based on its supervisory experience, the Commission preliminarily
believes that all covered clearing agencies have an independent audit
committee of the board and most covered clearing agencies already have
some rules governing recovery and wind-down of clearing operations but
have plans that vary in their degree of formality. As a result, the
benefits and costs associated with these requirements will likely be
limited to incremental changes associated with covered clearing
agencies' review of their policies and procedures for recovery and
wind-down and to registered clearing agencies that move into the set of
covered clearing agencies.

iv. Proposed Rules 17Ad-22(e)(4) Through (7): Financial Risk Management
(1) Proposed Rule 17Ad-22(e)(4): Credit Risk
    Proposed Rule 17Ad-22(e)(4) would establish requirements for credit
risk management by covered clearing agencies.\708\ Based on its
supervisory experience, the Commission preliminarily believes that all
entities that would be covered clearing agencies are already in
compliance with proposed Rules 17Ad-22(e)(4)(i) through (iv). Pursuant
to Rule 17Ad-22(b)(3), registered clearing agencies that provide CCP
services currently maintain additional financial resources to meet the
``cover one'' requirement, and registered clearing agencies that would
be complex risk profile clearing agencies under the proposed rules
currently maintain financial resources to meet the ``cover two''
requirement.\709\ All covered clearing agencies exclude resources that
are not prefunded when calculating this coverage.\710\ As a result, the
Commission preliminarily believes little or no additional direct costs
or benefits will result from these requirements unless registered
clearing agencies were to become covered clearing agencies and include
resources that are not prefunded towards their resource requirements.
The requirement to include only prefunded resources when calculating
the financial resources available to meet the standards under proposed
Rules 17Ad-22(e)(4)(i) through (iii) potentially reduces the risk that
covered clearing agencies request financial resources from their
members in times of financial stress, when members are least able to
provide these resources.
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    \708\ See supra Part 0 (discussing the full set of requirements
under proposed Rule 17Ad-22(e)(4)).
    \709\ The Commission also notes that no covered clearing agency
would be systemically important in multiple jurisdictions unless and
until the Commission made such a determination pursuant to proposed
Rule 17Ab2-2. See supra Part 0 and infra Part 0 (discussing the
determinations process under proposed Rule 17Ab2-2 and providing
proposed rule text, respectively).
    \710\ See supra Part 0 (discussing current practices regarding
credit risk management at registered clearing agencies).
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    While requiring ``cover two'' for complex risk profile clearing
agencies and for covered clearing agencies designated systemically
important in multiple jurisdictions would place additional burdens on
the affected clearing agencies, the Commission preliminarily believes
that the requirement is appropriate because disruption to these
entities due to member default carries relatively higher expected costs
than for other covered clearing agencies. These relatively higher
expected costs arise from the fact that covered clearing agencies
designated systemically important in multiple jurisdictions are exposed
to foreign financial markets and may serve as a conduit for the
transmission of risk; for complex risk profile clearing agencies, high
expected costs may arise from discrete jump-to-default price changes in
the products they clear and higher correlations in the default risk of
members.\711\