Source:

SR-NSCC-2022-00534-95245: Notice of Designation of Longer Period for Commission Action on a Proposed Rule Change to Revise the Excess Capital Premium Charge

Additional Materials: Exhibit 5Comments received are available for this proposal.

• Submit Comments on SR-NSCC-2022-005

Wut Mean?

The proposed rule change consists of modifications to Procedure XV (Clearing Fund Formula and Other Matters) of NSCC’s Rules & Procedures (“Rules”)4 to revise the Excess Capital Premium (“ECP”) charge by enhancing the methodology for calculating the charge to:

(1) compare a Member’s applicable capital amounts with the amount it contributes to the Clearing Fund that represents its volatility charge,

(2) for Members that are broker-dealers, use net capital amounts rather than excess net capital amounts in the calculation of the ECP charge; and for all other Members, use equity capital in the calculation of the ECP charge, and

(3) establish a cap of 2.0 for the Excess Capital Ratio (as defined below) that is used in calculating a Member’s ECP charge.

The proposed changes would also improve the transparency of the Rules regarding the ECP charge by (1) clarifying the capital amounts that are used in the calculation of the charge by introducing new defined terms, (2) removing NSCC’s discretion to waive or reduce the charge, and (3) providing that NSCC may calculate the charge based on updated capital information

Purpose

NSCC is proposing to modify the ECP charge, which is a component of its Clearing Fund that NSCC may impose on a Member when a portion of that Member’s Required Fund Deposit (defined in the Rules as the “Calculated Amount”) exceeds its applicable capital amounts by 1.0 (defined in the Rules as the “Excess Capital Ratio”), as described in greater detail below.5

The proposed changes would revise the ECP charge by enhancing the methodology for calculating the charge to:

(1) compare a Member’s applicable capital amounts with the amount it contributes to the Clearing Fund that represents its volatility charge,

(2) for Members that are broker-dealers, use net capital amounts rather than excess net capital amounts in the calculation of the ECP charge; and for all other Members, use equity capital in the calculation of the ECP charge, and

(3) establish a cap of 2.0 for the Excess Capital Ratio that is used in calculating a Member’s ECP charge.

The proposed changes would also improve the transparency of the Rules regarding the ECP charge by (1) clarifying the capital amounts that are used in the calculation of the charge by introducing new defined terms, (2) removing NSCC’s discretion to waive or reduce the charge, and (3) providing that NSCC may calculate the charge based on updated capital information, as described in greater detail below.

Overview of the Required Fund Deposit and NSCC’s Clearing Fund

As part of its market risk management strategy, NSCC manages its credit exposure to Members by determining the appropriate Required Fund Deposits to the Clearing Fund and monitoring its sufficiency, as provided for in the Rules. The Required Fund Deposit serves as each Member’s margin.

The objective of a Member’s Required Fund Deposit is to mitigate potential losses to NSCC associated with liquidating a Member’s portfolio in the event NSCC ceases to act for that Member (hereinafter referred to as a “default”).*

The aggregate of all Members’ Required Fund Deposits constitutes the Clearing Fund of NSCC. NSCC would access its Clearing Fund should a defaulting Member’s own Required Fund Deposit be insufficient to satisfy losses to NSCC caused by the liquidation of that Member’s portfolio. Pursuant to the Rules, each Member’s Required Fund Deposit consists of a number of applicable components, each of which is calculated to address specific risks faced by NSCC, as identified within Procedure XV of the Rules.

*The Rules identify when NSCC may cease to act for a Member and the types of actions NSCC may take. For example, NSCC may suspend a firm’s membership with NSCC or prohibit or limit a Member’s access to NSCC’s services in the event that Member defaults on a financial or other obligation to NSCC.

Similarly, the ECP charge is a component of the Clearing Fund that is designed to mitigate the heightened default risk a Member could pose to NSCC if it operates with lower capital levels relative to its margin requirements.

Each Business Day, NSCC determines if a Member may be subject to the ECP charge by first determining its Calculated Amount. The Calculated Amount is a portion of a Member’s Required Fund Deposit designed to represent its margin requirements to NSCC.

A Member’s Calculated Amount is calculated as its Required Fund Deposit excluding any applicable special charge, margin requirement differential charge, coverage component charge or margin liquidity adjustment charge,10 plus any additional amounts the Member is required to deposit to the Clearing Fund either due to being placed on the Watch List11 or pursuant to Rule 15 (Assurances of Financial Responsibility and Operational Capability) of the Rules.12

NSCC then divides the Member’s Calculated Amount by its current capital amount, which is the amount reported to NSCC pursuant to its ongoing membership standards, as set out in Rule 2B (Ongoing Membership Requirements and Monitoring) and Addendum B (Qualifications and Standards of Financial Responsibility, Operational Capability and Business History) of the Rules.

Pursuant to the current membership standards in Addendum B of the Rules, Members that are broker-dealers are required to maintain a certain level of excess net capital, and Members that are banks are required to maintain a certain level of equity capital as a requirement for continued membership with NSCC.14 Pursuant to Section 2 of Rule 2B of the Rules, Members are required to provide NSCC with financial information, including information regarding Members’ current capital amounts, on a regular basis and NSCC uses these reported capital amounts in the calculation of the ECP charge.

Pursuant to Section I(B)(2) of Procedure XV, if a Member’s Calculated Amount, when divided by its applicable capital amount, is greater than the Excess Capital Ratio of 1.0, NSCC may require that Member to deposit an ECP charge. The applicable ECP charge may be equal to the product of

(1) the amount by which a Member’s Calculated Amount exceeds its applicable capital amount, multiplied by

(2) the Member’s Excess Capital Ratio.

Members are able to access and view reports regarding their Clearing Fund and, through these reports, Members may be alerted when their Calculated Amount divided by the applicable capital amount is greater than 0.5, as an early warning regarding their capital levels.

Under Section I(B)(2) of Procedure XV, NSCC may collect a lower ECP charge than the amount calculated pursuant to the Rules, may determine not to collect the ECP charge from a Member at all, and may return all or a portion of a collected ECP charge if it believes the imposition or maintenance of the ECP charge is not necessary or appropriate. Section I(B)(2) of Procedure XV describes some circumstances when NSCC may determine not to collect an ECP charge from a Member, which includes, for example, when an ECP charge results from trading activity for which the Member submits later offsetting activity that lowers its Required Fund Deposit. The discretion to adjust, waive or return an ECP charge was designed to provide NSCC with the ability to determine when a calculated ECP charge may not be necessary or appropriate to mitigate the risks it was designed to address.

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Use Members’ Volatility Component as the Calculated Amount

NSCC is proposing to replace the Calculated Amount with the amount collected as that Member’s volatility component as determined pursuant to Sections I(A)(1)(a)(i)- (iii) and (2)(a)(i)-(iii) of Procedure XV of the Rules.*

In both determining if an ECP charge is applicable and in calculating an ECP charge, NSCC currently compares a Member’s Calculated Amount to its reported capital levels. As described above, the Calculated Amount is defined in Section I(B)(2) of Procedure XV as a Member’s Required Fund Deposit, excluding certain components and including other additional deposits to the Clearing Fund.

Because a goal of the ECP charge is to identify and mitigate risks presented when a Member’s capital levels may not be adequate to meet its margin requirements to NSCC, the Calculated Amount is designed to represent a material portion of those margin requirements.

As described above, because each component of the Clearing Fund is calculated to address specific risks faced by NSCC, some components are applied only to certain positions in a Member’s portfolio. For example, the CNS fails charge, which is included in the Calculated Amount, is based on the market value of only a Member’s CNS Fails Positions (as defined in the Rules) of the Member.

The volatility component of the Clearing Fund measures the market price volatility of all of a Member’s Net Unsettled Positions and Net Balance Order Unsettled Positions (as defined in the Rules). Therefore, the volatility component is often considered a comprehensive measurement of the risks presented by a Member’s clearing activity and usually comprises the largest portion of a Member’s Required Fund Deposit.

NSCC believes that replacing the Calculated Amount with a Member’s volatility charge would provide an appropriate measure for purposes of the ECP charge. Currently, determining a Member’s Calculated Amount requires a more complicated calculation, as it uses a Member’s Required Fund Deposit, excludes certain components, and includes other deposits. The proposal would simplify this calculation significantly by using only the volatility component.

* The volatility component is designed to capture the market price risk associated with each Member’s portfolio at a 99th percentile level of confidence. NSCC has two methodologies for calculating the volatility component – a model-based volatility-at-risk, or VaR, charge and a haircut-based calculation, for certain positions that are excluded from the VaR charge calculation. The charge that is applied to a Member’s Required Fund Deposit with respect to the volatility component is referred to as the volatility charge and is the sum of the applicable VaR charge and the haircut-based calculation. Amounts calculated pursuant to Sections I(A)(1)(a)(iv) and (2)(a)(iv) of Procedure XV with respect to long positions in Net Unsettled Positions in Family-Issued Securities are designed to address wrong-way risk presented by these positions, not volatility risks, and, as such, are not a part of a Member’s volatility charge.

Use Net Capital for Broker-Dealer Members and Equity Capital for All Other Members in the Calculation of the ECP Charge

In the calculation of the ECP charge, NSCC is proposing to use net capital rather than excess net capital for Members that are broker-dealers, and equity capital for all other Members.

As described above, NSCC’s ongoing membership requirements, set forth in Rule 2B of the Rules, require Members to provide NSCC with regular information regarding their financial positions, including capital levels.

This information is provided, in part, to confirm that Members continue to maintain the minimum financial requirements of membership set forth in Addendum B of the Rules.25 Currently, NSCC also uses these reported capital amounts in the calculation of the ECP charge.

First, NSCC believes it would be appropriate to revise the capital measure used to calculate the ECP charge for broker-dealer Members to replace excess net capital with net capital. This revision would align the capital measures used for broker-dealer Members and other Members, which would result in more consistent calculations of the ECP charge across different types of Members.

In addition to creating consistency in the calculations for different Members, NSCC believes that using net capital rather than excess net capital would also provide NSCC with a better measure of the increased default risks presented when a Member operates at low net capital levels relative to its margin requirements.

This approach would be consistent with the rationale for the Commission’s amendments to Rule 15c3-1 under the Act (the “Net Capital Rule”), which were designed to promote a broker-dealer’s capital quality and require the maintenance of “net capital” (i.e., capital in excess of liabilities) in specified amounts as determined by the type of business conducted.

The Net Capital Rule was designed to ensure the availability of funds and assets (including securities) in the event that a broker-dealer’s liquidation becomes necessary. The Net Capital Rule represented a net worth perspective, which is adjusted by unrealized profit or loss, deferred tax provisions, and certain liabilities as detailed in the rule. It also included deductions and offsets and required that a broker-dealer demonstrate compliance with the Net Capital Rule, including maintaining sufficient net capital at all times (including intraday).

Similarly, NSCC believes that the Net Capital Rule is an effective process of separating liquid and illiquid assets and computing a broker-dealer’s regulatory net capital that should replace NSCC’s existing practice of using excess net capital in the calculation of the ECP charge.

Therefore, in practice, the ECP charge is calculated for the majority of Members that are not broker dealers using their equity capital, and this proposed change is not expected to have a material impact on the collection of ECP charges. The proposal would simplify the calculation of the ECP charge for Members that are not broker-dealers by stating in Section I(B)(2) of Procedure XV that NSCC would use equity capital rather than use different measures that are based on other membership requirements. This proposed change would also create consistency in the calculations across Members.

Establish a Cap for the Excess Capital Ratio

NSCC is proposing to set a maximum amount of Excess Capital Ratio that is used in calculating Members’ ECP charge to 2.0. NSCC believes capping the multiplier that is used in this calculation would allow NSCC to appropriately address the risks it faces without imposing an overly burdensome ECP charge.

Historically, the Excess Capital Ratio has rarely exceeded 2.0 in the calculation of Members’ ECP charges, and in cases when 2.0 was exceeded NSCC typically exercised the discretion provided to it in the Rules to reduce the applicable charge.

NSCC’s discretion was appropriate in these circumstances because NSCC believes it is able to mitigate the risks presented to it by a Member’s lower capital levels by collecting an ECP charge calculated with an Excess Capital Ratio that is at or below 2.0. Therefore, given that NSCC is now proposing to remove its discretion to waive the ECP charge.

NSCC is proposing to retain some discretion in when it would accept updated capital information for this purpose. For example, NSCC may require a Member to provide documentation of the circumstances that caused a change in capital information, and if adequate evidence is not available or NSCC does not believe the evidence sufficiently verifies that the Member’s capital position has changed, NSCC would continue to calculate the ECP charge for that Member based on the prior capital information available to NSCC until the next financial reporting or financial statements are delivered. NSCC believes it is appropriate to retain some discretion to allow NSCC to determine if updated capital information is adequately verified before it agrees to rely on that information for this calculation.

Proposed Changes to Procedure XV of the Rules

The proposal would also amend Section I(B)(2) of Procedure XV of the Rules. This section would describe the calculation used to determine if an ECP charge may be applicable to a Member. The revised description of this calculation would (i) replace the definition of Calculated Amount with Members’ volatility charge, (ii) replace references to the capital amounts used in the calculation with the new defined terms for Net Capital and Equity Capital, and (iii) state that the Excess Capital Ratio used in calculating an ECP charge is set at a maximum of 2.0. The proposed change also includes a statement that the applicable capital amounts used in the calculation would be the amounts most recently reported to NSCC on Members’ FOCUS Reports or Call Reports, as applicable, or other equivalent financial reporting submitted to NSCC pursuant to Section 2 of Rule 2B.

Finally, the proposal would state that NSCC may, in its sole discretion, accept updated capital amounts in calculating an ECP charge

Impact Study Results

NSCC has provided the Commission with the results of an impact study that reviewed the potential impacts of the proposal during the period of June 1, 2020 through December 31, 2021. The study showed that the proposed enhancement would have reduced the number of ECP charges that would have been triggered by the calculation by 65 percent, from 327 ECP charges triggered for 17 Members to 114 ECP charges triggered for 14 Members.

The total aggregate amount that would have been triggered by the proposed calculation if the proposal was effective during that time would have been reduced from $50.95 billion (the actual total amount of ECP charges triggered by the current calculation during that period) to approximately $17.22 billion (the total amount of ECP charges that would have been triggered during that time by the proposed calculation).

The average amount that would have been calculated for each Member would have been reduced from $155.8 million to approximately $151.1 million. The study showed that the proposal would have had no impact to NSCC’s overall, or Member-level, end-of-day Clearing Fund Requirement backtesting coverage. Over the impact study period, NSCC waived and reduced calculated ECP charges by $38.46 billion. NSCC waived a total of 20 ECP charges, that totaled approximately $25.77 billion.

If the proposal had been in place at that time, 15 of these charges would have been collected from Members (although the amount would have been reduced), totaling $6.43 billion, 2 charges would not have been triggered as the calculated ECP ratio was below 1.0, and NSCC would have waived 3 of the ECP charges following receipt of updated financial information.

NSCC reduced the amount of 16 ECP charges by a total of approximately $12.69 billion. If the proposal had been in place at that time, 6 of these charges would have been still collected, totaling $6.35 billion, and 10 charges would not have been triggered as the calculated ECP ratio was below 1.0.

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