Petition for Rulemaking: Amend Clearing Agency Rules for Consistent Close Outs

Dear Ms. Countryman,

As a retail investor, I respectfully submit this petition for

rulemaking pursuant to ~Rule 192~ of the Securities and Exchange

Commission’s (“SEC”) Rules of Practice [1], to request that the SEC

amend Rules 18 and 22 of ~National Securities Clearing Corporation

(“NSCC”) Rules & Procedures~ [2] to provide investors with clarity and

certainty regarding settlement of guaranteed transactions, strengthen

the resilience of a registered Clearing agency (e.g., the NSCC) for

their role as a central counterparty (CCP), and support the stability

of our financial markets and financial system by incentivizing

appropriate risk management practices by market participants.

I respectfully submit this petition consistent with the SEC’s website

for ~Petitions for Rulemaking Submitted to the SEC~ [3] which states

“[a]ny person may request that the Commission issue, amend or repeal a

rule of general application” where “[p]etitions must be filed with the

Secretary of the Commission” and “[p]etitions may be submitted via

electronic mail to Secretarys-Office@SEC.GOV (preferred method)”.

This petition also satisfies requirements that “[p]etitions must

contain the text or substance of any proposed rule or amendment or

specify the rule or portion of a rule requested to be repealed” and

“petitions must also include a statement of their interest and/or

reasons for requesting Commission action.” [Id.]

Background

It has come to the attention of retail investors, like myself, that

NSCC Rules and Procedures do not codify strict procedures for closing

out positions (e.g., in the event of a Member default). Per ~NSCC’s

Disclosure Framework for Covered Clearing Agencies and Financial

Market Infrastructures~, “[a]s a cash market CCP, if a Member

defaults, NSCC will need to complete settlement of guaranteed

transactions on the failing Member’s behalf” [4 “Liquidity risk

management framework”]. However, NSCC Rule 18 SEC. 6(a) contains a

provision that “if, in the opinion of the Corporation, the close out

of a position in a specific security would create a disorderly market

in that security, then the completion of such close-out shall be in

the discretion of the Corporation”.

Retail investors like myself are concerned about potential market

distortion and market manipulation arising from the discretion

afforded to the NSCC based solely on the NSCC’s unreviewed and private

opinion regarding the [in-]completion of a close-out of a position in

a specific security that could distort markets and/or create

disorderly markets. A few questions must be considered:

What is the underlying root cause of the disorderly market?

How can this lead to market distortions and/or manipulation?

Who is responsible for the costs of closing out a position which would

create a disorderly market?

How do we fix this?

1. What is the underlying root cause?

The answer to this first question can be found by starting from NSCC

Rule 18 where the cause of a disorderly market is a Member building up

a position that would create a disorderly market if closed out.

Members with increasingly disruptive positions eventually become de

facto Too Big To Fail as their failure would create a sufficiently

disorderly market for one (or more) securities that could pose

systemic risks to our financial system. [5]

Thus as a Member’s risk of default increases, the Member is perversely

incentivized to increase the risk the Member poses to the financial

system by building up more positions that would be disorderly to close

in order to ensure a bail-in or bail-out to socialize losses amongst

investors and taxpayers (again) [6]. If and when a Member defaults,

any associated risks and costs are covered by CCPs, including the NSCC

and Options Clearing Corporation (“OCC”) which maintain settlement

guarantees [7].

As a Systemically Important Financial Market Utility (SIFMU)

designated CCP, the NSCC “provides clearing, settlement, risk

management, central counterparty services and a guarantee of

completion for certain transactions for virtually all broker-to-broker

trades involving equities, corporate and municipal debt, American

depositary receipts, exchange-traded funds, and unit investment

trusts” [8]. When a “Too Big To Fail” Member privatizes profits

without sufficient risk management, risks and costs of a Member

failure are socialized through CCPs which maintain guarantees on

settlement and transactions, including the NSCC which has rules,

regulations, and procedures attempting to maintain financial market

stability.

The current regulatory framework significantly handicaps CCPs,

including the NSCC, in their ability to maintain financial market

stability. Certain Members may privatize profits and socialize losses

by building large high risk portfolios yielding short term profits for

their executives where the Member’s failure would create a disorderly

market and systemic risk allowing the Members to take the financial

system hostage for a bailout. It is effectively impossible for CCPs

to maintain financial market stability against Members incentivized to

build up positions that would be disorderly for a CCP to close out.

2. How can this lead to market distortions and market manipulation?

Misaligned incentives. ~Adam Smith’s invisible hand~ explains why

Members will follow incentives to build positions that would create a

disorderly market if closed out because these positions are profitable

for them and costly to others. As a result, a build up of these

positions have been and continue to result in market distortions and

market manipulation. As an example, a naked short position [9] in a

security held by a Member that is not closed out due to a fear of

creating a disorderly market naturally distorts the market by

increasing the amount of that security in circulation. In economic

terms, the supply of the security has increased as a result of a naked

short transaction where a delay or failure to close out the naked

short position, due to fear of creating a disorderly market, secretly

perpetuates a market distortion by artificially and non-publicly [10]

inflating supply.

When CCPs become responsible for these disorder creating positions,

their goal of maintaining financial market stability (e.g., by

prioritizing price stability) prevents the CCPs from closing out

positions that may disrupt the market; which then perpetuates market

distortions as outstanding transactions are guaranteed, but not closed

out. Obviously, SIFMU designated CCPs guaranteeing open transactions

for fear of disrupting the market poses systemic risks to our

financial system; especially as accumulating guarantees will

inevitably overwhelm the risk management capability of a CCP.

CCPs prioritizing price stability to avoid the appearance of market

distortions handicaps the CCPs abilities to maintain overall financial

market stability resulting in larger systemic risks to our financial

markets when guarantees on market disruptive positions accumulate.

This is especially problematic when our current regulatory framework

incentivizes the creation of market distortions by Members and shifts

the costs and burden for unwinding those distortions to a CCP. In

essence, Members are incentivized to build up positions that would

create a disorderly market if closed out (e.g., significantly large

short positions) for short term profit, become Too Big To Fail when

their significant obligations pose a systemic risk, and then transfer

the costs of those obligations to a CCP upon failure. Privatized

profits and socialized losses, again.

3. Who is responsible for the costs?

Certain financial market participant members are clearly responsible

for building costly positions which pose a threat of disrupting

markets. For example, financial market participant members with the

aforementioned example of naked short positions face a risk of

unlimited loss. These risks are guaranteed by a CCP in the event a

Member with this type of unlimited loss position fails. There is no

comparable real world analogue to our financial markets which allows a

naked short sale, cashing out, and defaulting because selling

something one does not have is never tolerated, except in our

financial system where a CCP and the general public are currently

guaranteeing, and thus responsible for, closing costs.

A market in which some privatize profits while socializing losses

through bailouts (or bail-ins) is clearly unfair and must be

addressed. The status quo can not continue especially with more

people becoming aware of the underlying systemic issues (many of which

were raised previously and remained unaddressed). [11]

4. How do we fix this?

As popularized by the authors of ~Freakonomics~, we must identify

misaligned incentives in our regulatory framework and change our

regulatory framework to align incentives so that the invisible hand

guides financial market participants towards the desired behavior. As

described above, certain financial market participant members profit

from risky positions which could pose a disruptive threat if closed

(e.g., naked short positions) where the costs of closing those

positions are guaranteed by a CCP. Profit without risk is a clearly

misaligned incentive structure where those financial market

participants may compensate themselves lavishly for short term profits

while the ensuing risks and costs are later transferred to a CCP upon

default.

Fixing this misaligned incentive structure requires financial market

participants to be responsible for the costs of closing out their

positions; including clawing back compensation, if necessary, to

properly allocate costs to the responsible parties. CCPs, including

the NSCC and OCC, have defined Loss Allocation Waterfalls [12] which

define the allocation of costs and should be amended to first allocate

costs to the responsible parties before other financial market

participants. NSCC’s loss allocation waterfall allocates losses first

to the Defaulting Member followed by Corporate Contributions by other

Members. [Id.] OCC’s loss allocation waterfall allocates losses first

to the margin deposits and clearing fund deposits of the suspended

firm, followed by OCC’s own pre-funded financial resources, and then

clearing fund deposits of non-defaulting firms and EDCP unvested

balance, and clearing fund assessments. [Id.] Neither loss

allocation waterfalls include executives of a defaulting Member; a key

oversight which allows Members to compensate their executives for

short term profits while long term risks and costs are to be

transferred to a CCP upon default and/or suspension of the Member.

Therefore, changes are proposed below to include clawing back

compensation and assets from executives of a defaulting and/or

suspended Member for reimbursing a CCP for the costs of closing out

positions that may be disruptive to the market.

In order to ensure fairness for all market participants, CCPs should

have defined procedures for completing settlement of and/or closing

out guaranteed transactions and/or positions. Strictly defined

procedures eliminate bias, ambiguity, and discretion which avoid

potential for unfair, preferential, and/or discriminatory actions by

CCPs. Changes are proposed below to specify strict rules on closing

out positions regardless of any disorder that may be caused. As this

Petition proposes to include executives of a defaulting and/or

suspended Member in the loss allocation waterfalls for the costs of

closing out positions, including those which may be disruptive to the

market, Members (including their executives) are explicitly

disincentivized from attempting to shift risks and costs to a CCP

which will have strictly defined processes for closing out positions.

Using the very familiar and commonly understood “you break it, you

bought it” concept, this proposal ensures that executives of any

Member with positions that may disrupt the market when closed out are

also responsible for the costs of disrupting the market to encourage

and incentivize appropriate risk management practices.

As proposed, all executives (past or present) of a disruptive Member

are obligated to reimburse the CCP for losses up to an amount

equivalent to their preceding 5 years of compensation from the Member.

This approach ensures that (a) only the compensation received from the

disruptive Member is at risk, and (b) short, medium, and long term

risk management are encouraged by clawing back compensation from the 5

years prior to default. Including past executives ensures that a

Member does not simply switch out the executive team so that past

executives transfer responsibility for their actions to new,

potentially innocent, executives.

Proposed Changes

Regarding the text and substance of the amendment, I request that the

NSCC modify Rules 4, 18, and 22 of the NSCC’s Rules and Procedures to

address the aforementioned issues by:

(a) codifying strict procedures for completing settlement of

guaranteed transactions,

(b) removing ambiguity and discretion,

SIFMUs, particularly registered Clearing agencies such as the NSCC and

OCC,

(d) supporting the overall stability of our financial markets and

financial system, and

(e) incentivizing appropriate risk management practices of financial

market participants.

With respect to the text of the proposed changes itemized below (blue,

if available), additions are identified by square brackets (i.e., “[“

and “]”) and double-dashes (i.e., “--”) indicate deletions.

NSCC Rule 4 Proposed Change

SEC. 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 with respect to such Member. [To the extent that such loss or

liability is not satisfied by the Member, all executives of the Member

(past or present) shall be obligated to the Corporation for an amount

equivalent to the preceding 5 years of compensation from the Member.]

To the extent that such loss or liability is not satisfied pursuant to

Section 3 of this Rule 4, the Corporation shall apply a Corporate

Contribution thereto and charge the remaining amount of such loss or

liability ratably to other Members, as further provided below.

NSCC Rule 18 Proposed Change

SEC. 6. (a) Promptly after the Corporation has given notice that it

has ceased to act for the Member, and in a manner consistent with the

provisions of Section 3, the Net Close Out Position with respect to

each CNS Security shall be closed out (whether it be by buying in,

selling out or otherwise liquidating the position) by the

Corporation--; provided however, if, in the opinion of the

Corporation, the close out of a position in a specific security would

create a disorderly market in that security, then the completion of

such close-out shall be in the discretion of the Corporation--.

NSCC Rule 22 Proposed Change (Option A – Public Notice)

RULE 22. SUSPENSION OF RULES

The time fixed by these Rules, the Procedures or any regulations

issued by the Corporation for the doing of any act or acts may be

extended or the doing of any act or acts required by these Rules, the

Procedures or any regulations issued by the Corporation may be waived

or any provision of these Rules, the Procedures or any regulations

issued by the Corporation may be suspended by the Board of Directors

or by the Chairman of the Board, the President, the General Counsel or

such other officers of the Corporation having a rank of Managing

Director or higher whenever, in its or his judgment, such extension,

waiver or suspension is necessary or expedient.

A written report of any such extension, waiver or suspension (other

than an extension of time of less than eight hours), stating the

pertinent facts, the identity of the person or persons who authorized

such extension, waiver or suspension and the reason such extension,

waiver or suspension was deemed necessary or expedient, shall be

promptly made [and published on the Corporation’s website for access

by the general public within 1 business day] and filed with the

Corporation’s records and shall be available for inspection by any

[person,] Member, Mutual Fund/Insurance Services Member, Municipal

Comparison Only Member, Insurance Carrier/Retirement Services Member,

TPA Member, TPP Member, Investment Manager/Agent Member, Fund Member,

Data Services Only Member or AIP Member during regular business hours

on Business Days. Any such extension or waiver may continue in effect

after the event or events giving rise thereto but shall not continue

in effect for more than 60 calendar days after the date thereof unless

it shall be approved [by] the Board of Directors within such period of

60 calendar days [with a written report made and published as

described by this paragraph].

NSCC Rule 22 Proposed Change (Option B – No Exceptions)

RULE 22. --SUSPENSION OF RULES--[NO EXCEPTIONS]

--The time fixed by these Rules, the Procedures or any regulations