Securities and Exchange Commission

Monday,
                                                                                            June 21, 2004




                                                                                            Part II

                                                                                            Securities and
                                                                                            Exchange
                                                                                            Commission
                                                                                            17 CFR Parts 200 and 240
                                                                                            Alternative Net Capital Requirements for
                                                                                            Broker-Dealers That Are Part of
                                                                                            Consolidated Supervised Entities;
                                                                                            Supervised Investment Bank Holding
                                                                                            Companies; Final Rules




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34428               Federal Register / Vol. 69, No. 118 / Monday, June 21, 2004 / Rules and Regulations

      SECURITIES AND EXCHANGE                                 FOR FURTHER INFORMATION CONTACT:                       maintain the integrity of the securities
      COMMISSION                                              With respect to amendments to financial                markets by improving oversight of
                                                              responsibility rules and books and                     broker-dealers and providing an
      17 CFR Parts 200 and 240                                records requirements, contact Michael                  incentive for broker-dealers to
      [Release No. 34–49830; File No. S7–21–03]               A. Macchiaroli, Associate Director, at                 implement strong risk management
                                                              (202) 942–0132, Thomas K. McGowan,                     practices. Furthermore, by supervising
      RIN 3235–AI96                                           Assistant Director, at (202) 942–4886,                 the financial stability of the broker-
                                                              David Lynch, Financial Economist, at                   dealer and its affiliates on a
      Alternative Net Capital Requirements                    (202) 942–0059, Rose Russo Wells,                      consolidated basis, the Commission may
      for Broker-Dealers That Are Part of                     Attorney, at (202) 942–0143, Bonnie L.                 monitor better, and act more quickly in
      Consolidated Supervised Entities                        Gauch, Attorney, at (202) 942–0765, or                 response to, any risks that affiliates and
      AGENCY:  Securities and Exchange                        Matthew B. Comstock, Attorney, at (202)                the ultimate holding company may pose
      Commission (‘‘Commission’’).                            942–0156, Division of Market                           to the broker-dealer.
                                                              Regulation, Securities and Exchange                      These amendments are intended to
      ACTION: Final rule.
                                                              Commission, 450 Fifth Street, NW.,                     reduce regulatory costs for broker-
      SUMMARY: We are adopting rule                           Washington, DC 20549–1001.                             dealers by allowing very highly
      amendments under the Securities                           With respect to general questions,                   capitalized firms that have developed
      Exchange Act of 1934 that establish a                   contact Linda Stamp Sundberg,                          robust internal risk management
      voluntary, alternative method of                        Attorney Fellow, at (202) 942–0073,                    practices to use those risk management
      computing deductions to net capital for                 Division of Market Regulation,                         practices, such as mathematical risk
      certain broker-dealers. This alternative                Securities and Exchange Commission,                    measurement models, for regulatory
      method permits a broker-dealer to use                   450 Fifth Street, NW., Washington, DC                  purposes. A broker-dealer’s deductions
      mathematical models to calculate net                    20549–1001.                                            for market and credit risk probably will
      capital requirements for market and                     SUPPLEMENTARY INFORMATION: The                         be lower under the alternative method
      derivatives-related credit risk. A broker-              Securities and Exchange Commission is                  of computing net capital than under the
      dealer using the alternative method of                  amending § 200.19 and Rules 30–3,                      standard net capital rule.
      computing net capital is subject to                     15c3–1, 17a–4, 17a–5, 17a–11, 17h–1T,
                                                                                                                     A. Broker-Dealer Requirements
      enhanced net capital, early warning,                    and 17h–2T under the Securities
      recordkeeping, reporting, and certain                   Exchange Act of 1934 (‘‘Exchange Act’’).                  The alternative method of computing
      other requirements, and must                            We proposed amendments on                              net capital responds to the firms’
      implement and document an internal                      consolidated supervised entities for                   requests to align their supervisory risk
      risk management system. Furthermore,                    comment in October of 2003.1                           management practices and regulatory
      as a condition to its use of the                                                                               capital requirements more closely.
                                                              I. Introduction                                        Under the alternative method, firms
      alternative method, a broker-dealer’s
                                                                 The Commission is amending Rule                     with strong internal risk management
      ultimate holding company and affiliates
                                                              15c3–1 2 (the ‘‘net capital rule’’) under              practices may utilize mathematical
      (referred to collectively as a
                                                              the Securities Exchange Act of 1934 (the               modeling methods already used to
      consolidated supervised entity, or
                                                              ‘‘Exchange Act’’) to establish a                       manage their own business risk,
      ‘‘CSE’’) must consent to group-wide
                                                              voluntary, alternative method of                       including value-at-risk (‘‘VaR’’) models
      Commission supervision. This
                                                              computing net capital for certain broker-              and scenario analysis, for regulatory
      supervision would impose reporting
                                                              dealers. Under the amendments, a                       purposes.
      (including reporting of a capital
                                                              broker-dealer that maintains certain                      A broker-dealer that applies to the
      adequacy measurement consistent with
                                                              minimum levels of tentative net capital                Commission for an exemption from the
      the standards adopted by the Basel                      and net capital may apply to the                       standard net capital rules also must
      Committee on Banking Supervision),                      Commission for a conditional                           comply with specific requirements
      recordkeeping, and notification                         exemption from the application of the                  designed to address various types of
      requirements on the ultimate holding                    standard net capital calculation. As a                 risks that the broker-dealer assumes. A
      company. The ultimate holding                           condition to granting the exemption, the               broker-dealer is eligible to use the
      company (other than an ‘‘ultimate                       broker-dealer’s ultimate holding                       alternative method of computing net
      holding company that has a principal                    company 3 must consent to group-wide                   capital only if it maintains tentative net
      regulator’’) and its affiliates also would              Commission supervision.4 The                           capital 5 of at least $1 billion and net
      be subject to examination by the                        amendments should help the                             capital of at least $500 million.6 If the
      Commission. In addition, we have                        Commission to protect investors and                    tentative net capital of a broker-dealer
      modified the proposed rule
                                                                                                                     calculating net capital under this
      amendments on Commission                                  1 Exchange Act Release No. 48690 (Oct. 24, 2003),
                                                                                                                     alternative method falls below $5
      supervision of an ‘‘ultimate holding                    68 FR 62872 (Nov. 6, 2003) (‘‘Proposing Release’’).
                                                                                                                     billion, the broker-dealer must notify
      company that has a principal regulator’’                  2 17 CFR 240.15c3–1.
                                                                                                                     the Commission and the Commission
      to avoid duplicative or inconsistent                      3 We will review, on a case-by-case basis, the

                                                              broker-dealer’s designation of its ultimate holding    then would consider whether the
      regulation. Finally, we are amending the                company in its application to use the alternative      broker-dealer must take appropriate
      risk assessment rules to exempt a                       method of computing net capital.                       remedial action.7
      broker-dealer using the alternative                       We use the term ‘‘ultimate holding company’’ in         In addition, a broker-dealer that uses
      method of computing net capital from                    the final rules, rather than the term ‘‘holding
                                                                                                                     the alternative method must have in
      those rules if its ultimate holding                     company’’ that we used in the proposed rules.
                                                                4 If a broker-dealer were the ultimate parent        place comprehensive internal risk
      company does not have a principal                       company of its affiliate group, it would be            management procedures that address
      regulator. The rule amendments are                      considered the ultimate holding company for            market, credit, liquidity, legal, and
      intended to improve our oversight of                    purposes of these amendments. The ultimate
      broker-dealers and their ultimate                       holding company may not be a natural person.
                                                                                                                       5 See 17 CFR 240.15c3–1(c)(15).
                                                              Nothing in these amendments is intended to create
      holding companies.                                      a preference for one organizational structure over       6 17 CFR 240.15c3–1(a)(7)(i).
      EFFECTIVE DATE: August 20, 2004.                        another.                                                 7 17 CFR 240.15c3–1(a)(7)(ii).




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Federal Register / Vol. 69, No. 118 / Monday, June 21, 2004 / Rules and Regulations                                           34429

      operational risk at the firm. These                      by the Basel Committee on Banking                       individuals, and one from another
      requirements are designed to help                        Supervision (‘‘Basel Committee’’).                      regulator.
      ensure the integrity of the broker-                        In response to comments about bank                       The majority of commenters endorsed
      dealer’s risk measurement, monitoring,                   holding companies, we have revised the                  the Commission’s initiative to permit
      and management process and to clarify                    proposed rules for an ultimate holding                  certain broker-dealers to use the
      accountability, at the appropriate                       company that has a principal regulator.                 alternative method of computing net
      organizational level, for defining the                   Generally, under the final rules, this                  capital. These commenters supported
      permitted scope of activity and level of                 type of ultimate holding company is not                 the alternative capital calculation for
      risk. Furthermore, a broker-dealer must                  subject either to Commission                            broker-dealers that have developed
      provide the Commission with specified                    examination or those rules requiring                    mathematical models for measuring risk
      financial, operational, and risk                         internal risk management controls                       and group-wide internal risk
      management information on a monthly,                     outside of the broker-dealer and is                     management control systems to control
      quarterly, and annual basis.                             subject to reduced reporting,                           risk. One commenter, however,
                                                               recordkeeping, and notification                         questioned the use of models to the
      B. Ultimate Holding Company                              requirements.                                           extent that it would lower broker-dealer
      Requirements                                               The rule amendments also respond to                   capital requirements, and some
         As a condition to a broker-dealer’s use               international developments. Affiliates of               commenters questioned the
      of the alternative method of computing                   certain U.S. broker-dealers that conduct                Commission’s statutory authority to
      net capital, the rule amendments require                 business in the European Union (‘‘EU’’)                 adopt the proposal.
      a broker-dealer’s ultimate holding                       have stated that they must demonstrate                     The commenters that supported the
      company, if that ultimate holding                        that they are subject to consolidated                   proposal suggested that the Commission
      company does not have a principal                        supervision at the ultimate holding                     modify the proposed rule amendments
      regulator, to consent to certain                         company level that is ‘‘equivalent’’ to                 in various ways. Bank holding
      undertakings. In particular, the ultimate                EU consolidated supervision.9                           companies generally supported the
      holding company must:                                    Commission supervision incorporated                     alternative capital computation, but
         • Provide information about the                       into these rule amendments is intended                  expressed concern that the proposal
      financial and operational condition of                   to meet this standard. As a result, we                  could impose duplicative and
      the ultimate holding company.                            believe these amendments will                           inconsistent requirements on holding
      Specifically, it must provide the                        minimize duplicative regulatory                         companies and their affiliates that are
      Commission with certain capital and                      burdens on firms that are active in the                 subject to comprehensive consolidated
      risk exposure information provided to                    EU as well as in other jurisdictions that               supervision by the Federal Reserve and
      the ultimate holding company’s senior                    may have similar laws.                                  non-domestic financial regulators.
      risk managers. This information would                    II. Proposing Release and Comments                         Generally, commenters addressed
      include market and credit risk                                                                                   various aspects of the methods for
                                                                  The Commission proposed rule
      exposures, as well as an analysis of the                                                                         calculating deductions for market and
                                                               amendments in October 2003 that
      ultimate holding company’s liquidity                                                                             credit risk at the broker-dealer level and
                                                               would have established a voluntary,
      risk;                                                                                                            allowable capital at the ultimate holding
                                                               alternative method for computing net
         • Comply with rules regarding the                                                                             company level. They also stated that the
                                                               capital charges for certain broker-
      implementation and documentation of a                                                                            Commission should be flexible in
                                                               dealers. In the Proposing Release, the
      comprehensive, group-wide risk                                                                                   permitting firms to use interim methods
                                                               Commission solicited both general
      management system for identifying,                                                                               to calculate allowable capital at the
                                                               comments on the proposal and specific
      measuring, and managing market,                                                                                  ultimate holding company level until
                                                               comments on each rule amendment.
      credit, liquidity, legal, and operational                   The Commission received 20                           implementation of the New Basel
      risk;                                                    comment letters in response to the                      Capital Accord. Some commenters
         • Consent to Commission                               proposed rule amendments: Five from                     urged the Commission to take measures
      examination of the ultimate holding                      broker-dealers or broker-dealer holding                 to ensure the confidentiality of
      company and its material affiliates; and                 companies, five from bank holding                       information that the Commission
         • As part of its reporting                            companies subject to supervision by the                 obtains as a result of the proposed rules
      requirements, compute, on a monthly                      Board of Governors of the Federal                       and rule amendments. Commenters also
      basis, group-wide allowable capital and                  Reserve System (‘‘Federal Reserve’’) or a               suggested that the Commission align
      allowances for market, credit, and                       non-domestic ‘‘comprehensive                            CSE reporting requirements with public
      operational risk in accordance with the                  consolidated supervisor,’’ one from a                   company and other reporting
      standards (‘‘Basel Standards’’) 8 adopted                securities industry representative, six                 requirements.
                                                               from U.S. and international banking                        Comments on specific rule
        8 The central bank governors of the Group of Ten
                                                               industry representatives, two from                      amendments and the Commission’s
      countries (‘‘G–10 countries’’) established the Basel
      Committee in 1974 to provide a forum for ongoing
                                                                                                                       response to those comments are
      cooperation among member countries on banking            year-end 2006, and implementation of the most           discussed below in the descriptions of
      supervisory matters. Its basic consultative papers       advanced approaches by year-end 2007.                   the final rule amendments.
      are: the Basel Capital Accord (1988), the Core              9 EU ‘‘consolidated supervision’’ consists of a
      Principles for Effective Banking Supervision (1997),     series of quantitative and qualitative rules, imposed   III. Final Rule Amendments
      and the Core Principles Methodology (1999). The          at the level of the ultimate holding company,
      Basel Standards establish a common measurement           regarding firms’ internal controls, capital adequacy,   A. General
      system, a framework for supervision, and a               intra-group transactions, and risk concentration.
      minimum standard for capital adequacy for                Without a demonstration of ‘‘equivalent’’
                                                                                                                          After considering the comment letters,
      international banks in the G–10 countries. The           supervision, U.S. securities firms have expressed       we are adopting rule amendments that
      Basel Committee is currently developing a new            concerns that an affiliate institution located in the   provide broker-dealers with a voluntary,
      international agreement (the ‘‘proposed New Basel        EU either may be subject to additional capital          alternative method of computing net
      Capital Accord’’). It expects to issue a final version   charges or be required to form a sub-holding
      of the New Basel Capital Accord by the end of June       company in the EU. See ‘‘Directive 2002/87/EC of
                                                                                                                       capital that permits very highly
      2004, with an effective date for implementation of       the European Parliament and of the Council of 16        capitalized broker-dealers to use their
      the standardized and foundation approaches by            December 2002.’’                                        internal mathematical models for net


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34430               Federal Register / Vol. 69, No. 118 / Monday, June 21, 2004 / Rules and Regulations

      capital purposes, subject to specified                  the extent permitted by the net capital                broker-dealer’s application for
      conditions. Generally, we revised the                   rule, to support an affiliate experiencing             exemption from the standard net capital
      rule amendments related to the broker-                  financial difficulty. While this shift of              rule as well as reduced notification and
      dealer’s and the ultimate holding                       assets alone would not violate the net                 recordkeeping requirements.
      company’s computation of net capital                    capital rule, it could make it more likely               We have included what we believe
      and allowable capital, respectively. We                 that the firm would fail during volatile               are prudent parameters for measurement
      also revised the rule amendments with                   market conditions.                                     of a broker-dealer’s deductions for
      respect to broker-dealers that are                         To help ensure that the Commission
                                                                                                                     market and credit risk and allowances
      affiliated with ultimate holding                        can obtain information necessary to
                                                                                                                     for risk for its ultimate holding
      companies that have principal                           monitor the financial well-being of a
                                                              broker-dealer, a broker-dealer may use                 company, although in some cases these
      regulators.
         As stated in the Proposing Release,                  the alternative method of computing net                parameters may be more conservative
      the Commission has broad authority                      capital only if its ultimate holding                   than some firms may believe are
      under Exchange Act section 15(c)(3) to                  company agrees to provide the                          necessary to account for risk. For
      adopt rules and regulations regarding                   Commission’s with additional                           example, we have adopted, as proposed,
      the financial responsibility of broker-                 information about the financial                        rules that require the VaR model used
      dealers that we find are necessary or                   condition of the ultimate holding                      to calculate market risk for the broker-
      appropriate in the public interest or for               company and its affiliates. For an                     dealer to be based on a ten business-day
      the protection of investors.10 The                      ultimate holding company that does not                 movement in rates and prices and
      Commission has promulgated various                      have a principal regulator, this financial             calculated using a 99% confidence
      rules under this provision regarding net                information includes a monthly                         level. The VaR measure then must be
      capital requirements 11 and protection of               computation of group-wide allowable                    multiplied by a factor of at least three.
      customer property.12 As part of our                     capital and allowances for market,                     These parameters are based on our
      oversight of broker-dealers, we receive                 credit, and operational risk calculated in             experience and existing Commission
      financial and risk management                           accordance with the Basel Standards.                   rules and rules of other regulatory
      information about broker-dealers, their                 This type of ultimate holding company                  agencies where there are similar risk
      holding companies, and their affiliates.                also must provide the Commission with                  factors in the regulated entities.
      The rules and the information received                  specified financial, operational, and risk
                                                                                                                     B. Amendments to Paragraphs (a) and
      have assisted the Commission and the                    management information on a monthly,
                                                                                                                     (c) of Rule 15c3–1
      self-regulatory organizations (‘‘SROs’’)                quarterly, and annual basis. Moreover,
      in identifying, at an early stage, firms                an ultimate holding company that does                  1. Minimum and Early Warning Capital
      that are experiencing financial                         not have a principal regulator must                    Requirements
      problems.                                               implement and maintain a consolidated
         The principal purposes of Exchange                   internal risk management control                          We are revising proposed paragraph
      Act Rule 15c3–1 (the ‘‘net capital rule’’)              system and procedures to monitor and                   (a)(7) of Rule 15c3–1. As proposed,
      are to protect customers and other                      manage group-wide risk, including                      paragraph (a)(7) of Rule 15c3–1 would
      market participants from broker-dealer                  market, credit, funding, operational, and              have permitted the Commission to
      failures and to enable those firms that                 legal risks, and make and maintain                     approve, in whole or part, a broker-
      fall below the minimum net capital                      certain books and records. Both the                    dealer’s application, or amendment to
      requirements to liquidate in an orderly                 ultimate holding company and its                       an application, to use the alternative
      fashion without the need for a formal                   affiliates that do not have principal                  method of computing net capital.
      proceeding or financial assistance from                 regulators must consent to Commission                  Proposed paragraph (a)(7) also would
      the Securities Investor Protection                      examination.                                           have required the broker-dealer to
      Corporation. The net capital rule                          Under the final rules, an ultimate                  maintain at all times tentative net
      requires different minimum levels of                    holding company that has a principal                   capital of at least $1 billion and net
      capital based upon the nature of the                    regulator is subject to substantially                  capital of at least $500 million.
      firm’s business and whether the broker-                 fewer requirements than one that does
                                                                                                                        In the Proposing Release, we
      dealer handles customer funds or                        not have a principal regulator. As a
                                                                                                                     requested comment on whether the
      securities.                                             condition to its affiliated broker-dealer’s
                                                                                                                     proposed required minimum levels of
         Ultimate holding companies that own                  use of the alternative method of
                                                              computing net capital, this category of                tentative net capital and net capital
      large broker-dealers also may own many
                                                              ultimate holding company consents to                   described in proposed paragraph (a)(7)
      other entities. These affiliated entities
                                                              provide the Commission, on a quarterly                 of Rule 15c3–1 should be raised or
      may engage in both securities and non-
                                                              basis, with the capital measurements                   lowered. One commenter stated that we
      securities activities worldwide. Broker-
                                                              that it submits to its principal regulator,            should permit a broker-dealer with
      dealer holding company structures vary
                                                              consolidated and consolidating balance                 tentative net capital of less than $1
      and may be quite complex. Depending
                                                              sheets and income statements, and                      billion to use the alternative net capital
      upon the nature of these structures,
                                                              certain regular risk reports provided to               computation if it is an affiliate of an
      broker-dealers may incur risks because
                                                              the persons responsible for managing                   international bank with consolidated
      of their affiliation with unregistered
                                                              group-wide risk. Annually, an ultimate                 capital of over $1 billion. Another
      entities. For example, a broker-dealer’s
                                                              holding company that has a principal                   commenter asserted that ‘‘the
      access to short-term funding may be
                                                              regulator must provide audited                         Commission should permit other
      affected by the insolvency of an affiliate.
                                                              consolidated balance sheets and income                 broker-dealers in the CSE group-wide
      In addition, management at the ultimate
                                                              statements and capital measurements, as                affiliate structure’’ to use the alternative
      holding company level may attempt to
                                                              submitted to its principal regulator. An               method of computing net capital even if
      divert capital from the broker-dealer, to
                                                              ultimate holding company that has a                    those broker-dealers do not meet the
        10 15 U.S.C. 78o(c)(3).                               principal regulator also is subject to                 minimum capital levels. These
        11 17 CFR 240.15c3–1.                                 more limited undertaking and                           comments, however, do not take into
        12 17 CFR 240.15c3–3.                                 information requirements related to the                account certain regulatory and


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Federal Register / Vol. 69, No. 118 / Monday, June 21, 2004 / Rules and Regulations                                                    34431

      bankruptcy considerations.13                            alternative net capital computation will               Commenters also stated that the
      Accordingly, we are adopting the $1                     reduce deductions for market and credit                Commission could better use its
      billion tentative net capital and $500                  risk substantially for broker-dealers that             resources to supervise holding
      million net capital requirements as                     use that method. Moreover, inclusion in                companies that do not otherwise have
      proposed, but are setting forth these                   net capital of unsecured receivables and               principal regulators. Moreover,
      requirements in paragraph (a)(7)(i) of                  securities that do not have a ready                    commenters urged the Commission to
      Rule 15c3–1 in the final rules.                         market under the current net capital                   provide as much clarity as possible,
         We also are adding a new requirement                 rule will reduce the liquidity standards               both for regulated entities and
      to paragraph (a)(7) of Rule 15c3–1, as                  of Rule 15c3–1. Thus, the alternative                  consolidated supervisors, about
      adopted. The final rules incorporate                    method of computing net capital and, in                provisions intended to avoid
      changes to the proposed rules that may                  particular, its requirements that broker-              duplicative or inconsistent
      allow firms to take smaller deductions                  dealers using the alternative method of                requirements.
      for market and credit risk than the                     computing maintain minimum tentative                      In response to these comments, we are
      proposed rules would have permitted.                    net capital of at least $1 billion,                    adopting a revised definition of ‘‘entity
      Consequently, the final rules add                       maintain net capital of at least $500                  that has a principal regulator’’ and
      paragraph (a)(7)(ii), which requires a                  million, notify the Commission that                    adding a definition of an ‘‘ultimate
      broker-dealer to notify the Commission                  same day if their tentative net capital                holding company that has a principal
      if the broker-dealer’s tentative net                    falls below $5 billion, and comply with                regulator.’’ Creation of two definitions
      capital falls below $5 billion. This $5                 Rule 15c3–4 are intended to provide                    should help to clarify the scope of
      billion early warning requirement is                    broker-dealers with sufficient capital                 paragraph (c)(13) of Rule 15c3–1. We
      based upon the staff’s experience and                   reserves to account for market, credit,                will not examine any entity that has a
      the current levels of net capital                       operational, and other risks.                          principal regulator and we will use the
      maintained by the broker-dealers most                                                                          reports that it files with its principal
                                                              2. Entities That Have Principal                        regulator for our regulatory purposes, to
      likely to apply to use the alternative                  Regulators
      method of computing net capital. Upon                                                                          the greatest extent possible.
      written application, however, the                          We are revising proposed paragraph                     Under the revised definition in
      Commission may exempt, either                           (c)(13) of Rule 15c3–1. Proposed                       paragraph (c)(13)(i) of Rule 15c3–1, an
      unconditionally or on specified terms                   paragraph (c)(13) would have defined an                entity that has a principal regulator
      and conditions, a broker-dealer from the                ‘‘entity that has a principal regulator’’ as           includes certain functionally regulated
      $5 billion early warning requirement.                   a person (other than a natural person)                 affiliates of the ultimate holding
      To obtain an exemption, the broker-                     that is not a registered broker-dealer                 company that are not registered as a
      dealer must satisfy the Commission that                 (other than a broker-dealer registered                 broker or dealer.16 Entities that have
      because of the special nature of the                    under section 15(b)(11) of the Exchange                principal regulators include insured
      firm’s business, its financial positions,               Act) and that belongs to one of two                    depository institutions; futures
      its internal risk management systems,                   categories. Proposed paragraph                         commission merchants or introducing
      and its compliance history, among other                 (c)(13)(i), the first category, would have             brokers registered with the Commodity
      factors, application of the requirement is              included insured depository                            Futures Trading Commission; entities
      unnecessary or inappropriate in the                     institutions, entities registered with the             registered with or licensed by a State
                                                              Commodities Futures Trading                            insurance regulator that issues any
      public interest or for the protection of
                                                              Commission, or licensed or regulated                   insurance, endowment, or annuity
      investors.
         We also are revising Rule 15c3–1 to                  insurance companies. Proposed                          policy or contract; and certain foreign
      add paragraph (a)(7)(iii). Paragraph                    paragraph (c)(13)(ii), the second                      banks.17
      (a)(7)(iii) generally requires a broker-                category, would have included bank                        Paragraph (c)(13)(i) also includes Edge
      dealer that computes deductions for                     holding companies, savings and loan                    Act and Agreement Corporations,
      market and credit risk under Appendix                   holding companies, and foreign banks                   provided they are not primarily in the
      E to comply with Rule 15c3–4 14 as                      that do business in the U.S. The                       securities business. We added these
                                                              proposed rules would have required                     entities to the definition of entity that
      though it were an OTC derivatives
                                                              entities in this second category to have               has a principal regulator because they
      dealer. Paragraph (a)(7)(iii) replaces
                                                              in place appropriate arrangements to                   are subject to supervision by the Federal
      proposed amendments to Rule 15c3–4
                                                              ensure that information provided to the                Reserve. Under these rules, the
      and is discussed in greater detail in the
                                                              Commission was sufficiently reliable for               Commission may examine Edge Act and
      section of this release that addresses
                                                              the purposes of proposed Appendix E                    Agreement Corporations that primarily
      that rule.
         The requirements of paragraph (a)(7),                and proposed Appendix G. The                           are in the securities business.18
                                                              proposed rules also would have
      as revised, are intended to help ensure
                                                              required these entities to be primarily in               16 This reference is to brokers or dealers registered
      that a broker-dealer maintains prudent
                                                              the insured depository institutions                    under section 15(b)(11) of the Act (15 U.S.C.
      amounts of liquid assets against various                                                                       78o(b)(11)).
                                                              business (excluding their insurance and
      risks that it assumes and that it maintain                                                                       17 This category is limited to a foreign bank as
                                                              commercial businesses).
      a robust internal risk management                          Several commenters stated that the
                                                                                                                     defined in section 1(b)(7) of the International
      system. The current haircut structure                                                                          Banking Act of 1978 (12 U.S.C. 3101(7)) that has its
                                                              Commission should revise the proposed                  headquarters in a jurisdiction for which any foreign
      seeks to ensure that broker-dealers                     rules to minimize duplicative or                       bank has been approved by the Federal Reserve to
      maintain a sufficient capital base to                   inconsistent requirements for holding                  conduct business pursuant to the standards set forth
      account for operational, leverage, and                  companies that are subject to another                  in 12 CFR 211.24(c), provided such foreign bank
      liquidity risk, in addition to market and                                                                      represents to that Commission that it is subject to
                                                              regulator’s consolidated supervision.15                the same supervisory regime as the foreign bank
      credit risk. We expect that use of the                                                                         previously approved by the Federal Reserve.
                                                                15 See, e.g., Letter from Messrs. Michael J. Alix      18 The Federal Reserve charters an ‘‘Edge Act
        13 Bankruptcy or other statutes, rules, and           and Mark W. Holloway, Co-Chairs, CSE Steering          Corporation’’ to engage in international banking.
      regulations may restrict transfers from an entity in    Committee of the Securities Industry Association, to   Section 25A of the Federal Reserve Act (12 U.S.C.
      bankruptcy.                                             Jonathan G. Katz, Secretary, U.S. Securities and       611–633). A state charters an ‘‘Agreement
        14 17 CFR 240.15c3–4.                                 Exchange Commission, dated February 27, 2004.                                                       Continued




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34432               Federal Register / Vol. 69, No. 118 / Monday, June 21, 2004 / Rules and Regulations

         We also added paragraph (c)(13)(i)(F)                connection with financial holding                          as an ultimate holding company that has
      of Rule 15c3–1 to the final rules. Under                company elections by foreign banks, the                    a principal regulator.25
      this paragraph, the Commission may                      Federal Reserve also evaluates any
                                                                                                                         3. Tentative Net Capital
      determine if other types of entities                    foreign bank that operates a branch or
      subject to comprehensive supervision                    agency, or owns or controls a                                 We are adopting an amended
      by other regulators qualify as entities                 commercial lending company in the                          definition of tentative net capital. The
      that have principal regulators.19                       United States under capital and                            proposed amendment to paragraph
         The new definition of ultimate                       management standards that are                              (c)(15) of Rule 15c3–1 would have
      holding company that has a principal                    comparable to the standards applicable                     defined ‘‘tentative net capital’’ for a
      regulator in paragraph (c)(13)(ii)                      to U.S. banks and gives due regard to                      broker-dealer using the alternative
      recognizes the concept of                               the principle of national treatment and                    method of computing net capital as the
      comprehensive, consolidated                             equality of competitive opportunity.22                     net capital of the broker or dealer before
      supervision. Any financial holding                      For these foreign banking organizations,                   deductions for market and credit risk
      company or a company that is treated as                 the Federal Reserve also reviews                           computed pursuant to Appendix E to
      a financial holding company under the                   whether they are subject to                                Rule 15c3–1 or paragraph (c)(2)(vi) of
      Bank Holding Company Act of 1956 20                     comprehensive consolidated                                 Rule 15c3–1, if applicable, and
      will be considered an ultimate holding                  supervision.23 The Federal Reserve has                     increased by the balance sheet value
      company that has a principal regulator.                 found that home country supervision is                     (including counterparty net exposure)
      Accordingly, any U.S. holding company                   an important element in determining if                     resulting from transactions in derivative
      or foreign bank that has elected                        a bank is well managed.24                                  instruments that otherwise would be
      financial holding company status will                                                                              deducted by virtue of paragraph
                                                                 Based on these requirements, we
      be an ultimate holding company that                                                                                (c)(2)(iv) of Rule 15c3–1.
                                                              would not examine financial holding                           We are amending the definition of
      has a principal regulator.                              companies or companies that are treated
         By adopting this new definition of an                                                                           tentative net capital to include
                                                              as financial holding companies. In                         securities for which there is no ready
      ultimate holding company that has a                     addition, under the rules as adopted,
      principal regulator, we are recognizing                                                                            market, as that term is defined under
                                                              these entities are subject to a                            paragraph (c)(2)(11) of the net capital
      the comprehensive, consolidated                         streamlined application process, fewer
      supervision of both the Federal Reserve                                                                            rule. This modification is necessary
                                                              periodic reporting requirements, and                       because, as discussed below, we
      and non-domestic bank regulators. In                    may submit to the Commission the same
      addition, because we will consider the                                                                             eliminated the requirement that a
                                                              measurement of capital that they submit                    security have a ready market to qualify
      entity that elected to be treated as a                  to their primary regulator. Inclusion of
      financial holding company to be an                                                                                 for capital treatment using VaR models.
                                                              these entities in the definition of                        Under the final rules, a broker-dealer
      ultimate holding company that has a                     ‘‘ultimate holding company that has a
      principal regulator, we will not need to                                                                           may include securities for which there
                                                              principal regulator’’ is intended reduce                   is no ready market in calculating
      look for a higher holding company level                 duplicative or inconsistent regulation
      within a consolidated group. We also                                                                               tentative net capital under the
                                                              because these entities already are                         alternative method only if the
      understand that all of the banking                      subject to the reporting and examination
      organizations that have expressed                                                                                  Commission has approved the use of
                                                              requirements of the Federal Reserve.                       mathematical models for purposes of
      interest in the CSE proposal would
                                                                 Under paragraph (c)(13)(ii)(B), the                     calculating deductions to net capital for
      qualify as financial holding companies
                                                              Commission may determine that other                        those securities pursuant to Appendix
      or as companies that are treated as
                                                              persons also should be included as                         E.
      financial holding companies.
         A bank holding company may elect to                  ultimate holding companies that have
                                                                                                                         C. Broker-Dealer Requirements Under
      become a financial holding company                      principal regulators if it finds that the
                                                                                                                         Appendix E
      and be eligible to engage in expanded                   persons are subject to consolidated,
                                                              comprehensive supervision; there are in                       Appendix E to Exchange Act Rule
      financial activities if it is ‘‘well                                                                               15c3–1 describes the alternative method
      capitalized’’ and ‘‘well managed.’’ 21 In               place appropriate arrangements so that
                                                              information provided to the                                of computing net capital that a broker-
                                                              Commission is sufficiently reliable for                    dealer may use, including related
      Corporation’’ to engage in international banking
      activities. The Agreement Corporation enters into       the purposes of determining compliance                     application requirements. It also
      an ‘‘agreement’’ with the Federal Reserve to limit      with Appendix E and Appendix G; and                        imposes requirements regarding internal
      its activities to those that an Edge Act Corporation    based on the persons’ businesses, it is                    risk management controls and reporting,
      may undertake. Section 25 of the Federal Reserve                                                                   and describes additional supervisory
      Act (12 U.S.C. 601–604a). The purpose of both Edge
                                                              appropriate to consider the persons
      Act Corporations and Agreement Corporations is to       ultimate holding companies that have                       conditions that the Commission may
      aid in financing and stimulating foreign trade.         principal regulators for the purposes of                   impose on the broker-dealer in
      These entities may engage only in international         Appendix E and Appendix G. An                              appropriate circumstances.26 Under the
      banking or other financial transactions related to
                                                              affiliated broker-dealer of a domestic                     final rules, once a broker-dealer has
      international business. The Board of Governors                                                                     submitted an application, the
      approves or denies applications to establish Edge       entity or a foreign bank that has not
      Act Corporations and also examines both Edge Act        elected to be treated as a financial                       Commission will review how the firm
      and Agreement Corporations and their subsidiaries.      holding company could apply to use the                     manages its market, credit, liquidity and
         19 The Commission will determine if there are in
                                                              alternative method of computing net
      place appropriate arrangements so that information                                                                    25 This paragraph also governs the application of
      that the person provides to the Commission is           capital. Paragraph (c)(13)(ii)(B) permits                  a savings and loan holding company as defined in
      sufficiently reliable for the purposes of determining   us to consider whether, in appropriate                     Section 10(a)(1)(D) of the Home Owners’ Loan Act
      compliance with Appendices E and G, and it is           circumstances, the Commission should                       (12 U.S.C. 1467a(1)(D)).
      appropriate to deem the person to be an entity that     treat the domestic entity or foreign bank                     26 We have replaced old Appendix E. Old
      has a principal regulator considering all relevant                                                                 Appendix E outlined a phase-in schedule for
      circumstances, including the person’s mix of                                                                       increased minimum net capital requirements for
      business.                                                    22 12    U.S.C. 1843(l)(3) and 12 CFR 225.90.         broker-dealers. The increased net capital minimums
         20 12 U.S.C. 1840 et seq.                                 23 12    CFR 225.92(e).                               were fully effective as of July 1, 1994. Exchange Act
         21 12 U.S.C. 1843(l)(1) and 12 CFR 225.81(b).             24 Id.                                                Release No. 31511.



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Federal Register / Vol. 69, No. 118 / Monday, June 21, 2004 / Rules and Regulations                                                       34433

      funding, legal, and operational risk, and               rule and all submissions in connection                     the Commission generally will not
      its mathematical models, to determine if                with the application will be accorded                      publish or make available to any person
      the broker-dealer has met the                           confidential treatment, to the extent                      matters that are ‘‘contained in, or related
      requirements of Appendix E and is                       permitted by law. We received                              to, any examination, operating, or
      complying with other applicable rules.                  comments expressing some concern                           condition report prepared by, on behalf
      The Commission also will review                         with the Commission’s ability to                           of, or for the use of, the Commission,
      whether the broker-dealer’s ultimate                    maintain the confidentiality of                            any other Federal, state, local, or foreign
      holding company is complying with the                   documents and information filed with                       governmental authority or foreign
      terms of the undertaking that it agrees                 the Commission under these rules.                          securities authority, or any securities
      to provide as a condition of the broker-                Under the final rules, broker-dealers and                  industry self-regulatory organization,
      dealer’s use of the alternative method of               ultimate holding companies will submit                     responsible for the regulation or
      computing net capital.                                  information to the Commission based on                     supervision of financial institutions.’’ 30
         1. Application                                       their understanding that the information                   Significantly, the courts have ruled
         Under proposed paragraph (a) of                      will remain confidential. The                              consistently that Exemption 8 provides
      Appendix E, a broker-dealer would have                  information that we expect to receive                      categorical protection for information
      applied to the Commission for an                        from these entities is, by its nature,                     related to such reports.
      exemption from the standard net capital                 competitively sensitive. For example,
                                                                                                                         c. Commission Review
      rule and for permission to calculate                    we understand that broker-dealers and
      certain deductions for market and credit                their holding companies have a                                Paragraph (a)(6) of proposed
      risk in accordance with Appendix E.27                   commercial interest in their risk models,                  Appendix E would have permitted the
      Proposed paragraph (a) described the                    risk management systems and processes,                     Commission to approve a broker-
      various types of information that the                   and data that they obtain through use of                   dealer’s application to use the
      broker-dealer would have submitted to                   these models, systems, and processes.                      alternative method of computing net
      allow the Commission to determine                       We also have been advised that if the                      capital, subject to the imposition of any
      whether an exemption from the net                       Commission were unable to afford                           conditions or limitations that the
      capital rule was necessary or                           confidential protection to the                             Commission found were necessary or
      appropriate in the public interest or for               information that we expect to receive                      appropriate in the public interest or for
      the protection of investors.                            from broker-dealers and their ultimate                     the protection of investors, after a
                                                              holding companies, firms may hesitate                      review of whether the broker-dealer met
      a. Information To Be Submitted by the                   to apply for the exemption from the                        the requirements of Appendix E; the
      Broker-Dealer                                           standard net capital rule and consent to                   broker-dealer was in compliance with
         As proposed, paragraph (a)(1) of                     Commission supervision at the ultimate                     other, applicable Exchange Act
      Appendix E would have required a                        holding company level. This result                         provisions or rules or rules of a self-
      broker-dealer that applied to use the                   would undermine and jeopardize the                         regulatory organization; and the
      alternative method of computing net                     viability of the CSE system.                               ultimate holding company was in
      capital to include with its application                    The Freedom of Information Act                          compliance with applicable terms of its
      financial, risk management, and other                   (‘‘FOIA’’) provides at least two                           undertaking, which are conditions for
      information about the firm. Specifically,               exemptions under which the                                 the approval. We did not receive
      broker-dealers would have been                          Commission has authority to grant                          comments on this provision and the
      required to submit to the Commission a                  confidential treatment for applications                    Commission is redesignating paragraph
      description of their internal risk                      filed under this rule. First, FOIA                         (a)(6) as paragraph (a)(7) of Appendix E
      management control system and how                       Exemption 4 provides an exemption for                      and adopting it as proposed, with one
      that system satisfies the requirements of               ‘‘trade secrets and commercial or                          exception.31 We clarify in paragraph
      Rule 15c3–4, together with a description                financial information obtained from a                      (a)(7), as adopted, that the Commission
      of the method the broker-dealer                         person and privileged or                                   also must approve amendments to a
      intended to use to calculate deductions                 confidential.’’ 29 As specified in                         broker-dealer’s application to use the
      to net capital. We did not receive                      paragraph (a)(5) of new Appendix E,                        alternative method of computing net
      substantive comments on this rule                       ‘‘all information submitted in                             capital. Furthermore, note that
      related to information to be submitted                  connection with the application will be                    paragraph (a)(1)(ix)(D), which describes
                                                              accorded confidential treatment to the                     the undertaking that an ultimate holding
      about the broker-dealer and paragraph
                                                              extent permitted by law.’’ The                             company that has a principal regulator
      (a)(1) of Appendix E has been adopted
                                                              information to be filed with the                           must provide as a condition of its
      as proposed.28
                                                              Commission concerns firms’ trading                         affiliated broker-dealer’s exemption
      b. Confidential Treatment                               strategies, risk profiles, financial                       from the standard net capital rule, limits
        A broker-dealer’s application for                     positions, and other information that is                   the conditions that the Commission may
      exemption from the standard net capital                 protected from disclosure under                            place on an ultimate holding company
                                                              Exemption 4.                                               that has a principal regulator in
        27 From time to time, the broker-dealer will             Second, FOIA Exemption 8 provides
      submit amendments to its application. For example,      an exemption for matters that are                            30 See  5 U.S.C. 552(b)(4).
      the broker-dealer will be required to submit an         ‘‘contained in or related to examination,                    31 In its undertaking, an ultimate holding
      amendment to its application if it materially           operating, or condition reports prepared                   company agrees to comply with the applicable
      amends a VaR model that it uses to calculate a                                                                     provisions of Appendices E and G as a condition
      deduction for market or credit risk.
                                                              by, on behalf of, or for the use of an
                                                                                                                         to the broker-dealer’s use of the alternative method
        28 As described below, however, the Commission        agency responsible for the regulation or                   of computing net capital. Appendix E, for example,
      has amended the undertaking provisions of               supervision of financial institutions.’’                   requires a broker-dealer to include specified
      paragraph (a)(1) to describe separately the             Similarly, Commission Rule 80(b)(8),                       information from the ultimate holding company
      requirements for an undertaking that a broker-          Commission Records and Information,                        with the broker-dealer’s application to compute
      dealer must submit for an ultimate holding                                                                         deductions for market and credit risk under
      company that does not have a principal regulator        implementing Exemption 8, states that                      Appendix E. If the ultimate holding company did
      and an ultimate holding company that has a                                                                         not produce the requisite information, it would not
      principal regulator.                                         29 See   5 U.S.C. 552(b)(4).                          be in compliance with the terms of its undertaking.



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34434                 Federal Register / Vol. 69, No. 118 / Monday, June 21, 2004 / Rules and Regulations

      approving the broker-dealer’s exemption                   commenter also asserted the                             a broker-dealer must be in compliance
      application.32                                            Commission should limit revocation of                   with net capital requirements at all
         Paragraph (a)(7) of proposed                           the exemption ‘‘to instances in which                   times.
      Appendix E would have required a                          the Commission finds a material capital                    Under paragraphs (c)(1) and (2) of
      broker-dealer to amend and resubmit to                    deficiency or a substantial pattern of                  proposed Appendix E, the deduction for
      the Commission its application for                        material non-compliance.’’                              market risk would have been equal to
      exemption from the standard net capital                      In response to comments received, we                 the amount of the sum of the following:
      rule if the broker-dealer desired to                      are amending paragraph (a)(10). We also                 (i) For positions for which the
      change materially a mathematical model                    are redesignating paragraph (a)(10) as                  Commission has approved the use of
      used to calculate deductions for market                   paragraph (a)(11) in Appendix E, as                     VaR models, the VaR of those positions
      or credit risk or its internal risk                       adopted. Paragraph (a)(11) adds a                       multiplied by the appropriate
      management control system. We did not                     description of the factors that the                     multiplication factor; (ii) for positions
      receive comment on this requirement                       Commission will rely evaluate in                        for which the Commission has approved
      and are redesignating paragraph (a)(7) as                 determining whether to revoke a broker-                 the use of scenario analysis, the greatest
      paragraph (a)(8) and adopting it as                       dealer’s exemption from the net capital                 adverse movement of the positions, or
      proposed.                                                 rule. Specifically, the Commission will                 some multiple thereof based on
         Paragraph (a)(8) of proposed                           consider the compliance history of the                  liquidity or, if greater, a minimum
      Appendix E would have required a                          broker-dealer related to its use of                     deduction; and (iii) for all other
      broker-dealer to report any material                      models, the financial and operational                   positions, a deduction under the
      changes to its or its ultimate holding                    strength of the broker-dealer and its                   standard haircut method of paragraph
      company’s corporate structure. The final                  ultimate holding company, and the                       (c)(2)(vi) Rule 15c3–1.
      rules do not include this notification                    broker-dealer’s compliance with its                        Paragraph (b) 34 of Appendix E, as
      requirement because it is redundant.                      internal risk management controls.                      adopted, describes the method of
      The Commission will receive                                                                                       computing a broker-dealer’s deduction
                                                                2. Risk Management Control System                       for market risk. A broker-dealer’s
      notification of the changes as part of the
      regular filings that the ultimate holding                    Under proposed paragraph (b) of                      deduction for market risk under
      company submits under paragraph (b) of                    Appendix E, a broker-dealer using the                   paragraph (b) is an amount equal to the
      Appendix G.                                               alternative method of computing net                     sum of the following: (i) For positions
         Paragraph (a)(9) of proposed                           capital would have been required to                     for which the Commission has approved
      Appendix E would have required a                          establish, document, and maintain an                    the broker-dealer’s use of VaR models,
      broker-dealer to notify the Commission                    internal risk management control                        the VaR of those positions multiplied by
      45 days before it ceased using the                        system that met the requirements of                     the appropriate multiplication factor;
      alternative method of computing net                       § 240.15c3–4.33 The rule amendments,                    (ii) for positions for which the VaR
      capital under Appendix E. Under the                       as adopted, do not include this                         model does not incorporate specific
      proposed paragraph, the Commission                        requirement. Proposed paragraph (b) is                  risk, a deduction for specific risk to be
      could have ordered a shorter or longer                    omitted as unnecessary because the                      determined by the Commission based
      notification period upon broker-dealer                    broker-dealer must comply with Rule                     on a review of the broker-dealer’s
      consent or if the Commission found that                   15c3–4 under Rule 15c3–1(a)(7)(iii), as                 application and the positions involved;
      a shorter or longer period was necessary                  adopted.                                                (iii) for positions for which the
      or appropriate in the public interest or                                                                          Commission has approved the use of
                                                                3. Computation of the Deduction for
      for the protection of investors. We did                                                                           scenario analysis, the greatest loss
                                                                Market Risk
      not receive any comments on this                                                                                  resulting from the scenario over any ten-
      requirement. We are redesignating                            Commenters generally supported the                   day period, or some multiple thereof
      paragraph (a)(9) as paragraph (a)(10) and                 method for calculating a broker-dealer’s                based on liquidity or, if greater, a
      adopting it as proposed.                                  deductions for market risk described in                 minimum deduction; and (iv) for all
         Paragraph (a)(10) of proposed                          paragraph (c) of proposed Appendix E.                   other positions, a deduction under
      Appendix E would have permitted the                       They raised several issues with respect                 § 240.15c3–1(c)(2)(vi), (c)(2)(vii), and
      Commission, by order, to revoke a                         to specific provisions for calculating the              applicable appendices to § 240.15c3–1.
      broker-dealer’s exemption from the                        deduction, however. We address those                    We address each of the deductions for
      standard net capital rule under                           issues in the sections that follow.                     market risk in the sections that follow.
      Appendix E if the Commission found                           As a preliminary matter, we note that
                                                                a broker-dealer must compute its                        a. Deductions for Market Risk Using
      that the exemption no longer was
                                                                deduction for market risk monthly.                      VaR Models
      necessary or appropriate in the public
      interest or for the protection of                         Paragraph (c) of proposed Appendix E                       As noted, a broker-dealer may use a
      investors. A broker-dealer that no longer                 would have required a daily                             VaR model to calculate its deduction for
      could use Appendix E would have been                      computation of the deduction for market                 market risk for those positions for which
      required to compute its capital charges                   risk. Commenters raised a question as to                the Commission has approved the use of
      using the standard haircut method.                        whether a broker-dealer would be                        VaR models. To calculate the deduction,
         A commenter suggested that the                         required to make daily capital                          the broker-dealer multiplies the VaR of
      Commission’s authority to revoke a                        computations and, if so, stated that                    those positions by the appropriate
      broker-dealer’s exemption from the                        daily computations would be                             multiplication factor. The
      standard net capital rule ‘‘should clarify                unnecessary and burdensome. We have                     multiplication factor is intended to help
      that any limitations or remedial action                   revised these sections to clarify that as               provide adequate capital during periods
      must be narrowly circumscribed to                         part of their risk management practices,                of market stress or other eventualities.35
      address the relevant deficiency.’’ The                    firms must compute VaR and current                      The results of quarterly backtests
                                                                exposures daily. We note, however, that
        32 Refer to section (D)(a)(ii) of this release for a                                                              34 The final rules redesignate paragraph (c) of

      discussion of the undertaking for an ultimate                  33 See
                                                                         infra, discussion of proposed amendments       proposed Appendix E as paragraph (b).
      holding company that has a principal regulator.           to Rule 15c3–4.                                           35 17 CFR 240.15c3–1e(b)(1).




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Federal Register / Vol. 69, No. 118 / Monday, June 21, 2004 / Rules and Regulations                                                  34435

      determine which of the multiplication                   excluded these positions from inclusion                 period. Paragraph (b)(3) 38 of Appendix
      factors contained in Table 1 of                         in VaR models; that is, the positions                   E, as adopted, permits a broker-dealer to
      Appendix E a broker-dealer must use,                    would have been subject to a 100%                       determine a deduction for market risk
      except that the broker-dealer must use                  deduction.                                              using scenario analysis for those
      an initial multiplication factor of                        Commenters asserted that, while                      positions for which the Commission has
      three.36                                                positions with no ready market may                      approved the broker-dealer’s application
        We have amended the proposed rules                    lack historical data sufficient to allow                to use scenario analysis. The deduction
      with regard to specified provisions of                  accurate modeling, the rules should                     will be the greatest loss resulting from
      the VaR models used for computing a                                                                             a range of adverse movements in
                                                              require a broker-dealer to demonstrate
      deduction for market risk.                                                                                      relevant risk factors, prices, or spreads
                                                              that its models adequately capture the
                                                                                                                      designed to represent a negative
      i. Elimination of the VaR Phase-in                      material risks associated with the
                                                                                                                      movement greater than, or equal to, the
      Period                                                  categories of securities in which they
                                                                                                                      worst ten-day movement over the four
         In response to comments received,                    transact business, not limit use of VaR                 years preceding calculation of the loss,
      Appendix E, as adopted, no longer                       to those securities that have a ready                   or some multiple of that movement
      includes the phase-in period for VaR                    market. We agree with the commenters                    based on liquidity. Permitting the use of
      models. Under paragraph (c)(3) of                       and, therefore, Appendix E, as adopted,                 scenario analysis to calculate the
      proposed Appendix E, the Commission                     does not limit a broker-dealer’s use of                 deduction for market risk will provide
      would have phased in the use of VaR                     VaR models for computing deductions                     the broker-dealer with greater flexibility
      models to calculate deductions for net                  for market risk to securities that have a               in determining how it may use
      capital for three bands of positions over               ‘‘ready market.’’                                       mathematical models to calculate
      a period of at least 18 months.                         b. Deductions for Specific Risk                         market risk deductions for securities for
      Commenters stated that implementation                                                                           which a deduction calculated using VaR
      of VaR for calculation of deductions for                   Paragraph (b)(2) of Appendix E may                   would not be appropriate. The
      market risk on a phased-in basis would                  require a deduction for specific risk                   minimum deduction for market risk
      impose unnecessary operational costs                    because of the reliance on VaR models                   computed for positions using scenario
      and inefficiencies. Elimination of the                  for regulatory purposes, particularly for               analysis is the same under the final
      phase-in requirement is intended to                     determining deductions for market risk                  rules as it was in the proposed rules.
      promote more effective group-wide risk                  for securities with no ready market.                       The final amendments also change the
      management and eliminate unnecessary                    Generally, specific risk is the risk                    period over which the greatest adverse
      operational costs and inefficiencies.                   associated with how the price-change                    ten-day movements of data are
      Therefore, upon Commission approval                     on an individual position may differ                    evaluated. Paragraph (c)(5) of proposed
      of its VaR models, a broker-dealer may                  from broad, market-wide changes in                      Appendix E would have required the
      use its VaR models to calculate                         prices. If the VaR models that a broker-                scenario to include a range of adverse
      deductions for market risk capital for all              dealer uses to compute deductions for                   movements of risk factors, prices, or
      positions for which the broker-dealer                   market risk incorporate specific risk,                  spreads that move by the greatest
      can demonstrate that its modeling                       there is no additional deduction for                    amounts over the past five years, or a
      procedures meet the applicable                          specific risk in determining the                        three standard deviation movement in
      requirements in the final rules.                        deduction for market risk. If, however,                 those risk factors, prices, or spreads over
                                                              the VaR models do not incorporate                       a ten-day period. Commenters suggested
      ii. Positions With No ‘‘Ready Market’’
                                                              specific risk, paragraph (b)(2) requires a              that the period related to ten-day
      Under VaR
                                                              broker-dealer to include separate                       movements be reduced from five to four
         Paragraph (c)(2) of proposed                         deductions for specific risk. The                       years. In response to comments
      Appendix E generally would have                         Commission will determine the                           received, the final amendments reduce
      prohibited the use of VaR models to                     deduction for specific risk on a case-by-               the period over which the greatest
      compute deductions for market risk for                  case basis based on a review of the                     adverse ten-day movements of data are
      positions with no ‘‘ready market’’; debt                broker-dealer’s application and the                     determined to four years. This change is
      securities that are below investment                    positions involved.                                     intended to approximate more closely a
      grade; and any derivative instrument                                                                            ten-day movement of prices to a 99%
      based on the value of these positions,                  c. Deduction for Market Risk Using                      confidence level.
      unless the Commission granted the                       Scenario Analysis                                          The rule as proposed would have
      broker-dealer’s application to use a VaR                                                                        allowed for the use of a three standard
      model for those positions. Under                           The Commission is amending the                       deviations alternative if historical data
      paragraph (c)(2)(vii) of the net capital                proposed rule on calculation of                         for use in a scenario analysis were
      rule, positions for which there is no                   deductions for market risk using                        limited. Commenters expressed concern
      ‘‘ready market,’’ as defined in section                 scenario analysis. Under the paragraph                  that this requirement would restrict the
      240.15c3–1(c)(11),37 would have                         (c)(5) of proposed Appendix E, the                      use of scenario analysis when historical
                                                              deduction for market risk calculated                    data is limited. We are amending the
        36 Paragraph (e)(2)(iii) of proposed E would have     using scenario analysis generally would                 proposed rule to clarify, under
      required the VaR model to use an effective              have been three times the greatest                      paragraph (b)(3) of Appendix E, as
      historical observation period of at least one year      adverse movement resulting from the
      and to include periods of market stress in that                                                                 adopted, that a broker-dealer may use
      historical observation period. One commenter
                                                              scenario analysis over any ten-day                      implied data or price histories of similar
      observed that a one-year period might not contain                                                               securities to calculate the three standard
      periods of market stress. To address this concern,      bona fide offers to buy and sell so that a price
      under paragraph (d)(2)(iii) of Appendix E, as
                                                                                                                      deviation movement if historical data is
                                                              reasonably related to the last sales price or current
      adopted, a broker-dealer must consider the effects      bona fide competitive bid and offer quotations can      insufficient.
      of market stress in its construction of the model.      be determined for a particular security almost
        37 Under § 240.15c3–1(c)(11), ‘‘[t]he term ‘ready     instantaneously and where payment will be                 38 Paragraph (c)(5) of proposed Appendix E has

      market’ shall include a recognized established          received in settlement of a sale at such price within   been redesignated as paragraph (b)(4) under
      securities market in which there exists independent     a relatively short time conforming to trade custom.’’   Appendix E, as adopted.



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