May 9,1997 Office of the Commissioner Bureau of the Public Debt 999 E Street, N.W. Washington, D.C.

20239 Attention: Richard L. Gregg, Commissioner Re: 17 CFR Sections 402.1(e)(8) and 402.2(g)(1) Dear Mr. Gregg: I am writing on behalf of the Government Securities Clearing Corporation ("GSCC"), a corporation granted temporary registration as a clearing agency1 by the Securities and Exchange Commission ("Commission") pursuant to Sections 17A(b)(2) and 19(a) of the Securities Exchange Act of 1934, as amended ("Exchange Act").2 As the Office of the Commissioner ("Office") is aware, GSCC performs unique risk management and settlement efficiency functions with regard to the Government securities market.3 Recognizing these functions, in a letter dated December 11, 1990 ("Exemptive Letter"),4 you granted certain exemptions from the Treasury regulations implementing the Government Securities Act of 19865 for the benefit of registered government securities brokers or dealers ("Netting Members") that participate in GSCC's Netting System. The Exemptive Letter permits Netting Members to exclude from their credit risk haircuts and from their net exposure haircuts all calculations based on trades that have been netted and novated by GSCC. In a letter of January 9, 1995 ("When-Issued Letter"), you extended the exemptions granted in the Exemptive Letter regarding certain Government Securities Act capital rules for when-issued trades of Netting Members from the time such trades are netted and novated by GSCC.6 In the When-Issued Letter, you cited the netting and novation of when-issued trades prior to the auction date, and the structure and operation of GSCC's Netting System (emphases added), as warranting the extension of the exemptions for credit risk and net exposure haircuts to when-issued trades. The Exemptive Letter carved out Clearing Fund deposits from the relief granted netted and novated trades. GSCC believes that its experience during the last six years with the Clearing Fund formula clearly demonstrates that the risk of loss of a Netting Member's Clearing Fund deposits, which can arise only as the result of another Netting Member's default and the incurring of a loss by GSCC as the result of its liquidation of the defaulting member's positions, is insignificant in comparison to the credit risk haircut charge required by the Treasury regulations. Therefore, the purpose of this letter is to respectfully request that the Office grant an exemption for the benefit of GSCC Netting Members, pursuant to 15 U.S.C. 78o-5(a)(4), from Sections 402.1(e)(8) and 402.2(g)(1) of the Treasury Department regulations promulgated under Section 15C of the Exchange Act in respect of certain haircut calculations on assets placed with GSCC as Clearing Fund deposits by Netting Members that are registered Government securities brokers

(including any Government securities interdealer broker as defined in Section 402.1(e)(2) that has elected not to be subject to the limitations of Section 402.2 -- (an "Interdealer Broker")) or dealers. The requested exemptions would reduce a GSCC Netting Member's determination of its "credit risk haircut" under Section 402.2(g)(1) (or, in the case of an Interdealer Broker, the "net exposure to each counterparty" under Section 402.1(e)(8)). Discussion The Exemptive Letter granted Netting Members that participate in the GSCC Netting System permission to exclude from their credit risk haircuts and from their net exposure haircuts calculations all trades that had been netted and novated by GSCC.7 The exemptions were based on your concurrence that the GSCC Netting System greatly reduces the risk that GSCC, as contraparty to trades with Netting Members, will fail to settle its securities and funds obligations. Similarly, the When-Issued Letter concluded in pertinent part that, "[t]he elimination of [obligations, incident to] the vast majority of transactions between participants in the GSCC Netting System, novation by GSCC, the daily marking-to-market of Netting Members' net settlement positions, and other credit protections greatly reduce the risk that GSCC, as the counterparty to trades with Netting Members, will fail to settle its securities and funds obligations."8 (Emphasis added.) Clearing Fund deposits are part of those "other credit protections," and the Clearing Fund collateral program is designed specifically to "protect [GSCC] and participants in its Netting System (Netting Members) from credit and liquidity exposure."9 GSCC's Clearing Fund formula has been determined by the Commission to be consistent with Exchange Act requirements and has been closely analyzed in that regard by the Commission. Section 17A(b)(3)(F) of the Exchange Act provides, among other things, that the rules of a clearing agency must be designed to ensure the safeguarding of funds and securities that are in the custody or control of the clearing agency or for which it is responsible.10 In its release announcing standards for the registration of clearing agencies, the Commission stated that a clearing agency should establish an appropriate level of Clearing Fund contributions based on the particular types of risk to which it is subject.11 In 1990, the Commission, in granting temporary approval to GSCC's Clearing Fund formula,12 directed GSCC to assess the operation of the formula before it became a permanent part of GSCC's Netting System.13 GSCC was required to monitor its formula on a daily basis to determine the effectiveness of its formula in protecting GSCC against risks associated with forward-settling and regular trades. GSCC also was required to regularly report to the Commission, among other things, any situation where GSCC could make a special call for additional Clearing Fund deposits or where the collected deposits for a particular month were less than certain parameters, and also the accuracy of the formula's margin factors and disallowance percentages.14 The Commission also directed GSCC to conduct monitoring on a daily basis to ensure that GSCC -- principally through the Clearing Fund -- had sufficient liquidity during periods of high volatility to protect GSCC and its solvent members.

In 1993, the Commission granted permanent approval to GSCC's Clearing Fund formula, stating that GSCC's formula, by providing GSCC with effective methods for measuring the risk profile of its members' securities and funds settlement obligations, was consistent with GSCC's responsibilities relating to the safeguarding of funds and securities under the Exchange Act.15 After three years of monitoring and close examination of its Clearing Fund formula's operation, GSCC determined, and the Commission concurred, that the formula accurately assessed and protected GSCC against a Netting Member's risk in all market conditions.16 GSCC has continued to modify its Clearing Fund formula to ensure that its formula, as you stated in 1989, "protects [GSCC] and its Netting Members from credit and liquidity exposure."17 With the introduction of repurchase and reverse repurchase netting ("Repo Netting") in 1995, GSCC amended its Clearing Fund rules to incorporate provisions appropriate to accommodate the risks associated with Repo Netting.18 The Commission, in granting approval to GSCC's Repo Netting program, stated that it believed that the margin and Clearing Fund contributions appropriately take into account the risks posed to GSCC by the settlement of repos. In addition, the Commission stated "that by revising its Clearing Fund formula to take into account repo activity, GSCC will have sufficient liquidity to provide for the safeguarding of securities and funds."19 Recently, in compliance with GSCC's ongoing obligations as a registered clearing agency and self-regulatory organization, a comprehensive risk assessment of GSCC, analyzing the consequences to GSCC of the unexpected failure of a netting member, was completed. The assessment concludes, among other things, that GSCC's methodologies for computing risk, and its mechanisms for collateralizing and mitigating this exposure -- particularly Clearing Fund margin -- are sound and provide GSCC with a high level of confidence that: (a) the liquidation of an insolvent member's portfolio and the subsequent application of its collateral deposit would not likely result in either a loss or in any liquidation risk to GSCC, and (b) in those unlikely scenarios where a loss may occur, such loss would not induce the failure of any other member. A copy of the assessment is enclosed. Based on the specific findings in the assessment, it may be said that, in the event of a Netting Member's insolvency, the insolvent Netting Member's Clearing Fund deposits would be sufficient in virtually every circumstance to permit GSCC to close out the insolvent Netting Member's obligations without a loss that would require the use of solvent Netting Members' Clearing Fund deposits). In addition to the theoretical integrity of GSCC's Clearing Fund formula and general risk protection mechanisms, I note that, in its almost-eight years of netting experience, GSCC has never had occasion to declare a member insolvent and, thus, has never applied Clearing Fund assets in a liquidation. (Indeed, it is fair to say that GSCC has never even come close to taking such action.) In the only situation in which GSCC ceased to act for a netting member -- involving the now-defunct Fundamental Brokers Inc. (FBI") -- GSCC's early warning systems enabled it to identify FBI's problems far in advance of a potential default situation and to work with the firm to reduce and gradually eliminate its processing activity at GSCC before FBI withdrew from membership. While past history does not predict the future, we feel confident that the conservative nature of GSCC's Clearing Fund formula, when considered in combination with other Netting System safeguards, will

continue to enable GSCC to fully and appropriately protect its members against counterparty settlement and default risks. The Treasury regulations governing the calculation of credit risk haircuts and net exposure haircuts were promulgated following the passage by Congress of the Government Securities Act of 1986. Those regulations were created to protect the Government securities market from the risks associated with counterparty credit exposures pursuant to bilateral contracts between Government securities brokers and/or dealers. These regulations did not envision the existence of GSCC, nor did they take into account the nature and extent of the risk management controls introduced to the trading and original issue markets by GSCC. It is clear today that the introduction of a Government securities clearing agency that permits multilateral netting among Government securities brokers and dealers in an operating context and that also provides prudent financial and risk management controls dramatically reduces counterparty credit exposures across the agency's membership base.20 To that effect, the Treasury, the SEC, and the Board of Governors of the Federal Reserve System have stated that GSCC's Netting System, "along with the guarantee GSCC provides, substantially reduces counterparty risk for GSCC members."21 Based on its experience, GSCC does not believe that the credit risk haircut charges (or net exposure charges) of Sections 402.1(e)(8) and 402.2(g)(1) -- developed without regard to the presence of such a clearing agency -- are proportionate to the real, limited risk of loss that should be associated with a Netting Member's Clearing Fund deposits when GSCC is the counterparty. Conclusion In view of the above, GSCC believes that the recognized effectiveness of its Clearing Fund formula, coupled with the very limited degree to which Clearing Fund deposits of GSCC members are exposed to risk, warrants extending the exemptions granted in the Exemptive Letter and expanded in the When-Issued Letter to such deposits with GSCC. Therefore, GSCC respectfully requests that the Office grant an exemption, pursuant to 15 U.S.C. 78o-5(a)(4), from Sections 402.1(e)(8) and 402.2(g)(1) of the Treasury Department regulations promulgated under Section 15C of the Exchange Act, with respect to Clearing Fund deposits held by GSCC for a Netting Member that is a registered Government securities broker (including a Government securities Interdealer Broker as defined in Section 402.1(e)(2) that has elected not to be subject to the limitations of Section 402.2) or dealer, in determining the "credit risk haircut" under Section 402.2(g)(1) (or, in the case of an Interdealer Broker, determining its "net exposure to each counterparty" under Section 402.1(e)(8)). Such an exemption, appropriately we believe, would take into account the very limited degree to which any GSCC member, and the member's Clearing Fund deposits, are exposed to risk of loss and would materially increase the availability of GSCC member capital that is otherwise subject to substantial haircuts.22 Please contact me at (212) 412-8637 or, or Jeffrey T. Brown at the law firm of Smith Lodge & Schneider Chartered at (312) 853-3230, if you have any questions or desire any additional information regarding the above request. Sincerely, Jeffrey F. Ingber

Managing Director General Counsel and Secretary Government Securities Clearing Corporation 55 Water Street New York, New York 10041-0082 cc: Jeffrey T. Brown, Esq. -- Smith Lodge & Schneider Lori Santamorena -- Bureau of Public Debt Footnotes: 1 Securities Exchange Act Release No. 37983 (November 25, 1996). 2 3 15 U.S.C. 78q-1(b)(2) and 78s(a) (1988). GSCC brings to the Government securities market the credit protections afforded by: (1) the multilateral netting of GSCC members' trades, which significantly decreases the number of deliver and receive obligations necessary to settle members' trades; (2) novation of netted trades, with GSCC assuming the position of contraparty to its members on all trades going into the net for settlement purposes; (3) daily marking-to-market (taking into account accrued interest) of the net settlement positions of each member of its Netting System; (4) the maintenance of Clearing Fund collateral and other margin to protect GSCC members against settlement default risks; and (5) a centralized loss allocation procedure for handling the close out of positions carried by an insolvent market participant that is a Netting Member. See letter of December 11, 1990, from Commissioner Gregg to Jeffrey Ingber, Associate General Counsel, GSCC. GSA Regulations, 17 CFR 400, et seq. See letter of January 9, 1995, from Commissioner Gregg to Jeffrey F. Ingber, General Counsel, GSCC. "Credit risk haircut" is defined in Section 402.2(g)(1) to equal the sum of: (1) the total counterparty exposure haircut; (2) the total concentration of credit haircut; and (3) the credit volatility haircut. "Total counterparty exposure haircut" is defined in Section 402.2(g)(1)(ii) to equal the sum of the counterparty exposure haircuts taken for all counterparties, as specified, of the Government securities broker or dealer. "Counterparty exposure haircut" equals 5 percent of the net credit exposure to a single counterparty not in excess of 15 percent of the broker's or dealer's liquid capital. The term "total concentration of credit haircut" is similarly defined in Section 402.2(g)(1)(iii) to equal the sum of the concentration of credit haircuts taken for all counterparties of the Government securities broker or dealer, with the term "concentration of credit haircut" equaling the product of 25 percent of the amount by which the net credit exposure to a single counterparty exceeds 15 percent of the broker's or dealer's liquid capital. Similarly, Section 402.1(e)(8)(i) provides that an Interdealer broker shall deduct from net worth 5 percent of its net exposure to each counterparty. (As noted in the Exemptive Letter, the credit volatility haircut is not relevant to Netting System transactions because this particular haircut applies to risks arising

4 5 6 7

from certificates of deposit, bankers acceptances, and commercial paper -- instruments that are not eligible for GSCC's Netting System.) 8 When-Issued Letter at 1. In addition, the Division of Market Regulation, in a letter dated March 13, 1996, agreed not to take enforcement action if a broker-dealer, for net capital computation purposes under paragraph (c)(2)(iv)(F) of Rule 15c3-1, treats GSCC as its counterparty for repo transactions entered into GSCC's Netting System. See letter dated March 13, 1996, from Mike Macchiaroli, Associate Director, Division of Market Regulation, Commission to Jeffrey Ingber, General Counsel and Secretary, GSCC. See letter dated August 30, 1989, from Commissioner Gregg to Jeffrey F. Ingber, Associate General Counsel, GSCC (wherein the Office determined that Clearing Fund deposits should be treated as allowable assets in GSCC members' computation of liquid capital).


10 15 U.S.C. Sec. 78q-1(b)(3)(F) (1988). 11 Securities Exchange Act Release No. 16900 (June 17, 1980). 12 GSCC's Clearing Fund formula calculates the amount a member must contribute to the fund to collateralize the risk its daily settlement activities pose for GSCC. At the time temporary registration was granted, the two basic components of a participant's required Clearing Fund deposit related to funds-only settlement obligations and securities net settlement obligations. Securities Exchange Act Release No. 33238 (November 22, 1993). Subsequently, as discussed below, the formula was expanded to include a component relating to Repo Netting obligations. 13 Securities Exchange Act Release Nos. 27901 and 27902 (April 12, 1990). 14 The term "margin factors" means the set of percentages, specified in a schedule published by GSCC setting forth variations weighted by maturity and product, that is used to calculate the portion of a Netting Member's Clearing Fund deposit necessary to cover the securities settlement exposure posed by such Netting Member to GSCC. Accurate margin factors help GSCC ensure that it is requiring its members to contribute a Clearing Fund deposit that adequately protects GSCC from risk exposure should a member default. In the event of a member default or insolvency, GSCC would be obligated to sell-out and buy-in securities at prices that might vary greatly from those of the previous day. In that case, an insufficient margin factor could cause GSCC to suffer significant loses. Id. Disallowance percentages are factors by which GSCC reduces credits for offsetting positions (i.e., those displaying historical market price correlation sufficient to justify offsetting Clearing Fund formula credits and debits) to protect against the risk that market price correlation among offsetting securities is imperfect or will deviate from historical norms. Id. 15 Securities Exchange Act Release No. 33238 (November 22, 1993). 16 Id. 17 Supra Note 9. 18 Securities Exchange Act Release No. 36491 (Nov. 13, 1995). GSCC added

a new component, the repo volatility factor, to its Clearing Fund formula. Repo volatility factors are percentages that are applied to the net settlement repo positions to cover the rate exposure posed by such repo activity. Initially, the repo volatility factor was set at 50 basis points, which exceeded the largest one day movement (41 basis points) in all general collateral repos studied over a two-year period. As an illustration of the confidence level of the 50 basis point test, a two standard deviation movement test would only be equal to 10 basis points. 19 Id. 20 Supra Note 9. Such risk reduction underlies, in part, the arrangements under which the Treasury and the Federal Reserve Banks deliver to GSCC purchase and position data for GSCC members in connection with GSCC's program for processing and settling members' Treasury auction purchases. 21 See Joint Report on the Government Securities Market, Department of the Treasury, Securities and Exchange Commission, and Board of Governors of the Federal Reserve System (January 1992), at xi. 22 In 1996, netting and novation at GSCC reduced the daily average gross dollar value of GSCC members' aggregate trades processed through GSCC from $320 billion to $92 billion, ultimately facilitating many millions of dollars in relief from capital charges pursuant to the Exemptive Letter and the When-Issued Letter.