Stress Test Protocols and Minimum Fund Requirements

The Fixed Income Clearing Corporation (“FICC”), a subsidiary of the Depository Trust & Clearing Corporation (“DTCC”) created in 2003, as discussed in my June 8, 2021 blog “Fixing FICC: Agency Proposes Rule Changes to Encourage More Repo Closing,” provides a critical piece of the “plumbing” of the U.S. capital markets, particularly for government securities and for mortgage-backed securities, by providing the mechanisms for transactions in those debt securities. As the volume of those transactions has grown, and as market oversight bodies have become increasingly concerned about transactions not being cleared by FICC, the FICC has proposed further enhancements to its capacity to absorb market breaks and other turmoil including the changes discussed in my blog “Valuing the Risk: FICC Proposes Rule Change to Protect Against Repo Volatility” published on October 10, 2022.  

As part of a series of steps to enhance the capacity to manage the risks of losses by parties clearing through this platform, and the platform itself, the U.S. Securities and Exchange Commission (“SEC”) approved an FICC proposed rule change to increase materially the capital required for certain types of financial entities to be members that clear through FICC. Under the new Rule changes, banks and trust companies must have common equity tier 1 capital (a measure used in bank regulatory requirements) of at least $500 million (up from $100 million) and must be “well-capitalized” (another bank regulatory concept). Members that are not banks (e.g., broker/dealers and the like) must have capital at least equal to the regulatory requirements of their regulators and, in the case of mortgage-backed securities inter-dealer clearing members, at least $25 million in capital. Non-US banks must have the greater of the capital required by their home jurisdiction OR the minimum capital and ratios promulgated by the Basel Committee on Banking Supervision of the Bank for International Settlements. Other foreign Members must have minimum capital in an amount equal to that required for a comparable U.S. Member. The capital required for insurance company Members is unchanged. Government securities issuer Members, which did not previously have a capital requirement, now must have a minimum of at least $100 million.  FICC notes, and the SEC acknowledges, that these capital requirements had not been updated for nearly 20 years.

In addition to this new Rule change, FICC has recently proposed two additional changes to reduce financial risk in the clearing process. On May 26, 2022, FICC proposed amendments to its Stress Testing Framework (Market Risk) and to its Liquidity Risk Management Framework as did both its affiliate, the DTCC, and its sibling, the National Securities Clearing Corporation (“NSCC,” founded in 1976 to clear transactions in equity securities). These amendments are intended to make the stress testing programs for each agency more focused and more likely to identify problems. On Sept. 9, 2022, the Commission instituted proceedings to determine whether to approve the proposed amendments. 

Then, also on Sept. 9, 2022, FICC proposed a third Rule change setting forth the Minimum Required Fund Deposit (“MRFD”) for Government Securities Dealer Members. This proposed Rule change parallels the similar change to the MRFD for Members of FICC’s sibling, the NSCC, which I discussed in considerable detail in my May 27, 2021 blog, “’Margin, I Have to Have More Margin’: The National Securities Clearing Corporation Proposes to Increase the Minimum Required Fund Deposit.” The FICC proposal is spelled out in an SEC release dated Sept. 16, 2022 (the “Release”). The MRFD, in the words of the Release, “serves as each member’s margin. The objective is to mitigate potential losses to FICC associated with liquidation of a member’s portfolio in the event FICC ceases to act for that member… The aggregate of all Members’ Required Fund Deposits, together with certain other deposits… constitute the Clearing Fund, which FICC would access…, should a defaulting Member’s own Clearing Fund be insufficient to satisfy losses to FICC.”

The Release notes that the current requirement for Members is $100,000 and that for GSD Repo Brokers it is $5 million.

The Release goes on to note that FICC employs daily back-testing to determine whether Members are maintaining their respective MRFDs and has found that a significant number of Members fall below 99% of their MRFDs. This exposure is particularly frequent for Government securities dealers who are not Repo Brokers. In a year-long study, FICC assessed the result at an MRFD of $500,000 and at $1 million. As a result of that study FICC proposes to raise the MRFD for Government Securities Dealers from $100,000 to $1 million effective 60 days after the proposal is approved by the SEC. FICC laid out extensive comparisons with the margin requirements required to clear on other platforms in an effort to repulse any suggestion that the proposal was either unfair or anticompetitive. The proposals covered by the Release also includes other technical adjustments. In the Release, the SEC requested comments on the proposed amendments within 21 days of publication in the Federal Register.

That Release appeared in the Federal Register on Thursday, Sept. 22, 2022, and now the Commission has approved the proposed MRFD Rule change in an Order issued on Monday, Oct. 22, 2022, in Release No. 34 -96136 (the “Approving Release”). The relative speed of the SEC’s unanimous approval (ONE month) underscores the Commission’s concerns about the ability of clearing platforms such as FICC to absorb unexpected member defaults and other risks. The Approving Release cites with apparent acceptance both the factual research (both a year-long Back-testing Impact Study and a year-long CFR [i.e., Clearing Fund Requirement] Impact Study done by FICC and the arguments made by FICC to support the recommended changes. In the Approving Release the SEC specifically finds that:

…the proposed increase [in the MRFD] would have provided FICC with additional resources, which would have resulted in a decrease of back-testing deficiencies and thus a reduction in credit exposure to its members…Therefore, the Commission believes FICC would improve the probability … [that the increased MRFDs would be] sufficient to cover FICC’s credit exposure to those members, particularly in instances where the defaulted member’s clearing activity abruptly increases…

And later in the Approving Release:

[the Rule change] should better insure FICC maintains sufficient margin to cover its potential future exposure to its members in the interval between the last margin collection and the close out of positions following member default, thereby reducing the likelihood FICC or non- defaulting members would incur losses as a result.

Accordingly, the Commission found the proposed MRFD Rule change consistent with the Regulations applicable to clearing agencies, i.e., Rule 17Ad-22(e) under the Securities Exchange Act of 1934, as amended (the “34 Act”), and was not unfair or anticompetitive so as not to run afoul of Rule 17 A(b)(3) also under the 34 Act.

Unlike the patriarchal (and non-unanimous) proposal of the Commission to mandate specific governance rules for the various clearing agencies discussed in my blog “Delusional Improvement: SEC Proposes Governance Rules for Clearing Agencies,” published on Dec. 19, 2022, these proposed (and, in two cases, approved) rule changes emanate from FICC itself (and in the case of the stress test protocols, also from DTCC and NSCC) and reflect careful analysis based on experience (including the volatility seen of late in the wake of the pandemic and of “sky-rocketing” inflation) of the operation of FICC and ways to mitigate financial risks in order to preserve the orderly working of the agency.