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GSCC as Counterparty for IDBs

November 22, 1989

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

Dear Mr. Ingber:

This is in response to your letter of July 18, 1989, in which you request an interpretation of section 402.1 of the regulations promulgated pursuant to the Government Securities Act of 1986 (15 U.S.C. 78o-5). Specifically, you request an interpretation of section 402.1(e) such that a member of the Government Securities Clearing Corporation's (GSCC) Comparison System and Netting System (Netting Member) that is an interdealer broker (IDB Netting Member) could become, or, if it were already, would remain a government securities interdealer broker as defined in section 402.1(e)(2)(i), if the IDB Netting Member, at the request of GSCC, were to effect transactions in government securities with GSCC as a counterparty in order to facilitate GSCC's liquidation of an insolvent Netting Member's positions.

We understand the facts to be as follows. GSCC was granted temporary registration by the Securities and Exchange Commission (SEC) pursuant to sections 17A(b)(2) and 19(a) of the Securities Exchange Act of 1934 (Act) (15 U.S.C. 78q-1(b)(2) and 78s(a)) on May 24, 1988, for a period not to exceed 36 months. GSCC has proposed rule changes with the SEC in order for it to establish a legal framework for its Netting System. Upon receiving SEC approval, GSCC commenced its netting operation on July 7, 1989.

You represent that pursuant to section 4 of GSCC Rule 20, which governs GSCC's rights and duties as regards insolvent members (including Netting Members), GSCC is required after determining that a Netting Member is insolvent to cease acting for that member. You also state that GSCC is required to close out such Netting Member's long and short positions in each security by (1) establishing a final net settlement position by netting all of the Netting Member's outstanding deliver and receive obligations and (2) buying in or selling out the securities deliverable by or to such insolvent Netting Member in order to close out the final net settlement.

The close out procedure must be completed as promptly as practicable after GSCC has given notice of the treatment of the Netting Member as insolvent unless the GSCC Board determines that the immediate close out of positions in a security may be undesirable to GSCC or may promote a disorderly market in the security, except that the Board may not suspend the operation of the close out procedure for a period of longer than 30 calendar days without the approval of such by the SEC.

You reference section 402.1(e)(1) which states that a “government securities interdealer broker” may, with the prior written consent of the Secretary of the Treasury, elect not to be subject to the capital requirements for government securities brokers and dealers as set forth in 17 CFR 402.2 but may instead be subject to the provisions of section 402.1(e), which is similar to the SEC's capital rule (17 CFR 240.15c3-1), by filing its election in writing with its designated examining authority.

You further represent that it is highly desirable for the government securities market for GSCC to be able to effect the liquidation of an insolvent Netting Member through the use of an IDB Netting Member. You contend that, given the significant number of trades among the largest dealers in the government securities market being done through IDB Netting Members, the liquidation of insolvent Netting Members by GSCC through an IDB Netting Member would be the best method in terms of a quick liquidation at the most favorable value for the insolvent Netting Members' outstanding positions. You state that this method would mitigate the market's concerns about the effects of the insolvency and liquidation.

Therefore, it is your contention that the ability to effect a liquidation through an IDB Netting Member (including those who are government securities interdealer brokers pursuant to section 402.1(e)(2)(i)) would be to the benefit of other Netting Members and the government securities market in general. You further state your belief that this method of liquidation would not create added risk to the IDB Netting Member. Based on these representations, you request an interpretation of section 402.1 such that an IDB Netting Member that is a government securities interdealer broker for the purpose of section 402.1(e) would be able to participate in the liquidation of insolvent Netting Members at the request of GSCC in the manner described in your letter and remain within the regulatory definition.

Section 402.1(e)(2)(i) defines a “government securities interdealer broker” as “an entity engaged exclusively in business as a broker ... for counterparties that are government securities brokers or dealers who have registered or given notice pursuant to section 15C(a)(1) of the Act (15 U.S.C. 78o-5(a)(1)) ...” The term exclusively has no exceptions. If an IDB Netting Member effects a transaction in government securities with GSCC as a counterparty, then it is doing business with a counterparty who is not a government securities broker or dealer but is instead a clearing agency. Therefore, it would be no longer engaged exclusively in business as a broker whose counterparties are government securities brokers or dealers and thus the IDB Netting Member would no longer meet the definition of a government securities interdealer broker. We are therefore unable to interpret the provisions of 17 CFR 402.1(e) in the manner you request.

However, the Department is aware of the unique nature of GSCC's operation and function. We also recognize that the mechanism provided for by the GSCC that makes possible the fast and efficient liquidation of an insolvent Netting Member's positions at the best possible price fosters and enhances the liquidity of the government securities market. We are therefore prepared to grant an exemption from the exclusivity requirements of 402.1(e)(2)(i) to IDB Netting Members who are also government securities interdealer brokers pursuant to section 402.1(e)(2)(i) who engage in transactions with GSCC as a counterparty under the limited circumstances set out below.

Accordingly, pursuant to 15 U.S.C. 78o-5(a)(4), we hereby grant a limited exemption to IDB Netting Members of GSCC who are also government securities interdealer brokers pursuant to the Government Securities Act regulations from having to meet the definition of government securities interdealer brokers under 17 CFR 402.1(e)(2)(i) in order to receive the alternate capital treatment afforded to interdealer brokers. This exemption is limited to the circumstances where such IDB Netting Members at the request of GSCC engage in transactions in government securities with GSCC as a counterparty for the specific purpose of liquidating the positions of an insolvent Netting Member.

Any variance from these conditions would negate the exemption and would thus subject the affected IDB Netting Members to the circumstance that they would no longer be eligible for the capital treatment available to government securities interdealer brokers as described in section 402.1(e). These IDB Netting Members, therefore, would be subject to the capital requirements for registered government securities brokers and dealers.

We have determined that this limited exemption is consistent with the public interest, the protection of investors and the purposes of the Government Securities Act. Any change in facts or circumstances would require further analysis and will cause the exemption to terminate at that time.

Pursuant to 17 CFR 400.2(c)(7), this response and your letter dated July 18, 1989, will be made immediately available to the public.

Sincerely,
Richard L. Gregg
Commissioner