Dear Ms. Countryman,
As a retail investor, I respectfully submit this petition for rulemaking under Rule 192 of the Securities and Exchange Commission’s (SEC) Rules of Practice, to request that the SEC amend Rules 18 and 22 of the National Securities Clearing Corporation (NSCC) Rules & Procedures. The goal is to provide investors with clarity and certainty regarding the settlement of guaranteed transactions, bolster the resilience of clearing agencies like the NSCC in their role as a central counterparty (CCP), and support financial market stability by encouraging appropriate risk management practices among market participants.
This petition is submitted in accordance with the SEC's guidelines for rulemaking petitions, which allow any individual to request the Commission to issue, amend, or repeal a rule of general application. As required, this petition includes the proposed text of the amendment and a statement of my interest in this matter, as well as the reasons for requesting Commission action.
Background
Retail investors like myself are concerned that the NSCC’s Rules and Procedures lack clear and strict guidelines for closing out positions, especially in cases of member defaults. According to NSCC’s Disclosure Framework, if a member defaults, the NSCC is responsible for completing the settlement of guaranteed transactions on behalf of that member. However, under NSCC Rule 18, Section 6(a), if the NSCC believes closing a position in a specific security could create market instability, it has the discretion to delay or forego the close-out.
This discretionary power raises several important concerns for retail investors:
1. What is the root cause?
The root cause lies in NSCC Rule 18, which allows members to accumulate positions that, if closed, would disrupt the market. These members, becoming "too big to fail," may pose systemic risks to the financial system. The current framework perversely incentivizes such members to increase their exposure, knowing their failure could lead to bailouts, socializing losses among investors and taxpayers.
As their risk of default rises, these members continue to build larger positions, ultimately shifting the responsibility of closing out these market-disruptive positions onto CCPs like the NSCC and OCC.
2. How does this lead to market distortions or manipulation?
The misaligned incentives are clear. Members are encouraged to build up positions that are profitable for them, but disruptive to the market. For example, a naked short position left unresolved because of market disruption concerns artificially inflates the supply of a security. The NSCC, in its role of maintaining market stability, is left guaranteeing open transactions but hesitating to close them out, perpetuating the distortion.
By prioritizing price stability, CCPs are inadvertently creating systemic risks by guaranteeing positions that cannot be closed without significant market disruption.
3. Who bears the cost?
In cases of default, financial market participants and the public bear the cost of closing out positions. The current system allows members to privatize profits while socializing losses through bailouts or other mechanisms, further eroding market fairness. A system that tolerates naked short selling and defaulting without consequence is unsustainable and inherently unfair to all market participants.
4. How do we fix this?
We need to realign incentives within the regulatory framework to ensure that financial market participants are responsible for the risks they take. This petition proposes changes that hold members accountable for their positions, including clawing back executive compensation to cover the costs of closing out disruptive positions. This would ensure that executives are not rewarded for short-term profits while leaving the long-term risks to be absorbed by the broader financial system.
Proposed Changes
To address these concerns, I propose the following amendments to the NSCC’s Rules and Procedures:
NSCC Rule 4 Proposed Change
Section 4. Loss Allocation Waterfall, Off-the-Market Transactions
Each Member, including its executives, shall be obligated to the Corporation for the entire amount of any loss or liability incurred by the Corporation arising out of or relating to any Defaulting Member Event. To the extent that such loss or liability is not satisfied by the Member, all executives of the Member (past or present) shall be liable for an amount equivalent to their compensation from the Member over the preceding five years. If the loss or liability is still not fully satisfied, the Corporation shall apply a Corporate Contribution and charge the remaining amount ratably to other Members, as outlined below.
NSCC Rule 18 Proposed Change
Section 6.
(a) Promptly after the Corporation has notified that it has ceased to act for a Member, the Net Close Out Position with respect to each CNS Security shall be closed out—whether by buying in, selling out, or liquidating the position—by the Corporation. However, if in the opinion of the Corporation, the close-out of a position in a specific security would create a disorderly market, the Corporation has the discretion to delay or forego the close-out.
NSCC Rule 22 Proposed Change (Option A – Public Notice)
Rule 22. Suspension of Rules
The time set by these Rules, Procedures, or any regulations of the Corporation for performing any act may be extended, or the performance of any required act may be waived or suspended by the Board of Directors, the Chairman, the President, General Counsel, or any officer of the Corporation ranked Managing Director or higher if deemed necessary or expedient.
A written report explaining the extension, waiver, or suspension (except for extensions of less than eight hours), including the name of the person(s) authorizing it and the reasons behind it, must be promptly made and published on the Corporation’s website within one business day for public access. This report shall also be filed with the Corporation’s records and be available for inspection during regular business hours. Any extension or waiver may continue for up to 60 days unless approved by the Board of Directors, with the written report published as described.
NSCC Rule 22 Proposed Change (Option B – No Exceptions)
Rule 22. No Suspension of Rules
The time fixed by these Rules, Procedures, or any regulations may not be extended. The performance of any act required by these Rules, Procedures, or regulations may not be waived or suspended.
A written report explaining any deviation, including the identity of the authorizing person(s) and the reason for the deviation, must be promptly made and published on the Corporation’s website within one business day. This report shall also be filed with the Corporation’s records and be available for inspection by any member during regular business hours.
Final Remarks
As a retail investor, I believe these proposed enhancements to NSCC Rules 4, 18, and 22 will better protect investors, ensure the efficient functioning of markets, and support the SEC’s mission of facilitating capital formation. By eliminating ambiguity and discretionary decision-making in the settlement of guaranteed transactions, these rules foster a consistent and transparent environment, benefitting all market participants.
Between the two options for Rule 22, I strongly advocate for Option B – No Exceptions as the best approach to ensure the uniform application of rules and prevent market distortion. While Option A – Public Notice recognizes the need for flexibility, it mandates full public disclosure to mitigate the risk of information asymmetry, which could otherwise lead to unfair advantages and market inefficiencies.
The proposed changes to NSCC Rules 4, 18, and 22 create a clear “you break it, you buy it” framework. This ensures that the cost of closing out market-disruptive positions is first borne by the defaulting Member and its executives, promoting fairness and discouraging members from pushing the costs onto the broader financial system. Adding executive compensation clawbacks to the loss allocation waterfall strengthens the financial resources available to handle defaults while incentivizing proper risk management practices at all levels.
In conclusion, these enhancements bolster the liquidity and resilience of registered clearing agencies like the NSCC, contributing to the stability of our financial markets. I respectfully request that the Commission act promptly on this petition and consider applying similar changes to other relevant clearing organizations, such as DTC, FICC, and the OCC.
Sincerely,
A Concerned Retail Investor
Frederick Ragsdale
[2] NSCC Rules & Procedures are currently available at ~https://www.dtcc.com/~/media/Files/Downloads/legal/rules/nscc_rules.pdf~
[3] ~https://www.sec.gov/rules-regulations/petitions-rulemaking-submitted-to-sec~
[5] For a publicly available description of this issue, see “This is how Wall St ensures heads they win and tails you lose” at ~https://www.reddit.com/r/Superstonk/comments/yhx48w/this_is_how_wall_st_ensures_heads_they_win_and/~ which describes 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" [~https://www.newyorkfed.org/research/epr/96v02n2/9610dems.html~] available from the 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 bail outs. See, e.g, Investopedia (~https://www.investopedia.com/terms/b/bailin.asp~) and the Federal Reserve Bank of New York’s “Why Bail-In? And How!” (~https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412somm.pdf/1000~). 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 as exemplified by the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) which proposed to have new bond investors absorb losses first [2022 Proposed Rule Federal Reserve Docket R-1786 RIN 7100-AG4 and FDIC RIN 3064-AF86 available on the Federal Register at ~https://www.federalregister.gov/documents/2022/10/24/2022-23003/resolution-related-resource-requirements-for-large-banking-organizations~]. Additional discussion regarding this proposed rule may be found on Reddit (~https://www.reddit.com/r/Superstonk/comments/zdebh6/comment_against_the_federal_reserve_fdic_proposal/~ and ~https://www.reddit.com/r/Superstonk/comments/163ztcz/federal_reserve_fdic_seeking_bag_holders/~) which note that this strategy was successfully implemented with the failure of Credit Suisse where AT1 “bonds were created precisely for such situations” to “be fully written off in the event of a trigger event”.
[7] See, e.g., ~https://www.federalregister.gov/documents/2023/08/30/2023-18670/self-regulatory-organizations-national-securities-clearing-corporation-notice-of-filing-of-proposed~ which 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] ~https://www.dtcc.com/about/businesses-and-subsidiaries/nscc~
[9] While a naked short position is used as an example here, it is only chosen as an example due to its inherent risk of unlimited loss. Any type of position could become risky as an extremely large long position could also lead to a disorderly market on close out 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 [~https://www.sec.gov/page/sec-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” [Id. 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 are 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” and 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”. [See, e.g., ~https://www.sec.gov/news/press/2008/2008-211.htm~]
[12] NSCC’s Loss Allocation Waterfall may be found in, for example, NSCC’s Rules Rule 4 SEC 4 “Loss Allocation Waterfall, Off-the-Market Transactions”. OCC’s Loss Allocation Waterfall is described in OCC’s Clearing Member Default Rules and Procedures [~https://www.theocc.com/getmedia/e8792e3c-8802-4f5d-bef2-ada408ed1d96/default-rules-and-procedures.pdf~] publicly linked to from the OCC’s website on Default Rules & Procedures [~https://www.theocc.com/risk-management/default-rules-and-procedures~].
[13] The SEC has supported adoption of rules which “helps foster more resilient clearinghouses” [~https://www.sec.gov/newsroom/press-releases/2023-236~] where the need for more resilient clearinghouses is discussed in more detail on Reddit [~https://www.reddit.com/r/Superstonk/comments/17wzqc4/clearinghouses_busted_confirmation_bias_from_the/~].
[14] See, e.g., DTC Rule 18 “WAIVER OR SUSPENSION OF RULES AND PROCEDURES” [~https://www.dtcc.com/-/media/Files/Downloads/legal/rules/dtc_rules.pdf~], FICC Government Securities Division Rule 42 “SUSPENSION OF RULES” [~https://www.dtcc.com/~/media/Files/Downloads/legal/rules/ficc_gov_rules.pdf~], FICC Mortgage Backed Securities Division Rule 33 “SUSPENSION OF RULES IN EMERGENCY CIRCUMSTANCES” [~https://www.dtcc.com/~/media/Files/Downloads/legal/rules/ficc_mbsd_rules.pdf~]
[14] See, e.g., DTC Rules [~https://www.dtcc.com/-/media/Files/Downloads/legal/rules/dtc_rules.pdf~], FICC Government Securities Division Rules [~https://www.dtcc.com/~/media/Files/Downloads/legal/rules/ficc_gov_rules.pdf~], and FICC Mortgage Backed Securities Division Rules [~https://www.dtcc.com/~/media/Files/Downloads/legal/rules/ficc_mbsd_rules.pdf~] where DTC Rule 18 “WAIVER OR SUSPENSION OF RULES AND PROCEDURES”, FICC Government Securities Division Rule 42 “SUSPENSION OF RULES”, and FICC Mortgage Backed Securities Division Rule 33 “SUSPENSION OF RULES IN EMERGENCY CIRCUMSTANCES” 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., ~https://www.theocc.com/getmedia/e8792e3c-8802-4f5d-bef2-ada408ed1d96/default-rules-and-procedures.pdf~ which is linked to from ~https://www.theocc.com/risk-management/default-rules-and-procedures~.