April 6, 1998
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attn: Jonathan G. Katz, Secretary

Re: File No. S7-30-97

Dear Mr. Katz:

D. E. Shaw & Co. L.P. ("DESCO") appreciates the opportunity to provide comments to the Securities and Exchange Commission (the "Commission" or "SEC") regarding the Commission’s release on OTC derivatives dealers (the "Release"), including the proposed rule changes (the proposed "Rules" ) set forth therein. The Release proposes a set of regulations that would be applicable to OTC derivatives dealers who seek to engage in securities activities. The Release states that the proposed regulations "are intended to allow securities firms to establish dealer affiliates that would be able to compete more effectively against banks and foreign dealers in global over-the-counter markets."

DESCO wishes to express its general support for the comments and recommendations set forth in the comment letter submitted by the OTC Derivative Products Committee of the Securities Industry Association (the "DPC"). This letter addresses some of the points discussed in the DPC letter and presents additional recommendations which DESCO believes would allow a broader range of firms to avail themselves of the opportunity to establish an OTC derivatives dealer, thereby achieving the Commission’s goal of reducing competitive disadvantages faced by firms which conduct their OTC derivatives business in the U.S.

DESCO appreciates the Commission’s concern stated in the Release that U.S. securities firms should not be compelled to move business activities outside of the United States solely to address competitive disadvantages that result from Commission regulation and strongly supports the Commission’s efforts to make the U.S. regulatory environment more hospitable to derivatives business. DESCO wishes to highlight the point that the movement of business outside the United States actually moves jobs and expertise outside the United States into non-U.S. entities that compete with U.S. entities for U.S. business. As a result, DESCO believes that the Commission should ensure that the capital and other regulatory requirements set forth in the Release would not put U.S. firms who choose to conduct their securities OTC derivatives business in an OTC derivatives dealer at a competitive disadvantage against overseas competitors and U.S. competitors who conduct their OTC derivatives businesses overseas. To the extent that the Commission imposes capital and other regulatory requirements on OTC derivatives dealers which are more stringent than the requirements applicable to overseas competitors and, thereby, make U.S. firms less competitive, DESCO believes that the Commission bears a significant burden to justify such additional requirements. We also note that, to the extent that U.S. firms determine that the Rules as adopted do not sufficiently address the competitive disadvantages faced by U.S. firms as a result of the U.S. regulatory environment, fewer firms will avail themselves of the opportunity to establish an OTC derivatives dealer, with the consequence that the Rules will not achieve their stated goal of stopping the flow of business activities to offshore locations "solely to address competitive disadvantages that result from Commission regulation."

The Release states that the Commission expects 6 to 10 firms to utilize these provisions and register as OTC derivatives dealers. We believe that many other business organizations will develop diverse business models within the context of the final rules. Limiting your expectations of its uses to those firms that participated in the Derivatives Product Group Report and establishing requirements for capital and business organization geared to those firms will result in a rule that prohibits as a practical matter other firms that may have risk control procedures and capitalization fully appropriate to their business activity from being able to conduct their business operations within the safe harbor afforded by the proposed rule. DESCO believes that such a result would be anti-competitive and inconsistent with the Commission’s goals stated in the Release.

The following are our comments to specific provisions of the Release:

1. Effecting Transactions through a Registered Broker or Dealer

a. Position Limits

One of the stated purposes of the Release is to ensure fair competition between U.S. dealers and their affiliates, on the one hand, and banks and foreign dealers, on the other hand, in global over-the-counter markets. Currently, one principal competitive advantage for banks and foreign dealers is that U.S. securities firms are subject to the option position limits set forth in Rule 2860 of the Conduct Rules of the National Association of Securities Dealers, Inc. ("NASD Rule 2860"), while banks and foreign dealers are not subject to such limits. ¹

We believe that it is critical to the ability of an OTC derivatives dealer to compete fairly with banks and foreign broker-dealers that the OTC derivatives dealer, similarly, not be subject to the options position limits set forth in NASD Rule 2860. We request that the SEC clarify that the requirement for executing transactions through a regulated broker-dealer is not intended to subject OTC derivatives dealers to the options position limits set forth in Rule 2860.

b. Alternative Business Models

Proposed Rule 15a-1 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), would require that securities transactions engaged in by an OTC derivatives dealer be effected through an affiliated registered broker or dealer. This means that the counterparty for a securities transaction would be considered a customer of the fully regulated broker-dealer. The Commission indicates in the Release that this requirement is intended "to ensure that all securities transactions remain subject to existing sales practice requirements." The Commission indicates that this requirement is "also intended to prevent an unforeseen regulatory disparity from arising between OTC derivatives dealers, which would be subject to modified capital and margin requirements, and other fully regulated broker-dealers in connection with conducting securities transactions."

We believe that this provision should be expanded to permit an OTC derivatives dealer to effect securities transactions through a bank or broker-dealer with whom it has a working relationship. The restriction to affiliates proposed in the Release limits the business structures and models available to U.S. firms and puts an unnecessary and undue burden on those that conduct business in derivatives markets in the United States. Of course, permitting transactions to be effected through a bank would be subject to the requirement that the bank could lawfully enter into the transactions with its customer/counterparty.

Since banks are permitted to engage in certain permitted securities transactions directly without being subject to regulation by the Commission, we believe that OTC derivatives dealers should be able to enter into such transactions subject to the requirement that all such transactions are entered into through a regulated national bank or state member bank, or a regulated affiliate. We note that such a proposal does not expand in any way the securities activities which are permitted to be engaged in by banks or their affiliates. Rather, we propose that to the extent that banks are permitted to enter into securities transactions, OTC derivatives dealers with whom they are affiliated or with whom they have a working relationship should not be prohibited from entering into such transactions, as long as such transactions are effected through the regulated bank.

Although not explicitly stated, the apparent purpose in requiring affiliation is to assure that there will be an examination by an SRO. We suggest, in circumstances in which an OTC derivatives dealer is affiliated, or has a working relationship, with a regulated bank, that the Commission still require the OTC derivatives dealer to be affiliated with a fully regulated broker-dealer, although the sales and marketing effort may be, as set forth in the preceding paragraph, through the bank. This would create the nexus to ensure the ability of the applicable SRO to examine and inspect the activities of the OTC derivatives dealer, as set forth in the Release. ²

We note that one of the Commission’s goals as expressed in the Release is to ensure fair competition among OTC derivatives dealers. Our suggestions are intended to prevent unfair discrimination against OTC derivatives dealers which have business relationships with, or are affiliated with, either broker-dealers or banks.

Moreover, if one of the Commission’s goals is to level the playing field with non-U.S. broker- dealers, who are already accessing U.S. markets through arrangements under Rule 15a-6(a)(4) under the Exchange Act, then the Commission should permit OTC derivatives dealers to transact directly (without a U.S. broker-dealer intermediary) with all parties with whom a non-U.S. broker-dealer could effect business under Rule 15a-6(a)(4), including a registered broker or dealer or a bank acting in a broker or dealer capacity. If U.S. broker-dealer intermediaries are not required for the benefit of those U.S. counterparties engaging in securities transactions effected under Rule 15a-6(a)(4), then it is unclear why U.S. broker-dealer intermediaries should be required to intermediate OTC derivative transactions by those U.S. counterparties with (U.S. regulated) OTC derivatives dealers.

We believe, therefore, that an OTC derivatives dealer should not be required to effect securities transactions through a fully regulated broker-dealer where the counterparty to the transaction is a bank or broker-dealer. We also believe that OTC derivatives dealers should not be required to effect securities transactions through a fully regulated broker-dealer in connection with risk management, financing, arbitrage or other trading transactions in which the OTC derivatives dealer is not acting in its capacity as a dealer, but rather as an investor or end-user.

c. Registration

The Release states that "any person discussing the terms of (a) transaction with the counterparty would have to be a registered representative of the fully regulated broker-dealer." The Release further states that this person could be a dual employee of both the broker-dealer and the OTC derivatives dealer, subject to appropriate supervision by both firms. We believe that the quoted language is broader than the language set forth in the NASD registration provisions ³ and request that the Commission clarify that it is not intending to expand upon the types of activities which would require registration. In particular, we believe that an officer or employee of an OTC derivatives dealer should be able to contact directly any entity that is not a customer under SEC Rule 15c1-1 or NASD Rule 0120(g), or any of the types of entities set forth in Rule 15a-6(a)(4).

d. Joint Confirmations

Pursuant to the Release, both the fully regulated broker-dealer and the affiliated OTC derivatives dealer would be required to send a written confirmation to the customer for each securities transaction, unless the Firm obtains the customer’s written instruction that the broker-dealer and its affiliated OTC derivatives dealer may send one joint confirmation on behalf of both parties. We do not believe that there are any benefits in requiring multiple confirmations which would justify the additional costs and paperwork which would result from such a requirement. In addition, if, as proposed, both the regulated broker-dealer and the affiliated OTC derivatives dealer would be jointly and severally liable for a joint confirmation, we believe that the requirement to obtain customer consent to the sending of a joint confirmation statement is unduly burdensome given the sophistication of permissible derivatives counterparties.

In our view, the Commission should adopt a similar approach to the one adopted in Rule 15a-6, where the Commission requires the regulated broker-dealer to take responsibility for sending out a joint confirmation. The confirmation, of course, should accurately disclose the respective roles of the OTC derivatives dealer and the broker-dealer with whom it is affiliated or has a working relationship.

2. Joint Back Office

Section 210.11(a)(2) of Regulation T of the Federal Reserve Board ⁴ permits "creditors" (as defined in Regulation T) to establish a joint back office ("JBO"). To the extent that the JBO clears transactions for its owners, credit extended on such transactions to owners of the JBO is not subject to the margin requirements of §220.18(a) of Regulation T. ⁵ The purpose of the JBO provision is to enable the owners of the JBO to secure the same treatment under the margin rules afforded to self-clearing broker-dealers in their capacities as borrowers.

The Release provides that credit "extended to an OTC derivatives dealer, like credit extended to a fully regulated broker-dealer, would be exempted from Section 7 if it satisfies the exemptive provisions contained in Section 7." The Release further provides that to the extent,

that firms desiring to take advantage of the proposed regulations applicable to OTC derivatives dealers do not believe that they would be able to take advantage of the exemptive provisions of Section 7(d)(2), the Commission solicits further comment on the proposed business activities of OTC derivatives dealers, and whether other exemptive relief may be needed to address borrowing by these firms.

Under the Release, OTC derivatives dealers are broker-dealers as defined in Sections 3(a)(4) and 3(a)(5) and, as such, are "creditors" for purposes of Regulation T. The Release clearly acknowledges that OTC derivatives dealers who satisfy the exemptive provisions of Section 7 should be able to avail themselves of such exemptive provisions. An OTC derivatives dealer which is not affiliated with a self-clearing broker-dealer may wish to avail itself of the exemptive provisions of Section 7 by becoming a member of a JBO. We believe, therefore, that encompassed within this provision in the Release is the understanding that a qualifying OTC derivatives dealer may become a member of a JBO. We request that the SEC make clear in the adopting release that this is the intended result. We note that the proposed clarification would ensure equality of treatment between OTC derivatives dealers who are affiliated with self-clearing broker-dealers and OTC derivatives dealers who are not affiliated with self-clearing broker-dealers (but instead are participants in a JBO).

3. Eligible OTC Derivative Instrument

a. Standardized Agreements

Proposed Rule 15a-1 would authorize OTC derivatives dealers to engage in transactions in "eligible OTC derivative instruments." Proposed Rule 3b-13 provides that the term "eligible OTC derivative instruments" would include only those agreements or transactions that are not "part of a fungible class of agreements, contracts, or transactions that are standardized as to their material economic terms."

We believe that the concepts of "material economic terms" and "fungible class" need clarification. With respect to the phrase "material economic terms," the concern is that the phrase could be interpreted to include provisions related to collateral amounts or types, mark-to- market mechanisms or indemnities, and similar terms. We believe that clarification by way of example or language change would be useful.

We suggest you consider the most recent forms of ISDA Master Agreement, Schedule, Annexes and Confirmations as a guideline. Provisions which are covered in a Master Agreement, Schedule or Annex generally should not be considered "material economic terms." These would include provisions related to netting, events of default, collateral amount or type, mark-to-market mechanisms and indemnities. In contrast to the Master Agreement, Schedule and Annexes, Confirmations generally contain terms which are applicable to a specific transaction. Generally, these include some terms which are "material economic terms" and some terms which are not. In the case of an option, "material economic terms" would include provisions such as the number of options, term (i.e., trade date and expiration date), strike price and premium. We believe that clarification of the concept of "material economic terms" consistent with the foregoing discussion would be useful for OTC derivatives dealers.

We also believe that the concept of "fungibility" should be clarified. In our view, transactions which are customized or tailored to the requirements of one customer or a limited group of customers, and which are subject to transfer restrictions, ⁶ should not be considered fungible, even if the terms of the transactions may be equivalent.

b. One-Year Minimum Period for Forward Transactions

Proposed Rule 3b-13 provides that "eligible OTC derivative instruments" include transactions that "involve the purchase and sale of a security on a firm basis at least one year following the transaction date." In our experience, transactions for the forward delivery of a security often involve settlement prior to the first anniversary of the trade date. In many instances, the risk being hedged by the dealer or its counterparty is a short-term risk. In our view, an eligible OTC derivatives instrument should include any purchase or sale of a security which by its terms is not intended to settle within the normal settlement cycle for the security being traded. Obviously, to the extent that such a transaction is prohibited under the securities or commodities laws, such a transaction could not be entered into by the OTC derivatives dealer. However, to the extent that such a transaction is permitted, we do not believe that it is appropriate to require a minimum term of one year for the transaction. To the extent that the SEC is concerned that parties will structure transactions to settle on a forward basis to evade the capital costs associated with booking those transactions in a registered broker-dealer, we believe that the Commission can adequately address this concern by providing that a party may not use an OTC derivatives dealer to evade the requirements of the securities laws, or, if a period is absolutely necessary, by providing for a period significantly shorter than one year, such as two weeks, which would not unduly impact the business conducted by OTC derivatives dealers. If there are other concerns that the SEC has in this regard, we would welcome the opportunity to comment on such concerns.

4. Permissible Risk Management, Arbitrage and Trading Transactions

Rule 15a-1, as proposed, would authorize OTC derivatives dealers to engage in "permissible risk management, arbitrage, and trading transactions." Pursuant to proposed Rule 3b-15, this would include securities transactions which involve the hedging of "an element of market or credit risk associated with one or more existing or anticipated transactions..." and other types of transactions enumerated in Rule 3b-15. DESCO believes that OTC derivatives dealers should also be able to engage in risk management activities which involve the hedging of liquidity, legal or operational risks or any other risks for which derivative hedging products are developed.

5. Permissible Derivatives Counterparty

Pursuant to proposed Rule 15a-1, an OTC derivatives dealer may engage in securities transactions only with "permissible derivatives counterparties," as defined in proposed Rule 3b-14. Certain types of entities, such as banks, insurance companies, registered commodity pools and registered broker-dealers, are considered permissible derivatives counterparties, without regard to the assets or net worth of the entity. Other types of entities, such as corporations and partnerships, which do not fall within any of the other categories enumerated under Rule 3b-14, may be considered permissible derivatives counterparties depending upon the total assets or net worth of the entity. Similarly, individuals may be considered permissible derivatives counterparties if their net assets exceed a specified amount.

We note that an OTC derivatives dealer will need to rely upon information provided by the counterparty as to the total assets or net worth of the counterparty. This is particularly true in the case of an individual and in the case of a corporation, partnership or other entity which does not have publicly available audited financial statements. DESCO recommends that Rule 3b-14 be amended to require that an OTC derivatives dealer (or the fully regulated broker-dealer or bank through which a derivatives transaction may be effected) have a "reasonable belief" that the counterparty is a "permissible derivatives counterparty." We believe that such a provision is necessary to protect OTC derivatives dealers from liability for inaccurate information provided by counterparties. This proposal is consistent with the approach taken in Rule 144A under the Securities Act, which requires that securities be offered or sold only to a qualified institutional buyer "or to an offeree or purchaser that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer." ⁷

In the Release, the Commission requests comments on whether the definition of "permissible derivatives counterparties" should be broadened to include natural persons having at least $5 million in total assets. We believe that persons having at least this amount of assets would possess the level of sophistication necessary to understand the distinction between an OTC derivatives dealer as counterparty, and a U.S. broker-dealer, and the level of regulatory protection available when dealing with each type of dealer. As a result, we believe that such persons should be considered permissible derivatives counterparties.

6. Issuing and Reacquiring Issued Securities

Proposed Rule 15a-1 would authorize OTC derivatives dealers to issue and reacquire "issued securities, including warrants on securities, hybrid securities, and structured notes, through a registered broker or dealer (other than an OTC derivatives dealer)." We believe there is some ambiguity in the requirement that securities be issued "through" a fully regulated broker-dealer. Does this mean that the fully regulated broker-dealer must be the issuer of the security? Or does it mean that the fully regulated broker-dealer must act as principal or agent in the purchase of securities from, or sale of securities to, the customer? Alternatively, does it mean that the OTC derivatives dealer may be the issuer of the security, as long as the OTC derivatives dealer and the fully regulated broker-dealer affiliate comply with the registration, confirmation and similar requirements set forth in the proposed Rule? We believe it would be worthwhile if the Commission could provide additional guidance on the meaning of this phrase. In our view, Rule 15a-1 should provide that any of these alternatives would meet the "issued through" requirement because, in each case, the regulated entity would be subject to the registration, confirmation and similar requirements set forth in the proposed Rule.

7. Net Capital Requirements

The Release proposes amendments to Rule 15c3-1 which would establish net capital requirements for OTC derivatives dealers which are more favorable than the net capital requirements that have been established for fully regulated broker-dealers. The proposed net capital requirements for OTC derivatives dealers are set forth in a proposed Appendix F to Rule 15c3-1. Appendix F would require OTC derivatives dealers to take into account market risk, credit risk and other risks in calculating net capital requirements.

DESCO believes that the Commission has taken an important first step in authorizing the use of VAR models by OTC derivatives dealers and hopes that such models, which have been approved by the U.S. and international banking regulators, and other models which are demonstrated to accurately measure risk, can be incorporated in the SEC’s net capital rules for fully regulated broker-dealers. DESCO proposes that the final rule provide sufficient flexibility so that other valuation and risk measurement methodologies can be used if it can be demonstrated to the Commission that they provide accurate risk measurements. We are concerned that it will create an undue burden on the industry and regulators if the current state-of-the-art risk measurement methodologies are set in stone in regulation while at the same time market participants develop new and better methodologies. The rule certainly should not provide disincentives for OTC derivatives dealers to continue to strive to optimize their risk management processes by considering and employing other methodologies.

a. Tentative Net Capital

The proposed Rule would require $100 million of tentative net capital and $20 of net capital. We believe that an absolute minimum requirement for tentative net capital for OTC derivatives dealers is inappropriate where no other category of broker-dealer has such a requirement under the net capital rule. We do not understand the justification for such a policy change in the case of OTC derivatives dealers. This requirement is an important one in assessing the proposed Rules in the context of the competitive environment internationally and the barriers to entry imposed by the Rule.

As discussed in the introductory section, where the Commission proposes a requirement that would put U.S. firms at a competitive disadvantage as compared to overseas firms who may conduct U.S. business without comparable regulation, the Commission bears a significant burden to justify such a requirement. DESCO does not believe that a requirement for $100 million of tentative net capital is necessary or appropriate, particularly where all OTC derivatives dealers would be required to satisfy quantitative and qualitative criteria established by the Commission, including Commission pre-approval of firm VAR models. DESCO also believes that the $100 million tentative net capital requirement could have consequences which would be anti-competitive for small and medium-size firms and newer entrants to the OTC derivatives business, which, in turn, would minimize the intended benefits of the Rule.

b. Credit Risk—Alternative to NRSRO Ratings

Under the proposed Appendix F, the capital requirement for credit risk would be determined by multiplying (x) the net replacement value in the account of the counterparty, (y) 8% and (z) the counterparty factor. The counterparty factor, which would range from 20% to 100%, would be determined by reference to the rating of the counterparty’s senior unsecured long-term debt or commercial paper by at least two nationally recognized statistical rating organizations ("NRSROs"). In the Release, the Commission requests comment on alternatives to relying on NRSROs ratings to determine the counterparty factor.

Because of the long-term exposures inherent in certain of their businesses (such as OTC derivatives), securities firms and banks typically have credit personnel who evaluate the credit of counterparties. The employees performing this function typically are professionals with expertise in evaluating counterparty credit risk. Procedures at these firms typically provide that prior to the extension of credit to any customer or counterparty, the customer or counterparty must be approved by the firm’s credit personnel. Such approval typically sets forth the amount of credit to be extended and the terms upon which such credit can be extended. In making a credit determination, credit personnel typically follow guidelines which have been adopted by the firm for scoring the credit of counterparties. These guidelines cover the credit scoring of both rated and unrated counterparties and are designed so that counterparties of equivalent credit, whether rated or unrated, should be scored equivalently; however, the internal credit scoring may cover types of borrowers (such as pension plans, other institutional investors and individuals), and take into account factors such as collateral, that rating agencies do not address.

DESCO believes that so long as an OTC derivatives dealer, or the bank or broker-dealer with whom the OTC derivatives dealer has a working relationship or is affiliated, has professional credit personnel who follow either written guidelines that have been approved by management of the OTC derivatives dealer or the standards generally used by the credit personnel of the bank or broker-dealer, such personnel should be qualified to make determinations regarding the appropriate counterparty factor. ⁸ Such guidelines should be designed so that parties of equivalent credit, whether rated or unrated, are assigned an equivalent credit rating. In other words, if the counterparty factors are adopted as proposed, a counterparty whose credit is equivalent to counterparties whose senior unsecured long-term debt is rated in the third and fourth highest rating categories should be assigned a counterparty factor of 50%. It should also be required that firms be able to document that their guidelines do in fact result in the designation of equivalent counterparty factors for parties with equivalent credit, whether rated or unrated. Finally, these guidelines should take into account any collateral or other credit support provided by the counterparty. In particular, any capital charge on a position should be reduced by the value (after haircuts) of liquid collateral delivered or to be delivered during the standard settlement cycle for the applicable type of transaction.

In our view, credit personnel need not be employees of the OTC derivatives dealer. Rather, their activities on behalf of the OTC derivatives dealer could be performed in either the bank or the broker-dealer with whom the OTC derivatives dealer is affiliated or with whom it has a working relationship.

We believe that the proposals described in this subsection are consistent with the general approach adopted in the Release. If firms are viewed as having the capacity to develop VAR models, they also should be viewed as having the capacity to make credit determinations. We also note that under the proposal set forth in the Release, an individual always will be assigned the lowest counterparty factor (and, accordingly, OTC derivatives transactions will be either less available or more expensive). By contrast, under our approach, an individual could be assigned a higher counterparty factor depending upon the individual’s credit or collateral provided.

We also note the Commission’s statement in the Release that "net replacement value" would take into account the "effect of legally enforceable netting agreements and the application of liquid collateral." We believe that the Commission should provide additional guidance with respect to the definition of liquid collateral and allow for valuation of collateral by credit personnel at firms consistent with firm policy, as discussed above.

c. Market Risk—Ten-Business Day Movement in Rates and Prices

Under the proposed Release, OTC derivatives dealers would be required to calculate market risk through VAR measures using a confidence level with a price change equivalent to a ten-business day movement in rates and prices.

We believe that the applicable period to be used for VAR calculations for any transaction should be a function of the liquidity of the underlying instrument or, alternatively, the time period within which the OTC derivatives dealer would be able to enter into one or a series of derivative or other transactions which substantially closes out the risk of the existing transaction. This could be either through liquidation of the position or appropriate hedging activity. It is our experience that 10 business days is far longer than the period which generally is required in order for a dealer to close out the risk of an existing OTC transaction. Even where the OTC derivatives dealer has entered into a transaction which it is unable to terminate, as a general rule the dealer would be able to enter into an exchange transaction or a transaction in another liquid market which would enable the dealer to close out the risk of the existing transaction in significantly less than 10 business days. Many OTC derivatives transactions are designed to enable the dealer to hedge market risk on a dynamic basis. Conversely, in many situations, an OTC derivatives dealer will refuse to enter into a particular transaction due to the lack of liquidity of the underlying instrument.

We believe that a better approach would be to require dealers to include in their VAR models and risk management procedures appropriate periods for measuring risk for each type of transaction. These periods (which could be either shorter or longer than 10 days) should be determined based upon the liquidity of the underlying instrument or, alternatively, the period within which the dealer would be able to enter into a transaction which would substantially close out the risk of the particular type of transaction. These determinations should be substantiated in writing in the dealer’s risk management procedures. The Commission might still require minimum periods for particular types of transactions; however, we believe that a 10 business day period is too long for many transactions.

With respect to the quantitative standards for VAR models, it is our understanding that the requirement for a one-year historical observation period relates to the underlying security or instrument. We believe that there should be provision for instruments that are newly issued and have significant immediate liquidity. Liquidity could be measured by reference to the average daily trading volume of the instrument. ⁹

d. Additional Factors

In the Release, the Commission provides for a multiplication factor, ranging from 3 to 4, to cover risks other than credit and market risk. This multiplication factor is intended to cover legal, liquidity and operational risks. We believe that the Commission has failed to demonstrate the relationship between these risks and the proposed multiplication factors and therefore request clarification in this regard.

We would recommend that the Commission adopt a different approach. The Commission acknowledges in the Release that it is difficult to quantify and develop capital charges specifically for these risks. In fact, we do not believe that the multiplication factor will address these risks. Rather, we believe that liquidity, legal and operational risks are more appropriately managed through the development of risk management procedures, consistent with the qualitative requirements for VAR models set forth in the Release. These procedures should identify and provide for the monitoring of liquidity, legal and operational risks by management and the firm’s risk management and internal audit functions. We believe that our proposal relieves firms from the anti-competitive effect of the multiplication factor and is a more effective approach for managing liquidity, legal and operational risks.

We also believe that the Commission has failed to demonstrate the relationship between the number of exceptions which result from back testing of a VAR model, which may be related to market factors, and a firm’s liquidity, legal and operational risks. We therefore request clarification in this regard.

8. Authority for the Commission; SRO Exemption

Proposed Rule 3b-12 grants to the Commission the authority to expand the securities activities which are permitted for OTC derivatives dealers. DESCO believes that a broader grant of authority to the Commission to grant relief with respect to specific provisions of the rule, to the extent consistent with the purposes of the rule, would be appropriate. DESCO believes that the flexibility provided by such a provision would assist the Commission over time to ensure that the objectives of the final rules are achieved. In particular, as noted in Section 7 above, DESCO believes that the Commission should have the flexibility to approve other valuation and risk measurement methodologies to the extent that it can be demonstrated that such models adequately measure and protect against market, credit and other risks.

We would also recommend, consistent with the approach taken by the Release, that a procedure be established which would allow a fully regulated broker-dealer to apply for and obtain specific relief from SRO rules to the extent that the firm can demonstrate that such rules adversely affect the ability of the firm to operate an OTC derivatives subsidiary as contemplated by the Release or are otherwise inconsistent with the purposes of the Release.

9. SIPA Exemption; Rule 12d3-1 under the Investment Company
Act of 1940

Under proposed Rule 36a1-2, OTC derivatives dealers would be exempt from the provisions of the Securities Investor Protection Act of 1970 ("SIPA") and from membership in the Securities Investor Protection Corporation ("SIPC"). In its comment letter, the DPC states that it regards exemptive relief from the provisions of the SIPA and from SIPC membership as critical to the commercial viability of the OTC derivatives dealer category. DESCO agrees with the DPC that this exemptive relief is critical for OTC derivatives dealers.

The DPC also recommends in its comment letter that the Commission adopt amendments to Rule 12d3-1 under the Investment Company Act of 1940 to clarify Rule 12d3-1's scope in the context of OTC derivatives dealers and eligible OTC derivative instruments and to assure that Rule 12d3-1 would not unduly restrict the ability of OTC derivatives dealers to enter into OTC derivatives transactions with, and offer structured securities to, registered investment companies. DESCO supports the DPC’s recommendation regarding Rule 12d3-1.

Conclusion

DESCO wishes to thank the Commission for a full consideration of our comments on the OTC derivatives dealer release. While we have comments on various provisions of the Release, as discussed above, we commend the Commission for its determination to develop a set of regulations which are tailored to the type of activity and risks being regulated. The Release represents an important step forward in leveling the playing field among the various kinds of entities that compete in the OTC derivatives markets. We believe that the proposals described in this letter, including the consideration of alternative business models, will further the Commission’s goal of ensuring a level playing field among all competitors.

If DESCO can provide further information, or if you would like to discuss any of the foregoing comments, please contact Elizabeth Albert at (212) 478-0604.

Very truly yours,

Elizabeth Albert

Senior Vice President

Footnotes