SECURITIES AND EXCHANGE COMMISSION

     17 CFR Part 240

     [Release No. 34-39456; File No. S7-32-97]

     RIN 3235-AH29

     Net Capital Rule

     AGENCY:   Securities and Exchange Commission

     ACTION:   Concept Release; Request for Comments.

     SUMMARY:  The Securities and Exchange Commission is continuing its study of

     its approach to determining net capital requirements for broker-dealers. 

     As part of its study, the Commission is considering the extent to which

     statistical models should be used in setting the capital requirements for a

     broker-dealer's proprietary positions.  Accordingly, the Commission is

     posing a number of questions on this subject as well as soliciting views on

     other possible alternatives for establishing net capital requirements.

     DATES:  Comments must be received on or before [insert date 90 days after

     date of publication in the Federal Register].

     ADDRESSES:  Interested persons should submit three copies of their written

     data, views, and opinions to Jonathan G. Katz, Secretary, Securities and

     Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 

     Comments also may be submitted electronically at the following E-mail

     address: rule-comments@sec.gov.  Comment letters should refer to File No.

     S7-32-97; this file number should be included on the subject line if E-mail

     is used.  All submissions will be available for public inspection and

     copying at the Commission's Public Reference Room, 450 Fifth Street, N.W.,

     Washington, D.C. 20549.  Electronically submitted comment letters will be

     posted on the Commission's Internet web site (http://www.sec.gov).

     FOR FURTHER INFORMATION CONTACT:  Michael A. Macchiaroli, Associate







                              ======END OF PAGE 2======

     Director, at 202/942-0132; Peter R. Geraghty, Assistant Director, at

     202/942-0177; Thomas K. McGowan, Special Counsel, at 202/942-4886; Marc J.

     Hertzberg, Attorney, at 202/942-0146; or Gary Gregson, Statistician, at

     202/942-4156, Division of Market Regulation, Securities and Exchange

     Commission, 450 Fifth Street, N.W., Mail Stop 2-2, Washington, D.C. 20549.

     SUPPLEMENTARY INFORMATION:

     I.   Introduction

          As part of a comprehensive review of the net capital rule, Rule 15c3-1

     (17 CFR 240.15c3-1) (the "net capital rule" or the "Rule"), the Securities

     and Exchange Commission ("Commission") is publishing this release to

     solicit comment on how the net capital rule could be modified to

     incorporate modern risk management techniques as to a broker-dealer's

     proprietary positions and to reflect the continuing evolution of the

     securities markets.  More specifically, the Commission seeks comment on how

     the existing haircut structure could be modified and whether the net

     capital rule should be amended to allow firms to use statistical models to

     calculate net capital requirements.

     A.   The Current Net Capital Rule

          The Commission adopted the net capital rule in substantially its

     current form in 1975.  The Rule requires every broker-dealer to maintain

     specified minimum levels of liquid assets, or net capital.  The Rule

     requires broker-dealers to maintain sufficient liquid assets in order to

     enable those firms that fall below the minimum net capital requirements to

     liquidate in an orderly fashion.  The Rule is designed to protect the

     customers of a broker-dealer from losses upon the broker-dealer's failure. 

     The Rule requires different minimum levels of capital based upon the nature







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     of the firm's business and whether a broker-dealer handles customer funds

     or securities.  

          In calculating the capital requirement, the Rule requires a broker-

     dealer to deduct from its net worth certain percentages, known as haircuts,

     of the value of the securities and commodities positions in the firm's

     portfolio.  The applicable percentage haircut is designed to provide

     protection from the market risk, credit risk, and other risks inherent in

     particular positions.  Discounting the value of a broker-dealer's

     proprietary positions provides a capital cushion in case the portfolio

     value of the broker-dealer's positions decline.  

          The Rule requires a broker-dealer to compute its haircuts by

     multiplying the market value of its securities positions by prescribed

     percentages.  For example, a broker-dealer's haircut for equity securities

     is equal to 15 percent of the market value of the greater of the long or

     short equity position plus 15 percent of the market value of the lesser

     position, but only to the extent this position exceeds 25 percent of the

     greater position.<(1)>  In contrast to the uniform haircut for equity

     securities, the haircuts for several types of interest rate sensitive

     securities, such as government securities, are directly related to the time

     remaining until the particular security matures.  The Rule uses a sliding

                              

          <(1)>     For  example, in  the  case where  a  firm has  a  long
                    position of  $100,000 in equity securities  and a short
                    position of $50,000  in equity securities, that  firm's
                    haircut for equity securities would be:

                         1.   Long Position: $100,000 x 15% = $15,000
                         2.   Short Position:  $50,000  - $25,000  (25%  of
                              long position) x 15% = $3,750
                         3.   Total haircut for equity  securities: $15,000
                              + $3,750 = $18,750.







                              ======END OF PAGE 4======

     scale of haircut percentages with these securities because changes in

     interest rates will usually have a greater impact on the price of

     securities with longer remaining maturities compared to those securities

     with shorter remaining maturities.  For example, there is no haircut on

     government securities with less than three months remaining maturity, but

     there is a six percent haircut on government securities with 25 years or

     more remaining maturity.  

          The Commission believes the Rule has worked well over the years.  The

     Commission and the self-regulatory organizations ("SROs") have generally

     been able to identify at early stages broker-dealers that are experiencing

     financial problems and to supervise self-liquidations of failing securities

     firms.  This early regulatory intervention has helped to avoid customer

     losses and the need for formal proceedings under the Securities Investor

     Protection Act of 1970.

     B.   Prior Relevant Actions

          Since 1993, the Commission has undertaken a number of initiatives to

     better understand how securities firms manage market and credit risk and to

     evaluate whether the firms' risk management techniques could be

     incorporated into the net capital rule.  This section reviews four of the

     Commission's initiatives as well as recent rules addressing capital

     requirements for banks adopted by the Board of Governors of the Federal

     Reserve System, the Office of the Comptroller of the Currency, and the

     Federal Deposit Insurance Corporation (collectively, the "U.S. Banking

     Agencies").     

          1.   1993 Concept Release

          In May 1993, the Commission began a comprehensive review of the Rule







                              ======END OF PAGE 5======

     by issuing a concept release soliciting comment on alternative methods for

     computing haircuts on derivative financial instruments ("Concept

     Release").<(2)>  Although the Concept Release's focus was on

     derivative instruments, the Commission intended to commence a dialogue with

     the securities industry regarding how the Rule could better reflect the

     market and credit risks inherent in a broker-dealer's proprietary

     securities portfolio.  At that time, the Commission envisioned a multi-step

     revision of the net capital rule that would substantially change how

     broker-dealers calculate the market and credit risk haircuts arising from

     their proprietary positions.  

          2.   Derivatives Policy Group

          The Derivatives Policy Group ("DPG"), consisting of the six U.S.

     firms<(3)> most active in the over-the-counter ("OTC") derivatives

     market, was formed at the Commission's request to address the public policy

     issues arising from the activities of unregistered affiliates of registered

     broker-dealers and registered futures commission merchants.  In March 1995, 

     after discussions with the Commission, the DPG published its Framework for

     Voluntary Oversight ("Framework") under which the members of the DPG agreed

     to report voluntarily to the Commission on their activities in the OTC

     derivatives market.<(4)>  The Framework provides for the use of
                              

          <(2)>     Securities Exchange  Act Rel. No. 32256  (May 4, 1993),
                    58 FR 27486 (May 10, 1993).

          <(3)>     The six firms in  the DPG are CS First  Boston, Goldman
                    Sachs, Morgan Stanley, Merrill Lynch, Salomon Brothers,
                    and Lehman Brothers.

          <(4)>     Framework  For  Voluntary  Oversight,  A  Framework For
                    Voluntary Oversight Of  The OTC Derivatives  Activities
                    Of Securities Firm Affiliates To Promote Confidence And
                                                             (continued...)







                              ======END OF PAGE 6======

     proprietary statistical models to measure capital at risk due to the firms'

     OTC derivatives activities; however, the Framework was not intended to be

     used as a method for calculating minimum capital standards for the DPG

     firms.  

          For purposes of using models to measure capital at risk, the DPG

     defines risk of loss, or "capital at risk," to be "the maximum loss

     expected to be exceeded with a probability of one percent over a two-week

     holding period."<(5)>  The Framework covers several products,

     including: interest rate, currency, equity, and commodity swaps; OTC

     options (including caps, floors, and collars); and currency forwards (i.e.,

     currency transactions of more than a two-day duration, except that firms

     may elect to include only currency transactions of 14 days or more of

     duration).  The Framework provides that each firm's model must capture all

     material sources of market risk that might impact the value of the firm's

     positions, including nine specific material sources of risk, or core risk

     factors, based on interest rate shocks, changes in equity values, and

     changes in exchange rates.<(6)>
                              

          <(4)>(...continued)
                    Stability  In  Financial  Markets,  Derivatives  Policy
                    Group (March 1995). 

          <(5)>     Id. at 28.

          <(6)>     Specifically,  the  core   risk  factors  include:  (1)
                    parallel yield  curve shifts, (2) changes  in steepness
                    of  yield  curves,  (3)  parallel  yield  curve  shifts
                    combined with changes in steepness of yield curves, (4)
                    changes in yield volatilities, (5) changes in the value
                    of   equity  indices,  (6)   changes  in  equity  index
                    volatilities,  (7)   changes  in   the  value   of  key
                    currencies (relative  to the U.S.  dollar), (8) changes
                    in foreign exchange rate  volatilities, and (9) changes
                    in  swap spreads  in at  least the  G-7 countries  plus
                    Switzerland.







                              ======END OF PAGE 7======

          Each DPG firm agreed to calculate capital at risk under two scenarios. 

     Under the first scenario, each firm would independently determine the size

     of the shocks used to calculate its capital at risk.  Under the second

     scenario, each firm would calculate its capital at risk due to certain

     Commission specified, hypothetical large shocks to the core risk factors. 

     The purposes of preparing a second set of capital at risk data are to

     assist the Commission in comparing volatility among the firms' portfolios

     and to evaluate the usefulness of the firms' models in measuring market

     risk during times of unusual market stress.

          The Framework does not specify minimum correlations between securities

     that are to be used in the models.  The Framework states that there are

     many generally accepted methods for estimating historical or market-implied

     volatilities and correlations and, instead of utilizing predetermined

     correlation factors, the Framework provides that hedging would be permitted

     where contracts and instruments within the category exhibit an

     "ppropriately high degree of positive price correlation."  Thus, the degree

     to which firms would recognize positions as hedges was left to the

     individual discretion of each firm.  The Framework notes, however, that

     estimates of volatility and correlation may not be accurate during times of

     market stress.

          The Framework also sets forth common audit and verification procedures

     of the technical and performance characteristics of the models.  Under the

     Framework, the firms are responsible for making all computations necessary

     for purposes of assessing risk in relation to capital on a regular basis

     and to provide such computations on a current basis upon request.  Under

     the Framework, the inventory pricing and modelling procedures of firms are







                              ======END OF PAGE 8======

     to be reviewed at least annually by independent auditors or consultants. 

     The independent auditors or consultants provide reports summarizing the

     results of their reviews, and the firms provide the audit reports to the

     Commission.

          Under the Framework, the DPG firms have enhanced reporting

     requirements regarding their exposure to credit risk.  The information

     reported to the Commission falls primarily into two principal categories:

     credit concentration and portfolio credit quality.  Credit concentration in

     the portfolio is reported by separately identifying the top 20 net

     exposures on a counterparty-by-counterparty basis.  The credit quality of

     the portfolio is reported by aggregating for each counterparty the gross

     and net replacement value and net exposure of the firm.  Credit information

     also is categorized by credit rating, industry, and geographic location.

          The Framework established risk management guidelines that provide a

     comprehensive framework for the DPG firms to implement their business

     judgments as to the appropriate scope and level of their OTC derivatives

     activities.  The Framework provides that each firm's board of directors

     should adopt written guidelines addressing the scope of permitted

     activities, the acceptable levels of credit and market risk, and the

     structure and independence of the risk monitoring and risk management

     processes and related organizational checks and balances from the firm's

     trading operations.  Senior management should also implement independent

     risk measuring and risk monitoring processes to manage risk within the

     guidelines established by the board of directors.

          3.   Theoretical Options Pricing Models

          In February 1997, the Commission completed an important step in its







                              ======END OF PAGE 9======

     review of the net capital rule by amending the Rule to allow broker-dealers

     to use theoretical option pricing models to determine capital charges for

     listed equity, index, and currency options, and related positions that

     hedge these options.<(7)>  The amendment permits broker-dealers to use

     a model (other than a proprietary model) maintained and operated by a

     third-party source ("Third-Party Source") and approved by a designated

     examining authority ("DEA").<(8)>  The Third-Party Source is required

     to collect certain information on a daily basis concerning different

     options series.<(9)>  Using this information, the Third-Party Source

     measures the implied volatility for each option series and inputs to the

     model the resulting implied volatility for each option series.  For each

     option series, the model calculates theoretical prices at 10 equidistant

     valuation points using specified increases and decreases in the underlying

     instrument.

          After the model calculates the theoretical gain or loss valuations,

     the Third-Party Source provides the valuations to broker-dealers.  Broker-

     dealers download this information into a spreadsheet from which the broker-

                              

          <(7)>     Securities Exchange  Act Rel.  No.  38248 (February  6,
                    1997), 62 FR 6474 (February 12, 1997).

          <(8)>     Currently, the  model  maintained and  operated by  The
                    Options   Clearing  Corporation  ("OCC")  is  the  only
                    approved  model.    OCC's  model  has  been temporarily
                    approved until September 1, 1999.

          <(9)>     Under the rule  amendment, the Third-Party Source  will
                    collect the  following  information: (1)  the  dividend
                    streams  for  the underlying  securities,  (2) interest
                    rates (either  the current call rate  or the Eurodollar
                    rate  for  the  maturity  date  which  approximates the
                    expiration date of the option), (3) days to expiration,
                    and (4) closing  underlying security and  option prices
                    from various vendors.







                              ======END OF PAGE 10======

     dealer calculates the profit or loss for each of its proprietary and

     market-maker options positions.  The greatest loss at any one valuation

     point is the haircut.  This amendment to the Rule was a milestone because

     it was the first time the Commission allowed modelling techniques for

     regulatory capital purposes.

          4.   OTC Derivatives Dealers

          Simultaneously with this release, the Commission is proposing a new

     limited regulatory regime for OTC derivatives dealers.<(10)>  Under

     this regime, OTC derivatives dealers could register with the Commission and

     be subject to specialized net capital requirements.  The Commission is

     considering requiring OTC derivatives dealers registered under this

     framework to maintain tentative net capital of not less than $100 million

     and net capital of not less than $20 million.  As part of this proposal,

     the Commission is contemplating giving OTC derivatives dealers the option

     of taking either the existing securities haircuts or haircuts based on

     statistical models.  OTC derivatives dealers electing to use models would

     have to calculate potential losses and specific capital charges for both

     market and credit risk.  These OTC derivatives dealers also would have to

     maintain models that meet certain minimum qualitative and quantitative

     requirements that are substantially similar to the requirements set forth

     in the U.S. Banking Agencies' rules.

          5.   U.S. Banking Agencies

          In August 1996, the U.S. Banking Agencies adopted rules incorporating

     into their bank capital requirements risk-based capital standards for

                              

          <(10)>    Securities  Exchange Act  Rel. No. 39454  (December 17,
                    1997).







                              ======END OF PAGE 11======

     market risk that cover debt and equity positions in the trading accounts of

     certain banks and bank holding companies and foreign exchange and commodity

     positions wherever held by the institutions.  The U.S. Banking Agencies'

     rules were designed to implement the Basle Committee on Banking

     Supervision's ("Basle Committee")<(11)> agreement on a model based

     approach to cover market risk.  These rules apply to any bank or bank

     holding company whose trading activity equals ten percent or more of its

     total assets, or whose trading activity equals $1 billion or more.  The

     U.S. Banking Agencies' final rules became effective January 1, 1997 and

     compliance will be mandatory by January 1, 1998.  Institutions that do not

     meet these minimum securities trading thresholds will not be subject to

     market risk capital requirements.

          The U.S. Banking Agencies' rule amendments require affected banks or

     bank holding companies to adjust their risk-based capital ratio to reflect

     market risk by taking into account the general market risk and specific

     risk of debt and equity positions in their trading accounts.<(12)> 

     These institutions also must take into account the general market risk

     associated with their foreign exchange and commodity positions, wherever
                              

          <(11)>    The  Governors  of the  G-10 countries  established the
                    Basle  Committee on  Banking  Supervision  in  1974  to
                    provide  a forum for  ongoing cooperation  among member
                    countries on banking supervisory matters.

          <(12)>    The  Banking Agencies  defined general  market risk  as
                    changes in the market  value of on-balance sheet assets
                    and liabilities  and off-balance sheet  items resulting
                    from  broad market  movements, such  as changes  in the
                    general level of interest rates, equity prices, foreign
                    exchange rates, and commodity prices.  Specific risk is
                    defined  by  the Banking  Agencies  as  changes in  the
                    market  value of  individual positions  due to  factors
                    other than  broad market  movements  and includes  such
                    risks as the credit risk of an issuer.







                              ======END OF PAGE 12======

     located.  The capital charge for market risk must be calculated by using

     the institution's own internal model.  

     II.  Alternatives to the Current Financial Responsibility Regime

          The Commission is soliciting comment on possible alternative methods

     for calculating credit and market risk capital requirements for broker-

     dealers.  This release will help the Commission evaluate different ways the

     net capital rule could be modified to accommodate changes in the securities

     business since the current uniform net capital rule was adopted in 1975,

     with a particular emphasis on incorporating modern risk management

     techniques.  In this regard, the Commission believes it can modernize the

     Rule by either amending the current haircut percentages or by allowing

     certain broker-dealers to use a model-based system to calculate appropriate

     capital charges for market risk.  This section discusses each of the

     alternative structures and lists relevant questions.

     A.   Modify Current Haircut Approach

          As discussed above, the Rule requires a broker-dealer to deduct from

     its net worth certain fixed percentages, or haircuts, of the value of its

     securities positions.  The present prescriptive haircut methodology has

     several advantages.  It requires an amount of capital which will be

     sufficient as a provision against losses, even for unusual events.  It is

     an objective, although conservative, measurement of risk in positions that

     can act as a tool to compare firms against one another.  Moreover, the

     current methodology enables examiners to determine readily whether a firm

     is properly calculating haircuts.  The examiner can review either the

     entire net capital calculation or just material portions of the firm's

     proprietary positions.







                              ======END OF PAGE 13======

          However, there are some weaknesses associated with determining capital

     charges based on fixed percentage haircuts.  For example, the current

     method of calculating net capital by deducting fixed percentages from the

     market value of securities can allow only limited types of hedges without

     becoming unreasonably complicated.  Accordingly, the net capital rule

     recognizes only certain specified hedging activities, and the Rule does not

     account for historical correlations between foreign securities and U.S.

     securities or between equity securities and debt securities.  By failing to

     recognize offsets from these correlations between and within asset classes,

     the fixed percentage haircut method may cause firms with large, diverse

     portfolios to reserve capital that actually overcompensates for market

     risk. 

          To eliminate weaknesses in the current haircut structure, the

     Commission could modernize the Rule by maintaining the current methodology

     but changing the haircut percentages and recognizing additional offsetting

     positions.  For example, the proposing release issued simultaneously with

     this concept release proposes amendments to the Rule that would treat

     haircuts on certain interest rate products as being part of a single

     portfolio, similar to the standard approach in the Basle Committee's

     Capital Accord.<(13)>  As proposed, the net capital rule would

     recognize hedges among government securities, investment grade

     nonconvertible debt securities (or corporate debt securities), pass-through

     mortgage backed securities, repurchase and reverse repurchase agreements,

     money market instruments, and futures and forward contracts on these debt

     instruments.  As a next step, the Commission could revise the current
                              

               Securities Exchange Act Rel. No. 39455 (December 17, 1997).







                              ======END OF PAGE 14======

     haircut percentages and develop methodology to account for more

     correlations and hedges among other types of securities.  

          The Commission solicits comment on the following topics.  It is not

     necessary, however, that comments be limited to the specific issues raised

     in this release.  Commenters are encouraged to submit statements with

     respect to any aspect of the current net capital rule that may be useful to

     the Commission.

          Question 1: Should the Commission retain the current haircut approach
          but revise the current percentages?  If so, which haircut percentages
          should be modified?  How should these percentages be modified?  What
          should be the objective basis for modified haircut percentages? 
          Please provide relevant data to support your response.

          Question 2: Do the current haircut percentages adequately account for
          the market risk, credit risk, and other risks inherent in a particular
          position?  

          Question 3: Do the current haircut percentages enable firms to reserve
          sufficient capital for times of market stress, including one day
          movements and movements over a period of time?  Please provide
          relevant data to support your response.

          Question 4: How can haircut percentages be further adjusted to account
          for correlations between and within asset classes?  Please provide
          relevant data to support your response.

          Question 5: How can the current haircut approach be modified to
          improve the treatment for specific types of securities, including
          foreign securities, collateralized mortgage obligations ("CMOs"), and
          over-the-counter options on interest-rate securities?  Please provide
          relevant data to support your response.

          Question 6: Should the Commission include security-specific models,
          other than the option pricing models, in the Rule?  If so, what forms
          should these models take and what types of minimum requirements should
          apply to the use of such models?

          Question 7: If the Commission includes other security-specific models
          in the Rule, what types of securities should be covered by such models
          (i.e., CMOs, over-the-counter options, or treasury securities)?

     B.   Model Based Approach

          1.   Generally







                              ======END OF PAGE 15======

          A number of broker-dealers, primarily those with large proprietary

     securities portfolios, have indicated to the Commission that they may be

     willing to incur the expenses associated with developing and using

     statistical models to calculate haircuts on their securities portfolios. 

     Under a model based net capital rule, in lieu of taking fixed percentage

     haircuts, a broker-dealer would use either an external or internal model as

     the basis for a market risk charge and take a separate charge, or charges,

     for other types of risk, such as credit risk and liquidity risk.  

          The Commission could allow firms to calculate market risk capital

     charges according to external models for specific types of securities that

     are similar to the options pricing models allowed under Appendix A to the

     Rule.  The benefit of an external model is that all firms would be

     utilizing the same model.  However, the Commission could have difficulty

     finding a third party (comparable to the Options Clearing Corporation for

     listed options) that would have access to all the data necessary to

     facilitate external security-specific models for securities other than

     options.

          With respect to internal models, the Commission would need to

     prescribe certain minimum quantitative and qualitative standards that a

     firm's model would have to meet prior to that firm using its internal model

     for regulatory capital purposes.  Currently, several large firms use value

     at risk ("VAR") models as part of their risk management system.  These

     firms typically utilize VAR modelling to analyze, control, and report the

     level of market risk from their trading activities.  Generally, VAR is an

     estimate of the maximum potential loss expected over a fixed time period at

     a certain probability level.  For example, a firm may use a VAR model with







                              ======END OF PAGE 16======

     a ten-day holding period and a 99 percentile criteria to calculate that its

     $100 million portfolio has a potential loss of $150,000.  In other words,

     the firm's VAR model has forecasted that with this portfolio the firm may

     lose more than $150,000 during a ten-day period only once every 100 ten-day

     periods.

          In practice, VAR models aggregate several components of price risk

     into a single quantitative measure of the potential for loss.  In addition,

     VAR is based on a number of underlying mathematical assumptions and firm

     specific inputs.  For example, VAR models typically assume normality and

     that future return distributions and correlations can be predicted by past

     returns.<(14)>

                              

          <(14)>    The Commission recognizes that  there is a wide variety
                    of  secondary  source information  discussing  both the
                    positive  and negative  aspects of  VAR.   See Philippe
                    Jorion,   Value  at   Risk:   The  New   Benchmark  for
                    Controlling Market  Risk (1996) (explaining how  to use
                    VAR to  manage market  risk);  JP Morgan,  RiskMetrics-
                    Technical   Document   (1994)  (providing   a  detailed
                    description   of  RiskMetrics,  which  is  JP  Morgan's
                    proprietary  statistical  model for  quantifying market
                    risk  in fixed  income  and  equity portfolios);  Tanya
                    Styblo Beder, VAR:  Seductive but Dangerous,  Financial
                    Analysts Journal, September-October 1995, at 12 (giving
                    an extensive  analysis of  the  different results  from
                    applying  three  common  VAR  methods  to  three  model
                    portfolios); Darrell Duffie and Jun Pan, An Overview of
                    Value at Risk, The Journal of Derivatives, Spring 1997,
                    at  7 (giving a broad  overview of VAR models); Darryll
                    Hendricks,  Evaluation  of  Value-at-Risk Models  Using
                    Historical  Data,  Federal  Reserve Bank  of  New  York
                    Economic  Policy Review,  April 1996, at  39 (examining
                    twelve   approaches   to  value-at-risk   modelling  on
                    portfolios  that   do  not  include  options  or  other
                    securities   with   non-linear  pricing);   and  Robert
                    Litterman,  Hot Spots  and Hedges,  Goldman Sachs  Risk
                    Management Series (1996) (giving a detailed analysis on
                    portfolio  risk management,  including how  to identify
                    the primary  sources of  risk and  how to  reduce these
                    risks).   







                              ======END OF PAGE 17======

          Given the increased use and acceptance of VAR as a risk management

     tool, the Commission believes that it warrants consideration as a method of

     computing net capital requirements for broker-dealers.  However, while VAR

     can be used to manage market risk, broker-dealers that rely solely on VAR

     for risk management may not have a comprehensive risk management program. 

     VAR models, unlike haircuts, do not typically account for those risks other

     than market risk, such as credit risk, liquidity risk, and operational

     risk.  Broker-dealers that utilize VAR models should therefore use

     additional techniques to manage those risks.  

          Further, while VAR may be useful in helping broker-dealers project

     possible daily trading losses under "normal" market conditions, VAR may not

     help firms measure the losses that fall outside of normal conditions during

     times of market stress.  For example, VAR models may not capture possible

     steep market declines because these models typically measure exposure at

     the first percentile (or the fifth percentile) and steep market declines

     are, by definition, below the first percentile.  In addition, the most

     common VAR approaches may pose a problem for those portfolios that utilize

     options or other products with non-linear payoffs.<(15)>  

          The purpose of the Commission's net capital rule is to protect markets

     from broker-dealer failures and to enable those firms that fall below the

     minimum net capital requirements to liquidate in an orderly fashion without

     the need for a formal proceeding or financial assistance from the

                              

          <(15)>    See Autoro  Estrella  et al.,  Options Positions:  Risk
                    Measurement and Capital  Requirements, Federal  Reserve
                    Bank of New York  Research Paper number 9415, September
                    1994  (evaluating  different methods  of  measuring the
                    market  risk  of  options  and  analyzing  the  capital
                    treatment of the market and credit risk of options).  







                              ======END OF PAGE 18======

     Securities Investor Protection Corporation.  The Commission believes that

     market risk charges must adequately protect a broker-dealer during severe

     market stress, whether that stress occurs on only one day or over a period

     of several days, such as the drop in equity prices during the October 1987

     market break or the Mexican debt crisis in 1994.  Because VAR models do not

     typically reserve capital for severe market declines, it may be necessary

     to impose additional safeguards to account for possible losses or decreases

     in liquidity during times of stress.  This may include the use of a

     multiplier or the use of stress tests that firms could apply to their

     portfolios.  A multiplier could be used to account for the other risks in a

     firm's portfolio that are not captured by VAR models, such as operational,

     settlement, or legal risk.  On the other hand, stress testing could provide

     a more complete picture of the portfolio's sensitivity to changing market

     conditions and a more accurate representation of capital needs than a

     simple multiplier.  

          The primary advantage of incorporating models into the net capital

     rule is that a firm would be able to recognize, to a greater extent, the

     correlations and hedges in its securities portfolio and have a

     comparatively smaller capital charge for market risk.  Accordingly, if the

     Rule is amended to permit models to be used to calculate market risk in

     lieu of taking the haircuts currently imposed by the rule, the Commission

     solicits comment on how the Rule may be modified to include separate

     capital requirements to cover sources of risk other than market risk. 

     Other issues associated with incorporating models into the Rule are the

     need for management controls necessary to ensure that the firm is

     collecting accurate and comprehensive information on its proprietary







                              ======END OF PAGE 19======

     positions and the effectiveness of those controls to monitor the risk

     assumed by the firm.  

          2.   Two Tiered Approach

          One way that the Commission could incorporate models into the net

     capital rule would be to have different net capital requirements based on

     certain standards ("Two Tiered Approach").  Under the Two Tiered Approach,

     broker-dealers meeting certain minimum threshold levels would be required

     to use models to determine capital compliance.  For example, broker-dealers

     with net capital exceeding a certain amount and currently using models for

     in-house risk management purposes could use models to determine their

     market risk capital charge under prescribed circumstances.  Firms with less

     than the prescribed level of net capital and those firms with net capital

     greater than the prescribed level but not using models for risk management

     could be required to continue to follow the current Rule's haircut

     methodology.  These haircut percentages could either be the same as the

     current percentages or modified versions.

          A Two Tiered Approach potentially has two primary benefits.  First,

     the Commission could structure a Two Tiered Approach to limit the use of

     models to those firms that currently use sophisticated models such as VAR,

     thereby not requiring other firms to incur the cost of implementing such

     models.  Second, the Commission could design a Two Tiered Approach that

     establishes appropriate limits on which firms can utilize models to

     determine capital compliance.  

          A potential weakness of a Two Tiered Approach is that it could inhibit

     competition between large and small firms because models may give large

     firms more flexibility in determining their net capital requirements. 







                              ======END OF PAGE 20======

     However, this advantage could be small if smaller firms did not have to

     incur the start-up and maintenance costs associated with models and the

     risk management infrastructure to support their use.  Additionally, a Two

     Tiered Approach could still allow firms with simple portfolios to easily

     calculate the applicable haircuts on their portfolios.  

          3.   Base Approach with Pre-Commitment Feature

          Another option for incorporating models into the Rule could be to

     combine the current haircut methodology using fixed percentage haircuts

     with a model-based approach (the "Base Approach").  The Base Approach could

     combine the strengths of both haircuts and models and at the same time

     possibly address the weaknesses of each.  The Base Approach would include

     three primary components.  First, broker-dealers could be required to

     maintain a certain minimum base level of net capital for each of their

     business activities, similar to the minimum requirements under the current

     rule.  For example, higher capital levels could apply to broker-dealers

     that hold customer funds and securities as opposed to those firms that only

     introduce customer accounts to clearing firms.  Second, broker-dealers

     could take a fixed percentage haircut for each security in their portfolio. 

     This haircut would be similar to the haircut requirements under the current

     net capital rule; however, the size of the haircut would be lower due to

     the additional charge for market risk obtained from the third component.  

          The third component of the Base Approach could consist of a capital

     charge based on the firm's model and include a pre-commitment feature that

     could require a broker-dealer to take capital charges based on the realized

     performance of its models ("pre-commitment feature").  The pre-commitment

     feature could have two steps.  First, at the start of a pre-determined time







                              ======END OF PAGE 21======

     period (i.e., one month or one quarter), a broker-dealer could be required

     to represent that its losses, as computed by its model, would be within

     certain parameters over the fixed time period.  Second, at the conclusion

     of each fixed time period, the firm's minimum net capital level could

     increase by an amount equal to the difference between the actual portfolio

     gains and losses and those projected based on its model.  These additional

     capital contributions would be required because differences between the

     actual results and those projected by the model could indicate that the

     firm's models may not be accurately assessing the risk of the firm's

     portfolio.     By incorporating haircuts and models into the Base Approach,

     the inherent strengths and weaknesses of each could potentially offset each

     other.  Additionally, the Base Approach may be a viable capital standard

     for firms with diverse portfolios and those that use more sophisticated

     methods of risk management.  The pre-commitment feature would create

     additional incentives for broker-dealers to manage risk effectively.  On

     the other hand, a Base Approach may be too complicated for firms to apply. 

     In balance, however, the Base Approach could potentially provide firms with

     flexibility in developing models and control systems, encourage the

     development of accurate forecasts, and still ensure that firms reserve

     sufficient amounts of net capital.

          4.   Comments on the Potential Use of Models

          The Commission solicits comment on the following specific topics,

     including the appropriateness of using proprietary models generally and the

     recent initiatives of both the DPG and the U.S. Banking Agencies.  

               a.   Models as a means to determine broker-dealer regulatory
                    capital

          Question 8: Should the Commission permit the use of models to







                              ======END OF PAGE 22======

          calculate regulatory capital for registered broker-dealers?  If yes,
          please explain whether the Commission should allow firms to utilize
          internal models or whether the Commission should establish an external
          model approach similar to the treatment of options under Appendix A to
          the Rule.

          Question 9: If the Commission permits the use of internal models,
          should the model conform to certain objective criteria, or should they
          be subjective?  When could the assumptions upon which models rest be
          challenged?  Should internal or external auditors periodically review
          and approve the model and its application?  If so, how much should
          regulators rely on auditors' application of models?  Could the self-
          regulatory organizations adequately surveil and examine for net
          capital compliance utilizing models?

          Question 10: Should the Commission impose limits on the types of firms
          that can use models?  Should there be certain additional minimum
          criteria a firm must satisfy in order to use a proprietary model? 
          Should firms that meet the minimum criteria for using models have the
          option of using an alternate standard approach (i.e., not using
          models) to calculate regulatory capital?  If so, what should that
          approach be?

          Question 11: Is VAR an appropriate method of using models as the basis
          for calculating capital requirements for broker-dealers?  The
          Commission understands there are several approaches to calculating VAR
          that are currently used by firms (e.g., Monte Carlo,
          variance/covariance, and historical simulation approaches).  Given the
          various methods, the Commission seeks comment on whether minimum
          criteria should be established for models used for regulatory capital
          purposes?  If not, how can the Commission provide for the ability to
          compare levels of risks among firms or understand the significance of
          levels of risk reported by firms when determining their net capital
          requirements?

          Question 12: The Commission believes that any approach that uses
          models for setting regulatory capital requirements should result in
          broadly consistent results for firms with similar portfolios.  Can
          consistent results for similar portfolios be obtained without the
          Commission requiring firms to use a standard model?  How else can
          consistency of capital standards among firms with similar portfolios
          be achieved?  

          Question 13: Some firms use different types of statistical models to
          measure risk from different types of businesses, such as fixed income
          securities and foreign equities.  Should the Commission permit firms
          to use more than one model to calculate regulatory capital?  If yes,
          would the inefficiencies in each model get accentuated or mitigated
          when the results of the different models are aggregated?

          Question 14: Should the Commission allow the use of models gradually
          (i.e., first allow models for debt securities, then allow models for







                              ======END OF PAGE 23======

          equity securities and other securities)?

          Question 15: What will be the costs of implementing models?  How do
          the costs of implementing models compare to the current costs of
          computing net capital?  At what level would it be economical for firms
          to try to use models?  How do the start-up costs of implementing
          models compare to the ongoing costs of managing models incurred by
          firms that currently use models?  How does the availability (or
          anticipated future development) of software packages and databases
          impact cost estimates?  Will the costs of implementing models be a
          barrier to firms not currently using models?  Please provide relevant
          data to support your response.

          Question 16: Will firms not currently using models be at a competitive
          disadvantage to those firms that currently use models?  Please provide
          relevant data to support your response.

          Question 17: If the Commission permits the use of models, what
          additional reporting or recordkeeping requirements would the
          Commission need to impose on broker-dealers using models?  Should
          firms using models have to file additional reports with the Commission
          or their DEA?  Should the Commission amend its books and records rules
          to require firms using models to maintain certain books and records
          that they are currently not required to maintain?  How can the
          Commission ensure that it has access to information regarding a firm's
          models that is not maintained by the broker-dealer (i.e., information
          maintained at an unregistered entity)?  What measure could the
          Commission require to ensure broker-dealers would not be able to
          modify the model (or data inputs) to avoid falling out of net capital
          compliance?  Should the Commission require models to be stored with
          third-parties subject to escrow arrangements?

          Question 18: If the Commission permits the use of models, should firms
          using models be subject to modified forms of Commission and DEA
          inspections?  Should the models themselves be subject to review and
          approval by the Commission or DEA?

               b.  Abnormal Market Conditions

          Question 19: Because the purpose of VAR is to provide an estimate of
          losses over a short period under normal conditions, is it possible for
          VAR models to ensure an adequate capital cushion during unusual market
          stress or structural shifts in the economy given the nature, size, and
          liquidity of a broker-dealer's portfolio?  Given the complexity of
          models, could an accurate and rapid assessment be made of a firm's
          true financial condition?  Please provide relevant data to support
          your response.

          Question 20: Would models be more effective during times of severe
          market fluctuations if stress testing were required?  Should the
          Commission specify what stress tests should be used by the firms? 
          Please provide relevant data to support your response.







                              ======END OF PAGE 24======

          Question 21: If stress testing were required, should a firm be
          required to use the same parameters when conducting stress testing on
          each of its business units (i.e., apply the same levels and stress the
          same movements in the relevant securities, markets, and indexes)?

          Question 22: If stress testing were required, should a firm be
          required to test its models based on a predetermined number of
          volatile days of market movements (i.e., models would have to be
          stress tested based on the 100 most volatile days of market movements
          during the last ten years)?

          Question 23: Should the results of stress testing impact the
          calculation of a firm's capital requirements (i.e., through the use of
          some type of multiplication factor)?  Please provide relevant data to
          support your response.

          Question 24: Does the use of a minimum multiplier, as endorsed in the
          Basle Standard and by the U.S. Banking Agencies, adequately address
          risks arising from severe market movements?  Please provide relevant
          data to support your response.

          Question 25: Should back-testing (i.e., ex post comparisons between
          model results and actual performance) be required and, if so, to what
          extent?  Should back-testing results be used to determine a multiplier
          for minimum capital amounts?  Could back-testing results be used to
          raise minimum capital levels for the firms?  

               c.  Qualitative and Quantitative Criteria for Models

          Question 26: Will setting minimum qualitative and quantitative
          criteria prevent a firm from adjusting its model to encompass changing
          market conditions, the firm's structure, or the firm's business lines?

          Question 27: Two important components of models are the length of time
          over which market risk is to be measured and the confidence level at
          which market risk is measured.  The definition of "capital at risk" as
          used in the DPG Framework is the maximum loss expected to be exceeded
          with a probability of one percent over a two-week period.  Is this
          definition appropriate for regulatory capital purposes?

          Question 28: What should be the minimum criteria for models, including
          pricing accuracy, correlations, netting factors, and observation
          periods?  Please provide relevant data to support your response.

          Question 29: Are the minimum standards for the use of models, the
          separate calculation of capital at risk due to shocks to the core risk
          factors, and the audit requirements used in the DPG Framework
          appropriate?  Please provide relevant data to support your response.

          Question 30: VAR models typically assume normality and that future
          return distributions and correlations will behave similar to the way
          they behaved in the past.  For these reasons, the Commission needs to







                              ======END OF PAGE 25======

          ensure that VAR models can withstand steep market declines.  Other
          than by specifying minimum qualitative and quantitative criteria, how
          can regulators assure themselves that the proprietary models used by
          the firms are adequate for capital purposes?

          Question 31: Should the Commission require that broker-dealers
          utilizing models manage these models from a risk management division
          that is separate from the firm's business divisions?

          Question 32:  Should the Commission require that broker-dealers
          utilizing models use the same model for both computing net capital and
          internal risk management purposes?

          Question 33: Currently, firms utilize a wide variety of risk
          management techniques.  Should the Commission mandate specific minimum
          risk management standards for firms that wish to use models?

          Question 34: Should the Commission require that firms using models
          manage risk on either a firm-wide, legal entity, or business basis?

               d.  Additional Risks

          Question 35: Usually, VAR models do not handle options products well
          because the returns on an options portfolio are not typically normally
          distributed.  How should the non-linear nature of options be
          adequately addressed?  For firms with substantial options positions,
          is a standard approach (similar to the Commission's amendments to
          Appendix A of the net capital rule) more appropriate?  Is the approach
          set forth in the Commission's recent amendments to Appendix A a viable
          alternative?

          Question 36: Models typically measure losses by assuming that assets
          can be sold at current market prices.  However, if a firm has a
          portfolio which includes illiquid assets, highly customized structured
          products (including, for example, some CMOs), or aged items, the
          Commission is particularly concerned that models may underestimate the
          true losses since these assets may have to be sold at a discount. 
          Given the importance of liquidity risk, the Commission solicits
          specific comment with respect to how this risk should be addressed if
          models are permitted for regulatory purposes.  

          Question 37: Is it possible to include a credit risk analysis in a
          model based methodology?  Please provide relevant data to support your
          response.

          Question 38: As mentioned above, models may not properly account for
          additional risks, including credit risk, liquidity risk, operational
          risk, settlement risk, and legal risk.  How should these additional
          risks be treated?  Can the Rule be modified to include separate
          capital requirements to cover these sources of risk?  Please provide
          relevant data to support your response.







                              ======END OF PAGE 26======

          Question 39: Is there an alternative to using a multiplier to account
          for operational risk, legal risk, and other risks that are difficult
          to quantify?  Is the use of insurance to cover these risks a viable
          option?  Please provide relevant data to support your response.

          Question 40: In order for a firm to calculate VAR effectively, data
          must be aggregated from all its departments worldwide.  Also, there is
          often incompatibility of trading and back-office accounting computer
          systems that operate from different regions of the world.  How can
          this problem of integration be adequately addressed?

               e.   OTC Derivatives Dealer

          Question 41: Should the Commission amend the Rule so that all broker-
          dealers are eligible to use the methodology for calculating market and
          credit risk as in proposed  Appendix F to the Rule?

          Question 42: What minimum capital requirements should the Commission
          require a broker-dealer to meet to be eligible to use proposed
          Appendix F?  Should the criteria be based on tentative net capital,
          net capital, or both?  Are the $100 million tentative net capital and
          $20 million net capital requirements appropriate?

          Question 43: Assuming that the Commission were to allow all broker-
          dealers to utilize Proposed Appendix F, what sections in Proposed
          Appendix F need to be modified for all broker-dealers?  Are the market
          risk and credit risk sections in Proposed Appendix F appropriate for
          all broker-dealers?  Are the qualitative and quantitative requirements
          for VAR models in Proposed Appendix F appropriate to VAR models used
          by non-OTC derivatives dealers? 

               f.    Two Tiered Approach

          Question 44: Is a Two Tiered Approach a viable alternative to the
          current net capital rule?  If so, what standards should the Commission
          utilize to determine which broker-dealers are required to utilize
          statistical models?  Should the tier limits be based on capital,
          amount of customer business, level of proprietary trading, or some
          other factor(s)?  Should these minimum net capital amounts be fixed
          dollar amounts or be based on financial ratios such as aggregate
          indebtedness or aggregate debit items as in the current rule?  Please
          provide relevant data to support your response.

          Question 45: Should the current haircut percentages be maintained?  If
          not, what modifications should be made to the current haircut
          percentages?  Please provide relevant data to support your response.

          Question 46: What will be the impact on competition among firms in
          different tiers?  In this regard, the Commission seeks comment on the
          effects of creating a two-tiered system from broker-dealers that do
          not currently use models in their risk management system and from
          broker-dealers that currently use models for risk management purposes







                              ======END OF PAGE 27======

          but either lack sufficient capital or sufficiently diverse securities
          portfolios to use models for net capital purposes.  
      
               g.   Base Approach with Pre-Commitment Feature  

          Question 47: Is the Base Approach a viable alternative to the current
          net capital rule?

          Question 48: Should the Base Approach only apply to firms that meet
          certain standards?  If so, what are the appropriate standards?  

          Question 49: What minimum capital requirements should the Commission
          establish for certain broker-dealer activities?  Should these minimum
          net capital amounts be fixed dollar amounts or based on financial
          ratios such as aggregate indebtedness or aggregate debit items as in
          the current rule?  Should the current minimum levels be retained?

          Question 50: What modifications should the Commission make to the
          current haircut percentages?  Please provide relevant data to support
          your response.

          Question 51: What should be the parameters for the pre-commitment
          feature?  Should firms be penalized for differences between actual
          results and the results as projected by VAR models?  If so, what
          criteria should be used to determine the additional capital
          requirements for these differences?

     III. Summary of Requests for Comment

          Following receipt and review of comments, the Commission will

     determine whether rulemaking or other action is appropriate.  Commenters

     are invited to discuss the broad range of concepts and approaches described

     in this release concerning the Commission's regulation of broker-dealers'

     net capital requirements.  In addition to responding to the specific

     questions presented in this release, the Commission encourages commenters

     to provide any information to supplement the information and assumptions

     contained herein regarding the current net capital rule, VAR models, and

     the other suggested alternatives.  The Commission also invites commenters

     to provide views and data as to the costs and benefits associated with the

     possible changes discussed above in comparison to the costs and benefits of

     the current net capital rule.  In order for the Commission to assess the







                              ======END OF PAGE 28======

     impact of changes to the Rule, comment is solicited, without limitation,

     from investors, broker-dealers, SROs, and other persons involved in the

     securities markets.  

     By the Commission.
                                        Jonathan G. Katz
                                        Secretary
     Dated: December 17, 1997