Custodial Holdings-Clearing Lien
November 22, 1989
Mr. Thomas R. Cassella
Vice President - Financial Responsibility
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006
Dear Mr. Cassella:
The Department has received three written requests for exemption/interpretation and numerous oral inquiries questioning the application of 17 CFR 402.1(e)(8) (ii)(B)(5) and 17 CFR 402.2(g)(1)(i)(B)(5) of the regulations implementing the Government Securities Act of 1986. These two provisions address the exclusion of custodial holdings of securities at the firm's clearing bank or clearing broker from the calculation of net exposure and net credit exposure, respectively. Specifically, the requests questioned the classification of securities in a clearing account subject to a clearing firm's lien but which are in excess of any clearing loan balance as being considered non-custodial holdings and therefore included in the calculation of the exposures. The calculation is required of all government securities brokers and dealers subject to the capital requirements of 17 CFR 402.1(e) or 17 CFR 402.2.
We have considered these securities to be non-custodial because they are under the control of the clearing organization, are possibly exposed to claims related to indebtedness of affiliates and, in an event of default, are used to reimburse the clearing organization for “reasonable expenses.”
Due to the complexity of the many legal and operational issues involved and the concerns raised by the requesting parties concerning our interpretation of custodial holdings, we provided, in our July 21, 1988, letter to you, a temporary exemption from the concentration of credit haircut contained in 17 CFR 402.2(g)(1)(iii). In that letter, the Department granted a temporary exemption from the 25% concentration of credit haircut for net credit exposure in excess of 15% of the firm's liquid capital for exposure to a single clearing bank involving the holding of securities in an account subject to a clearing lien. The 5% counterparty exposure haircut, during this interim period, was specifically applied to any exposures which had been exempted from the 25% haircut.
Since then, we have analyzed the numerous issues involved with this topic, and we have concluded that an appropriate interpretation of the term “custodial holdings,” as applied in Part 402, must reflect not only the risks invariably involved with securities subject to a lien held by the creditor but also the legitimate operational concerns which effectively preclude many brokers and dealers from segregating excess securities from those held in clearing lien accounts. Accordingly, this interpretation distinguishes between custodial and non-custodial securities in the same account, subject to lien, by comparing the value of the securities to the amount of the indebtedness outstanding and treating as custodial only those excess securities that are least likely to be substantially at risk in the event of the broker's or dealer's insolvency. This treatment encompasses some risk in that unusual events such as substantial declines in market value or prolonged settlement of the insolvent broker's or dealer's estate could put more of the securities in the account at risk without being considered in the calculation of capital adequacy. However, it is important to recognize that clearing firms provide necessary clearing and custody services to brokers and dealers which enhance the liquidity and efficiency of the government securities market and this can necessitate that brokers and dealers hold excess securities at the clearing firms. Therefore, we believe that the operational problems of having multiple accounts, including frequent transfers of securities and the associated costs, and the importance of an efficient clearing mechanism to the government securities market require a compromise treatment.
Additionally, we are concerned about the ability of the clearing organization to claim securities subject to the lien in order to satisfy the obligations of related entities such as affiliates and subsidiaries (i.e., cross-liens). We have reviewed this area and have found that these concerns can be adequately assuaged in a number of ways and have also found that the variety of corporate structures employed by different organizations requires that flexibility be preserved in evaluating this risk. Based on this, we have left to the self-regulatory organizations the responsibility to assure themselves in each case that the securities of the broker or dealer are adequately insulated from the debts of its affiliates or subsidiaries. We believe that this review process isolates the problem and presents a means of dealing with it which is advantageous to both the regulators and the broker-dealer community.
Since this interpretation is different from the treatment prescribed in the temporary exemption, a transition period is provided to allow the affected government securities brokers and dealers to make the necessary changes to their operations. We believe that a 60-day period should provide sufficient time for the firms to make the necessary changes. Accordingly, the firms may rely on the July 21, 1988, exemption until 60 days after the date of this letter.
Pursuant to 15 U.S.C. 78o-5(b), we interpret the term “custodial holdings” as used in the provisions of 17 CFR 402.1(e)(8)(ii)(B)(5) and 402.2(g)(1) (i)(B)(5) to include securities held at a clearing bank or clearing broker that are in accounts subject to a lien only: (i) to the extent their market value is in excess of 125% of the balance of any indebtedness outstanding to the clearing entity and; (ii) provided that the government securities broker or dealer has demonstrated to the satisfaction of its self-regulatory organization that the securities subject to the lien are not subject to any other liens in support of, or in favor of, other related legal entities including subsidiaries and affiliates. This interpretation supersedes the exemption provided in the letter dated July 21, 1988, which will terminate effective 60 days from the date of this letter. We have consulted with the staff of the Securities and Exchange Commission in developing this interpretation.
Pursuant to the provisions of 17 CFR 400.2(c)(7), this letter, along with the three request letters, will be immediately available to the public.
Richard L. Gregg