[Federal Register Volume 85, Number 231 (Tuesday, December 1, 2020)]
[Notices]
[Pages 77281-77295]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-26401]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-90502; File No. SR-NSCC-2020-003]


Self-Regulatory Organizations; National Securities Clearing 
Corporation; Order Approving a Proposed Rule Change To Enhance National 
Securities Clearing Corporation's Haircut-Based Volatility Charge 
Applicable to Illiquid Securities and UITs and Make Certain Other 
Changes to Procedure XV

November 24, 2020.
    On March 16, 2020, National Securities Clearing Corporation 
(``NSCC'') filed with the Securities and Exchange Commission 
(``Commission'') proposed rule change SR-NSCC-2020-003 (``Proposed Rule 
Change'') pursuant to Section 19(b)(1) of the Securities Exchange Act 
of 1934 (``Act'') \1\ and Rule 19b-4 thereunder.\2\ The Proposed Rule 
Change was published for comment in the Federal Register on March 31, 
2020.\3\ The Commission received comment letters on the Proposed Rule 
Change.\4\ On May 15, 2020, pursuant to Section 19(b)(2) of the Act,\5\ 
the Commission designated a longer period within which to approve, 
disapprove, or institute proceedings to determine whether to approve or 
disapprove the Proposed Rule Change.\6\ On June 24, 2020, the 
Commission instituted proceedings to determine whether to approve or 
disapprove the Proposed Rule Change.\7\ On September 22, 2020, the 
Commission designated a longer period for Commission action on the 
proceedings to determine whether to approve or disapprove the Proposed 
Rule Change.\8\ For the reasons discussed below, the Commission is 
approving the proposed rule change.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 88474 (March 25, 2020), 
85 FR 17910 (March 31, 2020) (SR-NSCC-2020-003) (``Notice''). NSCC 
also filed the proposal contained in the Proposed Rule Change as 
advance notice SR-FICC-2020-802 (``Advance Notice'') with the 
Commission pursuant to Section 806(e)(1) of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act entitled the Payment, 
Clearing, and Settlement Supervision Act of 2010 (``Clearing 
Supervision Act''). 12 U.S.C. 5465(e)(1); 17 CFR 240.19b-4(n)(1)(i). 
Notice of filing of the Advance Notice was published for comment in 
the Federal Register on April 15, 2020. Securities Exchange Act 
Release No. 88615 (April 9, 2020), 85 FR 21037 (April 15, 2020) (SR-
NSCC-2020-802). On May 15, 2020, the Commission issued a request for 
information regarding the Advance Notice. See Commission's Request 
for Additional Information, available at https://www.sec.gov/rules/sro/nscc-an/2020/34-88615-request-for-info.pdf. On September 9, 
2020, NSCC submitted its response thereto, which it then amended on 
October 16, 2020. See Response to Commission's Request for 
Additional Information, available at https://www.sec.gov/rules/sro/nscc-an/2020/34-88615-response-to-request-for-info.pdf; Letters from 
James Nygard, Director and Assistant General Counsel, NSCC 
(September 9 and October 16, 2020), available at https://www.sec.gov/comments/sr-nscc-2020-802/srnscc2020802-7753722-223190.pdf and https://www.sec.gov/comments/sr-nscc-2020-802/srnscc2020802-7915013-224474.pdf. On November 6, 2020, the 
Commission published a notice of no objection to the Advance Notice. 
Securities Exchange Act Release No. 90367 (November 6, 2020), 85 FR 
73099 (November 16, 2020). The proposal contained in the Proposed 
Rule Change and the Advance Notice shall not take effect until all 
regulatory actions required with respect to the proposal are 
completed.
    \4\ Comments are available at https://www.sec.gov/comments/sr-nscc-2020-003/srnscc2020003-7108527-215929.pdf.
    \5\ 15 U.S.C. 78s(b)(2).
    \6\ Securities Exchange Act Release No. 88885 (May 15, 2020), 85 
FR 31007 (May 21, 2020) (SR-NSCC-2020-003).
    \7\ Securities Exchange Act Release No. 89145 (June 24, 2020), 
85 FR 39244 (June 30, 2020) (SR-NSCC-2020-003).
    \8\ Securities Exchange Act Release No. 89949 (September 22, 
2020), 85 FR 60854 (September 28, 2020) (SR-NSCC-2020-003).
---------------------------------------------------------------------------

I. Description of The Proposed Rule Change

A. Background

    NSCC provides clearing, settlement, risk management, central 
counterparty services, and a guarantee of completion for virtually all 
broker-to-broker trades involving equity securities, corporate and 
municipal debt securities, and unit investment trust transactions in 
the U.S. markets. A key tool that NSCC uses to manage its credit 
exposure to its Members is collecting an appropriate Required Fund 
Deposit (i.e., margin) from each Member.\9\ A Member's Required Fund 
Deposit is designed to mitigate potential losses to NSCC associated 
with liquidation of the Member's portfolio in the event of a Member 
default.\10\ The aggregate of all NSCC Members' Required Fund Deposits 
(together with certain other deposits required under the Rules) 
constitutes NSCC's Clearing Fund, which NSCC would access should a 
Member default and that Member's Required Fund Deposit, upon 
liquidation, be insufficient to satisfy NSCC's losses.\11\
---------------------------------------------------------------------------

    \9\ Terms not defined herein are defined in NSCC's Rules and 
Procedures (``Rules''), available at http://www.dtcc.com/~/media/
Files/Downloads/legal/rules/nscc_rules.pdf. See Rule 4 (Clearing 
Fund) and Procedure XV (Clearing Fund Formula and Other Matters) of 
the Rules.
    \10\ Under NSCC's Rules, a default would generally be referred 
to as a ``cease to act'' and could encompass a number of 
circumstances, such as a member's failure to make a Required Fund 
Deposit in a timely fashion. See Rule 46 (Restrictions on Access to 
Services), supra, note 9.
    \11\ See Rule 46 (Restrictions on Access to Services), supra, 
note 9.

---------------------------------------------------------------------------

[[Page 77282]]

    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 NSCC's Rules.\12\ Generally, 
the largest component of Members' Required Fund Deposits is the 
volatility component. The volatility component is designed to reflect 
the amount of money that could be lost on a portfolio over a given 
period within a 99% confidence level. This component represents the 
amount assumed necessary to absorb losses while liquidating the 
portfolio.
---------------------------------------------------------------------------

    \12\ See Procedure XV, supra note 9.
---------------------------------------------------------------------------

    NSCC's methodology for calculating the volatility component of a 
Member's Required Fund Deposit depends on the type of security and 
whether the security has sufficient pricing or trading history for NSCC 
to robustly estimate the volatility component using statistical 
techniques. Generally, for most securities (e.g., equity securities), 
NSCC calculates the volatility component using, among other things, a 
parametric Value at Risk (``VaR'') model, which results in a ``VaR 
Charge.'' \13\ However, the VaR model generally relies on 
predictability, and this model may be less reliable for measuring 
market risk of securities that exhibit illiquid characteristics. More 
specifically, the VaR model relies on assumptions that are based on 
historical observations of security prices. Securities that exhibit 
illiquid characteristics, which generally have low trading volumes or 
are not traded frequently, may not generate sufficient price 
observations to allow the VaR model to provide a precise estimate of 
market risk for such securities. Accordingly, for securities that do 
not have sufficient pricing or trading history to perform statistical 
analysis, NSCC applies a haircut to calculate the volatility component, 
in lieu of the VaR-based calculation.
---------------------------------------------------------------------------

    \13\ Specifically, NSCC calculates the VaR Charge as the 
greatest of (1) the larger of two separate calculations that utilize 
the VaR model, (2) a gap risk measure calculation based on the 
largest non-index position in a portfolio that exceeds a 
concentration threshold, which addresses concentration risk that can 
be present in a member's portfolio, and (3) a portfolio margin floor 
calculation based on the market values of the long and short 
positions in the portfolio, which addresses risks that might not be 
adequately addressed with the other volatility component 
calculations. See Sections I.(A)(1)(a)(i) and I.(A)(2)(a)(i) of 
Procedure XV, supra note 9.
---------------------------------------------------------------------------

B. Current Practice for Determining Volatility Component for Illiquid 
Securities and UITs

    Two types of securities for which NSCC uses a haircut to calculate 
the volatility component are securities that NSCC deems to be 
``Illiquid Securities'' and UITs. NSCC's Rules currently define an 
Illiquid Security as a security that is (i) not traded on or subject to 
the rules of a national securities exchange registered under the 
Exchange Act, or (ii) an OTC Bulletin Board \14\ or OTC Link issue.\15\ 
Based on its interpretation of that definition, NSCC considers 
securities that are not listed on the national securities exchanges, 
i.e., those exchanges which are covered by certain third party data/
pricing vendors, to be Illiquid Securities.\16\ UITs are redeemable 
securities, or units, issued by investment companies that offer fixed 
security portfolios for a defined period of time.
---------------------------------------------------------------------------

    \14\ The OTC Bulletin Board is an inter-dealer quotation system 
that is used by subscribing members of the Financial Industry 
Regulatory Authority (``FINRA'') to reflect market making interest 
in eligible securities (as defined in FINRA's Rules). See http://www.finra.org/industry/otcbb/otc-bulletin-board-otcbb.
    \15\ OTC Link is an electronic inter-dealer quotation system 
that displays quotes from broker-dealers for many over-the-counter 
securities. See https://www.otcmarkets.com.
    \16\ NSCC represents that it utilizes multiple third-party 
vendors to price its eligible securities. NSCC believes that 
national securities exchanges covered by these third party vendors 
tend to list securities that exhibit liquid characteristics such as 
having more available public information, larger trading volumes and 
higher capitalization. See Notice, supra note 3, 85 FR at 17912. The 
exchanges that have established listing services that the vendors 
cover for this purpose are: New York Stock Exchange LLC, NYSE 
American LLC, NYSE Arca, Inc., The Nasdaq Stock Market and Cboe BZX 
Exchange, Inc. NSCC represents that Members' Clearing Fund Summary 
reports, available through the DTCC Risk Portal, identify securities 
within their portfolio by the ticker symbol and indicate whether 
those securities are considered Illiquid Securities for purposes of 
the calculation of the Illiquid Charge. See id.
---------------------------------------------------------------------------

    Under NSCC's current rules, Illiquid Securities and UITs are 
subject to haircut-based charges to calculate the volatility component 
of a Member's Required Fund Deposit based upon two distinct but related 
rationales. Specifically, Illiquid Securities are considered 
``securities that are less amenable to statistical analysis, such as 
OTC Bulletin Board or Pink Sheet issues or issues trading below a 
designated dollar threshold (e.g., five dollars),'' and UITs are 
considered ``securities that are amenable to generally accepted 
statistical analysis only in a complex manner.'' \17\ Based on these 
determinations, NSCC considers Illiquid Securities and UITs as 
categories of securities that tend to exhibit illiquid characteristics, 
such as low trading volumes or infrequent trading.\18\ NSCC therefore 
calculates the volatility component for these two categories of 
securities by multiplying the absolute value of a given position by a 
percentage that is (1) not less than 10% for securities that are less 
amenable to statistical analysis, including Illiquid Securities,\19\ 
and (2) not less than 2% for securities that are amenable to generally 
accepted statistical analysis only in a complex manner, including UITs.
---------------------------------------------------------------------------

    \17\ A security that is less amenable to statistical analysis 
generally lacks pricing or trading history upon which to perform 
statistical analysis. A security that is amenable to generally 
accepted statistical analysis only in a complex manner generally may 
have pricing or trading history, but further calculations upon the 
pricing or trading history would be required to perform statistical 
analysis.
    \18\ Because the VaR model generally relies on predictability, 
this model may be less reliable for measuring market risk of 
securities that exhibit illiquid characteristics.
    \19\ NSCC currently calculates the volatility charge for IPOs, 
which have fewer than 31 business days of trading history over the 
past 153 business days, by applying a haircut of 15% and all other 
Illiquid Securities by applying a haircut of 20%. See Notice, supra 
note 3, 85 FR at 17915.
---------------------------------------------------------------------------

    In addition to using the haircut-based volatility charge for 
Illiquid Securities, NSCC currently can also apply an additional charge 
(an ``Illiquid Charge'') for certain positions in Illiquid Securities 
that exceed volume thresholds set forth in the Rules.\20\ NSCC 
represents that the Illiquid Charge was designed to address a situation 
where the defaulting Member may have a relatively large position in an 
Illiquid Security, which would increase the risk that NSCC might face 
losses when liquidating the Member's position in these securities due 
to the securities' lack of marketability and other characteristics.\21\
---------------------------------------------------------------------------

    \20\ Specifically, the Illiquid Charge applies to Illiquid 
Positions as defined under NSCC's Rules. The Rules specify the 
applicable thresholds that result in an Illiquid Position 
determination. For example, where a Member's net buy position in an 
Illiquid Security exceeds a threshold no greater than 100 million 
shares, that position may become subject to the Illiquid Charge. 
However, NSCC's rules also provide for certain offsets and credit 
risk considerations that will be considered when determining whether 
a position in an Illiquid Security should be considered an Illiquid 
Position and, thus, subject to the additional Illiquid Charge. See 
Rule 1 and Sections I.(A)(1)(h) and I.(A)(2)(f) of Procedure XV, 
supra note 9.
    \21\ See Notice, supra note 3, 85 FR at 17912. See also 
Securities Exchange Act Release No. 80597 (May 4, 2017), 82 FR 21863 
(May 10, 2017) (SR-NSCC-2017-001) (order approving proposed rule 
change to describe the illiquid charge that may be imposed on 
Members).
---------------------------------------------------------------------------

    NSCC states that it regularly assesses its market and credit risks, 
as such risks are related to its margin methodologies, to evaluate 
whether margin levels are commensurate with the particular risk 
attributes of each relevant product, portfolio, and market.\22\ Based 
on such assessments, NSCC seeks to refine its current approach to risk 
managing Member positions in Illiquid Securities and UITs. More 
specifically, NSCC

[[Page 77283]]

proposes to (1) revise the definition of Illiquid Security, (2) adopt 
specific exclusions from the VaR model, and corresponding haircut-based 
methods for determining volatility components for positions in Illiquid 
Securities and UITs, (3) eliminate the existing Illiquid Charge, and 
(4) make certain conforming changes regarding municipal and corporate 
bonds and Family-Issued Securities.\23\
---------------------------------------------------------------------------

    \22\ See Notice, supra note 3, 85 FR at 17912.
    \23\ The term ``Family-Issued Security'' means a security that 
was issued by a Member or an affiliate of that Member. See Rule 1, 
supra note 9.
---------------------------------------------------------------------------

C. Proposed Revision to the Definition of Illiquid Security

    Under the Proposed Rule Change, NSCC proposes a new definition of 
Illiquid Security that would consist of three particular categories of 
securities. As noted further below, application of the new definition 
of Illiquid Security would capture a broader set of securities than the 
current definition.
(i) Securities Not Listed on a Specified Securities Exchange
    The first category of the new definition of Illiquid Securities 
would include any security that is not listed on a ``specified 
securities exchange.'' For purposes of this definition, NSCC's Rules 
would define a ``specified securities exchange'' as a national 
securities exchange that has established listing services and is 
covered by industry pricing and data vendors.\24\ NSCC would make the 
determination of whether a security falls in this category on a daily 
basis. NSCC represents that this new definition would reflect the 
process that it currently employs to determine whether a security is 
not traded on or subject to the rules of a national securities exchange 
registered under the Securities Exchange Act of 1934, as amended.\25\
---------------------------------------------------------------------------

    \24\ NSCC has stated that the exchanges that would initially be 
specified securities exchanges are those listed in note 16. See 
supra note 16.
    \25\ See Notice, supra note 3, 85 FR at 17913. Based on historic 
performances, NSCC believes the national securities exchanges that 
the vendors cover are appropriate for determining if a security 
exhibits characteristics of liquidity because such exchanges tend to 
list securities that exhibit liquid characteristics such as having 
more available public information, larger trading volumes, and 
higher capitalization. See id.
---------------------------------------------------------------------------

(ii) Micro-Capitalization Securities and ADRs Subject to an Illiquidity 
Ratio
    The second category of the new definition of Illiquid Securities 
would apply to certain securities that are listed on a specified 
securities exchange. Specifically, the types of securities that would 
potentially be considered as Illiquid Securities under this second 
category either (i) have a market capitalization that is considered by 
NSCC to be a micro-capitalization (``micro-capitalization'' or ``micro-
cap'') as of the last business day of the prior month, or (ii) are 
American depositary receipts (``ADRs'').\26\ To determine whether these 
securities qualify as Illiquid Securities, NSCC would apply, on a 
monthly basis, an illiquidity ratio test to these two sets of 
securities.
---------------------------------------------------------------------------

    \26\ ADRs are securities that represent shares of non-U.S. 
companies that are held by a U.S. depository bank outside of the 
United States. Each ADR represents one or more shares of foreign 
stock or a fraction of a share.
---------------------------------------------------------------------------

1. Micro-Capitalization Definition
    Initially, NSCC would define ``micro-capitalization'' as market 
capitalization of less than $300 million. Changes to this threshold 
amount of $300 million would not be subject to any particular period of 
review, but would occur when NSCC determines changes may be 
appropriate.\27\ NSCC believes that using market capitalization to 
consider whether a security is illiquid, in conjunction with the 
illiquidity ratio test, is appropriate because securities with a market 
capitalization below a certain threshold tend to exhibit illiquid 
characteristics such as limited trading volumes and a lack of public 
information.\28\
---------------------------------------------------------------------------

    \27\ Any changes to the micro-cap threshold would be subject to 
NSCC's model risk management governance procedures as set forth in 
the Clearing Agency Model Risk Management Framework (``Model Risk 
Management Framework''). See Notice, supra note 3, 85 FR at 17914. 
See Securities Exchange Act Release No. 81485 (August 25, 2017), 82 
FR 41433 (August 31, 2017) (File No. SR-NSCC-2017-008) (describes 
the adoption of the Model Risk Management Framework of NSCC which 
sets forth the model risk management practices of NSCC) and 
Securities Exchange Act Release No. 84458 (October 19, 2018), 83 FR 
53925 (October 25, 2018) (File No. SR-NSCC-2018-009) (amends the 
Model Risk Management Framework). NSCC would notify Members of any 
changes to the micro-capitalization threshold by Important Notice.
    \28\ See Notice, supra note 3, 85 FR at 17914.
---------------------------------------------------------------------------

2. ADRs
    With respect to ADRs, NSCC believes that subjecting these 
securities to the illiquidity ratio test to determine whether a 
particular ADR is an Illiquid Security is appropriate because the 
market capitalization of an ADR may be difficult to calculate. This is 
because of challenges associated with the day-to-day fluctuation of the 
conversion rate of an ADR into the relevant local security, which in 
turn makes it difficult to price the ADR.\29\ Without knowing the 
market capitalization of the ADR, it is therefore difficult to 
determine whether an ADR represents a non-micro-cap issuer.
---------------------------------------------------------------------------

    \29\ See Notice, supra note 3, 85 FR at 17912.
---------------------------------------------------------------------------

3. Application of the Illiquidity Ratio and the Illiquidity Ratio Test 
to Micro-Cap Securities and ADRs
    The proposal would define the illiquidity ratio for a security as 
the ratio of the security's daily price return divided by the average 
daily trading amount \30\ of such security over the prior 20 business 
days. In addition, if NSCC is unable to retrieve data to calculate the 
illiquidity ratio for a security on any day, NSCC would use a default 
value for that day for the security (i.e., the security would be 
treated as illiquid for that day).
---------------------------------------------------------------------------

    \30\ The daily trading amount equals the daily trading volume 
multiplied by the end-of-day price. See id.
---------------------------------------------------------------------------

    In order to classify a micro-cap security or ADR as ``illiquid,'' 
NSCC then takes the illiquidity ratio calculated for these securities 
and applies an illiquidity ratio test. The test functions as follows: 
NSCC determines whether the security's median illiquidity ratio of the 
prior six months exceeds a threshold that is set to the 99th percentile 
of the illiquidity ratio of all non-micro-cap common stock using the 
prior six months of data. Where such a threshold is exceeded, NSCC will 
designate the relevant security as an Illiquid Security. NSCC performs 
this exercise, and thereby determines the set of micro-cap securities 
and ADRs to be considered Illiquid Securities, on a monthly basis.
    The illiquidity ratio test is designed to measure the level of a 
security's price movement relative to its level of trading activity. 
For example, given the same dollar amount of trading activity, a larger 
price movement typically indicates less liquidity. Conversely, for 
price movement of a given magnitude, a smaller dollar amount of trading 
activity would indicate less liquidity.
    Securities that are exchange-traded products (``ETPs'') with market 
capitalization of less than $300 million could be classified as 
illiquid upon application of the illiquidity test. However, ETPs and 
ADRs would be excluded when calculating the illiquidity ratio 
threshold. ETPs are excluded because the underlying common stocks that 
make up the ETPs are already included in the calculation. ADRs are 
excluded because it is difficult to determine whether an ADR represents 
a non-micro-cap issuer. An ADR's market capitalization may be difficult 
to calculate due to the fact that, as noted above, each ADR often 
converts to a different number of shares of a local security. The 
threshold used in the illiquidity ratio test will be determined

[[Page 77284]]

by NSCC on a monthly basis using the prior six months of data.
(iii) Securities With Limited Trading History
    The third category of the new definition of Illiquid Security would 
include securities that are listed on a specified securities exchange 
and, as determined by NSCC on a monthly basis, have fewer than 31 
business days of trading history over the past 153 business days on 
such exchange. NSCC represents that it has historically used such time 
period to identify initial public offerings (``IPOs'') which tend to 
exhibit illiquid characteristics due to their limited trading history, 
thereby making it an appropriate time period to use for the purposes of 
determining a security's liquidity, and IPOs would likely constitute 
most of the securities that would fall into this category.\31\
---------------------------------------------------------------------------

    \31\ See Notice, supra note 3, 85 FR at 17914.
---------------------------------------------------------------------------

D. Proposed Haircut-Based Volatility Charge Specifically Applicable to 
Illiquid Securities and UITs

(i) Haircut-Based Volatility Charge Applicable to Illiquid Securities
    As proposed in the Notice, NSCC would expressly exclude Illiquid 
Securities when calculating the volatility component of a Required Fund 
Deposit using the VaR model and instead would apply a haircut-based 
volatility charge specifically to Illiquid Securities. To determine the 
appropriate volatility charge, NSCC would group Illiquid Securities by 
price level.\32\ NSCC generally would calculate one haircut-based 
volatility charge for short and long positions together. However, with 
respect to an Illiquid Security that is a sub-penny security, NSCC 
would calculate the haircut-based volatility charge for short positions 
and long positions separately.\33\
---------------------------------------------------------------------------

    \32\ The price level groupings would be subject to NSCC's model 
risk management governance procedures set forth in the Model Risk 
Management Framework. See Notice, supra note 3, 85 FR at 17915; see 
also Model Risk Management Framework, supra note 27.
    \33\ NSCC states that the different treatment for Illiquid 
Securities that are sub-penny securities is appropriate because 
short positions in sub-penny securities have unlimited upside market 
price risk, as the price of a security may increase and could 
potentially subject NSCC to losses under its trade guaranty. NSCC 
further states the proposal would allow NSCC to calculate a haircut-
based volatility charge that accounts for this risk of such price 
movements. Further, NSCC states that sub-penny securities are 
typically issued by companies with low market capitalization, and 
may be susceptible to market manipulation, enforcement actions, or 
private litigation. See Notice, supra note 3, at 85 FR at 17915; 
Letter from Timothy J. Cuddihy, Managing Director, DTCC Financial 
Risk Management (September 3, 2020) (``NSCC Letter'') at 10.
---------------------------------------------------------------------------

    The haircut percentage applicable to each group of Illiquid 
Securities would be determined at least annually. The applicable 
percentage, and the decision of how often the applicable percentage is 
determined, would be subject to NSCC's model risk management governance 
procedures set forth in the Model Risk Management Framework.\34\ NSCC 
states that a number of important considerations consistent with the 
model risk management practices adopted by NSCC could prompt more 
frequent haircut review, such as material deterioration of a Member's 
backtesting performance, market events, market structure changes, and 
model validation findings.\35\
---------------------------------------------------------------------------

    \34\ See Notice, supra note 3, 85 FR at 17915; see also Model 
Risk Management Framework, supra note 27.
    \35\ See id.
---------------------------------------------------------------------------

    The haircut percentage would be the highest of the following 
percentages: (1) 10%, (2) a percent benchmarked to be sufficient to 
cover the 99.5th percentile of the historical 3-day returns of each 
group of Illiquid Securities in each Member's portfolio, and (3) a 
percent benchmarked to be sufficient to cover the 99th percentile of 
the historical 3-day returns of each group of Illiquid Securities in 
each Member's portfolio after incorporating a fixed transaction cost 
equal to one-half of the estimated bid-ask spread.\36\ The look-back 
period for purposes of calibrating the applicable percentage would be 
no less than five years and would initially be five years to be 
consistent with the historical data set used in model development. The 
look-back period may be adjusted by NSCC as necessary consistent with 
the model risk management practices adopted by NSCC to respond to, for 
example, market events that impact liquidity in the market and Member 
backtesting deficiencies.\37\
---------------------------------------------------------------------------

    \36\ If NSCC needs to liquidate a defaulting Member's portfolio, 
it may incur a transaction cost which represents bid-ask spreads. 
Bid-ask spreads account for the difference between the observed 
market price that a buyer is willing to pay for a security and the 
observed market price for which a seller is willing to sell that 
security.
    \37\ Adjustments to the look-back period would be subject to 
NSCC's model risk governance procedures set forth in the Model Risk 
Management Framework. See Notice, supra note 3, 85 FR at 17915; see 
also Model Risk Management Framework, supra note 27.
---------------------------------------------------------------------------

(ii) Haircut-Based Volatility Charge Applicable to UITs
    Similar to its proposed approach to risk managing Illiquid 
Securities, NSCC would exclude UITs from calculating the volatility 
component of the Required Fund Deposit using the VaR model, and instead 
would assign a percentage to be used in the calculation of a haircut-
based volatility charge. UITs are less suited to application of the VaR 
model because they generally have a limited trading history, which does 
not provide the type of pricing data that allows for application of the 
VaR model. NSCC would review the percentage used in this calculation at 
least annually.
    The haircut percentage applicable to UITs would be the highest of 
(1) 2%, and (2) the 99.5th percentile of the historical 3-day returns 
for the group of UITs within each Member's portfolio using a look-back 
period of no less than 5 years. The applicable percentage, and the 
decision of how often the applicable percentage is determined, would be 
subject to NSCC's model risk management governance procedures set forth 
in the Model Risk Management Framework.\38\
---------------------------------------------------------------------------

    \38\ See id.
---------------------------------------------------------------------------

(iii) Revisions to Description of Securities Not Amenable to Generally 
Accepted Statistical Analysis or Amenable to Statistical Analysis Only 
in a Complex Manner
    NSCC proposes to revise the existing language in its Rules relating 
to securities that are either less amenable to statistical analysis or 
amenable to statistical analysis only in a complex manner.\39\ Because 
Illiquid Securities and UITs would each have specific haircut-based 
volatility charges pursuant to the Proposed Rule Change, these sections 
would no longer apply to Illiquid Securities or UITs. Furthermore, NSCC 
represents that the proposed definition of Illiquid Security would 
effectively encompass all securities that are currently considered as 
securities that are less amenable to statistical analysis.\40\ However, 
NSCC believes that it should preserve this category of securities 
within its Rules because NSCC may find it necessary to calculate margin 
charges for certain securities that do not constitute Illiquid 
Securities or UITs and instead would continue to fall under this 
category.
---------------------------------------------------------------------------

    \39\ NSCC represents that it also would remove the phrase ``such 
as OTC Bulletin Board or Pink Sheet issues or issues trading below a 
designated dollar threshold (e.g., five dollars)'' from the existing 
language relating to securities that are less amenable to 
statistical analysis. While this language was intended as an example 
of these types of securities, NSCC now believes that the example 
inadequately describes all of the securities that are less amenable 
to statistical analysis and may be misleading. See Notice, supra 
note 3, 85 FR at 17912.
    \40\ See Notice, supra note 3, 85 FR at 17916.
---------------------------------------------------------------------------

    Further, NSCC represents that certain fixed income securities, such 
as preferred stocks,\41\ would continue to

[[Page 77285]]

fall into the category of securities that are amenable to statistical 
analysis only in a complex manner. Thus, these types of securities 
would still be subject to a haircut-based charge. The application of a 
haircut percentage to any new security, using these categories, would 
be subject to NSCC's model risk management governance procedures set 
forth in the Model Risk Management Framework.\42\
---------------------------------------------------------------------------

    \41\ See id.
    \42\ See id.; see also Model Risk Management Framework, supra 
note 27.
---------------------------------------------------------------------------

E. Proposed Elimination of the Illiquid Charge

    NSCC proposes to eliminate the existing Illiquid Charge (and the 
corresponding definition of Illiquid Position), which may be imposed as 
an additional charge in the volatility component that is applied to 
Illiquid Securities as securities that are less amenable to statistical 
analysis. NSCC represents that because the current haircut-based 
volatility charge that is applied to Illiquid Securities uses fixed 
percentages for all such securities (15% for IPOs and 20% for the rest 
of Illiquid Securities), the Illiquid Charge was added to cover some of 
the risks that the current volatility charge did not cover. NSCC also 
represents that the proposal would address the risks presented by 
positions in Illiquid Securities more adequately than the Illiquid 
Charge, and that therefore the Illiquid Charge would no longer be 
needed.\43\
---------------------------------------------------------------------------

    \43\ See Notice, supra note 3, 85 FR at 17917.
---------------------------------------------------------------------------

F. Proposed Conforming Changes

    NSCC proposes to make two conforming changes to harmonize the Rules 
in light of the proposed amendments discussed above. First, the current 
Rules state that securities less amenable to statistical analysis or 
amenable to statistical analysis only in a complex manner ``other than 
municipal and corporate bonds'' shall be excluded from the VaR 
Charge.\44\ NSCC believes that this drafting is unclear regarding 
whether municipal and corporate bonds are excluded from this section of 
the Rules. Moreover, the reference to municipal and corporate bonds is 
not necessary in this portion of the Rules because a different 
subsection of the Rules \45\ provides separately for haircut-based 
volatility charges for municipal and corporate bonds. The proposal 
would therefore remove this reference to municipal and corporate bonds 
from this section of the Rules.
---------------------------------------------------------------------------

    \44\ Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure 
XV, supra note 9.
    \45\ Section I.(A)(1)(a)(iii) of Procedure XV, supra note 9.
---------------------------------------------------------------------------

    Second, the Rules currently provide that Family-Issued Securities 
are excluded from calculation of the volatility component using the VaR 
model because the specific haircut-based volatility charge for such 
securities is provided in a separate subsection. However, the separate 
subsection only refers to ``long Net Unsettled Positions in Family-
Issued Securities.'' \46\ Based on the current drafting of the Rules, 
NSCC believes that it is unclear how positions in Family-Issued 
Securities would be treated.\47\ In practice, NSCC states that 
currently, short positions in Family-Issued Securities whose volatility 
is less amenable to statistical analysis are subject to the haircut set 
forth in Sections I.(A)(1)(a)(ii) and I.(A)(2)(a)(ii) of Procedure XV, 
and those short positions in Family-Issued Securities that meet 
particular volume thresholds are subject to the Illiquid Charge.\48\ 
NSCC proposes to revise the Rules to expressly reference its current 
practice that long positions in Family-Issued Securities would be 
excluded from the VaR Charge but subject to the haircut-based 
volatility charge exclusively applicable to such securities in a 
separate provision of the Rules. In addition, determination of the 
appropriate margin for short positions in Family-Issued Securities 
would continue to be covered by the haircut-based volatility charge in 
Sections I.(A)(1)(a)(ii) and I.(A)(2)(A)(ii) as securities that are 
less amenable to statistical analysis.
---------------------------------------------------------------------------

    \46\ Id. In addition, the current Rules exclude ``family issued 
security'' from the current definition of Illiquid Security, which 
is subject to Illiquid Charge, providing that the term is provided 
in Procedure XV, although Procedure XV does not provide such 
definition.
    \47\ See Notice, supra note 3, 85 FR at 17917.
    \48\ See Notice, supra note 3, 85 FR at 17913 and 17917 n. 52.
---------------------------------------------------------------------------

II. Discussion and Commission Findings

    Section 19(b)(2)(C) of the Act \49\ directs the Commission to 
approve a proposed rule change of a self-regulatory organization if it 
finds that such proposed rule change is consistent with the 
requirements of the Act and rules and regulations thereunder applicable 
to such organization. After carefully considering the proposed rule 
change, the Commission finds that the proposed rule change is 
consistent with the requirements of the Act and the rules and 
regulations thereunder applicable to NSCC. In particular, the 
Commission finds that the proposed rule change is consistent with 
Sections 17A(b)(3)(F) \50\ and (b)(3)(I) \51\ of the Act and Rules 
17Ad-22(e)(4)(i), (e)(6)(i), and (e)(23)(ii) thereunder.\52\
---------------------------------------------------------------------------

    \49\ 15 U.S.C. 78s(b)(2)(C).
    \50\ 15 U.S.C. 78q-1(b)(3)(F).
    \51\ 15 U.S.C. 78q-1(b)(3)(I).
    \52\ 17 CFR 240.17Ad-22(e)(4)(i), (e)(6)(i), and (e)(23)(ii).
---------------------------------------------------------------------------

A. Consistency With Section 17A(b)(3)(F) of the Act

    Section 17A(b)(3)(F) of the Act \53\ requires that the rules of a 
clearing agency, such as NSCC, be designed to: (i) Promote the prompt 
and accurate clearance and settlement of securities transactions; (ii) 
assure the safeguarding of securities and funds which are in the 
custody or control of the clearing agency or for which it is 
responsible; (iii) foster cooperation and coordination with persons 
engaged in the clearance and settlement of securities transactions; 
(iv) remove impediments to and perfect the mechanism of a national 
system for the prompt and accurate clearance and settlement of 
securities transactions; and (v) protect investors and the public 
interest.
---------------------------------------------------------------------------

    \53\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------

    The Commission believes that the proposal is consistent with 
Section 17A(b)(3)(F) of the Act for the reasons stated below.
(i) Prompt and Accurate Clearance and Settlement and Safeguarding of 
Securities and Funds
    As described above in Section I.C, NSCC proposes to revise the 
definition of ``Illiquid Securities'' to provide additional specific 
objective criteria that would lead to a security being considered as an 
Illiquid Security, which would, in turn, broaden the scope of 
securities that would be considered as Illiquid Securities for 
assessing margin requirements. For example, NSCC would consider 
additional factors such as an issuer's market capitalization and a 
defined illiquidity ratio to determine whether a security is illiquid, 
which would capture certain exchange-listed securities that the current 
rules do not include as Illiquid Securities. Therefore, the Commission 
believes that NSCC's proposed new definition of Illiquid Securities is 
designed to more precisely identify securities with illiquid 
characteristics than the current methodology.
    Moreover, as described above in Section I.D, NSCC proposes to 
specifically exclude Illiquid Securities and UITs when calculating the 
volatility component of a Required Fund Deposit using the VaR model, 
and to change the haircut-based volatility component of

[[Page 77286]]

the Clearing Fund formula that is applicable to positions in Illiquid 
Securities and UITs. Currently, in order to calculate the volatility 
component, fixed percentages are applied to two general categories of 
securities that encompass Illiquid Securities and UITs, i.e., (1) 
securities that are less amenable to statistical analysis, and (2) 
securities that are amenable to generally accepted statistical analysis 
only in a complex manner. The proposal would apply a specific 
percentage developed for Illiquid Securities and UITs. In addition, 
instead of using the current fixed haircut percentages for Illiquid 
Securities, the proposal would group such securities by price level and 
apply a different haircut percentage based on the specific price group. 
Illiquid Securities that are sub-penny securities would be separately 
grouped by long or short position to more accurately reflect different 
levels of risk presented by long and short positions of such securities 
(i.e., a higher level of risk is associated with the short positions in 
sub-penny securities). The proposal would also require NSCC to 
regularly assess appropriate haircut percentages to cover its credit 
risks. The Commission believes that by providing that the volatility 
component of margin for Illiquid Securities and UITs should be 
determined by applying haircuts tailored to specific groups of Illiquid 
Securities and to UITs, this change should result in margin amounts 
that are more commensurate with the risk attributes of these types of 
securities, thereby limiting NSCC's credit exposure to Members holding 
positions in such securities.
    NSCC provided information regarding the impact of the proposed rule 
change on its backtesting coverage.\54\ Specifically, a recent impact 
study shows that the proposal would improve its backtesting coverage 
from 96.2% to 99.5% for the asset group that exhibited the lowest 
average backtesting coverage percentages (i.e., short positions in sub-
penny securities and securities priced between one cent and one 
dollar).\55\ The Commission has reviewed NSCC's analysis and agrees 
that its results indicate that NSCC's proposal results in margin levels 
that better reflect the risks and particular attributes of the Member's 
portfolio.
---------------------------------------------------------------------------

    \54\ Backtesting is an ex-post comparison of actual outcomes 
with expected outcomes derived from the use of margin models. See 17 
CFR 240.17Ad-22(a)(1).
    \55\ See Notice, supra note 3, 85 FR at 17915. As part of the 
Proposed Rule Change, NSCC filed Exhibit 3--NSCC Impact Studies, 
comparing the current and proposed methodologies. Pursuant to 17 CFR 
240.24b-2, NSCC requested confidential treatment of Exhibit 3. NSCC 
also filed the proposal contained in the Proposed Rule Change as 
Advance Notice. See supra note 3. Because the proposals contained in 
the Advance Notice and the Proposed Rule Change are the same, all 
information provided by NSCC regarding the improvements in 
backtesting coverage for other asset groups was considered 
regardless of whether the information submitted with respect to the 
Advance Notice or the Proposed Rule Change.
---------------------------------------------------------------------------

    In addition, as described in Section I.E, NSCC proposes to 
eliminate the existing Illiquid Charge. This existing charge would no 
longer be needed in light of the revised definition and haircut-based 
margin methodology described in Sections I.C and I.D, which would more 
precisely address the risk that the Illiquid Charge purported to cover. 
As described in Section I.F, NSCC proposes to make conforming changes 
to harmonize the Rules in light of the changes described in Sections 
I.C and I.D. The Commission believes that these changes are designed to 
provide clear and coherent Rules regarding the haircut-based volatility 
charge for Illiquid Securities and UITs.
    Taken together, the Commission believes that the Proposed Rule 
Change is designed to allow NSCC to collect margin more precisely 
tailored to the nature of the risks presented by positions in 
securities with illiquid characteristics than the current methodology, 
and in a manner that fully addresses NSCC's applicable credit 
exposures. In turn, the proposal should help ensure that, in the event 
of a Member default, NSCC's operation of its critical clearance and 
settlement services would not be disrupted because of insufficient 
financial resources. Accordingly, the Commission finds that NSCC's 
proposal should help NSCC to continue providing prompt and accurate 
clearance and settlement of securities transactions in the event of a 
Member default, consistent with Section 17A(b)(3)(F) of the Act.
    Moreover, by better limiting NSCC's exposure to Members, the 
proposal is designed to help ensure that NSCC has collected sufficient 
margin from Members, so that non-defaulting Members would not be 
exposed to mutualized losses resulting from the default of a Member 
holding positions in Illiquid Securities and/or UITs. Accordingly, the 
Commission believes that by helping to limit non-defaulting Members' 
exposure to mutualized losses, the proposal is designed to help assure 
the safeguarding of securities and funds which are in NSCC's custody or 
control, consistent with Section 17A(b)(3)(F) of the Act.
    One commenter asserts that the proposal does not promote the prompt 
and accurate clearance and settlement of securities transactions, and 
also does not assure the safeguarding of securities and funds which are 
in the custody or control of NSCC or for which it is responsible 
because (1) the haircut-based volatility charge fails to bring clarity 
and transparency, (2) NSCC failed to explain how the current formula 
leaves members exposed to default, and (3) NSCC failed to explain how 
the proposed methodology would limit exposure in the event of a Member 
default.\56\
---------------------------------------------------------------------------

    \56\ See Letter from Daniel Zinn, General Counsel and Cass 
Sanford, Associate General Counsel, OTC Markets Group Inc. (July 21, 
2020) (``OTC II Letter'') at 2-3.
---------------------------------------------------------------------------

    The Commission disagrees with this comment. First, and as discussed 
further in Section II.E, the Commission believes that the Proposed Rule 
Change identifies what would constitute an Illiquid Security and 
describes how the haircut-based charge for Illiquid Securities and UITs 
would apply. Second, and as discussed further above, NSCC provided 
backtesting results to show that NSCC has a backtest coverage of 96.2% 
for the asset group that exhibited the lowest average backtesting 
coverage percentages (i.e., short positions in sub-penny securities and 
securities priced between one cent and one dollar), as compared to a 
backtest coverage of 99.5% under the Proposed Rule Change. As 
demonstrated by the backtesting analysis, under its current margin 
methodology, NSCC is not achieving its 99% targeted confidence level 
for asset groups that are Illiquid Securities. Based on its review of 
the Notice and the materials filed as part of the Proposed Rule Change, 
in conjunction with the Commission's supervisory observations, the 
Commission believes that the proposed changes would better enable NSCC 
to collect margin commensurate with the different levels of risk that 
Members pose to NSCC as a result of their particular trading activity 
in Illiquid Securities and UITs. Finally, the Commission believes that 
the proposed changes would enable NSCC to collect margin that more 
accurately reflects the risk characteristics of Illiquid Securities and 
UITs by applying a haircut more precisely tailored to Illiquid 
Securities (grouped by price level and a long or short positions) and 
UITs, and therefore allow NSCC to be in a better position to absorb 
losses in connection with a Member default and manage its credit 
exposure to such Member.

[[Page 77287]]

(ii) Protection of Investors and the Public Interest
    The Commission believes that the proposal should help protect 
investors and the public interest by mitigating some of the risks 
presented by NSCC as a central counterparty. Because a defaulting 
member could place stresses on NSCC with respect to NSCC's ability to 
meet its clearance and settlement obligations upon which the broader 
financial system relies, it is important that NSCC has a robust margin 
methodology to limit NSCC's credit risk exposure in the event of a 
Member default. As described above, the Proposed Rule Change would 
revise the definition of an ``Illiquid Security,'' and the haircut-
based methods for determining volatility components for positions in 
Illiquid Securities and UITs. These changes should help improve NSCC's 
ability to calculate margin accurately to better produce margin that is 
more commensurate with the risks associated with its Members' Illiquid 
Securities and UITs, and thus more effectively cover its credit 
exposures to its Members. By collecting margin that more accurately 
reflects the risk characteristics of such securities, NSCC would be in 
a better position to absorb and contain the spread of any losses that 
might arise from a Member default. Therefore, the proposal is designed 
to reduce the possibility that NSCC would need to call for additional 
resources from non-defaulting Members due to a Member default, which 
could inhibit the ability of these non-defaulting Members to facilitate 
securities transactions. Accordingly, the Commission believes that the 
proposal is designed to protect investors and the public interest by 
mitigating some of the systemic risks presented by NSCC as a central 
counterparty.
    One commenter states that the proposal does not protect investors 
because the increased costs will likely be passed on to retail 
shareholders of small firms.\57\ The Commission is not persuaded that 
the proposal will not protect investors solely because of the potential 
for increased costs that could be passed on to retail shareholders of 
small firms. While the proposal may result in an increase in the 
Required Fund Deposit for a Member who transacts in Illiquid Securities 
and UITs, such an increase is designed to allow NSCC to reduce the 
risks it faces associated with Illiquid Securities and UITs in the 
event of a Member default.\58\ As a result, NSCC should be more 
resilient so that it can satisfy its obligations as a central 
counterparty while reducing the possibility that NSCC would need to 
mutualize among non-defaulting Members any losses arising out of a 
Member default, which facilitates the protection of investors by 
helping to ensure that investors receive the proceeds from their 
securities transactions.
---------------------------------------------------------------------------

    \57\ See OTC II Letter at 3.
    \58\ This benefit may be particularly important since, as the 
Commission discussed elsewhere, small firms, which tend to be most 
financially constrained, may be disproportionately affected by 
downturns or tightening credit conditions. See Temporary Amendments 
to Regulation Crowdfunding, Securities Act Release No. 10781 (May 4, 
2020), 85 FR 27116, 27123 n. 40 (May 7, 2020) (citing to Gabriel 
Perez[hyphen]Quiros and Allan Timmermann, Firm Size and Cyclical 
Variations in Stock Returns, 55(3) Journal of Finance 1229-1262 
(2000) (showing that ``small firms display the highest degree of 
asymmetry in their risk across recession and expansion states, which 
translates into a higher sensitivity of their expected stock returns 
with respect to variables that measure credit market conditions''); 
Murillo Campello and Long Chen, Are Financial Constraints Priced? 
Evidence from Firm Fundamentals and Stock Returns, 42(6) Journal of 
Money, Credit, and Banking 1185-1198 (2010) (finding that 
financially constrained firms' business fundamentals are 
significantly more sensitive to macroeconomic movements than 
unconstrained firms' fundamentals); Eugene Fama and Kenneth French, 
Common Risk Factors in the Returns on Stocks and Bonds, 3 Journal of 
Financial Economics 3-56 (1993)).
---------------------------------------------------------------------------

    Several commenters expressed concerns that the proposal would 
discourage entry to the public market by small and growing companies, 
hinder small business capital formation, negatively impact small 
company liquidity, and dissuade investors from trading in Illiquid 
Securities.\59\ Several commenters stated that the proposal will hurt 
small broker-dealers, which in turn will hurt small businesses, and is 
detrimental to small business capital formation needs.\60\ Several 
commenters stated that the proposal would negate the objectives of 
Regulations D, A+, and Crowdfunding, and negatively affect small 
business capital formation.\61\
---------------------------------------------------------------------------

    \59\ Letter from John Busacca, Founder, The Securities Industry 
Professional Association (April 23, 2020) (``SIPA Letter'') at 3; 
Letter from James Snow, President, Wilson-Davis & Co., Inc. 
(November 20, 2020) (``Wilson III Letter'') at 5. The SIPA Letter 
also expresses concern regarding increased costs arising from 
regulatory and DTC requirements generally, as well as the results of 
SEC and FINRA trading suspensions. Id. at 3. Other commenters 
expressed similar concern regarding general increases in costs not 
related to this proposal. See also Letter from Kimberly Unger, The 
Security Traders Association of New York, Inc. (June 30, 2020) 
(``STANY Letter'') at 2-3; and Letter from James C. Snow, Chief 
Compliance Officer, Wilson-Davis & Co., Inc. (July 29, 2020) 
(``Wilson II Letter'') at 5. Such issue is not directed to the 
Proposed Rule Change and, accordingly, is beyond the scope of the 
Commission's consideration.
    \60\ See Letter from Charles F. Lek, Lek Securities Corporation 
(April 30, 2020) (``Lek Letter'') at 3; Letter from Daniel Zinn, 
General Counsel and Cass Sanford, Associate General Counsel, OTC 
Markets Group Inc. (June 26, 2020) (``OTC I Letter'') at 4; STANY 
Letter at 2.
    \61\ See SIPA Letter at 3; Wilson II Letter at 2; Wilson III 
Letter at 4; OTC I Letter at 4.
---------------------------------------------------------------------------

    In response, NSCC states that the Proposed Rule Change is not 
designed to advantage or disadvantage capital formation in any 
particular market segment.\62\ NSCC further states that the Proposed 
Rule Change focuses entirely on managing the clearance and settlement 
risk associated with secondary transactions in securities with illiquid 
characteristics as required by Section 17A of the Exchange Act, which 
is unaffected by those initiatives.\63\
---------------------------------------------------------------------------

    \62\ See NSCC Letter at 10.
    \63\ See id.
---------------------------------------------------------------------------

    First, with respect to the commenters who raised concerns regarding 
liquidity and capital formation, the Commission believes that limiting 
NSCC's exposure to its Members by allowing NSCC to collect more 
accurate margin to manage its exposure to Illiquid Securities and UITs 
would benefit Members due to NSCC's decreased exposure to losses 
resulting from a Member default. Effectively mitigating such risks 
would, in turn, reduce the likelihood that NSCC would have to call on 
its Members to contribute additional resources, which would otherwise 
could be used by its Members to facilitate securities transactions 
thereby providing liquidity to the securities markets. Thus, the 
Commission believes that NSCC's proposal, by helping non-defaulting 
members preserve their financial resources, could promote liquidity 
provision in such circumstances because these resources would be 
available to facilitate securities transactions.
    The Commission acknowledges that the proposal could increase the 
margin required to be collected from a Member who transacts in Illiquid 
Securities and UITs, which, in turn, may cause such a Member to incur 
additional costs to access needed liquidity for meeting margin 
requirements. Despite these potential impacts, the Commission is not 
persuaded that the Proposed Rule Change would have a negative effect on 
small business capital formation such that it would be inconsistent 
with the public interest. To the extent that Members incur funding 
costs associated with additional margin, they may choose to distribute 
these costs across transactions in all securities for which they make 
markets rather than allocate those costs only to transactions in 
securities that require additional margin. Thus, the fact that Members 
have flexibility in how they allocate

[[Page 77288]]

costs could mitigate negative impacts, if any, on the liquidity and 
capital formation of a particular subset of issuers.
    The Commission recognizes the possibility that, as a result of the 
proposed change, some Members may pass along some of the costs related 
to margin requirements such that they ultimately are borne, to some 
degree, by investors in Illiquid Securities. However, non-defaulting 
Members' exposure to mutualized losses resulting from a Member's 
default and any resulting disruptions to clearance and settlement 
absent the Proposed Rule Change may also increase costs to investors 
and potentially adversely impact market participation, liquidity, and 
access to capital by issuers, including issuers of Illiquid Securities. 
As a result, and as the Commission previously acknowledged, this 
proposed rule change may help reduce transaction costs in the markets 
NSCC clears, and reductions in counterparty default risk allow the 
corresponding portion of transaction costs to be allocated to more 
productive uses by market participants who otherwise would bear those 
costs.\64\ Moreover, as discussed in Section II.A(i) above, by helping 
to limit non-defaulting Members' exposure to mutualized losses, the 
proposed rule change is designed to help assure the safeguarding of 
securities and funds of its Members that are in NSCC's custody or 
control, consistent with Section 17A(b)(3)(F).
---------------------------------------------------------------------------

    \64\ See Securities Exchange Act Release No. 78961 (September 
28, 2016), 81 FR 70786, 70866-67 (October 13, 2016) (S7-03-14) 
(``CCA Standards Adopting Release'').
---------------------------------------------------------------------------

    Further, the Commission is not persuaded by the commenters' 
generalized statements on the potential impact on small business 
capital formation that could result from implementation of the Proposed 
Rule Change. The Commission acknowledges the possibility that, as the 
commenter asserted, issuers of securities in smaller companies may 
experience a reduction in liquidity because of the increased margin 
requirements applicable to transactions in Illiquid Securities. 
Nevertheless, the Commission believes that investors would not be 
discouraged from holding Illiquid Securities. The Commission 
understands that, in general, stock prices fall in response to a 
reduction in liquidity until such securities provide an adequate 
desired return for investors,\65\ and some studies indicate illiquid 
stocks pay investors a higher expected stock excess return to 
compensate for greater illiquidity.\66\ Thus, as long as stock prices 
can adjust to reflect the reduced liquidity, affected small issuers may 
still be able to attract capital from investors, albeit at a higher 
cost that appropriately reflects the risks inherent in the clearance 
and settlement of the securities they issue. Moreover, to the extent 
that investment decisions are driven by other factors, such as the 
future prospects of specific companies, there might be no decrease in 
access to capital or little change in cost.
---------------------------------------------------------------------------

    \65\ See, e.g., Viral Acharya and Lasse H. Pedersen, 2005, Asset 
pricing with liquidity risk, 77 Journal of Financial Economics 375-
410 (2005).
    \66\ See, e.g., Yakov Amihud, Illiquidity and stock returns: 
Cross-section and time series effects, 5(1) Journal of Financial 
Markets 31-56 (2002); Joel Hasbrouck, Trading costs and returns for 
US equities: Estimating effective costs from daily data, 64(3) The 
Journal of Finance 1445-1477 (2009); Robert. A. Korajczyk and Ronnie 
Sadka, Pricing the commonality across alternative measures of 
liquidity, 87(1) Journal of Financial Economics 45-72 (2008); and 
Michael J. Brennan, Tarun Chordia, Avanidhar Subrahmanyam and Qing 
Tong, Sell-order liquidity and the cross-section of expected stock 
returns, 105(3) Journal of Financial Economics 523-541 (2012). 
However, some studies do not find that more illiquid stocks have 
higher expected returns. See, e.g., Michael J. Brennan and Avanidhar 
Subrahmanyam, Market microstructure and asset pricing: On the 
compensation for illiquidity in stock returns, 41(3) Journal of 
Financial Economics 441-464 (1996); Matthew I. Spiegel and Xiaotong 
Wang, Cross-sectional variation in stock returns: Liquidity and 
idiosyncratic risk, Yale ICF Working Paper No. 05-13 (2005).
---------------------------------------------------------------------------

    In addition, the commenters' arguments ignore the potential 
benefits to small businesses when their securities are eligible for 
central clearing by NSCC. As do other clearing agencies, NSCC provides 
a number of services that mitigate risk, reduce costs, and enhance 
processing efficiencies for the securities markets, market 
participants, issuers (including small issuers), and investors. By 
reducing NSCC's risk exposure to its members and thus the likelihood of 
its failure, the proposal helps ensure that NSCC would continue to 
provide such services, which would benefit securities markets, market 
participants, issuers (including small issuers), and investors. Thus, 
the commenters do not take into account any potential positive impacts 
on small business capital formation that may arise as a result of the 
Proposed Rule Change.
    Therefore, notwithstanding the potential unspecified impact on 
capital formation in smaller and less liquid markets, as described 
above, the Commission believes that, in light of the potential benefits 
to investors arising from the Proposed Rule Change and the resulting 
overall improved risk management at NSCC, i.e., the prompt and accurate 
clearance and settlement of securities transactions and the 
safeguarding of securities and funds based on the collection of margin 
commensurate with the risks presented by these securities, the Proposed 
Rule Change is designed to protect investors and the public interest, 
consistent with Section 17A(b)(3)(F) of the Act.
(iii) Fostering Cooperation and Removing Impediments
    Several commenters asserted that the Proposed Rule Change is 
inconsistent with Section 17A(b)(3)(F) of the Act because the proposal 
neither addresses nor meets all of the elements prescribed in Section 
17A(b)(3)(F).\67\ In response to these comments, the Commission 
acknowledges that Section 17A(b)(3)(F) of the Act requires a clearing 
agency's rules to be designed to meet a number of objectives, as listed 
above. However, certain proposals may not necessarily directly 
implicate every aspect of Section 17A(b)(3)(F). Nevertheless, for the 
reasons discussed below, the Commission disagrees with the commenters 
that the Proposed Rule Change does not meet with the requirements of 
Section 17A(b)(3)(F) related to whether a clearing agency's rules are 
designed to foster cooperation and coordination with persons engaged in 
the clearance and settlement of securities transactions, and to remove 
impediments to and perfect the mechanism of a national system for the 
prompt and accurate clearance and settlement of securities 
transactions.
---------------------------------------------------------------------------

    \67\ See OTC I Letter at 4; OTC II Letter at 2-3; Wilson II 
Letter at 6; Wilson III Letter at 1.
---------------------------------------------------------------------------

    One commenter argues that the proposal will not foster cooperation 
and coordination between the various market participants engaged in 
processing transactions in Illiquid Securities because increased margin 
requirements will disadvantage smaller firms, exacerbating the trend of 
firms ceasing to provide liquidity in thinly traded stocks due to 
overly burdensome regulatory costs.\68\ As an initial matter, Section 
17A(b)(3)(F) has a narrower scope than the issue raised by the 
commenter, in that it addresses cooperation and coordination with 
persons engaged in the clearance and settlement of securities 
transactions and not among market participants more broadly. 
Nevertheless, even when considering Section 17A(b)(3)(F) as it could 
apply to market participants more broadly, the Commission does not 
agree with the commenter's argument that increased margin requirements 
could disadvantage smaller firms and is inconsistent with fostering 
cooperation and coordination with persons engaged in the clearance and 
settlement of

[[Page 77289]]

securities transactions. This proposal would establish a clear and 
transparent methodology for determining the volatility component of 
margin for a particular class of securities that would apply to all 
NSCC Members in a uniform manner.\69\ The use of such a uniform 
methodology is essential to fostering and ensuring cooperation and 
coordination with persons engaged in the clearance and settlement of 
securities transactions because it provides a generally applicable and 
understood methodology established ex ante for determining margin for 
this particular class of securities. The collection of appropriately 
tailored margin pursuant to this methodology would, in turn, help 
decrease the likelihood that losses arising out of a Member default 
would exceed NSCC's prefunded resources and threaten NSCC's ability to 
continue providing clearance and settlement of securities transactions 
and to serve market participants as a central counterparty and, 
therefore, to provide an infrastructure for cooperation in the 
continued clearance and settlement of securities transactions. 
Therefore, the Commission believes that the Proposed Rule Change is 
consistent with fostering cooperation and coordination, as provided 
under Section 17A(b)(3)(F).
---------------------------------------------------------------------------

    \68\ See OTC II Letter at 3.
    \69\ See Section II.E infra.
---------------------------------------------------------------------------

    The commenters further state that the proposal would not remove 
impediments to the national system for prompt and accurate clearance 
and settlement but would impose additional requirements and increase 
the already prohibitive transactional costs involved in clearing and 
settling OTC and small company stocks, making already thinly traded 
securities more illiquid.\70\ The Proposed Rule Change is designed to 
allow NSCC to better identify securities that present illiquid 
characteristics based on additional objective criteria and to impose 
tailored haircuts to determine the appropriate margin for such 
securities and UITs. These changes will, in turn, enable NSCC to 
collect margin more precisely tailored to the different levels of risk 
that Members pose to NSCC as a result of their particular trading 
activity in Illiquid Securities and UITs, resulting in more accurate 
clearance and settlement of securities transactions. The Commission 
believes that these improvements to the clearance and settlement of 
securities transactions are consistent with removing impediments to the 
national system for clearance and settlement, in that less precise 
margin determinations could constitute an impediment to NSCC's 
continued ability to clear and settle securities transactions if losses 
arising out of a Member default were to exceed NSCC's prefunded 
resources and threaten NSCC's continued operation as a central 
counterparty for securities transactions. For these reasons, the 
Commission believes that this change is consistent with removing 
impediments to the national system of clearance and settlement, as 
provided under Section 17A(b)(3)(F).
---------------------------------------------------------------------------

    \70\ See OTC II Letter at 3; Wilson III Letter at 1.
---------------------------------------------------------------------------

    For the reasons discussed above, the Commission believes that the 
Proposed Rule Change is consistent with the requirements of Section 
17A(b)(3)(F) of the Act.\71\
---------------------------------------------------------------------------

    \71\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------

B. Consistency With Section 17A(b)(3)(I) of the Act

    Section 17A(b)(3)(I) of the Act requires that the rules of a 
clearing agency do not impose any burden on competition not necessary 
or appropriate in furtherance of the Act.\72\ This provision does not 
require the Commission to find that a proposed rule change represents 
the least anticompetitive means of achieving the goal. Rather, it 
requires the Commission to balance the competitive considerations 
against other relevant policy goals of the Act.\73\
---------------------------------------------------------------------------

    \72\ 15 U.S.C. 78q-1(b)(3)(I).
    \73\ See Bradford National Clearing Corp., 590 F.2d 1085, 1105 
(D.C. Cir. 1978).
---------------------------------------------------------------------------

    The Commission received various comments regarding the proposal's 
impact on competition. Several commenters argued that the proposal 
would disproportionately affect smaller broker-dealer Members and small 
companies.\74\ One commenter acknowledged that the proposal would apply 
to all Members equally, but was concerned that the proposal is likely 
to disproportionately impact smaller Members and harm competition.\75\ 
Multiple commenters asserted that the proposal would discriminate 
against small Members because the proposal would demand higher margin, 
which would in turn raise the cost for liquidity.\76\ One commenter 
further contended that, while large bank-affiliated broker-dealer 
Members will not have a liquidity issue resulting from the proposal, 
other Members will have a liquidity issue under the proposal.\77\
---------------------------------------------------------------------------

    \74\ See Letter from Christopher R. Doubek, CEO, Alpine 
Securities Corporation (April 21, 2020) (``Alpine Letter'') at 2 and 
3; SIPA Letter at 3; and Lek Letter at 2 and 3.
    \75\ See OTC I Letter at 5.
    \76\ See Alpine Letter at 2; STANY Letter at 2; OTC I Letter at 
5; and Lek Letter at 2.
    \77\ See Lek Letter at 2. Lek Letter and SIPA Letter also argue 
that the unfair burden on competition is due to the fact that DTCC's 
board is almost entirely made up of representatives from large banks 
and other big-businesses. See Lek Letter at 3 and SIPA Letter at 2. 
This proposal does not change the composition of DTCC's board, and 
the commenter does not provide specifics information regarding the 
composition of DTCC's board and how it relates to this proposal. As 
discussed below, the impact of the proposed changes are determined 
by a Member's portfolio composition and trading activity rather than 
a Member's size or type. As addressed throughout, the Commission has 
concluded that the proposal does not impose any burden on 
competition not necessary or appropriate in furtherance of the Act.
---------------------------------------------------------------------------

    In response, NSCC acknowledges that the proposal may result in an 
increase in the Required Fund Deposit for a Member effecting 
transactions in Illiquid Securities, and that it may also result in 
higher margin costs overall for Members whose business is concentrated 
in Illiquid Securities, relative to other Members with more diversified 
portfolios. However, NSCC states that the methodology for computing the 
margin requirement for a Member's Required Fund Deposit under the 
proposal does not take into consideration the Member's size or overall 
mix of business in liquid or illiquid securities, including micro-cap 
securities, relative to other Members. Any effect the proposal would 
have on a particular Member's margin requirement is solely a function 
of the default risk posed to NSCC by the Member's activity at NSCC--
firm size or business model is not pertinent to the assessment of that 
risk.\78\ Accordingly, NSCC believes that the proposal does not 
discriminate against Members or affect them differently on either of 
those bases.
---------------------------------------------------------------------------

    \78\ See NSCC Letter at 4.
---------------------------------------------------------------------------

    NSCC states that it is required to manage clearance and settlement 
risk presented by each Member with respect to the particular securities 
products each Member transacts through the system by, among other 
things, collecting margin sufficient to cover the risk of default with 
respect to those trades with a high degree of confidence. Accordingly, 
each Member is primarily responsible for mitigating the risk associated 
with its own business.\79\ NSCC represents that the proposal is 
intended to provide a more robust assessment and coverage of the risk 
associated with volatility exhibited by Illiquid Securities that NSCC 
has identified through backtesting to the statutorily prescribed 
level.\80\ As contemplated by the Act and Rule 17Ad-22, each Member 
would be responsible to provide margin commensurate with the default 
risk

[[Page 77290]]

posed by its business to NSCC under the proposal.
---------------------------------------------------------------------------

    \79\ See NSCC Letter at 5.
    \80\ Id.
---------------------------------------------------------------------------

    The Commission acknowledges that the Proposed Rule Change could 
entail increased margin charges to some Members that would be borne by 
those Members. In considering the costs and benefits of the 
requirements of Rule 17Ad-22(e)(6), the Commission expressly 
acknowledged in the CCA Standards Adopting Release that risk-based 
initial margin requirements may cause market participants to 
internalize some of the costs borne by the central counterparty as a 
result of large or risky positions and stated that confirming that 
margin models are well-specified and correctly calibrated with respect 
to economic conditions will help ensure that the margin requirements 
continue to align the incentives of a central counterparty's members 
with the goal of financial stability.\81\ Nevertheless, in response to 
the comments that the proposal would disproportionately affect smaller 
broker-dealer Members or those broker-dealer Members that are not 
affiliated with large banks, the Commission believes that the impact of 
the proposed changes would be entirely determined by a Member's 
portfolio composition and trading activity rather than a Member's size 
or type. The Proposed Rule Change would calculate the volatility 
component of a Member's Required Fund Deposit based on the risks 
presented by positions in Illiquid Securities, as described in Section 
I.C. To the extent a Member's volatility component would increase under 
the Proposed Rule Change, that increase would be based on the 
securities held by the Member and NSCC's requirement to collect margin 
to appropriately address the risk.
---------------------------------------------------------------------------

    \81\ See CCA Standards Adopting Release, supra note 64, 81 FR at 
70870. In addition, when considering the benefits, costs, and 
effects on competition, efficiency, and capital formation, the 
Commission recognized that a covered clearing agency, such as NSCC, 
might pass incremental costs associated with compliance on to its 
members, and that such members may seek to terminate their 
membership with that CCA. See id., 81 FR at 70865. Moreover, when 
considering similar comments related to a proposed rule change 
designed to address a covered clearing agency's liquidity risk, the 
Commission concluded that the imposition of additional costs did not 
render the proposal inconsistent with the Exchange Act. See 
Securities Exchange Act Release No. 82090 (November 15, 2017), 82 FR 
55427, 55438 n. 209 (November 21, 2017) (SR-FICC-2017-002).
---------------------------------------------------------------------------

    In addition, as noted above, the Commission acknowledges that the 
impact of a higher margin requirement may present higher costs on some 
Members relative to others due to a number of factors, such as access 
to liquidity resources, cost of capital, business model, and applicable 
regulatory requirements. These higher relative burdens may weaken 
certain Members' competitive positions relative to other Members.\82\ 
However, the Commission believes that such burden on competition 
stemming from a higher impact on some members than on others is 
necessary and appropriate. The Commission believes that NSCC is 
required to establish, implement, maintain and enforce written policies 
and procedures reasonably designed to cover its credit exposures to its 
participants by establishing a risk-based margin system that, at a 
minimum, considers, and produces margin levels commensurate with, the 
risks and particular attributes of each relevant product, portfolio, 
and market. NSCC's members include a large and diverse population of 
entities. By participating in NSCC, each Member is subject to the same 
margin requirements, which are designed to satisfy NSCC's regulatory 
obligation to manage the risk presented by its Members. As discussed in 
more detail in Section II.D below, this Proposed Rule Change is 
designed to ensure that NSCC collects margin that is commensurate with 
the risks presented by Illiquid Securities and UITs.
---------------------------------------------------------------------------

    \82\ These potential burdens are not fixed, and affected Members 
may choose to restructure their liquidity sources, costs of capital, 
or business model, thereby moderating the potential impact of the 
Proposed Rule Change.
---------------------------------------------------------------------------

    Furthermore, NSCC has provided an impact study demonstrating that 
the proposal would raise the current lowest average backtesting 
coverage from 96.2% to 99.5%.\83\ As noted above, the Commission has 
reviewed NSCC's analysis and agrees that its results indicate that 
NSCC's proposal results in margin levels that better reflect the risks 
and particular attributes of the Member's portfolio and help NSCC 
achieve backtesting coverage that meets its targeted confidence level. 
In turn, the Commission believes that the Proposed Rule Change would 
help NSCC better maintain sufficient financial resources to cover its 
credit exposures to each Member in full with a high degree of 
confidence. By helping NSCC to better manage its credit exposure, the 
proposal would help NSCC better mitigate the potential losses to NSCC 
and its Members associated with liquidating a Member's portfolio in the 
event of a Member default, in furtherance of NSCC's obligations under 
Section 17A(b)(3)(F) of the Act as shown in Section II.A.
---------------------------------------------------------------------------

    \83\ See note 55.
---------------------------------------------------------------------------

    Therefore, for the reasons stated above, the Commission believes 
that the Proposed Rule Change is consistent with the requirements of 
Section 17A(b)(3)(I) of the Act \84\ because any competitive burden 
imposed by the proposal is necessary and appropriate in furtherance of 
the Act.
---------------------------------------------------------------------------

    \84\ 15 U.S.C. 78q-1(b)(3)(I).
---------------------------------------------------------------------------

C. Consistency With Rule 17Ad-22(e)(4)(i)

    Rule 17Ad-22(e)(4)(i) under the Exchange Act requires that each 
covered clearing agency establish, implement, maintain and enforce 
written policies and procedures reasonably designed to effectively 
identify, measure, monitor, and manage its credit exposures to 
participants and those arising from its payment, clearing, and 
settlement processes, including by maintaining sufficient financial 
resources to cover its credit exposure to each participant fully with a 
high degree of confidence.\85\
---------------------------------------------------------------------------

    \85\ 17 CFR 240.17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

    Several commenters question whether NSCC has adequately 
demonstrated that its proposal is consistent with Rule 17Ad-22(e)(4)(i) 
under the Exchange Act by showing the insufficiency of NSCC's current 
margin methodology and whether the increase in margin is necessary.\86\ 
Two commenters state that NSCC has not demonstrated that its current 
margin requirements are insufficient to cover credit risks to its 
Members.\87\
---------------------------------------------------------------------------

    \86\ See Lek Letter at 1; STANY Letter at 1; OTC I Letter at 2.
    \87\ See STANY Letter at 1; OTC I Letter at 2.
---------------------------------------------------------------------------

    In response, NSCC states that the proposal is designed to provide a 
more accurate measure of the risks associated with Illiquid Securities 
and to cover in full the risks presented by Members to NSCC.\88\ To 
demonstrate why the proposed revision to its methodology for assessing 
margin on Illiquid Securities is necessary to address the risk 
presented by such securities, NSCC relies upon the results of recent 
backtesting analyses. Specifically, NSCC examines the backtesting 
coverage for a historical time period under both the current and 
proposed margin methodologies. Based on this analysis, NSCC represents 
that the proposal would help NSCC to address the risk presented by 
Illiquid Securities and that it would improve the lowest average 
backtesting coverage with respect to Illiquid Securities from 96.2% to 
99.5% for the asset group that exhibited the lowest average backtesting 
coverage percentages (i.e., short positions in sub-penny securities and 
securities priced between one cent and one dollar).\89\

[[Page 77291]]

NSCC further states that its backtesting results and Member impact 
studies indicate that Illiquid Securities, particularly low-priced 
Illiquid Securities, are more likely to present additional risk.\90\
---------------------------------------------------------------------------

    \88\ See NSCC Letter at 6.
    \89\ Id. at 5; 17 CFR 240.17Ad-22(e)(4)(i). NSCC also notes that 
this improvement in coverage level would allow it to meet the high 
degree of confidence referenced in Rule 17Ad-22(e)(4)(i). Id. As 
stated above, the volatility component of the margin collected by 
NSCC is designed to reflect the amount of money that could be lost 
on a portfolio over a given period within a 99% confidence level, 
and NSCC has established a 99% target backtesting confidence level. 
See, e.g., Procedure XV, Section I.B(3), supra note 9.
    \90\ See NSCC Letter at 5.
---------------------------------------------------------------------------

    NSCC notes that the proposed changes to its methodology produce a 
more accurate haircut calculation by factoring in price levels, 
resulting in margin levels that better reflect the risks and particular 
attributes of Member portfolios.\91\ NSCC represents that the enhanced 
methodology for identifying Illiquid Securities and the calculation of 
the haircut-based volatility component applicable to these securities 
and UITs improve the risk-based methodology, which in turn, better 
manage its credit exposures to Members.\92\
---------------------------------------------------------------------------

    \91\ See NSCC Letter at 5-6.
    \92\ See NSCC Letter at 6.
---------------------------------------------------------------------------

    The Commission believes that the proposal is consistent with Rule 
17Ad-22(e)(4)(i) under the Exchange Act.\93\ Specifically, the proposal 
to revise the definition of Illiquid Securities would help NSCC to 
better identify securities that may present credit exposures unique to 
such securities for purposes of applying an appropriate margin charge. 
The proposal would provide additional criteria that use more objective 
factors to determine what constitutes an Illiquid Security. These 
factors consider a security's listing status, trading history, and 
market capitalization, and would result in a more accurate 
classification of securities with illiquid characteristics being 
considered as Illiquid Securities. In addition, the proposal to base 
the calculation of the haircut-based volatility charge applied to 
positions in Illiquid Securities and UITs on those securities' price 
level and risk profile would enable NSCC to collect and maintain 
sufficient and precisely calibrated resources to cover its credit 
exposures to each participant whose portfolio contains positions in 
Illiquid Securities and/or UITs with a high degree of confidence. The 
Commission has reviewed and analyzed NSCC's analysis of the 
improvements in its backtesting coverage, and agrees that the analysis 
demonstrates that the proposal would result in better backtesting 
coverage and, therefore, less credit exposure to its Members. Finally, 
the proposal appropriately requires NSCC to review and determine the 
haircut percentages at least annually. Accordingly, the Commission 
believes that the proposal would enable NSCC to better manage its 
credit risks by allowing it to respond regularly and more effectively 
to any material deterioration of backtesting performances, market 
events, market structure changes, or model validation findings.
---------------------------------------------------------------------------

    \93\ 17 CFR 240.17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

    In response to comments that NSCC has not demonstrated that current 
margin requirements are insufficient to cover credit risks to its 
Members, the Commission disagrees. In considering these comments, the 
Commission thoroughly reviewed and considered (i) the Proposed Rule 
Change, including the supporting exhibits that provided confidential 
information on the performance of the proposed revision to the 
definition of an Illiquid Security and the use of a revised haircut-
based methodology applicable to both Illiquid Securities and UITs and 
backtesting coverage results; (ii) the comments received; and (iii) the 
Commission's own understanding of the performance of the current margin 
methodology, with which the Commission has experience from its general 
supervision of NSCC, compared to the proposed margin methodology.\94\ 
Based on its review of these materials, the Commission believes that 
the proposal would, in fact, better enable NSCC to cover its credit 
exposure to Members and meet the applicable Commission regulatory 
requirements. Specifically, the Commission has considered the results 
of NSCC's backtesting coverage analyses, which indicate that the 
current margin methodology results in backtesting coverage that does 
not meet NSCC's targeted confidence level. The analyses also indicate 
that the proposal would result in improved backtesting coverage that 
meets NSCC's targeted coverage level. Therefore, the Commission 
believes that the proposal would provide NSCC with a more precise 
margin calculation designed to meet the applicable regulatory 
requirements for margin coverage.
---------------------------------------------------------------------------

    \94\ In addition, because the proposals contained in the Advance 
Notice and the Proposed Rule Change are the same, all information 
submitted by NSCC was considered regardless of whether the 
information submitted with respect to the Advance Notice or the 
Proposed Rule Change. See supra notes 3 and 55.
---------------------------------------------------------------------------

    Therefore, for the reasons discussed above, the Commission believes 
that the changes proposed in the Proposed Rule Change are reasonably 
designed to enable NSCC to effectively identify, measure, monitor, and 
manage its credit exposure to Members, consistent with Rule 17Ad-
22(e)(4)(i).\95\
---------------------------------------------------------------------------

    \95\ 17 CFR 240.17Ad-22(e)(4)(i).
---------------------------------------------------------------------------

D. Consistency With Rule 17Ad-22(e)(6)(i)

    Rule 17Ad-22(e)(6)(i) under the Exchange Act requires that each 
covered clearing agency that provides central counterparty services 
establish, implement, maintain and enforce written policies and 
procedures reasonably designed to cover its credit exposures to its 
participants by establishing a risk-based margin system that, at a 
minimum, considers, and produces margin levels commensurate with, the 
risks and particular attributes of each relevant product, portfolio, 
and market.\96\
---------------------------------------------------------------------------

    \96\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------

    Several commenters suggest that the proposal does not reflect the 
actual risk attributes of the securities to which it would apply.\97\ 
For example, two commenters state that treating as Illiquid Securities 
all securities that are not listed on a ``specified securities 
exchange,'' which would be defined as a national securities exchange 
that has established listing services and is covered by industry 
pricing and data vendors, is not tailored to accurately capture 
securities that present the defined liquidation and marketability 
risks, noting that many large international companies' securities are 
traded in the OTC marketplace.\98\ Two commenters state that the 
proposal is unwarranted because the existing margin has always been 
enough to cover a defaulting Member's losses, and accordingly, the 
current margin should be enough to cover the risks presented by 
Members' portfolios.\99\ One

[[Page 77292]]

commenter states that NSCC has not justified a $300 million market 
capitalization requirement for all exchange-listed stocks, and that 
this threshold does not consider the actual risks facing NSCC.\100\ 
Another commenter states that ETPs and ADRs, which are products 
typically offered by large banks and brokerages, are excluded from the 
definition of an Illiquid Security, and that such exclusion shows a 
bias against small Members.\101\ In addition, one commenter states that 
the proposal bears no relationship to a Member's actual credit 
rating.\102\
---------------------------------------------------------------------------

    \97\ See Alpine Letter; OTC I Letter; STANY Letter; and Letter 
from Daniel Zinn, General Counsel and Cass Sanford, Associate 
General Counsel, OTC Markets Group Inc. (July 21, 2020) (``OTC II 
Letter'').
    \98\ See OTC II Letter at 5; STANY Letter at 3.
    \99\ See Lek Letter at 1; Wilson III Letter at 3. Lek also 
states that net capital should be considered solely as additional 
insurance for agency firms, and that NSCC should include the margin 
that Lek collects from its customers when computing Lek's capital. 
Id. However, this issue is beyond the scope of this proposal and is 
not addressed herein. Further, one commenter argues that the 
Proposed Rule Change is also unwarranted because NSCC could address 
NSCC's market risk exposure by modifying the settlement timeline. 
See Wilson III Letter at 4. According to the commenter, if the NSCC 
proposed rules that would eliminate the two-day settlement cycle in 
favor of immediate, same-day electronic settlement, the market risk 
exposure would be eliminated. See id. The Commission disagrees with 
the argument. The securities industry transitioned to the current 
two-day settlement cycle on September 5, 2017, only after a multi-
year, industry-wide initiative and the Commission's amendment of 
Rule 15c6-1. See Securities Exchange Act Release No. 78962 
(September 28, 2016), 81 FR 69240, 69254 (October 5, 2016) 
(``Discussion of Current Efforts To Shorten the Settlement Cycle in 
the U.S.''); See Securities Exchange Act Release No. 80295 (March 
22, 2017), 82 FR 15564 (March 29, 2017). Therefore, the commenter's 
suggestion that NSCC could unilaterally shorten the current two-day 
settlement to a same-day settlement cycle is not a feasible 
alternative to the Proposed Rule Change.
    \100\ See STANY Letter at 3.
    \101\ See SIPA Letter.
    \102\ See Alpine Letter at 4.
---------------------------------------------------------------------------

    In response to comments regarding treating as Illiquid Securities 
all securities that are not listed on a national securities exchange 
that has established listing services and is covered by industry 
pricing and data vendors, NSCC states that securities that trade on a 
national securities exchange tend to trade with greater frequency in 
higher volumes than other venues, and national securities exchanges are 
subject to price and volume reporting regimes that assure greater 
accuracy of price and volume information.\103\ NSCC further states that 
securities that are not listed on a national securities exchange may 
trade without being registered with the Commission and have less 
reliable price and volume information.\104\
---------------------------------------------------------------------------

    \103\ See NSCC Letter at 8.
    \104\ See NSCC Letter at 8-9.
---------------------------------------------------------------------------

    In addition, NSCC explains that it included the second element of 
the criteria, ``covered by industry pricing and data vendors,'' to 
ensure that NSCC is able to access and utilize quality third party 
pricing data to derive returns in order to calculate the appropriate 
margin.\105\ NSCC further explains that the commercial availability of 
reliable information from independent, third party sources is critical 
to ensuring that NSCC can rely on end of day and intraday pricing in 
order to accurately manage risk positions consistent with its 
Rules.\106\ Accordingly, NSCC believes that the use of ``specified 
securities exchange'' as defined in the proposal is an appropriate 
basis for determining whether a security is an Illiquid Security.\107\
---------------------------------------------------------------------------

    \105\ See id.
    \106\ See id.
    \107\ See id.
---------------------------------------------------------------------------

    Regarding the comments that many large international companies' 
securities are traded in the OTC marketplace, NSCC acknowledges that 
the proposed definition of Illiquid Securities would cover the 
securities of some large, well-capitalized issuers not listed on a 
specified securities exchange.\108\ However, NSCC states that the 
proposal is designed to appropriately address risk in part by grouping 
Illiquid Securities by price level, and sub-penny securities by long or 
short position.\109\ Accordingly, not all Illiquid Securities would be 
given the same haircut or have the same margin requirements or result 
in a higher deposit than would be required under the current 
Rules.\110\
---------------------------------------------------------------------------

    \108\ See id.
    \109\ See id.
    \110\ See id.
---------------------------------------------------------------------------

    The Commission understands that, as described above, the proposal 
as a whole is designed to enable NSCC to more effectively address the 
risks presented by Members' positions in securities with illiquid 
characteristics, including Illiquid Securities and UITs. As such, NSCC 
seeks to produce margin levels that are more commensurate with the 
particular risk attributes of these securities, including the risk of 
increased transaction and market costs to NSCC to liquidate or hedge 
due to lack of liquidity or marketability of such positions. The 
Commission believes that the proposal would improve NSCC's ability to 
consider, and produce margin levels commensurate with, the risks and 
particular attributes of Illiquid Securities and UITs.
    First, by expanding and refining the definition of Illiquid 
Securities, the Commission believes that NSCC should be able to better 
identify those securities that may exhibit illiquid characteristics. 
Specifically, the proposal would ensure that three separate categories 
of securities are included in the definition of an Illiquid Security, 
and all three categories are calibrated to take into account specific 
and objective factors that are indicative of a security's liquidity. 
For example, the second category of the proposed definition of an 
Illiquid Security would apply an illiquidity ratio to micro-cap 
securities and ADRs to get a more precise measure of their liquidity. 
Moreover, consistent with NSCC's current practice for determining the 
margin for securities in an initial public offering, the third category 
of the proposed definition would consider the frequency of a security's 
trading, to take into account that infrequent trading reduces the 
amount of price and volume information available to measure market 
risk.
    In addition, the Commission believes that the proposed changes to 
the haircut-based volatility charges to base the calculation on the 
price level and risk profile of the applicable security would help NSCC 
to more effectively measure the risks that are particular to Illiquid 
Securities and UITs. Based on its analysis of the backtesting and 
impact analyses and its understanding of the proposed definition of an 
Illiquid Security, the Commission believes that the differentiated 
haircut percentages are reasonably designed to cover NSCC's exposures 
to Members more precisely and appropriately than the current fixed 
percentage approach because NSCC designed the variable haircut 
percentages to reflect specific risks presented by Illiquid Securities 
by price level and by UITs. The Commission also believes that it is 
reasonable to separate long and short positions of sub-penny securities 
in order to reflect the different risk levels presented by such 
positions.
    Taken together, the Commission believes that the proposal should 
permit NSCC to calculate a haircut-based volatility charge that is more 
appropriately designed to address the risks presented by the positions 
in Illiquid Securities and UITs.
    In response to the comments questioning whether the proposal is 
necessary because ``the existing margin has always been enough to 
cover'' \111\ a defaulting Member's losses, the Commission does not 
agree that the fact that margin has historically been sufficient to 
cover a defaulting Member's losses obviates the need for the changes 
proposed in the Proposed Rule Change. As an initial matter, credit 
exposures are not measured only by those events that have actually 
happened, but also include events that could potentially occur in the 
future. For this reason, a risk-based margin system is required to 
cover potential future exposure to participants.\112\ Potential future 
exposure is, in turn, defined as the maximum exposure estimated to 
occur at a future point in time with an established single-tailed

[[Page 77293]]

confidence level of at least 99% with respect to the estimated 
distribution of future exposure.\113\ Thus, to be consistent with its 
regulatory requirements, NSCC must consider potential future exposure, 
which includes, among other things, losses associated with the 
liquidation of a defaulted member's portfolio. As demonstrated by the 
backtesting analysis discussed above, under its current margin 
methodology, NSCC is not achieving its 99% targeted confidence level 
for asset groups that are Illiquid Securities. Based on its review of 
the Proposed Rule Change, in conjunction with the Commission's 
supervisory observations, the Commission believes that the proposed 
changes would better enable NSCC to collect margin commensurate with 
the different levels of risk that Members pose to NSCC as a result of 
their particular trading activity in Illiquid Securities and UITs. 
Further, the Commission believes the amount of margin NSCC would 
collect under the proposed changes would help NSCC better manage its 
credit exposures to its Members and those exposures arising from its 
payment, clearing, and settlement processes.
---------------------------------------------------------------------------

    \111\ See Lek Letter at 1; see also Wilson III at 3-4.
    \112\ 17 CFR 240.17Ad-22(e)(6)(iii) (requiring a covered 
clearing agency to establish, implement, maintain and enforce 
written policies and procedures reasonably designed to cover its 
credit exposures to its participants by establishing a risk-based 
margin system that, at a minimum, calculates margin sufficient to 
cover its potential future exposure to participants in the interval 
between the last margin collection and the close out of positions 
following a participant default).
    \113\ 17 CFR 240.17Ad-22(a)(13).
---------------------------------------------------------------------------

    In response to the comment asserting that a $300 million market 
capitalization requirement for all exchange-listed stocks is not 
justifiable, the Commission disagrees with this interpretation of the 
proposal. Not all securities that fall under the market capitalization 
threshold under the proposal would be deemed to be Illiquid Securities 
or require a higher margin compared to the current Rules. As set forth 
in the proposal, the determination of whether a micro-cap security is 
an Illiquid Security does not rely solely on capitalization. By 
contrast, under the proposal, the initial determination of whether a 
security is a micro-cap security would employ a $300 million 
threshold,\114\ and a micro-cap security would then be subject to the 
illiquidity ratio test described in Section I.C(ii)3 above to take into 
account the security's liquidity and determine whether it is an 
Illiquid Security. Therefore, depending on the liquidity of the issuer, 
there could be instances where a security with less than $300 million 
in market capitalization would not constitute an Illiquid Security.
---------------------------------------------------------------------------

    \114\ NSCC represents that the initial threshold is set at $300 
million because it is based on prevailing thresholds for market 
capitalization categories in the industry. See NSCC Letter at 9; 
Notice, supra note 3, 85 FR at 17912 n. 24 (citing, as an example of 
the prevailing views, https://www.sec.gov/reportspubs/investor-publications/investorpubs/microcapstockhtm.html).
---------------------------------------------------------------------------

    In response to the comments stating that treating all securities 
that are not listed on a specified exchange as Illiquid Securities is 
not tailored to accurately capture securities that present the defined 
liquidation and marketability risks, the Commission disagrees. This 
proposal does not change the current categorization as Illiquid 
Securities of securities that are not listed on a specified securities 
exchange, because the current Rules define Illiquid Securities to 
include securities that are not traded on a national securities 
exchange. Further, the Commission believes that this distinction is 
appropriate. Securities that are quoted on the OTC market differ from 
those listed on national securities exchanges.\115\ In particular, the 
average OTC security issuer is smaller, and their securities trade 
less, on average, than securities traded on a national securities 
exchange.\116\ Moreover, issuers of quoted OTC securities tend to have 
a lower market capitalization than those with securities listed on a 
national securities exchange,\117\ and many quoted OTC securities are 
illiquid.\118\ Quoted OTC securities are characterized by significantly 
lower dollar trading volumes than listed stocks, even for securities of 
similar size as measured by market capitalization.\119\
---------------------------------------------------------------------------

    \115\ Securities Act Release No. 68124 (September 16, 2020), 85 
FR 68124, 68185 (October 27, 2020) (S7-14-19) (``Publication or 
Submission of Quotations Without Specified Information'').
    \116\ See id.
    \117\ See id.
    \118\ See id.
    \119\ See id.
---------------------------------------------------------------------------

    In response to the comment that ETPs and ADRs are exempt from the 
definition of Illiquid Securities, the Commission disagrees. The 
Proposed Rule Change would not exclude all ETPs and ADRs by category 
from the definition of Illiquid Securities. Instead, the proposal would 
only exclude ETPs and ADRs when calculating the illiquidity ratio 
threshold for purposes of the second test under the definition of an 
Illiquid Security (i.e., the median of the illiquidity ratio threshold 
based on non-micro-cap common stocks). An ETP or an ADR could be 
determined to be an Illiquid Security, and NSCC would apply a haircut 
to ETPs and ADRs in the same manner as other Illiquid Securities.
    Finally, in response to the comment that the proposal bears no 
relationship to a Member's actual credit rating, the Commission 
disagrees that such a relationship is necessary in order to design an 
accurate and appropriate margin methodology for the securities that a 
Member holds. Neither the proposal, nor NSCC's margin methodology more 
broadly, is designed to calculate the volatility component based on a 
Member's credit rating but rather on the risks presented by each 
security. Therefore, the Member's credit rating is not relevant to the 
determination of the appropriate volatility component of the margin for 
a particular security.\120\
---------------------------------------------------------------------------

    \120\ The Alpine Letter also questions whether the Credit Risk 
Rating Matrix (``CRRM'') will continue to be used in the margin 
calculation for Illiquid Securities. See Alpine Letter at 3. NSCC 
responds that the calculation of the appropriate haircuts for 
Illiquid Securities, including calculation of the appropriate volume 
thresholds, does not consider the Member's CRRM rating. The CRRM 
rating currently is used in determining the Illiquid Position 
subject to NSCC's Illiquid Charge, which will be eliminated upon 
implementation of the proposal. See NSCC Letter at 7-8. Going 
forward, the CRRM would continue to be used in general credit risk 
monitoring of members, but would not be used for the determination 
of the volatility component of the margin for a particular security. 
See Securities Exchange Act Release No. 80734 (May 19, 2017), 82 FR 
24177 (May 25, 2017) (order approving proposed rule changes to 
enhance the CRRM).
---------------------------------------------------------------------------

    Accordingly, the Commission believes the proposal is consistent 
with Rule 17Ad-22(e)(6)(i) under the Exchange Act because it is 
designed to assist NSCC in maintaining a risk-based margin system that 
considers, and produces margin levels commensurate with, the risks and 
particular attributes of portfolios that exhibit illiquid risk 
attributes.\121\
---------------------------------------------------------------------------

    \121\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------

E. Consistency With Rule 17Ad-22(e)(23)(ii)

    Rule 17Ad-22(e)(23)(ii) under the Exchange Act requires each 
covered clearing agency to establish, implement, maintain, and enforce 
written policies and procedures reasonably designed to provide 
sufficient information to enable participants to identify and evaluate 
the risks, fees, and other material costs they incur by participating 
in the covered clearing agency.\122\
---------------------------------------------------------------------------

    \122\ 17 CFR 240.17Ad-22(e)(23)(ii).
---------------------------------------------------------------------------

    The majority of commenters express concerns regarding the method 
for determining the proposed volatility component for Illiquid 
Securities being confidential. Several commenters express concern that 
the proposal does not explain how the haircut-based volatility charge 
will be calculated and that the proposal does not allow Members to 
review the proposed margin equations, models, and calculations.\123\

[[Page 77294]]

Other commenters state that the proposal is overly complicated and does 
not allow Members to predict the financial consequences and operating 
impacts of their activities, and the impact on their liquidity 
needs.\124\
---------------------------------------------------------------------------

    \123\ See Alpine Letter at 2; SIPA Letter at 4-5; OTC I Letter 
at 2-3; OTC II Letter at 3-4; Wilson II Letter at 7. Wilson II also 
asserts that NSCC has failed to meet the requirements of Rule 17Ad-
22(e)(23)(iii) for failing to quantify the current inadequate market 
capitalization, median illiquidity ratios, and how those factors 
would be improved under the proposal. However, Rule 17Ad-
22(e)(23)(iii) requires each covered clearing agency to establish, 
implement, maintain, and enforce written policies and procedures 
reasonably designed to publicly disclose relevant basic data on 
transaction volume and values. This rule does not require a covered 
clearing agency to disclose the specific information that the 
commenter seeks because the information described by the commenter 
is not the basic data on transaction volumes and values required by 
the rule. Moreover, NSCC publicly provides data on transaction 
volumes and values in its quantitative disclosures, which are 
available at https://www.dtcc.com/legal/policy-and-compliance.
    \124\ See Letter from James C. Snow, President/CCO, Wilson-Davis 
& Co., Inc. (May 1, 2020) (``Wilson I Letter'') at 2-3; STANY Letter 
at 2; Wilson III Letter at 2. Wilson III also states that NSCC 
failed to meet the requirements of Rule 17Ad-22(e)(23)(ii) and 
(iii), which requires a clearing agency to provide sufficient 
information to enable participants to identify and evaluate the 
risks, fees, and other material costs they incur by participating in 
the covered clearing agency and to publicly disclose relevant basic 
data on transaction volume and values, because NSCC has not 
undertaken the requisite studies or gathered sufficient data to 
fully understand the impact of the Proposed Rule Change. See Wilson 
III Letter at 3. The Commission disagrees with this comment. First, 
as described in more detail below, NSCC provides methods for Members 
to understand their respective margin requirements. See infra note 
127 and accompanying text. Second, as stated above, NSCC submitted 
to the Commission impact studies comparing the impact of the current 
and proposed methodologies on its Members, and provided additional 
information regarding the improvements in backtesting coverage for 
other asset groups in confidential exhibits. See supra notes 55 and 
94.
---------------------------------------------------------------------------

    In response, NSCC states that the language of the proposal is 
reasonably transparent and clear enough to enable Members to determine 
the Member's Required Fund Deposit.\125\ NSCC states that the proposed 
parameters are definitive and non-discretionary to enable application 
on an algorithmic basis.\126\ For example, a security that is an ADR or 
has a micro-capitalization of less than $300 million would be subject 
to the illiquidity ratio test, which would be provided in the Rules, to 
determine whether it is an Illiquid Security. In addition, NSCC states 
that, because haircuts would be applied according to the price level of 
the Illiquid Securities, Members should be able to more easily 
determine the applied margin impact per the current market price of the 
security.\127\
---------------------------------------------------------------------------

    \125\ See NSCC Letter at 6.
    \126\ See id.
    \127\ See id.
---------------------------------------------------------------------------

    NSCC also represents that it maintains the NSCC Risk Management 
Reporting application on the Participant Browser Service (``PBS'') and 
the NSCC Risk Client Portal (``Portal'') to improve transparency of 
Members' Clearing Fund requirements.\128\ NSCC states that the PBS is a 
member-accessible website portal for accessing reports and other 
disclosures. NSCC further states that the Risk Management Reporting 
application enables a Member to view and download Clearing Fund 
requirement information and component details, including issue-level 
Clearing Fund information related to start of day volatility charges 
and mark-to-market, intraday exposure, and other components.\129\ NSCC 
represents that the application enables a Member to view, for example, 
a portfolio breakdown by asset type, including the amounts attributable 
to the parametric VaR model and the amounts associated with Illiquid 
Securities.\130\ NSCC also represents that Members are able to view and 
download spreadsheets that contain market amounts for current clearing 
positions and the associated volatility charges.\131\
---------------------------------------------------------------------------

    \128\ See id.
    \129\ See id.
    \130\ See id.
    \131\ See id.
---------------------------------------------------------------------------

    In addition, NSCC represents that the Portal provides members the 
ability, for information purposes, to view and analyze certain risks 
relating to their portfolio, including calculators to assess the risk 
and clearing fund impact of certain activities and to compare their 
portfolio to historical and average values. For example, it allows 
Members to review both hourly and 15-minute intra-day snapshots to 
monitor fluctuations in the volatility and exposure in their portfolios 
to help Members to anticipate potential intra-day margin calls. The 
intervals are available through 7:00 p.m. to provide additional reports 
that may help Members to forecast next-day margin requirements.\132\
---------------------------------------------------------------------------

    \132\ See NSCC Letter at 7.
---------------------------------------------------------------------------

    NSCC further represents that it maintains the NSCC Client 
Calculator on the Portal that provides functionality to Members to 
enter `what-if' position data and to recalculate their volatility 
charges to determine margin impact pre-trade.\133\ NSCC specifically 
states that this calculator allows Members to see the impact to the 
volatility charge if specific transactions are executed, or to 
anticipate the impact of an increase or decrease to a current clearing 
position.\134\ NSCC represents that the Client Calculator portfolio 
detail can be downloaded to modify a current margin portfolio, and then 
allow Members to upload the portfolio to run a margin calculation, and 
permit Members to view position level outputs in order to make informed 
risk management and execution decisions.\135\
---------------------------------------------------------------------------

    \133\ See id.
    \134\ See id.
    \135\ See id.
---------------------------------------------------------------------------

    Finally, NSCC states that it conducted member outreach in 
connection with the proposal described in the Proposed Rule Change. 
NSCC represents that, in 2019 and 2020, NSCC distributed three rounds 
of impact studies to Members impacted by the change to communicate 
revisions to the methodology and discuss specific portfolio impacts by 
reviewing charts and quantitative results.\136\ NSCC further represents 
that it has performed outreach to Members with details for this 
proposal for the past two years, which allowed Members to understand 
and ask questions about the proposal.\137\
---------------------------------------------------------------------------

    \136\ See id. Wilson III states that unlike NSCC's 
representation, only one impact study was received. See Wilson III 
Letter at 3. The Commission does not believe that NSCC's purported 
failure to provide particular impact studies to all of its Members 
is a dispositive factor in determining whether the Proposed Rule 
Change is designed to be consistent with Rule 17Ad-22(e)(23)(ii). 
Rule 17Ad-22(e)(23)(ii) requires NSCC to provide sufficient 
information to enable participants to identify and evaluate the 
risks, fees, and other material costs they may incur. NSCC has (1) 
acknowledged that that the proposal may result in an increase in the 
Required Fund Deposit for a Member effecting transactions in 
Illiquid Securities, and that it may also result in higher margin 
costs overall for Members whose business is concentrated in Illiquid 
Securities, relative to other Members with more diversified 
portfolios, and (2) provided Members with a Portal that enables them 
to identify and evaluate their costs.
    \137\ See NSCC Letter at 7.
---------------------------------------------------------------------------

    NSCC states that it has also posted an NSCC Risk Margin Component 
Guide (``Guide'') on the Portal which provides descriptions of some of 
the components used in NSCC's current risk-based methodology, including 
the volatility charges, mark-to-market charges, fail charges for CNS 
transactions, a charge for Family-Issued Securities to mitigate wrong 
way risk, a charge for Illiquid Positions, a charge to mitigate day 
over day margin differentials, a coverage component and a backtesting 
charge.\138\ NSCC represents that the Guide will be updated to reflect 
the changes in methodology set forth in the proposal.\139\
---------------------------------------------------------------------------

    \138\ See id.
    \139\ See id.
---------------------------------------------------------------------------

    The Commission believes that the proposal is consistent with Rule 
17Ad-22(e)(23)(ii) and is designed to provide sufficient information to 
enable Members to identify and evaluate the risks and other material 
costs they incur by participating in NSCC. The changes described in the 
proposal would be

[[Page 77295]]

reflected in NSCC's Rules and therefore publicly available to NSCC's 
Members and prospective members for application to their own 
portfolios. Specifically, the proposed rule text would reflect the two 
sets of changes in the proposal. First, the proposed rule text would 
define the types of securities that would constitute ``Illiquid 
Securities'' as three particular categories of securities, as described 
in Section I.C(i), (ii), and (iii). By reviewing the definitions of an 
Illiquid Security, NSCC's members should be able to understand the 
types of factors that would cause a security to be considered an 
Illiquid Security, all of which are ascertainable, such as its trading 
history (including whether it is traded on an exchange or not and, if 
so, on which exchange), its market capitalization, and the type of 
security (i.e., whether it is an ADR). The specific parameters of the 
illiquidity ratio test would also be reflected in NSCC's Rules, thereby 
enabling a Member to determine whether a security that is an ADR or has 
a micro-capitalization of less than $300 million would be an Illiquid 
Security.
    Second, the proposed rule text would provide that NSCC would apply 
a haircut to Illiquid Securities to determine the appropriate 
volatility component, with Illiquid Securities grouped by price level 
to determine the appropriate haircut to apply to a particular security. 
The proposed rule text would further specify that the haircut 
percentage would be the highest of the three percentages as provided in 
Section I.D(i), and would be determined at least annually. 
Additionally, if a Member had questions with respect to a particular 
security, it could use the various client-facing tools described above 
to determine whether a security would be considered an Illiquid 
Security. Taken together, the Commission believes that the proposal, 
which would be reflected in NSCC's Rules, in conjunction with the 
various client-facing tools, provides sufficient information to Members 
to understand the operation of the haircut-based volatility charges and 
how such charges would apply to particular transactions. The Commission 
further believes that NSCC provided sufficient information to Members 
to identify and evaluate the risks and other material costs they would 
incur due to securities with illiquid characteristics under the 
proposal.
    For these reasons, the Commission disagrees with the comments 
stating that the proposal lacks details and does not explain how the 
haircut-based volatility charge will be calculated, and that the 
proposal does not allow Members to predict the impact on their 
activities. The Commission acknowledges that, as some commenters have 
noted, the proposal does not provide or specify the actual models or 
calculations that NSCC would use to determine the appropriate haircut 
or what constitutes an Illiquid Security. However, when adopting the 
CCA Standards,\140\ the Commission declined to adopt a commenter's view 
that a covered clearing agency should be required to provide, at least 
quarterly, its methodology for determining initial margin requirements 
at a level of detail adequate to enable participants to replicate the 
covered clearing agency's calculations, or, in the alternative, that 
the covered clearing agency should be required to provide a 
computational method with the ability to determine the initial margin 
associated with changes to each respective participant's portfolio or 
hypothetical portfolio, participant defaults and other relevant 
information. The Commission stated that ``[m]andating disclosure of 
this frequency and granularity would be inconsistent with the 
principles-based approach the Commission is taking in Rule 17Ad-
22(e).'' \141\ Consistent with that approach, the Commission does not 
believe that Rule 17Ad-22(e)(23)(ii) would require NSCC to disclose its 
actual margin methodology, so long as NSCC has provided sufficient 
information for its Members to understand the potential costs and risks 
associated with participating in NSCC for clearing Illiquid Securities.
---------------------------------------------------------------------------

    \140\ 17 CFR 240.17Ad-22(e).
    \141\ See CCA Standards Adopting Release, supra note 64, 81 FR 
at 70845.
---------------------------------------------------------------------------

    For the reasons discussed above, the Commission believes that the 
proposals in the Proposed Rule Change would enable NSCC to establish, 
implement, maintain, and enforce written policies and procedures 
reasonably designed to provide sufficient information to enable Members 
to identify and evaluate the risks, fees, and other material costs they 
incur as NSCC's Members, consistent with Rule 17Ad-22(e)(23)(ii).\142\
---------------------------------------------------------------------------

    \142\ 17 CFR 240.17Ad-22(e)(23)(ii).
---------------------------------------------------------------------------

III. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
in particular with the requirements of Section 17A of the Act \143\ and 
the rules and regulations promulgated thereunder.
---------------------------------------------------------------------------

    \143\ 15 U.S.C. 78q-1.
---------------------------------------------------------------------------

    It is therefore ordered, pursuant to Section 19(b)(2) of the Act 
\144\ that proposed rule change SR-NSCC-2020-003, be, and hereby is, 
approved.\145\
---------------------------------------------------------------------------

    \144\ 15 U.S.C. 78s(b)(2).
    \145\ In approving the proposed rule change, the Commission 
considered the proposals' impact on efficiency, competition, and 
capital formation. 15 U.S.C. 78c(f). See also Section II.B.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\146\
---------------------------------------------------------------------------

    \146\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2020-26401 Filed 11-30-20; 8:45 am]
BILLING CODE 8011-01-P


