Margin, I Have to Have More Margin: The National Securities Clearing Corporation Proposes to Increase the Minimum Required Fund Deposit
On Monday, May 10, 2021, the U.S. Securities and Exchange Commission (“SEC”) issued a Notice that the National Securities Clearing Corporation (“NSCC”) filed a proposed rule change with the SEC to raise the amount of the Minimum Required Fund Deposit to be made and maintained by member firms using the NSCC. The Notice states that as a result of one of its regular reviews of the Minimum Required Fund Deposit, the NSCC determined the following:
There are circumstances where the current Minimum Required Fund Deposit amount is insufficient to manage NSCC’s risk in the event of an abrupt or sudden increase in a Member’s activity.
The Notice further states:
The Required Fund Deposit serves as each Member’s margin. The objective of a Member’s Required Fund Deposit is to mitigate potential losses to NSCC associated with liquidation of a Member’s portfolio in the event NSCC ceases to act for that Member (hereinafter referred to as a “default”).
The Notice then explains that the aggregate of all Member Required Fund Deposits can be drawn upon if the defaulting Member’s Required Fund Deposit is not adequate to satisfy losses experienced by NSCC in connection with the portfolio liquidation. The Minimum Required Fund Deposit is calculated using Procedure XV, a market risk assessment tool adopted by NSCC as part of its market risk management strategy designed to comply with SEC Rule 17 Ad-22(e)(4) under the Securities Exchange Act of 1934, as amended. Those market risks are identified as “credit risks” in the Rule.
The Minimum Required Fund Deposit
The Minimum Required Fund Deposit is $10,000, of which at least 40% must be in cash. That $10,000 Minimum must be maintained; if it drops below that number on a given day, an additional deposit must be made before the next trading day to bring the total deposit back up to $10,000. The calculation of the Required Minimum for any Member is based upon the relevant product, portfolio, and market of the Member. The NSCC conducts regular risk assessment reviews to confirm the adequacy of the Member’s Deposit or to require an increased deposit. In that connection, the NSCC uses daily backtesting to measure adequacy, comparing the amount of the Member’s deposit with the actual holdings in the Member’s portfolio. If more than two days of coverage deficiencies occur in a rolling 12-month period, the Member must take corrective action: either adjust its portfolio mix OR increase its deposit.
The Notice identifies three instances where a $10,000 Deposit may be inadequate:
When a new Member is growing its business
When a Member has limited or infrequent transactions that suddenly change
When a Member is winding down its business, including ending its NSCC membership
The National Securities Clearing Corporation Proposal
The NSCC conducted a 12-month study of backtesting deficiencies from June 3, 2019, to May 29, 2020, and found Members that maintain a Required Fund Deposit of less than $250,000 disproportionately accounted for backtesting deficiencies. Indeed, the study found that with a $250,000 Minimum Required Fund Deposit, 44 deficiencies, involving 13 Members, would have been eliminated. The Notice reports that the NSCC also checked on the deposits required by other registered clearing agencies and foreign central counterparty clearing houses. That comparison found those other clearing operations have significantly higher required deposits. For example, the Options Clearing Corporation requires a deposit of $500,000. The new NSCC proposal that the Minimum Required Fund Deposit be raised to $250,000 also requires that the entire Deposit be in cash.
The NSCC is the original clearing corporation, established in 1976 as a result, in part, of the 1960’s back-office crisis on Wall Street, when a sudden expansion of trading activity involving the transfer of stock evidenced by paper certificates almost brought Wall Street to its knees. The NSCC was seen as a complement to the Depository Trust Company, and in 1999 was brought into a holding company, the Depository Trust & Clearing Corporation, along with the Depository Trust Company and the Fixed Income Clearing Corporation. My April 29, 2021, blog post, “Tightening the Reins: SEC Approves Proposed Rule Change to Clearing Agency Investment Policy,” contains more information about these clearing agencies and affiliations. After a period of consolidation from the1980’s through 2010, seven SEC-registered clearing agencies remain, of which NSCC is both the oldest and the biggest.
Reactions to the Required Fund Deposit Change
It should not be a surprise that events that argued for the proposed material increase in a Member’s Minimum Required Fund Deposit from $10,000 to $250,000 reflect concerns about “abrupt or sudden increase in a Member’s activity.” Indeed there had never been anything quite like the so-called “Reddit Mob” and their pursuit of GameStop and other stocks, as discussed at length in my January 28 blog post, “Rupture Rapture: Should the GameStop?” As discussed, there was an extraordinary increase in trading volume, particularly by individuals using the Robinhood platform. According to published reports, Robinhood received an NSCC letter issued at 7 a.m. Eastern Time (4 a.m. Pacific Time where Robinhood is headquartered) on Wednesday, January 20, 2021.
These NSCC letters are regularly issued at that time to address margin deficiencies and other matters. The January 20 letter to Robinhood required that Robinhood, a Member of the NSCC, immediately post an additional $3 billion to its Member Fund Deposit. That led Robinhood to engage in an emergent effort to raise additional capital AND to suspend trading in 13 stocks, including GameStop. Eventually, that suspension was ended, and Robinhood resumed full operations.
Yet, that experience clearly fed into this NSCC proposal to raise the Minimum Deposit for Members to $250,000. In light of the recent surges in retail trading, especially of the so-called “meme stocks,” the proposed change seems justified. The Notice reports that the NSCC did extensive Member outreach with every Member that had an average Required Fund Deposit of less than $500,000 for a 12-month period.
“Margin, I Have to Have More Margin”
The NSCC received criticism and comments from some, but not a majority, of those Members. There follows in the Notice an almost three-page defense of the proposed changes by the NSCC. One wonders, however, whether the size of the proposed increase will cause some, especially smaller, less active Members to leave the NSCC and seek other, alternative trading systems to close transactions. See in that connection my December 1, 2020, blog post, “Treasury Transparency: Enhanced Regulations for Trading in Government Securities,” where I discuss SEC Regulation ATS.
The Notice provides that the NSCC proposed changes will take effect within 45 days of its publication in the Federal Register unless the SEC determines that a longer period is appropriate, after which the SEC will either approve or disapprove the changes OR institute proceedings “to determine whether the proposed rule change should be disapproved.” This approach suggests that the Commission anticipates that the NSCC proposal will evoke considerable opposition from affected Members, and perhaps from other market participants.
In the throes of the capital market collapse in the fall of 1929 at the beginning of the Depression, stockbrokers were heard telling clients who had purchased stock with funds borrowed from the broker, “Margin, I have to have more Margin.” [A quoted speaker on Edward R. Murrow’s Third Volume of “I Can Hear it Now, 1919 – 1932” Columbia Records, 1950]. Now, the NSCC seeks to reach comparable support for the credit risks involved in clearing securities transactions. One may hope for the success of this effort to make securities trading more secure.