Self-Regulatory Organizations; The Depository Trust Company; Notice of Filing of Advance Notice To Address and Update Practices and Policies With…

Self-Regulatory Organizations; The Depository Trust Company; Notice of Filing of Advance Notice To Address and Update Practices and Policies With Respect to the Credit Risk Rating Matrix and Make Other Changes

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April 7, 2017.

Pursuant to Section 806(e)(1) of Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act entitled the Payment, Clearing, and Settlement Supervision Act of 2010 (“Clearing Supervision Act”) /1/ and Rule 19b-4(n)(1)(i) under the Securities Exchange Act of 1934 (“Act”), /2/ notice is hereby given that on March 22, 2017, The Depository Trust Company (“DTC”) filed with the Securities and Exchange Commission (“Commission”) the advance notice SR-DTC-2017-801 (“Advance Notice”) as described in Items I, II and III below, which Items have been prepared by DTC. /3/ The Commission is publishing this notice to solicit comments on the Advance Notice from interested persons.

FOOTNOTE 1 12 U.S.C. 5465(e)(1). END FOOTNOTE

FOOTNOTE 2 17 CFR 240.19b-4(n)(1)(i). END FOOTNOTE

FOOTNOTE 3 On March 22, 2017, DTC filed this Advance Notice as a proposed rule change (SR-DTC-2017-002) with the Commission pursuant to Section 19(b)(1) of the Act, 15 U.S.C. 78s(b)(1), and Rule 19b-4, 17 CFR 240.19b-4. A copy of the proposed rule change is available at http://www.dtcc.com/legal/sec-rule-filings.aspx. END FOOTNOTE

I. Clearing Agency’s Statement of the Terms of Substance of the Advance Notice

This Advance Notice consists of proposed modifications to DTC’s Rules, By-Laws and Organization Certificate (“Rules”). /4/ The proposed rule change would amend Rules 1 and 2 in order to (i) address and update DTC’s practices and policies with respect to the existing matrix (hereinafter referred to as the “Credit Risk Rating Matrix” or “CRRM”), which was, as described in an earlier DTC rule filing, /5/ developed by DTC to assign a credit rating to certain Participants (“CRRM-Rated Participants”) by evaluating the risks posed by CRRM-Rated Participants to DTC and its Participants from providing services to these CRRM-Rated Participants and (ii) make other amendments to the Rules to provide more transparency and clarity regarding DTC’s current ongoing membership monitoring process.

FOOTNOTE 4 Capitalized terms not defined herein are defined in the Rules, available at www.dtcc.com/ [approx.] /media/Files/Downloads/legal/rules/dtc_rules.pdf. END FOOTNOTE

FOOTNOTE 5 See Securities Exchange Act Release No. 53655 (April 14, 2006), 71 FR 20428 (April 20, 2006) (SR-DTC-2006-03) (order of the Commission) approving a proposed rule change (“2006 Rule Change”) of DTC to amend the criteria used by DTC to place Participants on surveillance status, including, but not limited to DTC’s application of the CRRM and the placement of lower rated CRRM-Rated Participants on an internal list in order to be monitored more closely (“Watch List“). END FOOTNOTE

II. Clearing Agency’s Statement of the Purpose of, and Statutory Basis for, the Advance Notice

In its filing with the Commission, the clearing agency included statements concerning the purpose of and basis for the Advance Notice and discussed any comments it received on the Advance Notice. The text of these statements may be examined at the places specified in Item IV below. The clearing agency has prepared summaries, set forth in sections A and B below, of the most significant aspects of such statements.

(A) Clearing Agency’s Statement on Comments on the Advance Notice Received From Members, Participants, or Others

Written comments relating to this proposal have not been solicited or received. DTC will notify the Commission of any written comments received by DTC.

(B) Advance Notice Filed Pursuant to Section 806(e) of the Payment, Clearing and Settlement Supervision Act

Nature of the Proposed Change

The proposed rule change would amend Rules 1 and 2 in order to (i) address and update DTC’s practices and policies with respect to the CRRM and (ii) provide more transparency and clarity regarding DTC’s current membership monitoring process. In this regard, the proposed rule change would (i) add proposed definitions for the terms “Credit Risk Rating Matrix” and “Watch List” to Rule 1 (Definitions), as discussed below and (ii) amend Rule 2 (Participants and Pledgees) to (A) clarify a provision in Section 1 relating to the types of information a Participant must provide to DTC upon DTC’s request for the Participant to demonstrate its satisfactory financial condition and operational capability, including its risk management practices with respect to services of DTC utilized by the Participant for another Person and (B) add a new Section 10 to include provisions relating to the monitoring, surveillance and review of Participants, including, but not limited to, the application of the CRRM and proposed enhancements to the CRRM, as further discussed below.

(i) Background

DTC occupies an important role in the securities settlement system by, among other things, providing services for the settlement of book-entry transfer and pledge of interests in eligible deposited securities and net funds settlement, in connection with which Participants may incur net funds settlement obligations to DTC. DTC uses the CRRM, the Watch List and the enhanced surveillance to manage and monitor default risks of Participants on an ongoing basis, as discussed below. The level and frequency of such monitoring for a Participant is determined by the Participant’s risk of default as assessed by DTC. Participants that are deemed by DTC to pose a heightened risk to DTC and its Participants are subject to closer and more frequent monitoring.

Existing Credit Risk Rating Matrix

Pursuant to the 2006 Rule Change, all Participants that are either U.S. broker-dealers or U.S. banks are assigned a rating generated solely based on quantitative factors by entering financial data of those Participants into an internally generated credit rating matrix, i.e., the CRRM. /6/ All other types of Participants are monitored by credit risk staff using financial criteria deemed relevant by DTC but would not be assigned a rating by the CRRM. /7/

FOOTNOTE 6 See 2006 Rule Change, SR-DTC-2006-03, 71 FR 20428, which explained that the ratings assigned by the CRRM were generated using financial data extracted from standard regulatory reports of U.S. broker-dealers and banks. A small number of U.S. banks which submitted standard regulatory reports were not assigned a rating because they did not take deposits or make loans, and therefore the regulatory reports of these banks did not contain information on asset quality and/or liquidity, which was a data component used in the CRRM. Id. However, the 2006 Rule Change provided DTC with discretion to continue to “evaluate the matrix methodology and its effectiveness and make such changes as it deems prudent and practicable within such time frames as it determines to be appropriate.” Id. DTC has continued to evaluate the CRRM and has determined that the CRRM is the most effective method available to it to evaluate the default risk presented by any U.S. bank that submits regulatory reports, including a bank whose reports exclude certain data components as mentioned above. Accordingly, DTC applies the CRRM to assign ratings to any U.S. bank that submits regulatory reports, including those that were not covered by the CRRM in 2006, as reflected in the proposed rule change. END FOOTNOTE

FOOTNOTE 7 In the 2006 Rule Change, DTC noted that these Participants would be monitored by credit risk staff by reviewing similar criteria as those reviewed for Participants included on the matrix but such review would occur outside of the matrix process. Id. END FOOTNOTE

The 2006 Rule Change explained that credit risk staff could downgrade a particular Participant’s credit rating based on various qualitative factors. An example of such qualitative factors might be that the Participant in question received a qualified audit opinion on its annual audit. DTC noted in the 2006 Rule Change that in order to protect DTC and its other Participants, it was important that credit risk staff maintain the discretion to downgrade a Participant’s credit rating on the CRRM and thus subject the Participant to closer monitoring.

The current CRRM is comprised of two credit rating models–one for the U.S. broker-dealers and one for the U.S. banks–and generates credit ratings for the relevant Participants based on a 7-point rating system, with “1” being the strongest credit rating and “7” being the weakest credit rating.

Over time, the current CRRM has not kept pace with DTC’s evolving Participant membership base and heightened expectations from regulators and stakeholders for robustness of financial models. Specifically, the current CRRM only generates credit ratings for those Participants that are U.S. banks or U.S. broker-dealers that file standard reports with their regulators, which currently comprise 80% of Participants; foreign banks and trust companies currently account for 5% of Participants. /8/ The number of Participants that are foreign banks or trust companies increased from 12 in 2012 to 13 in 2017, and is expected to continue to grow over the coming years. Foreign banks and trust companies are typically large global financial institutions that have complex businesses and conduct a high volume of activities. Although foreign banks and trust companies are not currently rated by the CRRM, they are monitored by DTC’s credit risk staff using financial criteria deemed relevant by DTC and can be placed on the Watch List if they experience a financial change that presents risk to DTC. Given the increase in the number of foreign bank Participants in recent years, there is a need to formalize DTC’s credit risk evaluation process of the foreign bank or trust company Participants by assigning credit ratings to them in order to better facilitate the comparability of credit risks among Participants. /9/

FOOTNOTE 8 As of March 16, 2017, there are 251 Participants, of which 50 (or 20%) are U.S. banks, 151 (or 60%) are U.S. broker-dealers and 13 (or 5%) are foreign banks or trust companies. END FOOTNOTE

–This is a summary of a Federal Register article originally published on the page number listed below–

Citation: “82 FR 17901”

Document Number: “Release No. 34-80394; File No. SR-DTC-2017-801”

Federal Register Page Number: “17901”

“Notices”