I hope you are having a lovely day!
I am writing to you as a retail investor to formally request that the Securities and Exchange Commission (SEC) consider amending Rules 18 and 22 of the National Securities Clearing Corporation’s (NSCC) Rules & Procedures. This petition is submitted under Rule 192 of the SEC’s Rules of Practice, with the goal of providing clearer guidelines on the settlement of guaranteed transactions, enhancing the resilience of registered clearing agencies like the NSCC, and bolstering the stability of our financial markets by encouraging better risk management practices among market participants.
This petition aligns with the SEC’s guidelines for rulemaking petitions, which allow individuals to propose new rules, amendments, or repeals of existing rules. As outlined on the SEC's website, petitions must be filed with the Secretary of the Commission and may be submitted electronically to Secretarys-Office@SEC.GOV. Petitions must include the proposed rule changes or specify the rules to be amended or repealed, along with a statement of interest and reasons for the requested action.
Background
Retail investors have noted that the NSCC’s current rules lack specific procedures for closing out positions, particularly in the event of a member default. According to the NSCC’s Disclosure Framework, if a member defaults, the NSCC must settle guaranteed transactions on behalf of the failing member. However, NSCC Rule 18 SEC. 6(a) allows the NSCC discretion in closing out positions if it believes doing so would disrupt the market.
This discretion raises concerns about potential market distortions and manipulations. Key questions include:
1. Root Causes of Disorderly Markets
The primary cause is the buildup of large positions by members, which become problematic if they fail and must be closed out. Members with high-risk positions can become de facto "Too Big To Fail," creating systemic risks if they default. This incentivizes members to build risky positions that are difficult to unwind, potentially leading to bailouts or other socialized losses.
2. Market Distortions and Manipulation
Members might engage in practices like naked short selling, where the market is artificially inflated due to unclosed positions. If a clearinghouse like the NSCC is responsible for these positions, it may avoid closing them to prevent market disruption, perpetuating distortions and increasing systemic risks.
3. Responsibility for Costs
Financial market participants who create high-risk positions should bear the costs of closing them. However, the current system allows these costs to be shifted to clearinghouses and the general public, which is unfair and unsustainable.
4. Proposed Solutions
To address these issues, we must align incentives to ensure that market participants are responsible for the risks they create. This includes:
Proposed Rule Changes
I propose the following amendments to NSCC Rules 4, 18, and 22:
Final Remarks
These proposed changes aim to protect investors, maintain orderly markets, and support capital formation in line with the SEC’s mission. The inclusion of executive clawbacks and strict procedures will help create a fairer, more stable financial system. I appreciate the opportunity to submit this petition and request prompt action on these proposed amendments.
Sincerely,
A Concerned Retail Investor
[1] 17 C.F.R. § 201.192(a).
[2] NSCC Rules & Procedures are currently available at NSCC Rules.
[3] SEC Petitions for Rulemaking.
[4] NSCC Disclosure Framework.
[5] For a publicly available description of this issue, see “This is How Wall St Ensures Heads They Win and Tails You Lose” at Reddit, which discusses the moral hazard problem created by Too Big To Fail, based on a 1996 paper titled "Banks with Something to Lose: The Disciplinary Role of Franchise Value" Federal Reserve Bank of NY.
[6] Decades after the Global Financial Crisis, options for resolving large financial institutions remain limited, with bail-ins potentially replacing the unpopular bailouts. See, e.g., Investopedia and the Federal Reserve Bank of New York’s “Why Bail-In? And How!” Federal Reserve Bank of NY. While bail-ins are theoretically more palatable with creditors absorbing losses instead of taxpayers, self-serving, profit-motivated financial institutions remain committed to shifting losses to others. This is exemplified by the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) proposing that new bond investors absorb losses first 2022 Proposed Rule Federal Reserve Docket R-1786 RIN 7100-AG4 and FDIC RIN 3064-AF86. Additional discussion regarding this proposed rule may be found on Reddit Comment Against Federal Reserve FDIC Proposal and Seeking Bag Holders, which notes that this strategy was successfully implemented with the failure of Credit Suisse, where AT1 bonds were “fully written off in the event of a trigger event.”
[7] Self-Regulatory Organizations: NSCC Proposed Rule discusses the Existing Accord for the transfer between OCC and NSCC of responsibility for settlement obligations, including the time when OCC’s settlement guarantee ends and NSCC’s settlement guarantee begins.
[8] NSCC Businesses and Subsidiaries.
[9] While a naked short position is used as an example here due to its inherent risk of unlimited loss, any type of position could become risky. An extremely large long position could also lead to a disorderly market on closeout, even with limited loss potential. A large short position (whether naked or borrowed) is of particular relevance as the SEC’s Staff Release GameStop Report noted that GameStop (GME) had significant short interest (as a percent of float) in January 2021 of 122.97%, with “short interest of more than shares outstanding in January 2021” SEC Staff Release GameStop Report [pg. 21].
[10] Per the current NSCC Rule 22, only certain parties have access to records of any extension, waiver, or suspension of rules related to not closing out a position. A much smaller subset of those parties with access is actively made aware of the situation. One option to mitigate market distortions would be to timely (i.e., immediately) make the written reports of Rule 22, including the pertinent facts, available to the SEC and to the general public as proposed for NSCC Rule 22 as Option A - Public Notice.
[11] For example, naked shorts and failures to deliver were documented in Dr. Susanne Trimbath’s book “Naked, Short and Greedy: Wall Street’s Failure to Deliver.” In 2008, the SEC halted short selling of financial stocks (and only financial stocks) in an emergency action “to combat market manipulation” and “restore equilibrium to markets” SEC Press Release 2008-211.
[12] NSCC’s Loss Allocation Waterfall can be found in NSCC Rule 4, Section 4 “Loss Allocation Waterfall, Off-the-Market Transactions.” OCC’s Loss Allocation Waterfall is described in OCC’s Clearing Member Default Rules and Procedures, publicly linked from the OCC’s website on Default Rules & Procedures.
[13] The SEC has supported the adoption of rules that “help foster more resilient clearinghouses” SEC Press Release 2023-236, where the need for more resilient clearinghouses is discussed in more detail on Reddit.
[14] See, e.g., DTC Rule 18, "Waiver or Suspension of Rules and Procedures" DTC Rules; FICC Government Securities Division Rule 42, "Suspension of Rules" FICC Government Securities Division Rules; FICC Mortgage Backed Securities Division Rule 33, "Suspension of Rules in Emergency Circumstances" FICC Mortgage Backed Securities Division Rules. These rules are similar to NSCC Rule 22, "Suspension of Rules," while DTC Rule 4, Section 5, "Loss Allocation Waterfall," and FICC’s Rule 4, "Clearing Fund and Loss Allocation," are similar to NSCC Rule 4 in defining their loss allocation waterfalls.
[15] See, e.g., OCC Default Rules and Procedures, linked from OCC Risk Management.