When first proposing the Alternative Capital Computation, the SEC noted that it had been modeled on rule amendments previously adopted by the SEC for OTC derivatives dealers in 1998.\17\ In turn, the rules for OTC derivatives dealers parallel those that U.S. banking agencies had adopted in 1996 to require banks to compute a market risk charge, and to establish standards for the internallygenerated market risk estimates that banks could use to compute the charge.\18\ The rules adopted by the banking agencies implemented recommendations of the Basel Committee on Banking Supervision (``Basel Committee''),\19\ which recognized the growing use of VaR models as part of the risk management procedures of internationally active banks with large trading portfolios.\20\ The rules adopted by the banking agencies implemented capital charges for the market risks incurred by such banks, and approved the use of proprietary VaR models as part of the calculation of the required market risk charges, subject to the models satisfying certain ``qualitative'' and ``quantitative'' conditions.\21\ These [[Page 58988]]
conditions included the requirement of an appropriate multiplication factor, initially set at three and increased as indicated by backtesting results.\22\
\17\ 68 FR at 62872.
\18\ The SEC first proposed rules for OTC derivatives dealers in 1997, and stated that they were consistent with the market risk capital requirements adopted by the U.S. banking agencies. 62 FR 67940, 67947 (December 30, 1997).
\19\ The Basel Committee on Banking Supervision is a committee of banking supervisory authorities established in 1974 by the centralbank Governors of the Group of Ten countries. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States. It usually meets at the Bank for International Settlements in Basel, where its permanent Secretariat is located. \20\ In 1988, the Basel Committee published a document titled the ``International Convergence of Capital Measurement and Capital Standards'' (the ``Basel Capital Accord''), which set forth an agreed framework for measuring capital adequacy and the minimum requirements for capital for banking institutions. There have been several amendments to the Basel Capital Accord in the intervening years, including, in January of 1996, the ``Amendment to the Capital Accord to Incorporate Market Risks.'' Most recently, the Basel Committee issued a revised framework in June of 2004 (``Basel II'') that amends provisions related to credit risk and adds provisions to address operational risk.
\21\ See, generally, 61 FR 47358 (September 6, 1996) (final rules adopted by federal banking agencies to require market risk capital charge and adopting standards for the ``internal models'' approach for calculation of the charge).
\22\ The table in Appendix E that provides the required VaR multiplication factor is consistent with the recommendations made by the Basel Committee in 1996. See ``Supervisory Framework for the Use of Backtesting in Conjunction with the Internal Models Approach to Market Risk Capital Requirements'' (January 1996).

The amended SEC rules similarly specify several qualitative and quantitative requirements for the VaR models used by those BDs that are approved to use the Alternative Capital Computation. The qualitative requirements set forth in Appendix E include certain requirements already described above, i.e., those related to the multiplication factors applied to VaR based on backtesting results, and also include the following: (i) VaR models used to calculate market risk or credit risk must be integrated into the daily internal risk management system of the BD; (ii) VaR models must be reviewed both periodically (by either the BD's internal audit staff or an outside auditor) and annually (by a registered public accounting firm, as that term is defined in section 2(a)(12) of the SarbanesOxley Act of 2002 (15 U.S.C. 7201 et seq.); and (iii) the BD must have, for purposes of incorporating specific risk into its VaR model, methodologies in place to capture liquidity, event, and default risk adequately for each position. Other requirements for the models used to calculate deductions for specific risk include that they explain the historical price variation in the portfolio; capture concentration in terms of magnitude and changes in composition; be robust to an adverse environment; and be validated through backtesting.

The quantitative requirements for the VaR models are also set forth in Appendix E, and in addition to the requirement, described above, for market risk VaR models to be based on a 99 percent confidence level and tenday holding period, also include the following: (i) The VaR model must use an effective historical observation period of at least one year; (ii) the BD must consider the effects of market stress in its construction of the model; (iii) the historical data sets used for the models must be updated at least monthly and reassessed whenever market prices or volatilities change significantly; and (iv) the VaR model must take into account and incorporate all significant, identifiable market risk factors applicable to positions in the accounts of the BD.\23\ An additional quantitative requirement, related to the VaR models used for the BD's deduction for credit risk, is discussed below. \23\ The required market risk factors under the SEC's rule include not only specific risk for individual positions, but also the following general market risks: (i) Risks arising from the non linear price characteristics of derivatives and the sensitivity of the market value of those positions to changes in the volatility of the derivatives' underlying rates and prices; (ii) empirical correlations with and across risk factors or, alternatively, risk factors sufficient to cover all the market risk inherent in the positions in the proprietary or other trading accounts of the BD, including interest rate risk, equity price risk, foreign exchange risk, and commodity price risk; and (iii) where applicable, spread risk, and segments of the yield curve sufficient to capture differences in volatility and imperfect correlation of rates along the yield curve for securities and derivatives that are sensitive to different interest rates.

2. Deduction for Credit Risk

To determine its alternative deduction ``for credit risk on transactions in derivative instruments (if [Appendix E] is used to calculate a deduction for market risk on those instruments),'' Appendix E requires the BD to compute three separate capital charges and add them together. As set forth in 17 CFR 240.15c31e(c), the alternative deduction for credit risk is an amount equal to the sum of the following three charges:
(1) A ``counterparty exposure charge'' in an amount equal to the sum of the following: (i) The net replacement value in the account of each counterparty that is insolvent, or in bankruptcy, or that has senior unsecured longterm debt in default; and (ii) For each of the BD's other counterparties, a ``credit equivalent amount'' (generally speaking, the extent to which, after taking into account available collateral and enforceable netting agreements, the BD is exposed to the creditworthiness of the counterparty, both in terms of the current cost of replacing the positive cash flow under the OTC agreement if the counterparty were to default, and in terms of the potential for the replacement cost to increase over the length of the contract, due to movements in the rates or prices underlying the contract (the firm's ``maximum potential exposure'')), multiplied by the ``credit risk weight'' of the counterparty (counterparties with lower credit ratings have higher credit risk weights),\24\ multiplied by 8 percent.\25\ ``Maximum potential exposure'' will be determined using a VaR model, which, like the market risk VaR model, must use a 99 percent confidence level, but the price changes will be equivalent to a oneyear movement in rates and prices.\26\ The VaR for maximum potential exposure must also be multiplied by a multiplication factor, which will be initially set at one, but is also subject to increases based on backtesting exceptions, in accordance with a schedule of multiplication factors that has been proposed by the BD and approved by the SEC.
\24\ Appendix E assigns specific credit weights, ranging from 20 percent to 150 percent, based either on the ratings made by a nationally recognized statistical rating organization or internally by the firm. A BD may request approval to determine credit risk weights based on internal calculations. The BD must make and keep current a record of the basis for the credit rating, and credit risk weight, for each counterparty.
\25\ The SEC stated that the 8 percent multiplier is consistent with the calculation of credit risk in the OTC derivatives dealer rules and applicable requirements in Basel Committee publications, and is designed to dampen leverage to help ensure that the firm maintains a safe level of capital.
\26\ The SEC may approve a shorter time horizon (but not less than ten business days), based on a review of the BD's procedures for managing collateral, the daily marktomarket of the collateral, and the BD's ability to call for additional collateral daily. (2) A ``concentration charge by counterparty,'' which is the total determined by adding together, for each counterparty of a given credit risk weight, a specified percentage of the amount of the BD's current exposure to the counterparty that is in excess of 5 percent of the BD's tentative net capital.\27\
\27\ Appendix E requires that for each counterparty with a credit risk weight of 20 percent or less, the concentration charge is 5 percent of the amount of the current exposure to the
counterparty that is in excess of 5 percent of the BD's tentative net capital; for each counterparty with a credit risk weight of greater than 20 percent but less than 50 percent, the charge is 20 percent of the current exposure to the counterparty that is in excess of 5 percent of the BD's tentative net capital; and for each counterparty with a credit risk weight of greater than 50 percent, the charge is 50 percent of the current exposure to the counterparty that is in excess of 5 percent of the BD's tentative net capital. (3) A ``portfolio concentration charge'' of 100 percent of the amount of the BD's aggregate current exposure for all counterparties in excess of 50 percent of the tentative net capital of the BD.

The SEC has stated that the provisions related to OTC derivatives in the amended rules are based on its experience with the reporting provided by the Derivatives Policy Group,\28\ and
[[Page 58989]]
also with the SEC's regulation of OTC derivatives dealers.\29\ The provisions for OTC derivatives also reflect the reporting
recommendations made by the Basel Committee and the Technical Committee of the International Organization of Securities Commissions (``IOSCO'') in a joint report issued in 1995 and revised in 1998, which included recommendations for the reporting by banks and securities firms related to the credit risk of their OTC derivatives, particularly their current and potential credit exposures to their counterparties, the credit quality of their counterparties, and the concentration of credit risk with these counterparties.\30\
\28\ The Derivatives Policy Group (``DPG'') consists of several U.S. firms that are most active in the OTC derivatives market. The DPG was formed at the request of the SEC to address the public policy issues arising from the activities of unregistered affiliates of BDs. In March of 1995 the DPG published its ``Framework for Voluntary Oversight, a Framework for Voluntary Oversight of the OTC Derivatives Activities of Securities Firm Affiliates to Promote Confidence and Stability in Financial Markets,'' under which the members of the DPG agreed to report voluntarily to the SEC on their activities in the OTC derivatives market.
\29\ 68 FR at 62879.
\30\ See ``Framework for Supervisory Information about Derivatives and Trading Activities,'' published in September of 1998 by the Basel Committee and IOSCO. IOSCO provides an international cooperative forum for securities regulatory agencies, and its member securities agencies regulate more than 90 percent of the world's securities markets.

B. SEC Application Process

The approval process under Appendix E of SEC Rule 15c31 is initiated by the filing of an application by the BD, which is required to: (i) Describe the mathematical models used to price positions and to compute market risk and credit risk capital deductions, and explain how the models meet the required quantitative and qualitative standards set forth in SEC regulations; (ii) describe the BD's internal risk management control system and how that system satisfies the requirements set forth in SEC regulations; (iii) include corrected or updated information going forward as appropriate; and (iv) provide a written undertaking and certain information from the BD's holding company. Furthermore, the BD must amend or resubmit an application to obtain SEC approval of any material change to its approved mathematical models. The SEC may approve the application in whole or in part, and the SEC may revoke its approval upon certain conditions. The SEC delegates to the Director of the SEC's Division of Market Regulation the authority to undertake specific activities and determinations under the rule, including the authority to approve any amendments to the BD's application. If a BD decides it no longer wishes to continue using its approved alternative market risk and credit risk charges, it must give notice to the SEC 45 days (or a shorter or longer period as approved by SEC) prior to the BD ceasing use of the approved models and reverting to the standard haircuts. The SEC has also specified in Appendix E, at paragraph (a)(11), that the BD's approval to use the Alternative Capital Computation may be revoked by SEC order, upon a finding that the exemption is no longer necessary or appropriate in the public interest or for the protection of investors. The rule further states that in making its finding, the SEC will consider the compliance history of the BD related to its use of models, the financial and operational strength of the BD and its ultimate holding company, the BD's compliance with its internal risk management controls, and the holding company's compliance with its written undertaking with the SEC. C. Reporting Required by SEC for the Alternative Capital Computation

To implement other conditions for the use of the Alternative Capital Computation, the SEC also amended its Rule 17a5 (17 CFR 240.17a5), which sets forth financial reporting requirements applicable to all BDs. In addition to the information otherwise required under SEC Rule 17a5(a), a BD that uses the Alternative Capital Computation must, on a monthly basis, file reports that include: (i) Regular risk reports supplied to the BD's senior management in the format described in the application; (ii) for each product for which the BD calculates a deduction for market risk in accordance with Appendix E, the product category and the amount of the deduction for market risk; (iii) a graph reflecting, for each business line, the daily intramonth VaR; (iv) the aggregate value at risk for the BD; (v) for each product for which the BD uses scenario analysis, the product category and the deduction for market risk; and (vi) credit risk information on derivatives exposures. More specifically, the credit risk information to be filed for OTC derivatives exposures includes: (i) The BD's overall current exposure; (ii) its current exposure (including commitments) listed by counterparty for the 15 largest exposures; (iii) the 10 largest commitments listed by counterparty; (iv) the BD's maximum potential exposure listed by counterparty for the 15 largest exposures; (v) the BD's aggregate maximum potential exposure; (vi) a summary report reflecting the BD's current and maximum potential exposures by credit rating category; and (vii) a summary report reflecting the BD's current exposure for each of the top ten countries to which the BD is exposed (by residence of the main operating group of the counterparty).

The amended SEC Rule 17a5(a) also requires quarterly reports that include: (i) the number of business days for which the actual daily net trading loss exceeded the corresponding daily VaR; and (ii) the results of backtesting of all internal models used to compute allowable capital, including VaR and credit risk models, indicating the number of backtesting exceptions. BDs approved to use the Alternative Capital Computation must also file supplements to their annual financial statements, which under amended SEC Rule 17a5(k) are to consist of: (i) An accountant's report on management controls (indicating the results of the review made by a registered public accounting firm of the BD's internal risk management control system); and (ii) a related statement, made prior to commencement of the accountant's review, that describes the review procedures agreed to by the BD and the accountant. III. Proposed Rules for FCMs Registered as BDs To Use Their SEC Approved Capital Charges

The SEC, in adopting its rules permitting alternative capital charges incorporating VaR measurements for qualifying BDs subject to consolidated supervision, commented that ``the alternative method of computing net capital responds to [broker and dealer] requests to align their supervisory risk management practices and regulatory capital requirements more closely.'' \31\ Absent the changes that are being proposed in this release to Commission Rule 1.17, the potential for reduced capital charges that is available to dual registrants under the Alternative Capital Computation would not be available under the Commission's rules. As a result, FCM/BDs would be faced with potentially complex capital computations and compliance burdens. Given the commonality of purpose between the capital charges required by the SEC for BD registrants and by the Commission for FCM registrants, the Commission is therefore proposing to permit dual registrants that have qualified for the exemption under the SEC's net capital rule to use the same alternative charges with respect to their calculation of minimum CFTC net capital, subject to the general requirement that the Commission receive the same notices and the monthly, quarterly and annual reporting information, as described above, that the SEC's amended rules require FCM/BDs to provide to the SEC. As for holding company information that is provided to the SEC under the new Appendix G to SEC Rule 15c31, or as part of the
[[Page 58990]]
application that the BD files with the SEC to request approval to use the Alternative Capital Computation, the proposed rules in the release do not require the Commission's receipt of such holding company information, because such information is being provided to the SEC for purposes of the SEC's consolidated supervision of the holding company. \31\ 69 FR at 34428.

In formulating the proposed amendments, the Commission has taken into consideration that the Alternative Capital Computation, unlike the current standardized charges, is determined by an ongoing oversight process that results in individualized capital charges that require considerable firmspecific information. Pursuant to Commission Rule 1.17(a)(3), FCMs must be able to demonstrate to the satisfaction of the Commission their compliance with their minimum financial requirements under the Commodity Exchange Act and implementing regulations of the Commission. The proposed amendments to Rule 1.17 would enable FCM/BDs to elect to use their SEC approved capital charges in satisfaction of their requirements under Rule 1.17, subject to compliance with FCM notification and filing requirements that would promote the Commission's risk oversight of FCMs, given their critically important role as risk intermediaries in the futures and options markets.

The Commission is not proposing any amendments in this release to Rules 1.14 and 1.15, pursuant to which FCMs are required to maintain and report ``risk assessment'' information to the Commission concerning the FCM's material affiliates. The SEC imposes similar requirements on BDs, through SEC Rules 17h1T and 17h2T, for recordkeeping and reporting on the material affiliates of the BD. A firm that is dually registered as a BD and an FCM must comply with the risk assessment regulations of the SEC and the Commission, but Commission Rule 1.15(d)(1) permits FCM/BDs to meet their filing requirements by providing copies to the Commission of the risk assessment documents that are filed with the SEC.\32\
\32\ To comply with SEC Rule 17h2T, BDs file SEC Form 17H, and Commission Rule 1.15(d)(1) allows FCM/BDs to comply with the requirements in Rules 1.15(a)(1)(i) and (a)(2) by filing copies with the Commission of their Forms 17H, if these are additionally supplemented to ensure that the Commission receives all of the information required under Rule 1.15.

Given the overlap between information that the SEC requires under the newly adopted Appendix G and under SEC Rules 17h1T and 17h2T, the SEC amended its rules so that BDs whose holding companies are directly examined by the SEC are relieved of having to also meet the filing obligations required by SEC Rules 17h1T and 17h2T. Because the Commission does not require holding company information under the amendments to Rule 1.17 proposed in this release, the proposed rule amendments do not duplicate the filing requirements of Commission Rules 1.14 and 1.15. FCM/BDs that elect to use the Alternative Capital Computation will therefore continue to be required to comply with the provisions of Rules 1.14 and 1.15.
A. Proposal to Permit FCMs To Elect To Use Their SECApproved Capital Charges

The Commission proposes to amend paragraph (c)(6) of Rule 1.17 by providing that an FCM/BD may elect, if it satisfies the requirements of proposed paragraph (c)(6), to compute its adjusted net capital using alternative capital deductions that the SEC has approved by written order under 17 CFR 240.15c31(a)(7). To the extent that the SEC has approved alternative capital deductions for the FCM/BD's unsecured receivables from OTC transactions in derivatives, or for its proprietary positions in securities, forward contracts, or futures contracts, the FCM/BD may use these same alternative capital deductions when computing its adjusted net capital. These alternative deductions would be used in lieu of the amounts that otherwise would be required by the following regulations: Rule 1.17(c)(2)(ii) for unsecured receivables from OTC derivatives transactions; Rule 1.17(c)(5)(ii) for proprietary positions in forward contracts; Rule 1.17(c)(5)(v) for proprietary positions in securities; and Rule 1.17(c)(5)(x) for proprietary positions in futures contracts. The proposed rulemaking would not alter or affect the haircuts that Rule 1.17(c)(5)(v) and Rule 1.32(b) require for securities that are held in segregation under Section 4d of the Commodity Exchange Act, because the alternative deductions apply solely to an FCM/BD's proprietary positions.\33\ \33\ FCM/BDs using the Alternative Capital Computation would continue to be required, under Rule 1.17(c)(5)(v), to deduct the securities haircuts specified in SEC Rules 15c31(c)(2)(vi) and (vii) from the value of securities that are held in segregated accounts under Section 4d and the Commission's implementing regulations and which were not deposited by customers. Such FCM/BDs would also continue to be required, when computing the amount of funds required to be in segregated accounts, to use the standard SEC securities haircut expressly referenced in Rule 1.32(b), i.e., SEC Rule 15c31(c)(2)(vi). Rule 1.32 applies this haircut for purposes of the permissible offset of any net deficit in a customer's account against the current market value of readily marketable securities, less the SEC standard haircut, that are held for the same customer's account.
B. Proposed Requirements for FCMs Electing the Alternative Capital Computation

1. Notice of Election or of Changes to Election

Proposed paragraph (c)(6)(ii) of Rule 1.17 would specify that an FCM's election to use the Alternative Capital Computation would not be effective unless and until it has filed with the Commission a notice, addressed to the Director of the Division of Clearing and Intermediary Oversight, that is to include: (i) A copy of the SEC order approving its alternative market risk and credit risk capital charges; and (ii) a statement that identifies the amount of tentative net capital below which the FCM is required to provide notice to the SEC, and that also includes portions of the information made available to the SEC for purposes of its request for approval to use the Alternative Capital Computation, as follows: \34\
\34\ As noted earlier, SEC Rule 15c31(a)(7)(ii) requires same day notice to the SEC if the BD's tentative net capital is less than $5 billion, or a lower amount that has been agreed to by the SEC. (1) A list of the categories of positions that the firm holds in its proprietary accounts, and, for each such category, a description of the methods that the firm will use to calculate its deductions for market risk and credit risk, and, if calculated separately, its deductions for specific risk;
(2) A description of the VaR models to be used for its market risk and credit risk deductions, and an overview of the integration of the models into the internal risk management control system of the firm; (3) A description of how the firm will calculate current exposure and maximum potential exposure for its deductions for credit risk; (4) A description of how the firm will determine internal credit ratings of counterparties and internal credit risk weights of counterparties, if applicable; and
(5) A description of the estimated effect of the alternative market risk and credit risk deductions on the amounts reported by the firm as net capital and adjusted net capital.

Proposed Rule 1.17(c)(6)(ii) would also require the FCM to supplement its statement, upon the request of the Commission made at any time, with any other explanatory information for the firm's computation of its alternative market risk and credit risk deductions as the Commission may require at its
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discretion. The requests for explanatory information under proposed Rule 1.17(c)(6)(ii) may be made by the Director of the Division of Clearing and Intermediary Oversight, to whom, as set forth in Commission Rule 140.91(a)(6), the Commission has delegated authority for the functions reserved for the Commission under Rule 1.17.

Proposed Rule 1.17(c)(6)(ii) would further provide that the FCM must file, as a supplemental notice with the Director of the Division of Clearing and Intermediary Oversight, a notice advising that the SEC has imposed additional or revised conditions after the date of the SEC order filed with the FCM's original notice to the Director of the Division of Clearing and Intermediary Oversight. The FCM must also file as a supplemental notice a copy of any approval by the SEC of amendments that the firm has requested for its application to use the Alternative Capital Computation.

An FCM would also be permitted under the proposed rule to voluntarily change its election, by filing with the Director of the Division of Clearing and Intermediary Oversight a written notice that specifies a future date as of which its market risk and credit risk capital charges will no longer be determined by the Alternative Capital Computation, but will instead be computed as otherwise required under the Commission's rules.
2. Conditions UNDER Which FCM May No Longer Elect Alternative Capital Charges

Proposed paragraph (c)(6)(iii) of Rule 1.17 would provide that an FCM may no longer elect to use its SECapproved alternative market risk and credit risk deductions, and shall instead compute the charges otherwise required under Rules 1.17(c)(5) or 1.17(c)(2), upon the occurrence of any of the following: (i) The SEC revokes its approval of the firm's market risk and credit risk deductions; (ii) the firm fails to come into compliance with its filing requirements under the proposed rule, after having received from the Director of the Division of Clearing and Intermediary Oversight written notification that the firm is not in compliance with its filing requirements, and must cease using the Alternative Capital Computation if it has not come into compliance by a date specified in the notice; or (iii) the Commission by written order finds that permitting the firm to continue to use such alternative market risk and credit risk deductions is no longer appropriate for the protection of customers of the FCM or the financial integrity of the futures or options markets.\35\
\35\ Because the proposed rule would permit only dual
registrants to use the Alternative Capital Computation, an FCM's election to use the Alternative Capital Computation would
automatically terminate immediately, without further action by the Commission, if it ceases to be duallyregistered as a BD.

3. Additional Filing Requirements

In addition to the notice and supplemental notices described above, proposed paragraph (c)(6)(iv) of Rule 1.17 would also provide that any firm that elects to use the Alternative Capital Computation must file with the Commission copies of all additional monthly, quarterly, and annual reporting items that BDs who are approved to use the Alternative Capital Computation must file with SEC, as discussed above. The FCM would also be required to file with the Commission a copy of the notice that it must file with the SEC whenever its tentative net capital falls below the amount required by the SEC, or of the notice filed with the SEC or the firm's designated examining authority in regard to planned withdrawals of excess net capital.

Specifically, the proposed rule would require the following to be filed with the Commission, at the same time that originals are filed with the SEC:
(1) All information that the firm files on a monthly basis with its designated examining authority or the SEC in satisfaction of SEC Rule 17a5(a)(5)(i), whether by way of schedules to the firm's FOCUS reports or by other filings;
(2) The quarterly reports required by SEC Rule 17a5(a)(5)(ii); (3) The supplemental annual filings as required by SEC Rule 17a 5(k), which consist of a report on management controls that is prepared by a registered public accounting firm and is filed by the firm concurrently with its annual audit report, and also a related statement, filed prior to the commencement of the accountant's review but no later than December 10 of each year, that includes a description of the procedures agreed to by the firm and the accountant and a notice describing changes to the agreedupon procedures, if any, or stating that there are no changes; and
(4) Any notification to the SEC or the firm's designated examining authority of planned withdrawals of excess net capital, and any notification that the firm is required to file with the SEC when its tentative net capital is below an amount specified by the SEC.

BDs that use the Alternative Capital Computation also file a revised Part II to the FOCUS report, designated ``Part II CSE''. This revised FOCUS report includes financial information that BDs previously reported in Part II of the FOCUS Report, and also includes new schedules that provide much of the additional information that BDs who use the Alternative Capital Computation must report on a monthly basis. In order to facilitate the firm's reporting requirements and reduce administrative burden, the Commission proposes to amend Rule 1.10(h) to specify that a dual registrant may file, in lieu of its Form 1FRFCM report, a copy of the FOCUS Report, Part II CSE that the firm files with the SEC.\36\
\36\ Several other Commission rules include references to Parts II and Part IIA of the FOCUS report, in order to facilitate the filing of the FOCUS report in lieu of the Form 1FRFCM. The Commission also proposes be amend these rules to add a reference to Part II CSE. In particular, the Commission proposes to amend the following rules: Rule 1.10(d)(4)(ii), which sets forth the requirements for ``authorized signers'' of the FOCUS report; Rule 1.10(f)(1), which sets forth the procedures required to obtain extensions of time for filing the FOCUS report; Rule 1.16(c)(5), which requires the accountant's supplemental report on material inadequacies to be filed as of the same date as the Form 1FR or FOCUS report; Rules 1.18(a) and (b)(2), which permit FOCUS filings to satisfy certain recordkeeping requirements of the FCM; and Rule 1.52(a), which permits the designated selfregulatory organization of a dual registrant to accept a FOCUS report in lieu of a Form 1 FRFCM.
C. Treatment of Information Received From FCMs Electing the Alternative Capital Computation

1. The Freedom of Information and Sunshine Acts

The Freedom of Information Act, 5 U.S.C. 552 et seq. (``FOIA''), provides generally that the public has a right of access to federal agency records except to the extent such records, or portions of them, are protected from disclosure by one (or more) of nine narrow exemptions. The Government in the Sunshine Act, 5 U.S.C. 552b (``Sunshine Act''), enacted to ensure that agency action is open to public scrutiny, contains identical exceptions. Accordingly, the Commission is required by the FOIA and the Sunshine Act to make public its records and actions unless a specific exemption is available.

Historically, portions of the Form 1FR and FOCUS reports that are filed with the Commission under Rule 1.10 have been available to the public.\37\
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Other portions of these reports currently are exempt from disclosure \38\ as confidential commercial or financial information pursuant to Commission regulation 145.5(d), which tracks the language of its FOIA counterpart, exemption (b)(4).\39\ Similarly, Commission meetings (or portions of meetings) may be ``closed'' under the Sunshine Act where the Commission determines that open meetings will likely reveal information protected by an exemption.\40\
\37\ The statement of financial condition, which consists of a balance sheet showing assets, liabilities and ownership equity; the computations for net capital and minimum capital requirements; and the statements related to the segregation of customer funds under Section 4d of the Commodity Exchange Act. See 17 CFR 1.10g. Since 1995, the Commission routinely has published on its Web site selected financial information for every FCM from the publicly available statements and schedules listed in rule 1.10(g): (1) Total adjusted net capital; (2) minimum capital requirement; (3) adjusted net capital in excess of the minimum requirement; (4) customer funds that the Commission requires to be held in segregated accounts in accordance with Section 4d of the Act; and (5) customer funds that the Commission requires to be held in secured accounts in accordance with Part 30 of the Commission's regulations.
\38\ See 17 CFR 145.5 and 147.3. Those portions are: the Statement of Income (Loss); the Statement of Cash Flows; the Statement of Changes in Ownership Equity; the Statement of Changes in Liabilities Subordinated to the Claims of General Creditors Pursuant to a Satisfactory Subordination Agreement; the Statement of Changes in Financial Position; the Computation for Determination of Reserve Requirements for BrokerDealers under (SEC) Rule 15c33; the Statement denoted ``Exemptive Provision Under (SEC) Rule 15c33;'' the Statement of Ownership Equity and Subordinated Liabilities maturing or proposed to be withdrawn within the next six months and accruals, which have not been deducted in the computation of net capital, and the Recap thereof; the Statement of Financial and Operational Data; and the accountant's report on material
inadequacies filed under Rule 1.16(c)(5). The foregoing include items that all FCMs and IBs are required to file, and also include items that are filed only by BDs that file FOCUS reports in lieu of Form 1FR.
\39\ Both the FOIA exemption (b)(4) and Commission rule 145.5(d) exempt from disclosure matters that are ``trade secrets and commercial or financial information obtained from a person and privileged or confidential.''
\40\ As noted, the Sunshine Act exemptions are identical to their FOIA counterparts. The Commission's Sunshine Act obligations are codified in its Part 147 rules, 17 CFR 147.

The Commission believes that the filings required by the proposed amendments, as well as certain portions of the Form 1FR and FOCUS reports presently filed with the Commission pursuant to Rule 1.10, also are protected from disclosure by FOIA and Sunshine Act exemption (8), pursuant to which the Commission is authorized to withhold from the public matters ``contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions.'' 5 U.S.C. 552(b)(8) and 5 U.S.C. 552b(c)(8). Commission Rules 145.5(h) and 147.3(b)(8) similarly provide that the Commission generally will not make public matters that are ``contained in or related to examinations, operating, or condition reports prepared by, on behalf of, or for the use of the Commission or any other agency responsible for the regulation or supervision of financial institutions.''

Because the term ``financial institution'' is not defined either in the FOIA or its legislative history, courts have relied on the legislative history of the Government in the Sunshine Act,\41\ a statute in pari materia with the FOIA, to take an inclusionary and expansive view of the term.\42\ The Commission is aware that no court directly has considered whether Commission registrants are financial institutions for purposes of either exemption 8; the Commission believes, however, that the language of the Sunshine Act's legislative history contemplates the inclusion of commodities professionals, including futures commission merchants, designated contract markets, derivatives transaction execution facilities, commodity pool operators and commodity trading advisors. Recent legislation bolsters this view. The USA PATRIOT Act \43\ defines FCMs, CPOs and CTAs as financial institutions for purposes of the antimoney laundering requirements of the Bank Secrecy Act, 31 U.S.C. 5311 et seq.; 31 U.S.C. 5312(c), and identifies the Commission as a ``federal functional regulator.'' \44\ Similarly, Section 5g(a) of the Commodity Exchange Act provides that any FCM, CTA, CPO or IB that is subject to the Commission's jurisdiction with respect to any financial activity shall be treated as a financial institutions for purposes of the privacy requirements in Title V of the GrammLeachBliley Act. 7 U.S.C. 7b2(a).\45\
\41\ The Senate Report accompanying the Sunshine Act states that: [The term is] intended to include banks, savings and loan associations, credit unions, brokers and dealers in securities or commodities, exchanges dealing in securities or commodities, such as the New York Stock Exchange, investment companies, investment advisors, selfregulatory organizations subject to 15 U.S.C. 78s, and institutional managers as defined in 15 U.S.C. 78m. S. Rep. No. 354, 94th Cong., 1st Sess. 24 (1975). (emphasis supplied).
\42\ Accordingly, several district courts have interpreted the term ``financial institutions'' broadly for purposes of FOIA exemption 8. See Mermelstein v. SEC, 629 F.Supp.672, 67375 (D.D.C. 1986) (Congress did not take a restrictive view of ``financial institutions'' and intended to include securities exchanges); Berliner, Zisser, Walter & Gallegos, P.C. v. SEC, 962 F.Supp. 1348, 135253 (D. Colo. 1997) (including investment advisors, as
fiduciaries who direct and make important investment decisions, in the definition ``furthers Exemption 8's dual purposes of protecting the integrity of financial institutions and facilitating cooperation between the SEC and the entities regulated by it''); Feshbach v. SEC, 5 F.Supp. 2d 774, 781 (N.D. Cal. 1997) (the term financial institution encompasses selfregulatory organizations such as the NASD).
\43\ The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, Pub. L. 10756, 115 Stat. 272 (2001).
\44\ Section 509(2) of the GrammLeachBliley Act includes as federal functional regulators the Board of Governors of the Federal Reserve System; the Office of the Comptroller of the Currency; the Board of Directors of the Federal Deposit Insurance Corporation; the Director of the Office of Thrift Supervision; the National Credit Union Administration Board; and the Securities and Exchange Commission.

As a separate matter, the Chairman of the Commission is a member of the President's Working Group on Financial Markets, along with the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, and the Chairman of the Securities and Exchange Commission. The Working Group was formed with the goal of enhancing the integrity, efficiency, orderliness, and competitiveness of the U.S. financial markets and maintaining investor confidence. See Executive Order 12631 (March 18, 1988). \45\ Generally, Title V of the GrammLeachBliley Act limits the instances in which a financial institution may disclose nonpublic personal information about a consumer to nonaffiliated third parties, and requires a financial institution to disclose to all of its customers the institution's privacy policies and practices with respect to information sharing with both affiliates and

nonaffiliated third parties.

The primary purposes of FOIA exemption 8 have been described as ``protecting the integrity of financial institutions and facilitating cooperation between [agencies] and the entities regulated by [them].'' \46\ In light of the expanded activities and growing impact of FCMs as financial institutions,\47\ and the delineation in the Commodity Futures Modernization Act of 2000 (``CFMA'') \48\ of the Commission's oversight role with respect to all Commission registrants, these goals are especially desirable.
\46\ Berliner, Zisser, Walter & Gallegos, supra.
\47\ The Commission noted the increased significance of FCMs in global financial markets when proposing, and subsequently adopting, amendments to Rule 1.10 to require that Form 1FRFCM reports and equivalent FOCUS reports be filed on a monthly rather than quarterly basis. 69 FR 49874 (August 12, 2004).
\48\ Pub. L. 106554, App. E, 114 Stat. 2763 (2000).

2. Proposed Amendments to Parts 1, 145, and 147

In light of these considerations, the Commission proposes to treat as nonpublic certain financial information filed with it by FCMs and BDs. Under the proposed amendments to Rule 1.10(g), statements of financial condition in monthly FOCUS reports, the full computations of net capital, and the minimum capital requirements in monthly FOCUS reports would no longer be publicly available. The express mandates of the Commodity Exchange Act, however, support the Commission's determination that certain information that is filed in Form 1FR and FOCUS reports remain
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publicly available. As proposed to be amended, Rule 1.10(g) would provide that the following information in Forms 1FR and FOCUS reports would be publicly available: (i) The amounts for a registrant's adjusted net capital, its minimum capital requirement under Rule 1.17, and its adjusted net capital in excess of its minimum capital requirement; (ii) the statement of financial condition in the certified annual financial report, and footnote disclosures thereof; and (iii) the statements related to customer funds that the Commission requires to be held in segregated accounts in accordance with Section 4d of the Commodity Exchange Act, or in secured accounts in accordance with Part 30 of the Commission's regulations.\49\ Such information provides insight into the financial resources of an FCM relative to its aggregate obligations and assures that market users may assess the financial integrity of the intermediaries they employ in their trading activities.
\49\ Rule 1.10(g) currently provides, and will continue to provide, that all information on Forms 1FR and FOCUS reports that is nonpublic will be available for official use by any official or employee of the United States or any State, by any selfregulatory organization of which the person filing such report is a member, by the National Futures Association in the case of an applicant, and by any other person to whom the Commission believes disclosure of such information is in the public interest. Rule 1.10(g) also specifies that the rule does not limit the authority of any selfregulatory organization to request or receive any information relative to its members' financial condition.

Accordingly, the Commission proposes to amend Rules 145.5 and 147.3 to exempt from mandatory public disclosure, pursuant to FOIA exemption 8,\50\ the following specific categories of information, except as provided for in Rules 1.10(g) and 31.13:
\50\ Certain of this information would continue to be exempt from disclosure under FOIA exemption 4 as well.
(1) Forms 1FR required to be filed pursuant to Rule 1.10; (2) FOCUS reports that are filed in lieu of Forms 1FR pursuant to Rule 1.10(h);
(3) Forms 2FR \51\ required to be filed pursuant to Rule 31.13; and
\51\ Rule 31.13 requires leverage transaction merchants (``LTMs'') to file with the Commission financial condition information using ``Forms 2FR,'' and provides that certain information in such reports shall be deemed public. For a number of years there have been no registered LTMs, and the Commission is not proposing any amendments to Rule 31.13 in this release.
(4) All reports and statements required to be filed pursuant to Rule 1.17(c)(6).\52\
\52\ The accountant's report on material inadequacies filed in accordance with Rule 1.16(c)(5), which is already included in Rules 145 and 147 as exempt from disclosure under FOIA Exemption 4, would also be included as exempt from disclosure under FOIA Exemption 8. IV. Proposed Amendment To Reduce Capital Charges for Foreign Currency Forwards and Inventory in Specified Currencies

The Commission is further proposing to amend Commission Rule 1.17(c)(5)(ii), pursuant to which an FCM or IB, in computing its adjusted net capital, must deduct from its net capital specified percentages of the market value of its inventory, fixed price commitments and forward contracts. Such capital charges, which are imposed in percentages of up to twenty percent of market value, are reduced if the FCM's or IB's inventory, fixed price commitments or forward contracts are covered (i.e., hedged) by an open futures

FOR FURTHER INFORMATION CONTACT

Thomas J. Smith, Associate Deputy Director and Chief Accountant, at (202) 4185430, or Thelma Diaz, Special Counsel, at (202) 4185137, Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, D.C. 20581. Electronic mail: (tsmith@cftc.gov) or (tdiaz@cftc.gov).