

[Federal Register: December 23, 2005 (Volume 70, Number 246)]
[Notices]               
[Page 76337-76344]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr23de05-116]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-52969; File No. SR-NYSE-2005-38]

 
Self-Regulatory Organizations; New York Stock Exchange, Inc.; 
Notice of Filing of Proposed Rule Change and Amendment No. 1 Thereto to 
Rules 104 (``Dealings by Specialists'') and 123E (``Specialist 
Combination Review Policy'') To Change the Exchange's Capital 
Requirements for Specialist Organizations.

 December 16, 2005.
    Pursuant to section 19(b)(1) \1\ of the Securities Exchange Act of 
1934 (the ``Exchange Act''),\2\ and Rule 19b-4 thereunder,\3\ notice is 
hereby given that on May 26, 2005, the New York Stock Exchange, Inc. 
(``NYSE'' or the ``Exchange'') filed with the Securities and Exchange 
Commission (``SEC'' or

[[Page 76338]]

the ``Commission'') a proposed rule change. On November 22, 2005, NYSE 
amended the proposed rule change, replacing it in its entirety 
(``Amendment No. 1''). The amended proposed rule change is described in 
Items I, II, and III below, which have been substantially prepared by 
the Exchange. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 15 U.S.C. 78a et seq.
    \3\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The New York Stock Exchange, Inc. (``NYSE'' or the ``Exchange'') 
hereby proposes amendments to Rules 104 (``Dealings by Specialists'') 
and 123E (``Specialist Combination Review Policy'') to change the 
capital requirement of specialist organizations. The text of the 
proposed rule change is set forth below. Italics indicate additions; 
brackets indicate deletions.
* * * * *
Rule 104. Dealings by Specialists
    (a)-(b) No Change
    * * *
Supplementary Material:
Functions of Specialists
    .10 through .17 No Change
Capital Requirements of Specialists [(effective June 1, 1971.)]
.20 [Regular s]Specialist[s] Organizations--Minimum Capital 
Requirements.--
    [(1) A member registered as a regular specialist at an active post 
must be able to assume maintain a position of 150 trading units in each 
common stock in which he is registered.
    (2) A member registered as a regular specialist at an active post 
must be able to assume a position of 30 trading units in each 
convertible preferred stock, of 1200 shares in each of the 100 share 
trading unit non-convertible preferred stocks and of 300 shares in each 
of the 10 share unit non-convertible preferred stocks in which he is 
registered.
    (3) The position which a member registered as a regular specialist 
at an active post must be able to assume, for each stock in which he is 
registered that is not included in (1) or (2) above, shall be 
determined by the Exchange. Such determinations shall be based upon the 
structure and characteristics of the security and shall be the amount 
prescribed in (1) or (2) above for the type of stock with the most 
similar structure and characteristics.
    (4) A member registered as a regular specialist at the inactive 
Post must have, at all times, net liquid assets of at least $150,000.
    (5) With respect to any Investment Company Unit (as defined in 
paragraph 703.16 of the Listed Company Manual) or a Trust Issued 
Receipt, a member registered as a regular specialist [at an active 
post] shall maintain net liquid assets equivalent to $500,000 for each 
such security in which the specialist is registered.]
    (1) A specialist organization that is only registered in Exchange 
Traded Funds shall maintain the greater of $500,000 for each Exchange 
Traded Fund or $1,000,000.
    ([6]2) [Notwithstanding .30 of this Rule, e] Each [member 
registered as a regular] specialist organization [at an active post] 
must [be able to] maintain net liquid assets which shall be the greater 
of $1,000,000 or the requirements set forth in Rule 104.21, except for 
those specialist organizations that are only registered in Exchange 
Traded Funds, as set forth in 104.20(1) above. [establish that he can 
meet, with his own net liquid assets, a minimum capital requirement 
which shall be the greater of $1,000,000 or 25% of the position 
requirements as set forth in Paragraphs (1), (2) and (3) above, except 
as determined by the Exchange in unusual circumstances.]
    (3) The Division of Member Firm Regulation must be informed 
immediately by a specialist organization [, in each instance, of his 
inability] whenever it is unable to comply with the [provisions] 
requirements set forth in [the above Paragraphs] Rules 104.20 or .21, 
as applicable.
    ([7]4) [For those members registered as a regular specialist 
subject to the Net Capital Rule (SEA Rule 15c3-1), t] The term ``net 
liquid assets'' refers to excess net capital computed in accordance 
with Rule 15c3-1, promulgated under the Securities Exchange Act of 1934 
(the ``Exchange Act'') and the provisions of Exchange Rule 325 
(``Capital Requirements'') with the following adjustments:
    (i) Additions for haircuts and undue concentration charges taken 
pursuant to Section (c)(2)(vi)(M) of Rule 15c3-1 on specialty 
securities in dealer accounts;
    [(ii) Additions for any other haircuts on long positions which are 
deposited or pledged as collateral for funds borrowed to finance dealer 
transactions or positions in specialist securities;]
    ([i]ii) Deductions for floor brokerage and/or commissions 
receivable;
    ([iv]iii) Deductions for clearing organization deposits; and
    (iv) Deductions for any cash surrender value of life insurance 
policies allowable under [the Net Capital Rule] Rule 15c3-1, under the 
Exchange Act.
    [(8) For members registered as a regular specialist not subject to 
the Net Capital Rule, ``net liquid assets'' is defined as the excess of 
cash, net credit balances at clearing broker(s), and readily marketable 
securities over all liabilities.]
    (5) In the event that two or more specialist[s] organizations are 
associated with each other and deal for the same specialist account, 
the [above] capital requirements enumerated in Rules 104.20 and .21 
shall apply to such specialist[s] organizations as one unit, rather 
than to each specialist organization individually. Any joint account 
must be approved by the Divisions of Market Surveillance and Member 
Firm Regulation.
.21 [Concentration Measure] Specialist Organizations--Additional 
Capital Requirements.--
Notwithstanding the provisions of (1) through (5) in Rule 104.20 above, 
if a regular specialist entity's market share exceeds 5% of any of the 
following concentration measures:
    (1) All listed common stock (current);
    (2) The 250 most active listed common stocks (over the previous 12 
months);
    (3) The total share volume of stock trading on the Exchange (over 
the previous 12 months); or
    (4) The total dollar value of stock trading on the Exchange (over 
the previous 12 months)

such entity shall maintain net liquid assets equivalent to the 
following applicable requirements:
    (i) $4 million for each specialist security contained in the DJIA;
    (ii) $2 million for each specialist security contained in the S&P 
100, not contained in (i);
    (iii) $1 million for each specialist security contained in the S&P 
500, not contained in (i) or (ii);
    (iv) $500 thousand for each specialist common stock, excluding bond 
funds, not contained in (i), (ii) or (iii);
    (v) $100 thousand for each specialist security not included in (i) 
through (iv), excluding warrants.
    (vi) $500,000 for each specialist security that is an Investment 
Company Unit (as defined in paragraph 703.16 of the Listed Company 
Manual) or a Trust Issued Receipt.]
    (1) Each specialist organization subject to Rule 104.21 must 
maintain minimum net liquid assets equal to:
    (i) $1,000,000 for each one tenth of one percent (.1%) of Exchange 
transaction dollar volume in its

[[Page 76339]]

registered securities, exclusive of Exchange Traded Funds, plus 
$500,000 for each Exchange Traded Fund; and
    (ii) A market risk add-on, which shall be calculated as follows:
    (a) The specialist organization may use an Exchange-approved value-
at-risk (VaR) model to calculate its market risk add-on. The VaR model 
must have a 99%, one-tailed confidence level with price changes 
equivalent to a ten business day movement in rates and prices. To 
calculate the market risk add-on, the specialist organization 
multiplies the VaR of specialist dealer and related positions by the 
appropriate multiplication factor, which is set at a minimum of three. 
The results of quarterly backtesting determine which of the 
multiplication factors contained in Table 1 of Rule 104.22 a specialist 
organization must use; or
    (b) For those specialist organizations not utilizing VaR or whose 
models have not been approved by the NYSE, three times the average of 
the prior twenty business days' securities haircuts on its specialist 
dealer's positions computed pursuant to Rule 15c3-1(c)(2)(vi), 
exclusive of paragraph (N), under the Exchange Act.
    (2) A specialist organization may apply to the Exchange for 
authorization to use a VaR model to calculate its market risk add-on, 
in lieu of calculating the average of the prior twenty business days' 
capital requirement for securities haircuts under Exchange Act Rule 
15c3-1(c)(2)(vi), exclusive of paragraph (N). Once a specialist 
organization has been granted approval by the Exchange to use a VaR 
model, it shall continue to compute its net liquid asset market risk 
add-on using VaR, unless a change is approved upon application to the 
Exchange. To apply for authorization to use a VaR model pursuant to 
NYSE Rule 104.21(1)(ii)(a), a specialist must submit in writing the 
following information to Member Firm Regulation with its application:
    (a) A description of the mathematical models to be used to compute 
its market risk add-on;
    (b) A description of the requirements as set forth in Exchange Rule 
104.22; and
    (c) Any other material the Exchange may request.
    (3) Notwithstanding the requirements of Rule 98(b)(vii) (Capital 
Requirements Met Separately), the specialist organization's net liquid 
assets needed to meet the requirements in Rules 104.20 and .21 must be 
dedicated exclusively to specialist dealer activities, and must not be 
used for any other purpose without the express written consent of the 
Exchange.
.22 [Combinations of Specialist Entities]Definitions and Model Approval 
Process
    [A specialist entity resulting from the merger, consolidation, 
acquisition, or other combination of specialist assets:
    (i) subject to the concentration measure requirements of Rule 
104.21, shall maintain net liquid assets in accordance with those 
provisions, or equivalent to the aggregate net liquid assets of the 
specialist entities prior to their combination, whichever is greater;
    (ii) not subject to the concentration measure requirements of Rule 
104.21, shall maintain net liquid assets according to the provisions of 
Rule 104.20, or equivalent to the aggregate net liquid assets of the 
specialist entities prior to their combination, whichever is greater.]
    (1) For purposes of this Rule 104, specialist organizations must 
define the term ``Exchange transaction dollar volume'' consistent with 
the most recent Statistical Data, calculated and provided by the NYSE 
on a monthly basis.
    (2) For a specialist organization's VaR model to be approved, it 
must meet the following minimum qualitative and quantitative 
requirements:
    (a) Qualitative Requirements.
    (i) The VaR model used to calculate the market risk add-on for a 
position, along with a system of internal risk management controls to 
assist the specialist organization in managing the risks associated 
with its business activities, must be integrated into the daily 
internal risk management system of the specialist organization;
    (ii) The VaR model must be reviewed both periodically and annually 
by qualified independent member organization personnel or a qualified 
third party; and
    (iii) For purposes of computing the market risk add-on, the 
specialist organization must determine the appropriate multiplication 
factor as follows:
    (A) As soon as possible, but no later than three months after the 
specialist organization begins using the VaR model to calculate their 
market risk add-on, the specialist organization must conduct 
backtesting of the model by comparing its actual daily net trading 
profit or loss with the corresponding VaR measure generated by the VaR 
model, using a 99 percent, one-tailed confidence level with price 
changes equivalent to a one business day movement in rates and prices, 
for each of the past 250 business days, or other period as may be 
appropriate for the first year of its use;
    (B) On the last business day of each quarter, the specialist 
organization must identify the number of backtesting exceptions of the 
VaR model, that is, the number of business days in the past 250 
business days, or other period as may be appropriate for the first year 
of its use, for which the actual net trading loss, if any, exceeds the 
corresponding VaR measure; and
    (C) The specialist organization must use the multiplication factor 
indicated in Table 1 below in determining its market risk add-on until 
it obtains the next quarter's backtesting results;

   Table 1.--Multiplication Factor Based on the Number of Backtesting
                       Exceptions of the VaR Model
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                                                          Multiplication
                  Number of exceptions                        factor
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4 or fewer..............................................            3.00
5.......................................................            3.40
6.......................................................            3.50
7.......................................................            3.65
8.......................................................            3.75
9.......................................................            3.85
10 or more..............................................            4.00
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    (iv) For purposes of incorporating specific risk into a VaR model, 
a specialist organization must demonstrate that it has methodologies in 
place to capture liquidity, event, and default risk adequately for each 
position. Furthermore, the models used to calculate deductions for 
specific risk must:
    (A) Explain the historical price variation in the portfolio;
    (B) Capture concentration (magnitude and changes in composition);
    (C) Be robust to an adverse environment; and
    (D) Be validated through backtesting.
    (b) Quantitative Requirements.
    (i) For purposes of determining market risk add-on, the VaR model 
must use a 99 percent, one-tailed confidence level with price changes 
equivalent to a ten-business day movement in rates and prices;
    (ii) The VaR model must use an effective historical observation 
period of at least one year. The specialist organization must consider 
the effects of market stress in its construction of the model. 
Historical data sets must be updated at least monthly and reassessed 
whenever market prices or volatilities change significantly; and
    (iii) The VaR model must take into account and incorporate all 
significant, identifiable market risk factors applicable to positions 
in the accounts of the specialist organization, including:

[[Page 76340]]

    (A) Risks arising from the non-linear price characteristics of 
derivatives and the sensitivity of the market value of those positions 
to changes in the volatility of the derivatives' underlying rates and 
prices;
    (B) Empirical correlations with and across risk factors or, 
alternatively, risk factors sufficient to cover all the market risk 
inherent in the positions in the dealer accounts of the specialist 
organization; and
    (C) Specific risk for individual positions.
.23 Maintaining a Fair and Orderly Market.--
    Solely for the purpose of maintaining a fair and orderly market, 
the Exchange may, for a period not to exceed 5 business days, allow a 
specialist entity to continue to operate despite such specialist 
entity's non-compliance with the provisions of Rules 104.2[1]0 [and] or 
104.2[2]1.
.24 Relief specialists.--
    (1) The requirements with respect to a member registered as a full 
time relief specialist, i.e., one who may be called upon to act as a 
relief specialist for an entire business day, shall be, net liquid 
assets of $150,000. [or a joint account with the regular specialist in 
the stock. Any joint account must be approved by Regulation & 
Surveillance.]
    (2) There is no requirement with respect to a member registered as 
a part-time relief specialist, i.e., one who may be called upon to act 
as a relief specialist for less than the entire business day, usually 
for lunch periods, etc. Dealings effected by a part-time relief 
specialist while relieving the regular specialist must be made for the 
account of the regular specialist whom he is relieving.
    [Specialists may meet the above requirements either with their own 
capital or by availing themselves of the financing privileges provided 
by Sec.  220.04(g) of Regulation T or Sec.  221.3(o) of Regulation U of 
the Board of Directors of the Federal Reserve System ] 8121, 8218 which 
are explained at .30, below.]
    [.30 Financing of specialists.--Under Sec.  220.04(g) of Regulation 
T and Sec.  221.3(o) Regulation U of the Board of Directors of the 
Federal Reserve System ] 8121, 8218, a member may have his transactions 
as a specialist financed on a basis which is mutually satisfactory to 
the specialist and the creditor. He may finance such transactions by 
borrowing from a bank on terms which are mutually agreeable; he may 
have a member organization finance such transactions in a special 
account on a margin basis which is mutually satisfactory to the 
specialist and the carrying organization; or he may have a joint 
account with the carrying organization for the purpose of having his 
specialist transactions financed on a margin basis which is mutually 
satisfactory.]
    [Each specialist who makes such an arrangement must inform The 
Market Surveillance Division of the name of the creditor and the terms 
of the arrangement. The Market Surveillance Division must be informed 
immediately by telephone of the intention: (1) To terminate or change 
an existing financing arrangement (confirmed subsequently in writing); 
or (2) to issue a margin call. (This Rule does not in any manner alter 
a member's notification requirements to Regulation & Surveillance.) The 
specialist is required to submit to that Department on Form SPC (see 
.40 below) an initial report at such time as the arrangement becomes 
operative, and monthly reports thereafter.]
    [.40 Reports on Form SPC.--Each specialist who arranges to have his 
specialist transactions carried by a member organization on a margin 
basis lower than that required by the Board of Directors of the Federal 
Reserve System for regular margin accounts, must file with The Market 
Surveillance Division a report of Form SPC, (1) as of the first date 
that such arrangement becomes operative, i.e., when the margin in the 
specialist's account first fails to meet the requirements of the Board 
of Directors of the Federal Reserve System for regular margin accounts, 
(2) as of the date previous to the first date that the arrangement 
becomes operative, and (3) monthly thereafter, as of the last ledger 
date of the month, including the month in which the arrangement first 
becomes operative.
    Similar reports must be filed by each specialist who, for the 
purpose of financing his transactions as a specialist, arranges with a 
bank to have a loan value extended to him in an amount greater than 
that permitted for the financing of his non-specialist transactions.
General Instructions
    The report of a joint account may be prepared and forwarded by any 
participant. Forms may be obtained from Market Surveillance Division. 
Reports should be filed with that Department as promptly as possible 
after the ledger date as of which the report is prepared.
Specific Instructions
    For specific instruction see the reverse side of Form SPC.]
    [.50 Income records.--Each specialist and specialist organization 
shall submit, for the confidential use of the Exchange, such 
information relating to his or its specialty business as may be 
requested by the Exchange.
    Each specialist and specialist organization shall keep its records 
showing the data set forth below so that they will be readily available 
when the Exchange requests them for its confidential use for the 
purpose of surveillance and study of specialists' operations:
    (i) total ``actual'' commission income earned in all specialty 
stock;
    (ii) share volume executed as agent by specialty stock; and
    (iii) dealer profit and loss by specialty stock.
    Dealer profit and loss data must reflect, by specialty stock, any 
gain or loss occurring within an investment account.]
     * * *
Rule 123E. Specialist Combination Review Policy
    (a)--(e) No Change
    (f) [Proponents of a] A specialist unit combination subject to 
review by either the Quality of Markets Committee or the Market 
Performance Committee under this policy must [agree that] result in:
    (i) [the] total [amount of] capital [which each unit had separately 
prior to the proposed combination shall not be reduced, regardless of 
whether it would exceed the combined unit's new capital requirement] of 
the combined unit meeting, at a minimum: (a) the requirements of Rules 
104.20-104.21, (b) be acceptable to the Exchange, and (c) the combined 
unit's capital requirement may be temporarily revised at the discretion 
of the Exchange; and
    (ii) all required specialist capital be accounted for separately 
from any other capital, and be used solely for the specialist business.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Exchange included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The Exchange has prepared summaries, set forth in 
Sections (A), (B), and (C) below, of the most significant aspects of 
such statements.

[[Page 76341]]

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

(1) Purpose
    Exchange specialist organizations must maintain net liquid assets 
as required by NYSE Rule 104, and in addition, must satisfy the net 
capital requirements prescribed in Rule 15c3-1,\4\ promulgated under 
the Securities Exchange Act of 1934 (the ``Exchange Act'').\5\ NYSE 
Rule 325 requires members and member organizations to comply with 
Exchange Act Rule 15c3-1 and also requires notification to the Exchange 
whenever tentative net capital has declined below defined levels. In 
addition, Rule 325 gives the Exchange the authority, at any time, to 
prescribe greater net capital or net worth requirements than those 
explicitly prescribed by the rule, or to require more stringent 
treatment of items when computing net capital, net worth and, by 
implication, net liquid assets. Further, the NYSE can restrict the 
business activities of specialist organizations consistent with good 
business practices and its obligation to maintain a fair and orderly 
market. Such restrictions may include prohibitions against business 
expansion and business reduction requirements.
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    \4\ 17 CFR 240.15c3-1.
    \5\ 15 U.S.C. 78a et seq.
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    The Exchange proposes to amend Rules 104 and 123E to change the 
capital requirement of specialist organizations. The Exchange believes 
that if the proposed amendments are adopted, Rule 104 would more 
accurately address market risks and volatility. Further, the changes to 
Rule 123E would eliminate the ``marriage penalty'' capital requirement 
for specialist organization combinations.
    (i) Difference Between Net Capital and Net Liquid Assets. According 
to the Exchange, ``Net capital'' is a regulatory measure of the prudent 
level of liquid assets required for a broker-dealer.
    However, the Exchange contends that the term ``net liquid assets'' 
refers to liquidity in the form of cash and cash equivalents that is 
immediately available (or within twenty four hours) to a specialist 
organization for the continuing purchase and sale of securities in 
which a specialist is registered, in support of the specialist book, 
and market maintenance. The Exchange believes that net liquid assets 
are a shorter-term form of liquidity that is meant to be available to 
the specialist organization pursuant to its daily activities of 
maintaining a fair and orderly market on the Exchange.
    The Exchange believes that specialist organizations' unique 
liquidity needs dictate the general form of the net liquid asset 
requirement. Further, the Exchange believes that it is important for 
all specialist organizations and market participants to know that 
specialists have sufficient liquidity to support the specialist book 
and market maintenance activities. Therefore, the Exchange contends 
that a specialist organization's net liquid asset requirement functions 
to ensure that the specialist continues to operate; whereas a broker-
dealer's net capital requirement functions to ensure that, if the 
broker-dealer were liquidated, the broker-dealer's obligations to its 
customers and creditors would be satisfied.
    (ii) Background. (a) Position-Based Capital Requirements (Rule 
104.20). Exchange Rule 104.20 (``Regular Specialists'') sets position 
requirements a specialist organization must be able to assume in each 
stock that it is allocated. For each Investment Company Unit or Trust 
Issued Receipt for which a specialist organization is registered, it 
must maintain net liquid assets equivalent to $500,000. The rule also 
sets a minimum capital requirement, which is the greater of $1,000,000 
or 25% of the current position requirements.
    (b) Concentration Requirements (Rule 104.21). Specialist 
organizations are also subject to NYSE Rule 104.21 (``Concentration 
Measure Requirements'') if a specialist organization's market share 
exceeds 5% of certain ``concentration measures.'' \6\
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    \6\ (1) All listed common stock; (2) The 250 most active listed 
common stocks (over the previous twelve months); (3) Total share 
volume of stock trading on the Exchange (over the previous twelve 
months); or (4) Total dollar value of stock trading on the Exchange 
(over the previous twelve months).
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    Further, a specialist organization must maintain the following net 
liquid assets: (i) $4 million for each specialist security contained in 
the Dow Jones Industrial Average; (ii) $2 million for each specialist 
security contained in the S&P 100, not contained in (i); (iii) $1 
million for each specialist security contained in the S&P 500, not 
contained in (i) or (ii); (iv) $500,000 for each specialist common 
stock, Investment Company Unit (including Exchange Traded Funds) or a 
Trust Issued Receipt, excluding bond funds, not contained in (i), (ii) 
or (iii); and (v) $100,000 for each specialist security not included in 
(i) through (iv), excluding warrants.
    (c) Combinations of Specialist Entities (Rule 104.22). When two or 
more specialist organizations combine as the result of a merger, 
consolidation, acquisition or other combination of assets, NYSE Rule 
104.22 (``Combinations of Specialists Entities''), commonly referred to 
as the ``marriage penalty,'' generally requires the maintenance of:
    (a) net liquid assets in accordance with Rule 104.21, or equivalent 
to the aggregate net liquid assets of the respective specialist 
entities prior to their combination, whichever is greater; or
    (b) for those combinations not subject to Rule 104.21, net liquid 
assets pursuant to Rule 104.20, or the equivalent of the aggregate net 
liquid assets of the respective specialist entities prior to their 
combination, whichever is greater.
    (d) Specialist Combination Review Policy (Rule 123E(f)(i)). 
Exchange Rule 123E(f) currently requires proponents of a specialist 
unit combination to agree that: (i) The total amount of capital which 
each unit had separately prior to the proposed combination shall not be 
reduced regardless of whether it would exceed the combined unit's new 
capital requirement; and (ii) all required specialist capital be 
accounted for separately from any other capital and be used solely for 
the specialist business.
    NYSE Rule 123E(f)(i) applies a ``marriage penalty,'' similar to 
that set forth in Exchange Rule 104.22, to a combination of specialist 
organizations by requiring a higher capital requirement of the combined 
unit, rather than allowing a possible reduction of capital, in line 
with the new combined specialist organization's capital requirement. 
Rule 123E(f)(i) does not recognize the benefits derived from such 
combinations, nor does it compensate for excess capital that may have 
been in each specialist organization prior to the merger.
    (iii) Issues/Concerns With the Current Capital Requirements. In mid 
December 1987--soon after the 1987 major stock market correction--there 
were 55 specialist organizations on the Floor of the Exchange. By the 
year 2000, when Exchange Rule 104.22 was adopted, those specialist 
organizations had merged, consolidated, acquired or combined to reduce 
that number to 25. By April 2005, further consolidation had reduced the 
number of specialist organizations to seven.\7\
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    \7\ Because of the marriage penalty the capital requirements for 
the remaining seven specalist organizations represent the combined 
amount of capital requirements of the 25 specialist organizations 
that since 2000 were merged, consolidated, acquired or combined. The 
Exchange believes that the current capital requirement does not 
recognize the benefits derived from such consolidation.

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[[Page 76342]]

    The Exchange believes that the position-based requirement 
methodology set forth in NYSE Rule 104.20 is no longer appropriate in a 
marketplace where there are seven specialist organizations with 
sizeable capital bases and sophisticated risk management systems. The 
Exchange contends that concentration requirements set forth currently 
in Exchange Rule 104.21 significantly increase specialist 
organizations' capital requirements: However, there is no gradual 
increase in the requirement. Once a specialist organization's market 
share exceeds 5% of any of the concentration measures they immediately 
are subject to the rule. The Exchange believes that this creates an 
unintended disincentive for a specialist organization to increase its 
market share.
    The marriage penalty imposed by Rules 104.22 and 123E(f)(i) 
effectively subjects specialist organizations that have merged to the 
combined net liquid asset requirements of the two entities, although 
the Exchange contends that the incremental risk assumed may not be 
commensurate with the amount of net liquid assets required to be 
maintained. The Exchange believes that the current net liquid assets 
requirement for such specialist organizations is based neither upon the 
amount of risk a specialist organization is taking, nor upon the dollar 
value or volatility of its portfolio.
    (iv) Proposed Amendments. The Exchange is proposing that NYSE Rule 
104.20 (to be re-titled ``Specialist Organizations--Minimum Capital 
Requirements'') be amended to adopt risk-based requirements in lieu of 
the outdated and irrelevant position requirements, with the exception 
of Exchange Traded Funds (``ETFs''). For ETFs, the Exchange is 
proposing to amend Rule 104.20 to clarify that specialist organizations 
that are registered solely in ETFs maintain the greater of $500,000 for 
each ETF or $1,000,000.
    Proposed amendments to NYSE Rule 104.21 (to be re-titled 
``Specialist Organizations--Additional Capital Requirements'') would 
require a specialist organization to meet, with its own net liquid 
assets, a minimum capital requirement equal to:
    (i) $1,000,000 for each one tenth of one percent (.1%) of Exchange 
transaction dollar volume in its specialty securities, plus $500,000 
for each Exchange Traded Fund; and
    (ii) A market risk add-on, which is calculated as either:
    (a) An Exchange-approved value-at-risk (VaR) \8\ model to calculate 
its requirement for market risk; or
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    \8\ The Exchange believes that value-at-risk is a generally 
accepted method of measuring risk for financial organizations and 
notes that it is primarily used to establish trading limits and to 
stress test models and limits. It uses standard statistical 
techniques to design trading strategies and to correlate past risks 
with future risks to set trading limimts and thereby to minimize 
potential losses. Value-at-risk models assess market risk based on 
the probability distribution for a portfolio's market value.
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    (b) For those not utilizing VaR or whose models have not been 
approved by the NYSE, three times the average of the prior twenty 
business day's securities haircuts on its specialist dealer's 
positions.
    The Exchange believes this proposal utilizes the more generally 
recognized and, effective risk measurement tools employed by financial 
services firms, and increasingly by the Commission with particular 
respect to larger organizations, such as Consolidated Supervised 
Entities (``CSE''),\9\ whose financial impact upon the market is 
significant.
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    \9\ See Exchange Act Rule 15c3-1(c)(15) which, as part of the 
SEC's Consolidated Supervised Entity (``CSE'') rules, establishes a 
voluntary method of computing net capital for large broker-dealers 
that are part of a CSE. Eligibility to use the alternative/CSE 
method is conditioned upon a broker-dealer's compliance with several 
requirements, including comprehensive internal risk management 
procedures that address the firm's market, credit, liquidity and 
operations risk.
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    The Exchange is proposing definitions and guidelines for the model 
approval process in proposed Rule 104.22 (to be re-titled ``Definitions 
and Model Approval Process''). The model approval process is designed 
after the SEC's rules for consolidated supervised entities and includes 
qualitative and quantitative requirements for a specialist 
organization's VaR model. Some of these requirements include: (1) the 
VaR model must be integrated into the specialist organization's 
internal risk management system; (2) the VaR model must be reviewed 
both periodically and annually; and (3) methodologies to capture 
liquidity, event and default risk adequately for each position.
    Specialists' internal risk management systems must generally be 
consistent with standards outlined in the Commission's CSE rules, 
particularly SEA Rule 15c3-4. Once a specialist organization has been 
granted approval by the Exchange to use a VaR model, it may continue to 
compute its net liquid asset requirement using VaR, unless a change is 
approved upon application to the Exchange. The Exchange will, from time 
to time, revisit and examine approved net liquid asset models and may, 
for good cause and consistent with standards set forth in the 
Commission's CSE rules, increase or decrease the market risk add-on 
requirement. The Exchange will provide prompt subsequent notice to the 
Commission of any such adjustments.
    The Exchange is proposing to add a section requiring that a 
specialist organization's net liquid assets needed to meet the 
requirements in NYSE Rules 104.20 and .21 must be dedicated exclusively 
to specialist dealer activities, and must not be used for any other 
purpose without the express written consent of the Exchange. This is 
currently required under Rule 123(f)(ii) when specialist organizations 
combine, and the Exchange believes it should be expanded to all 
specialist organizations' required net liquid assets.
    The Exchange is proposing to eliminate the marriage penalty of NYSE 
Rule 104.22 in its entirety. With a net liquid assets requirement based 
upon a specialist organization's traded volume on the Floor of the 
Exchange combined with an add-on for market risk requirement, the 
Exchange believes that it is not appropriate or necessary to 
arbitrarily increase a specialist organization's requirement when it 
combines with another.
    The Exchange is also proposing to eliminate the marriage penalty of 
NYSE Rule 123E(f)(i) by requiring the specialist organization to 
maintain net liquid assets in accordance with the specialist capital 
requirements of Exchange Rule 104.20 to .21, and granting the Exchange 
discretion to temporarily revise the combined unit's requirements.
    The Exchange is also proposing to delete specialist organization 
financing sections 104.30 (``Financing of Specialists''), 104.40 
(``Reports on Form SPC'') and 104.50 (``Income Records''). The deletion 
of Rule 104.30 is proposed to reflect the current reality that net 
liquid asset requirements must be met from specialists' own books and 
records and not from an account carried by a third party. The deletion 
of Rule 104.30 would render Rule 104.40 irrelevant. The recordkeeping 
requirements of Rule 104.50 have been rendered irrelevant in light of 
NYSE Rule 440 (``Books and Records'') which incorporates, by reference, 
Securities and Exchange Act Rules 17a-3 and 17a-4.
    Finally, the filing includes several minor technical amendments to 
the rules for purposes of clarity and consistency.
    (v) Discussion. The Exchange believes that current net liquid asset 
requirements impose excessively high capital requirements on 
specialists that are not based upon the amount of risk

[[Page 76343]]

a specialist takes or the volatility of its portfolio. As a result, the 
Exchange believes that the rules impose unjustified costs on existing 
specialists and discourage new entrants to the market. The Exchange 
contends that under this proposal, current rules based on classes of 
allocated securities and capital penalties for mergers among 
specialists would be replaced by rules that focus on market stress and 
volatility, and market share measured by total dollar volume traded. 
The Exchange further contends that the new rules may encourage new 
specialist organizations to begin operations on the Floor of the 
Exchange.
    (a) Correlation Between Specialist Organization Inventory Positions 
and the Market. The Exchange contends that changes in specialist 
organizations' inventory positions are highly correlated to changes in 
price movements in the broader market. They base their conclusion on 
data, compiled from September 1998 through October 2004, that compares 
aggregate long and short specialist position data with market 
movements, as represented by the S&P 500.\10\ The Exchange found that, 
on average, specialist organizations bought $75 million of securities 
for each 1% decline in prices and sold $75 million in securities for 
each 1% increase in prices. The greatest price decline in one day over 
this six year period was 6.2% on the S&P 500, which occurred on April 
14, 2000. Total specialist net liquid assets decreased $16 million as a 
result of this market move.
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    \10\ The NYSE performed an analysis of specialist risk exposure 
in volatile trading scenarios over a period of years with its member 
specialist organizations, including simulations of how specialist 
capital levels would fare if faced with extremely volatile 
situations similar to the October 19, 1987 market correction, and 
other ``worst case'' consecutive day price declines.
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    (b) Worst-Case Market Risk Scenario for Specialist Organizations. 
Utilizing the historical worst-case scenario,\11\ and assuming 
specialist organizations open the trading day with a $100 million net 
long position and incur a non-stop 30% market decline, the Exchange 
determined that a cumulative loss of $377 million would result 
(assuming specialist organizations' purchases of $75 million for each 
1% decline in the market). Consequently, the Exchange believes that if 
specialist organizations started with $1.1 billion of net liquid 
assets, they should have sufficient capital and liquidity during normal 
markets and be able to withstand worst case market shocks without 
interruption to their businesses. The Exchange believes that the 
remaining net liquid assets of $723 million provides buying power \12\ 
of $2.9 billion, which should provide adequate liquidity in a normal 
market.\13\
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    \11\ A prime example of a worst-case scenario is the consecutive 
day declines that occurred in October 1987 when the DJIA dropped 31% 
and the S&P lost 29%. On October 16, 1987, 55 NYSE specialist 
organizations had net liquid assets totaling $808 million. These 
assets dropped by $196 million to $612 million at the close on 
October 19, 1987. Buying power decreased from $2.3 billion to $1.1 
billion. One half of this buying power was concentrated in eight 
specialist organizations. Twenty-three specialist organizations had 
less than $5 million of buying power and thirteen specialist 
organizations had no buying power. In comparison, the 1929 crash 
resulted in a four consecutive day decline in the DJIA of 16%.
    \12\ Buying power is the total market value of securities in 
which a specialist is registered that can be purchased and/or sold 
on margin by the specialist organization, without depositing 
additional funds into the specialist organization's dealer account 
carried by another broker-dealer.
    \13\ In such a scenario, the Exchange would have the flexibility 
under Exchange Rules 325 and 326 to prescribe greater net capital or 
net worth requirements, and/or restricting a specialist 
organization's business activities.
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    (c) Market Risk/Net Liquid Asset Requirements. Therefore, based on 
the above analysis, the Exchange believes that maintaining a minimum of 
approximately $1.1 billion of net liquid assets across all specialist 
organizations would provide a prudent level of capitalization for 
normal business operations with sufficient reserve in the event of 
severe shocks to the market. The Exchange intends to reassess this 
proposed requirement annually based upon market volatility as well as 
the dollar volume of total shares traded by all specialist 
organizations to determine its continuing adequacy.
    The Exchange contends that this proposal also encompasses a 
methodology whereby a specialist organization's risk measurement system 
is considered in determining required capital standards. In order to 
use a VaR model to calculate the specialist organization's net liquid 
asset requirement, the specialist must incorporate the VaR methodology 
into its risk management practices. The Exchange will be required to 
evaluate those risk management practices at specialist organizations, 
including a review of each firm's infrastructure for monitoring and 
controlling market risk, before they will be allowed to utilize VaR 
model requirements.
    As the proposal is based on dollar volumes traded and average 
inventory positions, as well as average haircuts, the Exchange believes 
it does not unduly penalize a specialist organization for taking on 
larger positions in adverse market conditions. The Exchange believes 
that utilizing value-at-risk modeling as a component of the net liquid 
asset requirement creates an incentive for specialist organizations to 
develop state of the art risk measurement systems, as well as hedge 
their positions, thereby limiting potential losses.
    d. Financing of Specialists. Under current Rule 104.30, specialist 
organizations can finance their transactions pursuant to Regulations T 
and U of the Federal Reserve System. Pursuant to the section, a 
specialist organization must notify the Market Surveillance Department 
of the name of the creditor and the terms of the arrangement. The 
Exchange proposes to delete the section in its entirety since it is no 
longer relevant as specialist organizations can currently arrange for 
credit under other existing Exchange rules.
    e. Reports on Form SPC. Under current Rule 104.40, specialist 
organizations that finance their transactions on a margin basis lower 
than that required by the Federal Reserve for regular margin accounts, 
must file Form SPC with the Market Surveillance Department. Similar 
reports must be filed by specialist organizations that arrange for a 
bank to have a loan value extended to the non-specialist organization 
in an amount greater than that permitted for the financing of the non-
specialist transactions. The Exchange purposes to delete the section in 
its entirety as it would no longer be applicable in the absence of Rule 
104.30.
    f. Income Records. Under current Rule 104.50, specialist 
organizations must keep and produce, at the request of the Exchange, 
information on commission income, share volume, and dealer profit and 
loss. The Exchange proposes to delete the section in its entirety as it 
is no longer applicable with the adoption of Rule 440 (Books and 
Records), which incorporates by reference Rules 17a-3 and 17a-4, under 
the Exchange Act.
2. Statutory Basis
    The statutory basis for this proposed rule change is section 
6(b)(5) \14\ of the Exchange Act. The proposed amendments to Exchange 
Rules 104 and 123E are consistent with the requirements of section 
6(b)(5), which requires that the rules of the Exchange must be 
designed, among other things, to promote just and equitable principles 
of trade, to remove impediments to and perfect the mechanism of a free 
and open market and national market system, and, in general, to protect 
investors and the public interest. The proposed amendments are 
consistent

[[Page 76344]]

with the Section in that they encompass a methodology whereby risk 
management is considered in determining required capital standards--
similar to recent Commission amendments to Exchange Act Rule 15c3-1 
regarding the alternative method for computing net capital for broker-
dealers that are part of a consolidated supervised entity.\15\
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    \14\ 15 U.S.C. 78f(b)(5).
    \15\ See Release No. 34-49830 (S7-21-03).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition not necessary or appropriate in 
furtherance of the purposes of the Exchange Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    The Exchange has neither solicited nor received written comments on 
the proposed rule change.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding, or (ii) as to 
which the Exchange consents, the Commission will:
    (A) By order approve such proposed rule change; or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act.
    Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or     Send e-mail to rule-comments@sec.gov. Please include File 

Number SR-NYSE-2005-38 on the subject line.

Paper Comments

    Send paper comments in triplicate to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-9303. All submissions should refer to File Number SR-NYSE-2005-
38.
    To help the Commission process and review your comments more 
efficiently, please use only one method.
    The Commission will post all comments on the Commission's Internet 
Web site (http://www.sec.gov/rules/sro/shtml). Copies of the 

submission, all subsequent amendments, all written statements with 
respect to the proposed rule change that are filed with the Commission, 
and all written communications relating to the proposed rule change 
between the Commission and any person, other than those that may be 
withheld from the public in accordance with the provisions of 5 U.S.C. 
552, will be available for inspection and copying in the Commission's 
Public Reference Room. Copies of such filing also will be available for 
inspection and copying at the principal office of the NYSE. All 
comments received will be posted without change; the Commission does 
not edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly. All 
submission should refer to File Number SR-NYSE-2005-38 and should be 
submitted on or before January 13, 2006.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. E5-7769 Filed 12-22-05; 8:45 am]

BILLING CODE 8010-01-P
