Clearing Fund Deposits-Allowable Assets

August 30, 1989

Jeffrey F. Ingber, Esquire
Associate General Counsel
Government Securities Clearing Corporation
55 Water Street
New York, New York 10041

Dear Mr. Ingber:

This is in response to your letter of June 6, 1989, in which you request an interpretation of Section 402.2 of the regulations implementing the Government Securities Act Of 1986. Specifically, you request that certain cash and securities required to be deposited with the Government Securities Clearing Corporation (GSCC) by registered government securities brokers or dealers who participate in GSCC's system for netting compared trades, as described in GSCC rule filings 89-4, 89-5, 89-6 and 89-7, (Netting System), be treated as allowable assets in the calculation of liquid capital.

We understand the facts to be as follows. The GSCC is registered as a clearing agency with the Securities and Exchange Commission (SEC) pursuant to Sections 17A(b)(2) and 19(a) of the Securities Exchange Act of 1934 (Exchange Act) (15 U.S.C. 78q-l(b)(2) and 78s(a)). Registration was granted, effective May 24, 1988, for a period not to exceed 36 months. In this role, GSCC has filed various proposed rule changes with the SEC in order to establish a legal framework for its Netting System. Upon receiving SEC approval, GSCC began its netting operation on July 7, 1989. In order to protect itself and participants in its Netting System (Netting Members) from credit and liquidity exposure, GSCC will establish and maintain, among other protections, a fund comprised of required deposits of cash and securities from each Netting Member (Clearing Fund).

The Clearing Fund will be used to cover: (i) losses arising from the default of a Netting Member; (ii) other losses arising from GSCC's clearance and settlement activity; and (iii) temporary financing obligations of GSCC normally incident to the business of clearance and settlement. Each Netting Member will contribute a minimum required amount, including a minimum amount in cash, to the Clearing Fund based on a formula that measures risk exposure to GSCC arising from the Netting Member's securities settlement activity and funds-only settlement activity, except for deposits by interdealer brokers, as defined by GSCC, which are separately defined. Additionally, the Netting Member's required fund deposit can be increased if an event or condition has been experienced that could materially affect its financial or operational capability.

Any loss resulting from the insolvency of a Netting Member will first be covered by application of that member's Clearing Fund deposit. Any residual losses allocated to direct, non-brokered transactions will be absorbed fully by all Netting Members, pro rata, based on their respective activity with the insolvent member for settlement on the day of default. For brokered transactions, 10 percent of the loss will be assessed to the interdealer brokers, as defined in the GSCC rules, with the balance allocated to all other Netting Members, pro rata, based on the trading activity of each member with the insolvent member. For a loss arising other than from a Netting Member's insolvency, GSCC's retained earnings would first be applied. If the application of retained earnings is insufficient, the cash component of the Clearing Fund collateral of each Netting Member will be used in an amount not to exceed $50,000 per Netting Member, with any remaining loss satisfied from the balance of each Netting Member's Clearing Fund Deposit. We understand that any Netting Member which is assessed an amount in excess of its Clearing Fund deposit is able to terminate its membership in GSCC and thereby not be liable for the amount in excess of its requirement.

You represent that the Clearing Fund deposits are in excess of any required margin amounts and that they do not constitute an ownership interest in GSCC. Based on the described situation, you request that the Clearing Fund deposits be determined to be allowable assets and, therefore, included in the calculation of liquid capital for government securities brokers and dealers pursuant to 17 CFR 402.2(d).

The definition of liquid capital, set out at Section 402.2(d), incorporates the SEC's definition of net capital (17 CFR 240.15c3-1(c)(2)) with certain modifications which are not relevant to your requested interpretation. Section 240.15c3-1(c)(2)(iv) of the SEC definition of net capital provides that assets not readily convertible into cash, including unsecured receivables, are to be deducted in computing net capital and, accordingly, deducted in the computation of liquid capital.

However, Paragraph 240.15c3-1(c)(2)(iv)(E) also provides that “clearing deposits” need not be so deducted. SEC Exchange Act Release 34-9587 (May 8, 1972) provides clarification of the term “clearing deposits.” The release states: “The term “clearing fund” shall mean a fund established by a clearing agency to receive and hold deposits of cash or securities or both cash and securities from members of such clearing agency for use in payment, and as security for payment, of the liabilities of such members to such clearing agency, or for use in payment by the clearing agency of liabilities it has incurred as a result of its clearing and settling of securities transactions.” In explaining this position, the release states: “Because of the importance of fostering systems for the clearance and settlement of securities transactions, because CNS [continuous net settlement] systems appear to offer substantial reductions in the movement of share certificates, ... clearing fund deposits by clearing members of clearing agencies using a CNS system for the clearance and settlement of securities transactions need not be deducted from such member's net worth in the computation of net capital under subsection (c)(2).” Additionally, in a letter to Shearman & Sterling (August 24, 1976), the staff of the Division of Market Regulation stated that an introducing broker's clearing deposit held by a registered broker or dealer can be included in the net worth of the introducing broker provided that the deposit is in excess of normal margin requirements and does not constitute an ownership interest in the caring firm.

Analysis of the nature of the Clearing Fund deposits required by GSCC indicates that they closely resemble the type of clearing deposits referred to in Paragraph 15c3-1(c)(2)(iv)(E) of SEC Rule 15c3-1. The type of clearing deposits intended to be included in the calculation of liquid capital are directly applicable to GSCC's operations and its intended purposes. Additionally, GSCC's Clearing Fund deposits are in addition to normal margin requirements and do not constitute an ownership interest in GSCC. Accordingly, based on your representations of the structure and functioning of the Clearing Fund deposits held by GSCC, it is our interpretation that the deposits should be treated as allowable assets in the computation of liquid capital. We have consulted with the staff of the SEC in arriving at this position.

Pursuant to 15 U.S.C. 78o-5(b), the provisions of 17 CFR 402.2(d), incorporating the provisions of 17 CFR 240.15c3-1(c)(2), are interpreted to mean that the Clearing Fund deposits, including deposits by interdealer brokers as defined by GSCC, provided to GSCC by the Netting Members of GSCC are “clearing deposits” within the meaning of Paragraph 240.15c3-1(c)(2)(iv)(E) and, therefore, should not be deducted in the computation of liquid capital. Any change in the facts or circumstances from what you have represented could result in a change to this interpretation.

Pursuant to 17 CFR 400.2(c)(7), this response and your incoming letter will be made immediately available to the public.

Sincerely
Richard L. Gregg
Commissioner