Self-Regulatory Organizations; Government Securities Clearing Corporation; Order Granting Approval of a Proposed Rule Change Establishing a Loss Allocation Cap for Dealers Acting as Brokers on Substantially All of Their Repurchase Agreement Trades

I. Introduction

On August 16, 2001, the Government Securities Clearing Corporation (“GSCC”) filed with the Securities and Exchange Commission (“Commission”) a proposed rule change (File No. SR-GSCC-2001-10) pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”). On August 31, 2001, GSCC amended the proposed rule change. Notice of the proposed rule change was published in the Federal Register on March 27, 2002. No comment letters were received. For the reasons discussed below, the Commission is granting approval of the proposed rule change.

II. Description

GSCC is amending its current loss allocation rule concerning non-inter-dealer broker (“dealer”) members who act as brokers in certain of their repurchase agreement (repo) transactions. Under the amended rule, repo transaction accounts of these dealers will be subject to the same $5 million per event absolute loss allocation cap currently applicable to inter-dealer brokers (“IDBs”) instead of an unlimited loss allocation liability. The rule change is designed to afford appropriate relief for these dealers while not unfairly burdening other members.

A. Loss Allocation Procedure Without Benefit of Current Rule Change

If upon liquidating a defaulting member's positions GSCC incurs a loss due to the failure of the defaulting member to fulfill its obligations to GSCC, GSCC looks to the collateral deposited by that defaulting member to satisfy the loss. If the defaulting member's collateral is insufficient to cover the loss, the defaulting member's most “recent” trading partners will be looked to, on a pro rata basis, in order to satisfy the “remaining loss.”

Before the loss can be allocated to the defaulting member's most “recent” trading partners, GSCC must first determine the proportion of the loss that arose in connection with member-brokered transactions and non-member brokered transactions and the proportion that arose in connection with direct transactions.

To the extent the remaining loss is determined by GSCC to arise in connection with member brokered transactions, GSCC's rules provide that fifty percent of the loss will be allocated to netting members that are category 1 IDBs or category 2 IDBs pro rata based upon the dollar value of each such IDB netting member's trading activity with the defaulting member compared, netted, and novated on the day of default. The remaining fifty percent of the loss will be allocated to the dealer netting members pro rata based upon the dollar value of the trading activity through IDBs of each such dealer netting member's trading activity with the defaulting member compared, netted, and novated on the day of default. For purposes of an allocation of loss determined to arise in connection with member brokered transactions, an IDB netting member will not be subject to an allocation of loss for any single loss-allocation event in an amount greater than $5 million. A dealer netting member will not be subject to an allocation of loss for any single loss-allocation event in an amount greater than the lesser of $5 million or five percent of the overall loss amount allocated to dealer netting members. To the extent that this cap is applicable, any excess amounts not collected from individual netting members, whether an IDB or a dealer, will be reallocated pro rata to the netting membership in general based on average daily clearing fund deposit requirement over the twelve-month period prior to the insolvency. However, even with the reallocation, an IDB netting member would not be subject to an aggregate loss allocation for any single loss allocation event in an amount greater than $5 million.

To the extent a remaining loss is determined by GSCC to arise in connection with non-member brokered transactions, it is allocated among the recent category 2 IDB netting members that were parties to such non-member brokered transactions pro rata based upon the dollar value of each such category 2 IDB netting member's trading activity with the defaulting member compared, netted, and novated on the day of default. For purposes of an allocation of loss determined to arise in connection with non-member brokered transactions, there is no loss-allocation cap.

To the extent a remaining loss is determined to arise in connection with direct transactions, it is allocated among the recent counterparty netting members pro rata based on the dollar value of the trading activity of each such netting member's trading activity with the defaulting member compared, netted, and novated during the recent trading period. For purposes of an allocation of loss determined to arise in connection with direct transactions, there is no loss-allocation cap.

Under the current loss allocation procedure, dealer netting members acting as brokers on all or substantially all of their repo transactions do not enjoy the $5 million per event absolute loss allocation cap applicable to IDBs. Consequently, these dealers are likely to be disproportionately assessed for allocation loss in the current environment.

B. Changes to Loss Allocation Procedure Under the Rule Change

The rule change addresses the manner in which the loss allocation procedure described above will apply to dealers that act as brokers in their repo transactions. Specifically, the rule change establishes an account-based loss allocation process whereby the segregated repo accounts of these dealers are treated in the same way as IDB accounts.

In order to accomplish this, GSCC added two new definitions to its rules, “non-IDB repo broker” and “segregated repo account.” A non-IDB repo broker with respect to activity in its segregated repo account is a dealer netting member that GSCC has determined operates in the same manner as a broker and participates in GSCC's repo netting service pursuant to the same requirements imposed under GSCC's rules on IDB netting members that participate in that service. These requirements include keeping their brokered repo activity (with a GSCC netting member on each side of each trade) in a separate account called the segregated repo account.

Since GSCC's loss allocation procedures with respect to remaining losses distinguish between brokered transactions and direct transactions and since it is with respect to non-IDB repo brokers' brokered transactions that GSCC is giving relief, the rule change amends: (i) The definition of “brokered transaction” to include transactions in which a non-IDB repo broker with regard to activity in its segregated repo account is a party; (ii) the loss allocation rule applicable to brokered transactions to include references to non-IDB repo brokers and the activity in their segregated repo accounts; and (iii) the loss allocation rule to provide non-IDB repo brokers with regard to activity in their segregated repo accounts with a cap on their total loss allocation obligation of $5 million as is currently applied to IDB netting members.

All of the other activity processed by non-IDB repo brokers outside of their segregated repo broker accounts will continue to be subject to the loss allocation rules applicable to dealer netting members.

III. Discussion

Section 17A(b)(3)(F) of the Act requires that the rules of a clearing agency not be designed to permit unfair discrimination among participants in the use of the clearing agency. The rule change provides that dealer participants of GSCC that act as brokers in their repo transactions will be subject to the same $5 million per event absolute loss allocation cap that is applicable to IDBs instead of to an unlimited loss allocation liability. The rule change should provide for a more equitable loss allocation process among GSCC's participants and, therefore, should remove any unfair discrimination in the area of loss allocation among GSCC dealers and brokers where their securities businesses are similar. Therefore, the Commission finds that the rule change is consistent with Section 17A of the Act and the rules and regulations thereunder.

IV. Conclusion

On the basis of the foregoing, the Commission finds that the proposed rule change is consistent with the requirements of the Act and in particular with the requirements of Section 17A of the Act and the rules and regulations thereunder applicable.

It is therefore ordered, pursuant to Section 19(b)(2) of the Act, that the proposed rule change (File No. SR-GSCC-2001-10) be and hereby is approved.