Self-Regulatory Organizations; Fixed Income Clearing Corporation; Notice of No Objection to Advance Notice Filing To Implement a Change to the Methodology Used in the MBSD VaR Model, 8555-8559 [2017-01716]

Download as PDF Federal Register / Vol. 82, No. 16 / Thursday, January 26, 2017 / Notices III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action The foregoing rule change has become effective pursuant to Section 19(b)(3)(A)(ii) of the Act.8 At any time within 60 days of the filing of the proposed rule change, the Commission summarily may temporarily suspend such rule change if it appears to the Commission that such action is: (i) Necessary or appropriate in the public interest; (ii) for the protection of investors; or (iii) otherwise in furtherance of the purposes of the Act. If the Commission takes such action, the Commission shall institute proceedings to determine whether the proposed rule should be approved or disapproved. IV. Solicitation of Comments Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. Copies of the filing also will be available for inspection and copying at the principal office of the Exchange. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR– NASDAQ–2017–005 and should be submitted on or before February 16, 2017. For the Commission, by the Division of Trading and Markets, pursuant to delegated authority.9 Eduardo A. Aleman, Assistant Secretary. [FR Doc. 2017–01719 Filed 1–25–17; 8:45 am] BILLING CODE 8011–01–P SECURITIES AND EXCHANGE COMMISSION [Release No. 34–79843; File No. SR–FICC– 2016–801] Self-Regulatory Organizations; Fixed Income Clearing Corporation; Notice of No Objection to Advance Notice Filing To Implement a Change to the Methodology Used in the MBSD VaR Model Paper Comments jstallworth on DSK7TPTVN1PROD with NOTICES • Use the Commission’s Internet comment form (http://www.sec.gov/ rules/sro.shtml); or • Send an email to rule-comments@ sec.gov. Please include File Number SR– NASDAQ–2017–005 on the subject line. January 19, 2017. • Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549–1090. All submissions should refer to File Number SR–NASDAQ–2017–005. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s Internet Web site (http://www.sec.gov/ rules/sro.shtml). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for Web site viewing and printing in the Commission’s Public Reference Room, 100 F Street NE., On November 23, 2016, the Fixed Income Clearing Corporation (‘‘FICC’’) filed with the Securities and Exchange Commission (‘‘Commission’’) the advance notice SR–FICC–2016–801 pursuant to Section 806(e)(1) of the Payment, Clearing, and Settlement Supervision Act of 2010 (‘‘Clearing Supervision Act’’) 1 and Rule 19b– 4(n)(1)(i) under the Securities Exchange Act of 1934 (‘‘Exchange Act’’).2 The advance notice was published for comment in the Federal Register on December 28, 2016.3 The Commission 8 15 U.S.C. 78s(b)(3)(A)(ii). VerDate Sep<11>2014 15:10 Jan 25, 2017 Jkt 241001 9 17 CFR 200.30–3(a)(12). U.S.C. 5465(e)(1). The Financial Stability Oversight Council designated FICC a systemically important financial market utility on July 18, 2012. See Financial Stability Oversight Council 2012 Annual Report, Appendix A, http:// www.treasury.gov/initiatives/fsoc/Documents/ 2012%20Annual%20Report.pdf. Therefore, FICC is required to comply with the Clearing Supervision Act and file advance notices with the Commission. See 12 U.S.C. 5465(e). 2 17 CFR 240.19b–4(n)(1)(i). 3 Securities Exchange Act Release No. 79643 (December 21, 2016), 81 FR 95669 (December 28, 2016) (SR–FICC–2016–801) (‘‘Notice’’). FICC also filed a proposed rule change with the Commission pursuant to Section 19(b)(1) of the Exchange Act and Rule 19b–4 thereunder, seeking approval of changes to its rules necessary to implement the 1 12 PO 00000 Frm 00053 Fmt 4703 Sfmt 4703 8555 did not receive any comments on the advance notice. This publication serves as notice that the Commission does not object to the changes set forth in the advance notice. I. Description of the Advance Notice As described by FICC in the advance notice, FICC proposes to change the methodology that it currently uses in the Mortgage-Backed Securities Division’s (‘‘MBSD’’) value-at-risk (‘‘VaR’’) model from one that employs a full revaluation approach to one that would employ a sensitivity approach.4 In connection with this change, FICC also proposes to amend the MBSD Clearing Rules (‘‘MBSD Rules’’) to: (i) Amend the definition of VaR Charge 5 to reference an alternative volatility calculation (‘‘Margin Proxy’’) that FICC would use in the event that data used for the sensitivity approach is unavailable for an extended period of time; 6 (ii) revise the definition of VaR Charge to include a VaR floor that FICC would use as an alternative to the amount calculated by the proposed VaR model for portfolios where the VaR floor would be greater than the model-based charge amount (‘‘VaR Floor’’); (iii) eliminate two components from the Required Fund Deposit 7 calculation that would no longer be necessary following implementation of the proposed VaR Charge; and (iv) change the margining approach that FICC may use for certain securities with inadequate historical pricing data from one that calculates charges using a historic index volatility model to one that would use a haircut method. proposal. 15 U.S.C. 78s(b)(1) and 17 CFR 240.19b– 4, respectively. The proposed rule change was published for comment in the Federal Register on December 13, 2016. Securities Exchange Act Release No. 79491 (December 7, 2016), 81 FR 90001 (December 13, 2016) (SR–FICC–2016–007). The Commission did not receive any comments on the proposed rule change. 4 The proposed sensitivity approach methodology would be reflected in the Methodology and Model Operations Document—MBSD Quantitative Risk Model (‘‘QRM Methodology’’). FICC requested confidential treatment of the QRM Methodology and filed it separately with the Secretary of the Commission, pursuant to Rule 24b–2 under the Exchange Act. See 17 CFR 240.24b–2. 5 The term ‘‘VaR Charge’’ means, with respect to each margin portfolio, a calculation of the volatility of specified net unsettled positions of an MBSD clearing member, as of the time of such calculation. See MBSD Rule 1. 6 Details of the Margin Proxy methodology would be reflected in the QRM Methodology. 7 The term ‘‘Required Fund Deposit’’ means the amount an MBSD clearing member is required to deposit to the Clearing Fund pursuant to MBSD Rule 4. See MBSD Rule 1 and MBSD Rule 4 Section 2. E:\FR\FM\26JAN1.SGM 26JAN1 8556 Federal Register / Vol. 82, No. 16 / Thursday, January 26, 2017 / Notices A. Overview of the Required Fund Deposit and Clearing Fund Calculation jstallworth on DSK7TPTVN1PROD with NOTICES A key tool that FICC uses to manage market risk is the daily calculation and collection of Required Fund Deposits from MBSD clearing members (‘‘Clearing Members’’).8 The Required Fund Deposit serves as each Clearing Member’s margin. The aggregate of all Clearing Members’ Required Fund Deposits constitutes the Clearing Fund 9 of MBSD, which FICC would access should a defaulting Clearing Member’s own Required Fund Deposit be insufficient to satisfy losses to FICC caused by the liquidation of that Clearing Member’s portfolio. According to FICC, the objective of a Clearing Member’s Required Fund Deposit is to mitigate potential losses to FICC associated with liquidation of such Clearing Member’s portfolio in the event that FICC ceases to act for such Clearing Member (i.e., a ‘‘default’’).10 Pursuant to MBSD Rules, each Clearing Member’s Required Fund Deposit amount consists of multiple components. Of all of the components, the VaR Charge comprises the largest portion of a Clearing Member’s Required Fund Deposit amount. Generally, the VaR Charge is calculated using a risk-based margin methodology that is intended to capture the market price risk associated with the securities in a Clearing Member’s portfolio. More specifically, FICC calculates the VaR Charge using a methodology referred to as the full revaluation approach. The full revaluation approach uses a historical simulation method to fully re-price each security in a Clearing Member’s portfolio. According to FICC, the methodology is designed to project the potential gains or losses that could occur in connection with the liquidation of a defaulting Clearing Member’s portfolio, assuming that a portfolio would take three days to hedge or liquidate in normal market conditions.11 The projected liquidation gains or losses are used to determine the amount of the VaR Charge, which is calculated to cover projected liquidation losses at a 99 percent confidence level.12 8 The term ‘‘Clearing Member’’ means any entity admitted into membership pursuant to MBSD Rule 2A. See MBSD Rule 1. 9 The term ‘‘Clearing Fund’’ means the Clearing Fund established by FICC pursuant to MBSD Rules, which shall be comprised of the aggregate of all Required Fund Deposits and all other deposits, including cross-guaranty repayment deposits. See MBSD Rule 1. 10 See Notice, 81 FR at 95670. 11 Id. 12 The 99 percent confidence level does not apply to unregistered investment pool clearing members, VerDate Sep<11>2014 15:10 Jan 25, 2017 Jkt 241001 If FICC determines that a security’s price history is incomplete and the market price risk cannot be calculated by the VaR model, then FICC applies the Margin Proxy until such security’s trading history and pricing reflects market risk factors that can be appropriately calibrated from the security’s historical data.13 B. Proposed Changes to the VaR Charge Calculation According to FICC, during the volatile market period that occurred during the second and third quarters of 2013, FICC’s full revaluation approach did not respond effectively to the levels of market volatility at that time, and the model did not achieve a 99 percent confidence level.14 This prompted FICC to employ the Margin Proxy—a supplemental risk charge to ensure that each Clearing Member’s VaR Charge would achieve a minimum 99 percent confidence level.15 FICC reviewed the existing model’s deficiencies, examined the root causes of the deficiencies, and considered options that would remediate the model weaknesses. As a result of this review, FICC now proposes to change MBSD’s methodology for calculating the VaR Charge by: (i) Replacing the full revaluation approach with the sensitivity approach; (ii) using the Margin Proxy as an alternative volatility calculation in the event that the data used for the sensitivity approach is unavailable for an extended period of time; and (iii) establishing a VaR Floor to address a circumstance where the proposed VaR model yields a VaR Charge amount that is lower than 5 basis points of the market value of a Clearing Member’s gross unsettled positions.16 (i) Proposed Sensitivity Approach FICC’s current full revaluation method uses valuation algorithms to fully re-price each security in a Clearing Member’s portfolio over a range of historically simulated scenarios. While which are subject to a VaR Charge with a higher minimum targeted confidence level assumption of 99.5 percent. 13 See MBSD Rule 4 Section 2(c). 14 See Notice, 81 FR at 95670. 15 The Margin Proxy is currently used to provide supplemental coverage to the VaR Charge; however, under this proposed change, the Margin Proxy would only be used as an alternative volatility calculation in the event that the requisite data used for the sensitivity approach is unavailable for an extended period of time. 16 Assuming the market value of gross unsettled positions of $500,000,000, the VaR Floor calculation would be .0005 multiplied by $500,000,000 = $250,000. If the VaR model charge is less than $250,000, then the VaR Floor calculation of $250,000 would be set as the VaR Charge. PO 00000 Frm 00054 Fmt 4703 Sfmt 4703 there are benefits to this method, according to FICC, its deficiencies are that it requires significant historical market data inputs, calibration of various model parameters, and extensive quantitative support for price simulations.17 FICC believes that the proposed sensitivity approach would address these deficiencies because it would leverage external vendor expertise in supplying the market risk attributes,18 which would then be incorporated by FICC into its model to calculate the VaR Charge.19 Because data quality is an important component of calculating the VaR Charge, FICC would conduct independent data checks to verify the accuracy and consistency of the data feed received from the vendor. According to FICC, it has reviewed a description of the vendor’s calculation methodology and the manner in which the market data is used to calibrate the vendor’s models, and it states that it understands and is comfortable with the vendor’s controls, governance process, and data quality standards.20 Additionally, FICC would conduct an independent review of the vendor’s release of a new version of the model. To the extent that the vendor changes its model and methodologies that produce the risk factors and risk sensitivities, FICC would review the effects (if any) of these changes on FICC’s proposed sensitivity approach. Moreover, according to FICC, it does not believe that engaging the vendor would present a conflict of interest to FICC because the vendor is not an existing Clearing Member nor are any of the vendor’s affiliates existing Clearing Members.21 To the extent that the vendor or any of its affiliates submit an application to become a Clearing Member, FICC states that it will negotiate an appropriate information barrier with the applicant in an effort to prevent a conflict of interest from arising.22 According to FICC, the sensitivity approach would provide three key benefits.23 First, the sensitivity 17 See Notice, 81 FR at 95670. risk factors that would be incorporated into MBSD’s proposed VaR methodology are key rate, convexity, spread, volatility, mortgage basis and time, as more fully described in the Notice. See Notice, 81 FR at 95671. 19 FICC states that by leveraging external vendor expertise, FICC would not need to develop such expertise in-house to supply the market risk attributes that would then be incorporated by FICC into its model to calculate the VaR Charge. See Notice, 81 FR at 95671. 20 See Notice, 81 FR at 95671. 21 See Notice, 81 FR at 95672. 22 The Commission understands that FICC will address any potential conflicts of interest. 23 See Notice, 81 FR at 95671. 18 The E:\FR\FM\26JAN1.SGM 26JAN1 Federal Register / Vol. 82, No. 16 / Thursday, January 26, 2017 / Notices approach would incorporate both historical data and current risk factor sensitivities while the full revaluation approach is calibrated with only historical data. According to FICC, the integration of both observed risk factor changes and current market conditions would enable the model to more effectively respond to current market price moves that may not be reflected in the historical price moves.24 FICC performed backtesting to validate the performance of the proposed model and determine the impact on the VaR Charge. According to FICC, the backtesting results and impact study show that the sensitivity approach provides better coverage on volatile days and a material improvement in margin coverage, while not significantly increasing the overall Clearing Fund.25 FICC believes that the proposed sensitivity approach would be more responsive to changing market dynamics and would not negatively impact FICC or its Clearing Members.26 Second, FICC states that the proposed sensitivity approach would provide more transparency to Clearing Members. Since Clearing Members typically use risk factor analysis for their own risk and financial reporting, these Clearing Members would have comparable data and analysis to assess the variation in their VaR Charges based on changes in the market value of their portfolios. Therefore, Clearing Members would be able to simulate the VaR Charge to a closer degree than under the existing VaR model. Third, FICC states that the proposed sensitivity approach would better provide FICC with the ability to increase the look-back period used to generate the risk scenarios from one year to 10 years plus an additional stressed period, as determined necessary by FICC.27 The extended look-back period would be 24 Id. 25 Id. 26 Id. jstallworth on DSK7TPTVN1PROD with NOTICES 27 Under the proposed model, the 10-year lookback period would include the 2008/2009 financial crisis scenario. To the extent that an equally or more stressed market period does not occur when the 2008/2009 financial crisis period is phased out from the 10-year look-back period (e.g., from September 2018 onward), FICC would continue to include the 2008/2009 financial crisis scenario in its historical scenarios. However, if an equally or more stressed market period emerges in the future, FICC may choose not to augment its 10-year historical scenarios with those from the 2008/2009 financial crisis. On an annual basis, FICC would assess whether an additional stressed period should be included. This assessment would include a review of: (i) The largest moves in the dominating market risk factor of the proposed VaR model; (ii) the impact analyses resulting from the removal and/ or addition of a stressed period; and (iii) the backtesting results of the proposed look-back period. VerDate Sep<11>2014 15:10 Jan 25, 2017 Jkt 241001 8557 used to ensure that the historical simulation is inclusive of stressed market periods. While FICC could extend the one-year look-back period in the existing full revaluation approach to a 10-year look-back period, performance of the existing model could deteriorate if current market conditions are materially different than indicated in the historical data. Additionally, since the full revaluation method requires FICC to maintain in-house complex pricing models and mortgage prepayment models, enhancing these models to extend the look-back period to include 10-years of historical data would involve significant model development. also backtest the Margin Proxy results versus the three-day profit and loss based on actual market price moves. If FICC observes material differences between the Margin Proxy calculations and the aggregate Clearing Fund requirement calculated using the proposed VaR model, or if the Margin Proxy’s backtesting results do not meet FICC’s 99 percent confidence level, management may recommend remedial actions, such as increasing the look-back period and/or applying an appropriate historical stressed period to the Margin Proxy calibration. (ii) Proposed Margin Proxy In connection with FICC’s proposal to source data for the proposed sensitivity approach from an external vendor, FICC is also proposing procedures that would govern in the event that the vendor fails to provide sensitivity data and risk factor data. If the vendor fails to provide any data or a significant portion of the data timely, FICC would use the most recently available data on the first day that such data disruption occurs.28 If it is determined that the vendor will resume providing data within five business days, management would determine whether the VaR Charge should continue to be calculated by using the most recently available data along with an extended look-back period or whether the Margin Proxy should be invoked, as described below. If it is determined that the data disruption will extend beyond five business days, the Margin Proxy would be applied. FICC would calculate the Margin Proxy on a daily basis, and the Margin Proxy method would be subject to monthly performance review. FICC would monitor the performance of the calculation on a monthly basis to ensure that it could be used in the circumstance described above. Specifically, FICC would monitor each Clearing Member’s Required Fund Deposit and the aggregate Clearing Fund requirements versus the requirements calculated by Margin Proxy. FICC would FICC proposes to amend the definition of VaR Charge to include a VaR Floor. The VaR Floor would be used as an alternative to the amount calculated by the proposed model for portfolios where the VaR Floor would be greater than the model-based charge amount. FICC’s proposal to establish a VaR Floor seeks to address the risk that the proposed VaR model may calculate too low a VaR Charge for certain portfolios where the VaR model applies substantial risk offsets among long and short positions in different classes of mortgage-backed securities that have a high degree of historical price correlation. According to FICC, because this high degree of historical price correlation may not apply in future changing market conditions,29 it is prudent to apply a VaR Floor that is based upon the market value of the gross unsettled positions in the Clearing Member’s portfolio to protect FICC against such risk in the event that FICC is required to liquidate a large mortgagebacked securities portfolio in stressed market conditions. 28 FICC states it has existing policies and procedures in accordance with Regulation Systems Compliance and Integrity (‘‘SCI’’), 17 CFR 242.1001(c)(1) (‘‘Regulation SCI’’), to determine whether a disruption to, or significant downgrade of, the normal operation of FICC’s risk management system has occurred as defined under Regulation SCI. In the event that the vendor fails to provide the requisite sensitivity data and risk factor data, the responsible SCI personnel at FICC would determine whether an SCI event has occurred, and FICC would fulfill its obligations with respect to the SCI event. PO 00000 Frm 00055 Fmt 4703 Sfmt 4703 (iii) Proposed Change To Establish a VaR Floor C. Proposed Change to Eliminate the Coverage Charge and the Margin Requirement Differential FICC proposes to eliminate two components of the Required Fund Deposit—the Coverage Charge 30 and the Margin Requirement Differential 29 According to FICC, for example, and without limitation, certain classes of mortgage-backed securities may have highly correlated historical price returns despite having different coupons. However, if future mortgage market conditions were to generate substantially greater prepayment activity for some but not all such classes, these historical correlations could break down, leading to model-generated offsets that would not adequately capture a portfolio’s risk. 30 The Coverage Charge is an additional charge to help bring a Clearing Member’s margin coverage to a targeted confidence level by preemptively increasing the Required Fund Deposit by an amount calculated to forecast potential deficiencies in the margin coverage. See MBSD Rule 1. E:\FR\FM\26JAN1.SGM 26JAN1 8558 Federal Register / Vol. 82, No. 16 / Thursday, January 26, 2017 / Notices jstallworth on DSK7TPTVN1PROD with NOTICES (‘‘MRD’’) 31—that FICC believes would become unnecessary with the proposed changes to the VaR Charge. Both components are based on historical portfolio activity, which may not be indicative of a Clearing Member’s current risk profile, but were determined by FICC to be appropriate to address potential shortfalls in margin charges under the existing VaR model. According to FICC, as part of the development and assessment of the sensitivity approach for the proposed VaR model, FICC obtained an independent validation of the proposed model by an external party, backtested the model’s performance and analyzed the impact of the margin changes. Results of the analysis indicated that the proposed sensitivity approach would be more responsive to changing market dynamics and a Clearing Member’s portfolio composition coverage than the existing model. The model validation and backtesting analysis also demonstrated that the proposed sensitivity model would provide sufficient margin coverage on a standalone basis. Because testing and validation of MBSD’s proposed VaR model show a material improvement in margin coverage, FICC believes that the Coverage Charge and MRD components are no longer necessary. D. Proposed Change To Replace the Historic Index Volatility Model With a Haircut Method According to FICC, occasionally, portfolios contain classes of securities that reflect market price changes not consistently related to historical risk factors. The value of these securities is often uncertain because the securities’ market volume varies widely, which limits their price histories. Since the volume and price information for such securities is not robust, a historical simulation approach would not generate VaR Charge amounts that adequately reflect the risk profile of such securities. Currently, MBSD Rule 4 provides that FICC may use a historic index volatility model to calculate the VaR component of the Required Fund Deposit for these classes of securities.32 FICC is proposing to amend MBSD Rule 4 to replace the historic index volatility model with a haircut method. FICC believes that the haircut method would better capture the risk profile of these securities because 31 The MRD is designed to help mitigate the risks posed to FICC by day-over-day fluctuations in a Clearing Member’s portfolio. It does this by forecasting future changes in a Clearing Member’s portfolio based on a historical look-back of each portfolio over a given time period. See MBSD Rule 4 Section 2. 32 See MBSD Rule 4 Section 2(c). VerDate Sep<11>2014 15:10 Jan 25, 2017 Jkt 241001 the lack of adequate historical data makes it difficult to map such securities to a historic index volatility model. FICC proposes to calculate the component of the Required Fund Deposit applicable to these securities by applying a fixed haircut level to the gross market value of the positions. FICC has selected an initial haircut of one percent based on its analysis of a five-year historical study of three-day returns during a period that such securities were traded. This percentage would be reviewed annually or more frequently if market conditions warrant and updated, if necessary, to ensure sufficient coverage. II. Discussion and Commission Findings Although the Clearing Supervision Act does not specify a standard of review for an advance notice, its stated purpose is instructive: To mitigate systemic risk in the financial system and promote financial stability by, among other things, promoting uniform risk management standards for systemically important financial market utilities and strengthening the liquidity of systemically important financial market utilities.33 Section 805(a)(2) of the Clearing Supervision Act 34 authorizes the Commission to prescribe risk management standards for the payment, clearing, and settlement activities of designated clearing entities and financial institutions engaged in designated activities for which it is the Supervisory Agency or the appropriate financial regulator. Section 805(b) of the Clearing Supervision Act 35 states that the objectives and principles for the risk management standards prescribed under Section 805(a) shall be to: • Promote robust risk management; • promote safety and soundness; • reduce systemic risks; and • support the stability of the broader financial system. The Commission has adopted risk management standards under Section 805(a)(2) of the Clearing Supervision Act 36 and Section 17A of the Exchange Act (‘‘Clearing Agency Standards’’).37 The Clearing Agency Standards require registered clearing agencies to establish, implement, maintain, and enforce written policies and procedures that are reasonably designed to meet certain minimum requirements for their operations and risk management 33 See 12 U.S.C. 5461(b). U.S.C. 5464(a)(2). 35 12 U.S.C. 5464(b). 36 12 U.S.C. 5464(a)(2). 37 See 17 CFR 240.17Ad–22. Securities Exchange Act Release No. 68080 (October 22, 2012), 77 FR 66220 (November 2, 2012) (S7–08–11). 34 12 PO 00000 Frm 00056 Fmt 4703 Sfmt 4703 practices on an ongoing basis.38 Therefore, it is appropriate for the Commission to review proposed changes in advance notices against the objectives and principles of these risk management standards as described in Section 805(b) of the Clearing Supervision Act and in the Clearing Agency Standards. A. Consistency With Section 805(b) of the Clearing Supervision Act The Commission believes that the changes proposed in the advance notice are consistent with the objectives and principles described in Section 805(b) of the Clearing Supervision Act.39 As discussed above, FICC is proposing a number of changes to the way it calculates its Required Fund Deposits—a key tool that FICC uses to mitigate potential losses to FICC associated with liquidating a Clearing Member’s portfolio in the event of Clearing Member default. The Commission believes that the proposed changes are consistent with promoting robust risk management because they are designed to enable FICC to better limit its exposure to Clearing Members in the event of Clearing Member default. First, FICC proposes to implement the sensitivity approach to its VaR Charge calculation. The change would enable FICC to better limit its exposure to Clearing Members by correcting deficiencies in MBSD’s existing VaR methodology by leveraging an external vendor’s expertise in supplying market risk attributes used to calculate the VaR Charge in the proposed sensitivity approach. In turn, the sensitivity approach would enable FICC to view and respond more effectively to market volatility by allowing FICC to attribute market price moves to various risk factors such as key rates. Second, the proposal to implement the Margin Proxy as a back-up methodology to the sensitivity approach would enable FICC to better limit its exposure to Clearing Members by helping ensure that FICC could continue to calculate each Clearing Member’s VaR Charge in the event that FICC experiences a data disruption with the vendor that supplies the sensitivity data. Third, FICC’s proposal to implement the VaR Floor is designed to enable FICC to better limit its exposure to Clearing Members in the event that the proposed sensitivity VaR model calculates too low of a VaR Charge for portfolios where the model applies substantial offsets from certain offsetting long and short positions. Fourth, the proposed change to 38 Id. 39 12 E:\FR\FM\26JAN1.SGM U.S.C. 5464(b). 26JAN1 Federal Register / Vol. 82, No. 16 / Thursday, January 26, 2017 / Notices jstallworth on DSK7TPTVN1PROD with NOTICES implement a haircut method for securities with inadequate historical pricing data would enable FICC to better limit its exposure to Clearing Members by better capturing the risk profile of the securities. Finally, FICC’s proposal to remove the Coverage Charge and MRD components would enable FICC to remove unnecessary components from the Clearing Fund calculation that may not be indicative of a Clearing Member’s current risk profile. Therefore, because the proposal is designed to enable FICC to better limit its exposure to Clearing Members in the manner described above, the Commission believes it is consistent with promoting robust risk management. Furthermore, the Commission believes that the changes proposed in the advance notice are consistent with promoting safety and soundness, which, in turn, is consistent with reducing systemic risks and supporting the stability of the broader financial system, consistent with Section 805(b) of the Clearing Supervision Act.40 The proposed changes are designed to better limit FICC’s exposure to Clearing Members in the event of Clearing Member default. As discussed above, the sensitivity approach would enable FICC to view and respond more effectively to market volatility. The Margin Proxy would help manage data disruption. The VaR Floor would ensure FICC collects at least a minimum VaR Charge. The haircut method would better capture the risk profile of securities with inadequate historical pricing data. Finally, removing the Coverage Charge and MRD would help ensure the Clearing Fund calculation would not include unnecessary components that may not be indicative of a Clearing Member’s current risk profile. By better limiting exposure to Clearing Members, the proposed changes are designed to ensure that, in the event of Clearing Member default, MBSD’s operations would not be disrupted and non-defaulting Clearing Members would not be exposed to losses that they cannot anticipate or control. This is consistent with promoting safety and soundness, which in turn, is consistent with reducing systemic risks and supporting the stability of the broader financial system. B. Consistency with Rule 17Ad–22(b)(1) and (b)(2) Under the Exchange Act The Commission believes that FICC’s proposal is consistent with Clearing Agency Standards, in particular, Rules 17Ad–22(b)(1) and (b)(2) under the Exchange Act.41 Rule 17Ad–22(b)(1) under the Exchange Act 42 requires a registered clearing agency that performs central counterparty services to establish, implement, maintain and enforce written policies and procedures reasonably designed to, among other things, limit its exposures to potential losses from defaults by its participants under normal market conditions so that the operations of the clearing agency would not be disrupted and nondefaulting participants would not be exposed to losses that they cannot anticipate or control. FICC’s proposal would enable FICC to better limit its exposure to potential losses from defaults by its Clearing Members under normal market conditions. As discussed above, the sensitivity approach would enable FICC to view and respond more effectively to market volatility. The Margin Proxy would help manage data disruption. The VaR Floor would ensure FICC collects at least a minimum VaR Charge. The haircut method would better capture the risk profile of securities with inadequate historical pricing data. Finally, removing the Coverage Charge and MRD would help ensure the Clearing Fund calculation would not include unnecessary components that may not be indicative of a Clearing Member’s current risk profile. By better limiting its exposures to potential losses from defaults by its participants under normal market conditions, the proposed changes are designed to ensure that the operations of the clearing agency would not be disrupted and non-defaulting participants would not be exposed to losses that they cannot anticipate or control. Therefore, the Commission believes this proposal is consistent with Rule 17Ad–22(b)(1) under the Exchange Act.43 Rule 17Ad–22(b)(2) under the Exchange Act 44 requires a registered clearing agency that performs central counterparty services to establish, implement, maintain and enforce written policies and procedures reasonably designed to, among other things, use margin requirements to limit its credit exposures to participants under normal market conditions and use risk-based models and parameters to set margin requirements. The Required Fund Deposits are the margin requirements that FICC collects to limit its credit exposures to participants under normal market conditions. Additionally, FICC’s proposed changes 41 17 42 17 CFR 240.17Ad–22(b)(1) and (b)(2). CFR 240.17Ad–22(b)(1). 43 Id. 40 Id. VerDate Sep<11>2014 44 17 15:10 Jan 25, 2017 Jkt 241001 PO 00000 use a risk-based model (i.e., the sensitivity approach) and parameters (e.g., the VaR Floor and Margin Proxy) to set margin requirements. The proposed changes are designed to improve FICC’s margin requirements to better limit FICC’s credit exposures to Clearing Members, in the event of default, under normal market conditions. Therefore, the Commission believes this proposal is consistent with Rule 17Ad–22(b)(2) under the Exchange Act 45 For these reasons, the Commission does not object to the advance notice. III. Conclusion It is therefore noticed, pursuant to Section 806(e)(1)(I) of the Clearing Supervision Act,46 that the Commission does not object to this advance notice proposal (SR–FICC–2016–801) and that FICC is authorized to implement the proposal as of the date of this notice or the date of an order by the Commission approving a proposed rule change that reflects rule changes that are consistent with this advance notice proposal (SR– FICC–2016–007), whichever is later. By the Commission. Eduardo A. Aleman, Assistant Secretary. [FR Doc. 2017–01716 Filed 1–25–17; 8:45 am] BILLING CODE 8011–01–P SELECTIVE SERVICE SYSTEM Forms Submitted to the Office of Management and Budget for Extension of Clearance Selective Service System. Notice. AGENCY: ACTION: The following forms have been submitted to the Office of Management and Budget (OMB) for extension of clearance in compliance with the Paperwork Reduction Act (44 U.S.C. Chapter 35): SSS Form—402 Title: Uncompensated Registrar Appointment Form. Purpose: Is used to verify the official status of applicants for the position of Uncompensated Registrars and to establish authority for those appointed to perform as Selective Service System Registrars. Respondents: United States citizens over the age of 18. Frequency: One time. Burden: The reporting burden is three minutes or less per respondent. 45 Id. CFR 240.17Ad–22(b)(2). Frm 00057 Fmt 4703 Sfmt 4703 8559 46 12 E:\FR\FM\26JAN1.SGM U.S.C. 5465(e)(1)(I). 26JAN1

Agencies

[Federal Register Volume 82, Number 16 (Thursday, January 26, 2017)]
[Notices]
[Pages 8555-8559]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-01716]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-79843; File No. SR-FICC-2016-801]


Self-Regulatory Organizations; Fixed Income Clearing Corporation; 
Notice of No Objection to Advance Notice Filing To Implement a Change 
to the Methodology Used in the MBSD VaR Model

January 19, 2017.
    On November 23, 2016, the Fixed Income Clearing Corporation 
(``FICC'') filed with the Securities and Exchange Commission 
(``Commission'') the advance notice SR-FICC-2016-801 pursuant to 
Section 806(e)(1) of the Payment, Clearing, and Settlement Supervision 
Act of 2010 (``Clearing Supervision Act'') \1\ and Rule 19b-4(n)(1)(i) 
under the Securities Exchange Act of 1934 (``Exchange Act'').\2\ The 
advance notice was published for comment in the Federal Register on 
December 28, 2016.\3\ The Commission did not receive any comments on 
the advance notice. This publication serves as notice that the 
Commission does not object to the changes set forth in the advance 
notice.
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    \1\ 12 U.S.C. 5465(e)(1). The Financial Stability Oversight 
Council designated FICC a systemically important financial market 
utility on July 18, 2012. See Financial Stability Oversight Council 
2012 Annual Report, Appendix A, http://www.treasury.gov/initiatives/fsoc/Documents/2012%20Annual%20Report.pdf. Therefore, FICC is 
required to comply with the Clearing Supervision Act and file 
advance notices with the Commission. See 12 U.S.C. 5465(e).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ Securities Exchange Act Release No. 79643 (December 21, 
2016), 81 FR 95669 (December 28, 2016) (SR-FICC-2016-801) 
(``Notice''). FICC also filed a proposed rule change with the 
Commission pursuant to Section 19(b)(1) of the Exchange Act and Rule 
19b-4 thereunder, seeking approval of changes to its rules necessary 
to implement the proposal. 15 U.S.C. 78s(b)(1) and 17 CFR 240.19b-4, 
respectively. The proposed rule change was published for comment in 
the Federal Register on December 13, 2016. Securities Exchange Act 
Release No. 79491 (December 7, 2016), 81 FR 90001 (December 13, 
2016) (SR-FICC-2016-007). The Commission did not receive any 
comments on the proposed rule change.
---------------------------------------------------------------------------

I. Description of the Advance Notice

    As described by FICC in the advance notice, FICC proposes to change 
the methodology that it currently uses in the Mortgage-Backed 
Securities Division's (``MBSD'') value-at-risk (``VaR'') model from one 
that employs a full revaluation approach to one that would employ a 
sensitivity approach.\4\ In connection with this change, FICC also 
proposes to amend the MBSD Clearing Rules (``MBSD Rules'') to: (i) 
Amend the definition of VaR Charge \5\ to reference an alternative 
volatility calculation (``Margin Proxy'') that FICC would use in the 
event that data used for the sensitivity approach is unavailable for an 
extended period of time; \6\ (ii) revise the definition of VaR Charge 
to include a VaR floor that FICC would use as an alternative to the 
amount calculated by the proposed VaR model for portfolios where the 
VaR floor would be greater than the model-based charge amount (``VaR 
Floor''); (iii) eliminate two components from the Required Fund Deposit 
\7\ calculation that would no longer be necessary following 
implementation of the proposed VaR Charge; and (iv) change the 
margining approach that FICC may use for certain securities with 
inadequate historical pricing data from one that calculates charges 
using a historic index volatility model to one that would use a haircut 
method.
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    \4\ The proposed sensitivity approach methodology would be 
reflected in the Methodology and Model Operations Document--MBSD 
Quantitative Risk Model (``QRM Methodology''). FICC requested 
confidential treatment of the QRM Methodology and filed it 
separately with the Secretary of the Commission, pursuant to Rule 
24b-2 under the Exchange Act. See 17 CFR 240.24b-2.
    \5\ The term ``VaR Charge'' means, with respect to each margin 
portfolio, a calculation of the volatility of specified net 
unsettled positions of an MBSD clearing member, as of the time of 
such calculation. See MBSD Rule 1.
    \6\ Details of the Margin Proxy methodology would be reflected 
in the QRM Methodology.
    \7\ The term ``Required Fund Deposit'' means the amount an MBSD 
clearing member is required to deposit to the Clearing Fund pursuant 
to MBSD Rule 4. See MBSD Rule 1 and MBSD Rule 4 Section 2.

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[[Page 8556]]

A. Overview of the Required Fund Deposit and Clearing Fund Calculation

    A key tool that FICC uses to manage market risk is the daily 
calculation and collection of Required Fund Deposits from MBSD clearing 
members (``Clearing Members'').\8\ The Required Fund Deposit serves as 
each Clearing Member's margin. The aggregate of all Clearing Members' 
Required Fund Deposits constitutes the Clearing Fund \9\ of MBSD, which 
FICC would access should a defaulting Clearing Member's own Required 
Fund Deposit be insufficient to satisfy losses to FICC caused by the 
liquidation of that Clearing Member's portfolio.
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    \8\ The term ``Clearing Member'' means any entity admitted into 
membership pursuant to MBSD Rule 2A. See MBSD Rule 1.
    \9\ The term ``Clearing Fund'' means the Clearing Fund 
established by FICC pursuant to MBSD Rules, which shall be comprised 
of the aggregate of all Required Fund Deposits and all other 
deposits, including cross-guaranty repayment deposits. See MBSD Rule 
1.
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    According to FICC, the objective of a Clearing Member's Required 
Fund Deposit is to mitigate potential losses to FICC associated with 
liquidation of such Clearing Member's portfolio in the event that FICC 
ceases to act for such Clearing Member (i.e., a ``default'').\10\ 
Pursuant to MBSD Rules, each Clearing Member's Required Fund Deposit 
amount consists of multiple components. Of all of the components, the 
VaR Charge comprises the largest portion of a Clearing Member's 
Required Fund Deposit amount.
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    \10\ See Notice, 81 FR at 95670.
---------------------------------------------------------------------------

    Generally, the VaR Charge is calculated using a risk-based margin 
methodology that is intended to capture the market price risk 
associated with the securities in a Clearing Member's portfolio. More 
specifically, FICC calculates the VaR Charge using a methodology 
referred to as the full revaluation approach. The full revaluation 
approach uses a historical simulation method to fully re-price each 
security in a Clearing Member's portfolio. According to FICC, the 
methodology is designed to project the potential gains or losses that 
could occur in connection with the liquidation of a defaulting Clearing 
Member's portfolio, assuming that a portfolio would take three days to 
hedge or liquidate in normal market conditions.\11\ The projected 
liquidation gains or losses are used to determine the amount of the VaR 
Charge, which is calculated to cover projected liquidation losses at a 
99 percent confidence level.\12\
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    \11\ Id.
    \12\ The 99 percent confidence level does not apply to 
unregistered investment pool clearing members, which are subject to 
a VaR Charge with a higher minimum targeted confidence level 
assumption of 99.5 percent.
---------------------------------------------------------------------------

    If FICC determines that a security's price history is incomplete 
and the market price risk cannot be calculated by the VaR model, then 
FICC applies the Margin Proxy until such security's trading history and 
pricing reflects market risk factors that can be appropriately 
calibrated from the security's historical data.\13\
---------------------------------------------------------------------------

    \13\ See MBSD Rule 4 Section 2(c).
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B. Proposed Changes to the VaR Charge Calculation

    According to FICC, during the volatile market period that occurred 
during the second and third quarters of 2013, FICC's full revaluation 
approach did not respond effectively to the levels of market volatility 
at that time, and the model did not achieve a 99 percent confidence 
level.\14\ This prompted FICC to employ the Margin Proxy--a 
supplemental risk charge to ensure that each Clearing Member's VaR 
Charge would achieve a minimum 99 percent confidence level.\15\
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    \14\ See Notice, 81 FR at 95670.
    \15\ The Margin Proxy is currently used to provide supplemental 
coverage to the VaR Charge; however, under this proposed change, the 
Margin Proxy would only be used as an alternative volatility 
calculation in the event that the requisite data used for the 
sensitivity approach is unavailable for an extended period of time.
---------------------------------------------------------------------------

    FICC reviewed the existing model's deficiencies, examined the root 
causes of the deficiencies, and considered options that would remediate 
the model weaknesses. As a result of this review, FICC now proposes to 
change MBSD's methodology for calculating the VaR Charge by: (i) 
Replacing the full revaluation approach with the sensitivity approach; 
(ii) using the Margin Proxy as an alternative volatility calculation in 
the event that the data used for the sensitivity approach is 
unavailable for an extended period of time; and (iii) establishing a 
VaR Floor to address a circumstance where the proposed VaR model yields 
a VaR Charge amount that is lower than 5 basis points of the market 
value of a Clearing Member's gross unsettled positions.\16\
---------------------------------------------------------------------------

    \16\ Assuming the market value of gross unsettled positions of 
$500,000,000, the VaR Floor calculation would be .0005 multiplied by 
$500,000,000 = $250,000. If the VaR model charge is less than 
$250,000, then the VaR Floor calculation of $250,000 would be set as 
the VaR Charge.
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(i) Proposed Sensitivity Approach
    FICC's current full revaluation method uses valuation algorithms to 
fully re-price each security in a Clearing Member's portfolio over a 
range of historically simulated scenarios. While there are benefits to 
this method, according to FICC, its deficiencies are that it requires 
significant historical market data inputs, calibration of various model 
parameters, and extensive quantitative support for price 
simulations.\17\ FICC believes that the proposed sensitivity approach 
would address these deficiencies because it would leverage external 
vendor expertise in supplying the market risk attributes,\18\ which 
would then be incorporated by FICC into its model to calculate the VaR 
Charge.\19\
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    \17\ See Notice, 81 FR at 95670.
    \18\ The risk factors that would be incorporated into MBSD's 
proposed VaR methodology are key rate, convexity, spread, 
volatility, mortgage basis and time, as more fully described in the 
Notice. See Notice, 81 FR at 95671.
    \19\ FICC states that by leveraging external vendor expertise, 
FICC would not need to develop such expertise in-house to supply the 
market risk attributes that would then be incorporated by FICC into 
its model to calculate the VaR Charge. See Notice, 81 FR at 95671.
---------------------------------------------------------------------------

    Because data quality is an important component of calculating the 
VaR Charge, FICC would conduct independent data checks to verify the 
accuracy and consistency of the data feed received from the vendor. 
According to FICC, it has reviewed a description of the vendor's 
calculation methodology and the manner in which the market data is used 
to calibrate the vendor's models, and it states that it understands and 
is comfortable with the vendor's controls, governance process, and data 
quality standards.\20\ Additionally, FICC would conduct an independent 
review of the vendor's release of a new version of the model. To the 
extent that the vendor changes its model and methodologies that produce 
the risk factors and risk sensitivities, FICC would review the effects 
(if any) of these changes on FICC's proposed sensitivity approach. 
Moreover, according to FICC, it does not believe that engaging the 
vendor would present a conflict of interest to FICC because the vendor 
is not an existing Clearing Member nor are any of the vendor's 
affiliates existing Clearing Members.\21\ To the extent that the vendor 
or any of its affiliates submit an application to become a Clearing 
Member, FICC states that it will negotiate an appropriate information 
barrier with the applicant in an effort to prevent a conflict of 
interest from arising.\22\
---------------------------------------------------------------------------

    \20\ See Notice, 81 FR at 95671.
    \21\ See Notice, 81 FR at 95672.
    \22\ The Commission understands that FICC will address any 
potential conflicts of interest.
---------------------------------------------------------------------------

    According to FICC, the sensitivity approach would provide three key 
benefits.\23\ First, the sensitivity

[[Page 8557]]

approach would incorporate both historical data and current risk factor 
sensitivities while the full revaluation approach is calibrated with 
only historical data. According to FICC, the integration of both 
observed risk factor changes and current market conditions would enable 
the model to more effectively respond to current market price moves 
that may not be reflected in the historical price moves.\24\ FICC 
performed backtesting to validate the performance of the proposed model 
and determine the impact on the VaR Charge. According to FICC, the 
backtesting results and impact study show that the sensitivity approach 
provides better coverage on volatile days and a material improvement in 
margin coverage, while not significantly increasing the overall 
Clearing Fund.\25\ FICC believes that the proposed sensitivity approach 
would be more responsive to changing market dynamics and would not 
negatively impact FICC or its Clearing Members.\26\
---------------------------------------------------------------------------

    \23\ See Notice, 81 FR at 95671.
    \24\ Id.
    \25\ Id.
    \26\ Id.
---------------------------------------------------------------------------

    Second, FICC states that the proposed sensitivity approach would 
provide more transparency to Clearing Members. Since Clearing Members 
typically use risk factor analysis for their own risk and financial 
reporting, these Clearing Members would have comparable data and 
analysis to assess the variation in their VaR Charges based on changes 
in the market value of their portfolios. Therefore, Clearing Members 
would be able to simulate the VaR Charge to a closer degree than under 
the existing VaR model.
    Third, FICC states that the proposed sensitivity approach would 
better provide FICC with the ability to increase the look-back period 
used to generate the risk scenarios from one year to 10 years plus an 
additional stressed period, as determined necessary by FICC.\27\ The 
extended look-back period would be used to ensure that the historical 
simulation is inclusive of stressed market periods. While FICC could 
extend the one-year look-back period in the existing full revaluation 
approach to a 10-year look-back period, performance of the existing 
model could deteriorate if current market conditions are materially 
different than indicated in the historical data. Additionally, since 
the full revaluation method requires FICC to maintain in-house complex 
pricing models and mortgage prepayment models, enhancing these models 
to extend the look-back period to include 10-years of historical data 
would involve significant model development.
---------------------------------------------------------------------------

    \27\ Under the proposed model, the 10-year look-back period 
would include the 2008/2009 financial crisis scenario. To the extent 
that an equally or more stressed market period does not occur when 
the 2008/2009 financial crisis period is phased out from the 10-year 
look-back period (e.g., from September 2018 onward), FICC would 
continue to include the 2008/2009 financial crisis scenario in its 
historical scenarios. However, if an equally or more stressed market 
period emerges in the future, FICC may choose not to augment its 10-
year historical scenarios with those from the 2008/2009 financial 
crisis. On an annual basis, FICC would assess whether an additional 
stressed period should be included. This assessment would include a 
review of: (i) The largest moves in the dominating market risk 
factor of the proposed VaR model; (ii) the impact analyses resulting 
from the removal and/or addition of a stressed period; and (iii) the 
backtesting results of the proposed look-back period.
---------------------------------------------------------------------------

(ii) Proposed Margin Proxy
    In connection with FICC's proposal to source data for the proposed 
sensitivity approach from an external vendor, FICC is also proposing 
procedures that would govern in the event that the vendor fails to 
provide sensitivity data and risk factor data. If the vendor fails to 
provide any data or a significant portion of the data timely, FICC 
would use the most recently available data on the first day that such 
data disruption occurs.\28\ If it is determined that the vendor will 
resume providing data within five business days, management would 
determine whether the VaR Charge should continue to be calculated by 
using the most recently available data along with an extended look-back 
period or whether the Margin Proxy should be invoked, as described 
below. If it is determined that the data disruption will extend beyond 
five business days, the Margin Proxy would be applied.
---------------------------------------------------------------------------

    \28\ FICC states it has existing policies and procedures in 
accordance with Regulation Systems Compliance and Integrity 
(``SCI''), 17 CFR 242.1001(c)(1) (``Regulation SCI''), to determine 
whether a disruption to, or significant downgrade of, the normal 
operation of FICC's risk management system has occurred as defined 
under Regulation SCI. In the event that the vendor fails to provide 
the requisite sensitivity data and risk factor data, the responsible 
SCI personnel at FICC would determine whether an SCI event has 
occurred, and FICC would fulfill its obligations with respect to the 
SCI event.
---------------------------------------------------------------------------

    FICC would calculate the Margin Proxy on a daily basis, and the 
Margin Proxy method would be subject to monthly performance review. 
FICC would monitor the performance of the calculation on a monthly 
basis to ensure that it could be used in the circumstance described 
above. Specifically, FICC would monitor each Clearing Member's Required 
Fund Deposit and the aggregate Clearing Fund requirements versus the 
requirements calculated by Margin Proxy. FICC would also backtest the 
Margin Proxy results versus the three-day profit and loss based on 
actual market price moves. If FICC observes material differences 
between the Margin Proxy calculations and the aggregate Clearing Fund 
requirement calculated using the proposed VaR model, or if the Margin 
Proxy's backtesting results do not meet FICC's 99 percent confidence 
level, management may recommend remedial actions, such as increasing 
the look-back period and/or applying an appropriate historical stressed 
period to the Margin Proxy calibration.
(iii) Proposed Change To Establish a VaR Floor
    FICC proposes to amend the definition of VaR Charge to include a 
VaR Floor. The VaR Floor would be used as an alternative to the amount 
calculated by the proposed model for portfolios where the VaR Floor 
would be greater than the model-based charge amount. FICC's proposal to 
establish a VaR Floor seeks to address the risk that the proposed VaR 
model may calculate too low a VaR Charge for certain portfolios where 
the VaR model applies substantial risk offsets among long and short 
positions in different classes of mortgage-backed securities that have 
a high degree of historical price correlation. According to FICC, 
because this high degree of historical price correlation may not apply 
in future changing market conditions,\29\ it is prudent to apply a VaR 
Floor that is based upon the market value of the gross unsettled 
positions in the Clearing Member's portfolio to protect FICC against 
such risk in the event that FICC is required to liquidate a large 
mortgage-backed securities portfolio in stressed market conditions.
---------------------------------------------------------------------------

    \29\ According to FICC, for example, and without limitation, 
certain classes of mortgage-backed securities may have highly 
correlated historical price returns despite having different 
coupons. However, if future mortgage market conditions were to 
generate substantially greater prepayment activity for some but not 
all such classes, these historical correlations could break down, 
leading to model-generated offsets that would not adequately capture 
a portfolio's risk.
---------------------------------------------------------------------------

C. Proposed Change to Eliminate the Coverage Charge and the Margin 
Requirement Differential

    FICC proposes to eliminate two components of the Required Fund 
Deposit--the Coverage Charge \30\ and the Margin Requirement 
Differential

[[Page 8558]]

(``MRD'') \31\--that FICC believes would become unnecessary with the 
proposed changes to the VaR Charge. Both components are based on 
historical portfolio activity, which may not be indicative of a 
Clearing Member's current risk profile, but were determined by FICC to 
be appropriate to address potential shortfalls in margin charges under 
the existing VaR model.
---------------------------------------------------------------------------

    \30\ The Coverage Charge is an additional charge to help bring a 
Clearing Member's margin coverage to a targeted confidence level by 
preemptively increasing the Required Fund Deposit by an amount 
calculated to forecast potential deficiencies in the margin 
coverage. See MBSD Rule 1.
    \31\ The MRD is designed to help mitigate the risks posed to 
FICC by day-over-day fluctuations in a Clearing Member's portfolio. 
It does this by forecasting future changes in a Clearing Member's 
portfolio based on a historical look-back of each portfolio over a 
given time period. See MBSD Rule 4 Section 2.
---------------------------------------------------------------------------

    According to FICC, as part of the development and assessment of the 
sensitivity approach for the proposed VaR model, FICC obtained an 
independent validation of the proposed model by an external party, 
backtested the model's performance and analyzed the impact of the 
margin changes. Results of the analysis indicated that the proposed 
sensitivity approach would be more responsive to changing market 
dynamics and a Clearing Member's portfolio composition coverage than 
the existing model. The model validation and backtesting analysis also 
demonstrated that the proposed sensitivity model would provide 
sufficient margin coverage on a standalone basis. Because testing and 
validation of MBSD's proposed VaR model show a material improvement in 
margin coverage, FICC believes that the Coverage Charge and MRD 
components are no longer necessary.

D. Proposed Change To Replace the Historic Index Volatility Model With 
a Haircut Method

    According to FICC, occasionally, portfolios contain classes of 
securities that reflect market price changes not consistently related 
to historical risk factors. The value of these securities is often 
uncertain because the securities' market volume varies widely, which 
limits their price histories. Since the volume and price information 
for such securities is not robust, a historical simulation approach 
would not generate VaR Charge amounts that adequately reflect the risk 
profile of such securities. Currently, MBSD Rule 4 provides that FICC 
may use a historic index volatility model to calculate the VaR 
component of the Required Fund Deposit for these classes of 
securities.\32\ FICC is proposing to amend MBSD Rule 4 to replace the 
historic index volatility model with a haircut method. FICC believes 
that the haircut method would better capture the risk profile of these 
securities because the lack of adequate historical data makes it 
difficult to map such securities to a historic index volatility model.
---------------------------------------------------------------------------

    \32\ See MBSD Rule 4 Section 2(c).
---------------------------------------------------------------------------

    FICC proposes to calculate the component of the Required Fund 
Deposit applicable to these securities by applying a fixed haircut 
level to the gross market value of the positions. FICC has selected an 
initial haircut of one percent based on its analysis of a five-year 
historical study of three-day returns during a period that such 
securities were traded. This percentage would be reviewed annually or 
more frequently if market conditions warrant and updated, if necessary, 
to ensure sufficient coverage.

II. Discussion and Commission Findings

    Although the Clearing Supervision Act does not specify a standard 
of review for an advance notice, its stated purpose is instructive: To 
mitigate systemic risk in the financial system and promote financial 
stability by, among other things, promoting uniform risk management 
standards for systemically important financial market utilities and 
strengthening the liquidity of systemically important financial market 
utilities.\33\ Section 805(a)(2) of the Clearing Supervision Act \34\ 
authorizes the Commission to prescribe risk management standards for 
the payment, clearing, and settlement activities of designated clearing 
entities and financial institutions engaged in designated activities 
for which it is the Supervisory Agency or the appropriate financial 
regulator. Section 805(b) of the Clearing Supervision Act \35\ states 
that the objectives and principles for the risk management standards 
prescribed under Section 805(a) shall be to:
---------------------------------------------------------------------------

    \33\ See 12 U.S.C. 5461(b).
    \34\ 12 U.S.C. 5464(a)(2).
    \35\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------

     Promote robust risk management;
     promote safety and soundness;
     reduce systemic risks; and
     support the stability of the broader financial system.
    The Commission has adopted risk management standards under Section 
805(a)(2) of the Clearing Supervision Act \36\ and Section 17A of the 
Exchange Act (``Clearing Agency Standards'').\37\ The Clearing Agency 
Standards require registered clearing agencies to establish, implement, 
maintain, and enforce written policies and procedures that are 
reasonably designed to meet certain minimum requirements for their 
operations and risk management practices on an ongoing basis.\38\ 
Therefore, it is appropriate for the Commission to review proposed 
changes in advance notices against the objectives and principles of 
these risk management standards as described in Section 805(b) of the 
Clearing Supervision Act and in the Clearing Agency Standards.
---------------------------------------------------------------------------

    \36\ 12 U.S.C. 5464(a)(2).
    \37\ See 17 CFR 240.17Ad-22. Securities Exchange Act Release No. 
68080 (October 22, 2012), 77 FR 66220 (November 2, 2012) (S7-08-11).
    \38\ Id.
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A. Consistency With Section 805(b) of the Clearing Supervision Act

    The Commission believes that the changes proposed in the advance 
notice are consistent with the objectives and principles described in 
Section 805(b) of the Clearing Supervision Act.\39\
---------------------------------------------------------------------------

    \39\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------

    As discussed above, FICC is proposing a number of changes to the 
way it calculates its Required Fund Deposits--a key tool that FICC uses 
to mitigate potential losses to FICC associated with liquidating a 
Clearing Member's portfolio in the event of Clearing Member default. 
The Commission believes that the proposed changes are consistent with 
promoting robust risk management because they are designed to enable 
FICC to better limit its exposure to Clearing Members in the event of 
Clearing Member default.
    First, FICC proposes to implement the sensitivity approach to its 
VaR Charge calculation. The change would enable FICC to better limit 
its exposure to Clearing Members by correcting deficiencies in MBSD's 
existing VaR methodology by leveraging an external vendor's expertise 
in supplying market risk attributes used to calculate the VaR Charge in 
the proposed sensitivity approach. In turn, the sensitivity approach 
would enable FICC to view and respond more effectively to market 
volatility by allowing FICC to attribute market price moves to various 
risk factors such as key rates. Second, the proposal to implement the 
Margin Proxy as a back-up methodology to the sensitivity approach would 
enable FICC to better limit its exposure to Clearing Members by helping 
ensure that FICC could continue to calculate each Clearing Member's VaR 
Charge in the event that FICC experiences a data disruption with the 
vendor that supplies the sensitivity data. Third, FICC's proposal to 
implement the VaR Floor is designed to enable FICC to better limit its 
exposure to Clearing Members in the event that the proposed sensitivity 
VaR model calculates too low of a VaR Charge for portfolios where the 
model applies substantial offsets from certain offsetting long and 
short positions. Fourth, the proposed change to

[[Page 8559]]

implement a haircut method for securities with inadequate historical 
pricing data would enable FICC to better limit its exposure to Clearing 
Members by better capturing the risk profile of the securities. 
Finally, FICC's proposal to remove the Coverage Charge and MRD 
components would enable FICC to remove unnecessary components from the 
Clearing Fund calculation that may not be indicative of a Clearing 
Member's current risk profile.
    Therefore, because the proposal is designed to enable FICC to 
better limit its exposure to Clearing Members in the manner described 
above, the Commission believes it is consistent with promoting robust 
risk management.
    Furthermore, the Commission believes that the changes proposed in 
the advance notice are consistent with promoting safety and soundness, 
which, in turn, is consistent with reducing systemic risks and 
supporting the stability of the broader financial system, consistent 
with Section 805(b) of the Clearing Supervision Act.\40\ The proposed 
changes are designed to better limit FICC's exposure to Clearing 
Members in the event of Clearing Member default. As discussed above, 
the sensitivity approach would enable FICC to view and respond more 
effectively to market volatility. The Margin Proxy would help manage 
data disruption. The VaR Floor would ensure FICC collects at least a 
minimum VaR Charge. The haircut method would better capture the risk 
profile of securities with inadequate historical pricing data. Finally, 
removing the Coverage Charge and MRD would help ensure the Clearing 
Fund calculation would not include unnecessary components that may not 
be indicative of a Clearing Member's current risk profile. By better 
limiting exposure to Clearing Members, the proposed changes are 
designed to ensure that, in the event of Clearing Member default, 
MBSD's operations would not be disrupted and non-defaulting Clearing 
Members would not be exposed to losses that they cannot anticipate or 
control. This is consistent with promoting safety and soundness, which 
in turn, is consistent with reducing systemic risks and supporting the 
stability of the broader financial system.
---------------------------------------------------------------------------

    \40\ Id.
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B. Consistency with Rule 17Ad-22(b)(1) and (b)(2) Under the Exchange 
Act

    The Commission believes that FICC's proposal is consistent with 
Clearing Agency Standards, in particular, Rules 17Ad-22(b)(1) and 
(b)(2) under the Exchange Act.\41\ Rule 17Ad-22(b)(1) under the 
Exchange Act \42\ requires a registered clearing agency that performs 
central counterparty services to establish, implement, maintain and 
enforce written policies and procedures reasonably designed to, among 
other things, limit its exposures to potential losses from defaults by 
its participants under normal market conditions so that the operations 
of the clearing agency would not be disrupted and non-defaulting 
participants would not be exposed to losses that they cannot anticipate 
or control. FICC's proposal would enable FICC to better limit its 
exposure to potential losses from defaults by its Clearing Members 
under normal market conditions. As discussed above, the sensitivity 
approach would enable FICC to view and respond more effectively to 
market volatility. The Margin Proxy would help manage data disruption. 
The VaR Floor would ensure FICC collects at least a minimum VaR Charge. 
The haircut method would better capture the risk profile of securities 
with inadequate historical pricing data. Finally, removing the Coverage 
Charge and MRD would help ensure the Clearing Fund calculation would 
not include unnecessary components that may not be indicative of a 
Clearing Member's current risk profile. By better limiting its 
exposures to potential losses from defaults by its participants under 
normal market conditions, the proposed changes are designed to ensure 
that the operations of the clearing agency would not be disrupted and 
non-defaulting participants would not be exposed to losses that they 
cannot anticipate or control. Therefore, the Commission believes this 
proposal is consistent with Rule 17Ad-22(b)(1) under the Exchange 
Act.\43\
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    \41\ 17 CFR 240.17Ad-22(b)(1) and (b)(2).
    \42\ 17 CFR 240.17Ad-22(b)(1).
    \43\ Id.
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    Rule 17Ad-22(b)(2) under the Exchange Act \44\ requires a 
registered clearing agency that performs central counterparty services 
to establish, implement, maintain and enforce written policies and 
procedures reasonably designed to, among other things, use margin 
requirements to limit its credit exposures to participants under normal 
market conditions and use risk-based models and parameters to set 
margin requirements. The Required Fund Deposits are the margin 
requirements that FICC collects to limit its credit exposures to 
participants under normal market conditions. Additionally, FICC's 
proposed changes use a risk-based model (i.e., the sensitivity 
approach) and parameters (e.g., the VaR Floor and Margin Proxy) to set 
margin requirements. The proposed changes are designed to improve 
FICC's margin requirements to better limit FICC's credit exposures to 
Clearing Members, in the event of default, under normal market 
conditions. Therefore, the Commission believes this proposal is 
consistent with Rule 17Ad-22(b)(2) under the Exchange Act \45\
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    \44\ 17 CFR 240.17Ad-22(b)(2).
    \45\ Id.
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    For these reasons, the Commission does not object to the advance 
notice.

III. Conclusion

    It is therefore noticed, pursuant to Section 806(e)(1)(I) of the 
Clearing Supervision Act,\46\ that the Commission does not object to 
this advance notice proposal (SR-FICC-2016-801) and that FICC is 
authorized to implement the proposal as of the date of this notice or 
the date of an order by the Commission approving a proposed rule change 
that reflects rule changes that are consistent with this advance notice 
proposal (SR-FICC-2016-007), whichever is later.
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    \46\ 12 U.S.C. 5465(e)(1)(I).

    By the Commission.
Eduardo A. Aleman,
Assistant Secretary.
[FR Doc. 2017-01716 Filed 1-25-17; 8:45 am]
 BILLING CODE 8011-01-P