SEC Proposes Amendments To Regulation T

Executive Summary

The Board of Governors of the Federal Reserve System is seeking comments on proposed amendments to Regulation T (Credit by Brokers and Dealers) regarding settlement of securities purchases and the status of government securities transactions. Comments on the proposed changes should be received by August 15, 1994.

Background

On August 18, 1992, the Board of Governors of the Federal Reserve System (Board) published an advance notice of proposed rulemaking requesting public comments in connection with a general review of Regulation T. The review is not yet complete, but the Board believes that certain developments warrant the publication of three proposed amendments in two areas.

Proposed Amendment

Three Day Settlement (T+3)

In light of the adoption by the Securities and Exchange Commission (SEC) of a rule shortening the standard settlement period for securities transactions from five to three business days (T+3), the Board proposes to shorten the time periods specified in Regulation T for customers to meet margin calls or make full cash payment by a corresponding two days. Related amendments would raise the de minimis amount below which liquidation of unpaid transactions is not required from $500 to $1,000, require brokers seeking extensions of the payment periods to obtain them from their designated examining authority (DEA), and clarify that foreign settlement periods are used to calculate when restrictions in the cash account are applied to foreign securities.

Regulation T has always required cash payment for securities purchases within seven business days of trade date. The seven-day period was initially chosen for the cash account because it was felt that a customer should have no obligation to pay for securities before they were delivered. The two days permitted beyond settlement date provide a short period of time for resolution of problems before the broker is required to act under Regulation T, that is, either obtain an extension on the customer's behalf (if it is determined that a valid reason exists) or sell out the customer's position.

The Board's advance notice was issued before the SEC proposed its rule adopting a T+3 settlement period. The advance notice mentioned the Group of Thirty's recommendation of a world-wide settlement standard of T+3 and said the Board "may consider shortening the time for customer payment once the settlement period is shortened from the current five days." The Board supported the SEC when it proposed requiring T+3 settlement, calling the proposal "an important and achievable step" to reduce potential systemic disturbances to financial markets and to the economy. The SEC also received several comment letters stating that the implementation of T+3 settlement will require the Board to address the possible shortening of its Regulation T payment periods. Those letters were forwarded to Board staff for consideration in the context of the ongoing Regulation T review.

The Board proposes to reword Regulation T to specifically incorporate the standard settlement cycle and the current two-day cushion. Instead of requiring payment within "seven business days," the regulation would require payment within "one payment period," with "payment period" being defined as the standard settlement period in the United States plus two business days. This will not change the operation of the rule at this time, but once the new language is put into place the conversion to T+3 next year will automatically result in a reduction in the amount of time brokers can give their customers to pay for securities or to meet initial margin calls. Future changes in settlement periods by the SEC will similarly be automatically reflected in the Board's rule without the necessity of further amendment.

The payment periods in Regulation T can be extended for exceptional circumstances if the broker applies to a self-regulatory organization (SRO) for an extension. In 1988, the New York Stock Exchange (NYSE) sought SEC approval of a rule that would require a broker seeking a Regulation T extension to obtain the extension from the NYSE if the NYSE is the broker's designated examining authority (DEA). The proposal was noted by the Board in the advance notice, as was a suggestion by the Credit Division of the Securities Industry Association that brokers be permitted to grant customer extensions without approval of an SRO. The SEC approved the NYSE rule firing in May 1994. In its approval order, the SEC stated that it does not agree with assertions that the objectives of the Securities Exchange Act of 1934 (the Act) could be better met by implementing a uniform system of sharing extension information. As to the other objections raised by commenters (and also raised with the Board pursuant to the advance notice), the SEC found that "the regulatory benefits from the NYSE rule outweigh any competitive concerns raised by the commenters." Finally, the SEC said it does not agree with those commenters who argue that broker/dealers should not be required to submit requests for extensions of time to either their DEA or any SRO. The Board believes, along with the SEC, that a good case has been made to restore to the broker's DEA sole responsibility for granting and monitoring extensions of time and the language proposed by the Board today reflects this conclusion.

Government Securities

In light of the recent enactment of the Government Securities Act Amendments of 1993, the Board proposes to exempt most transactions involving government securities from the restrictions of Regulation T. This would be accomplished with two separate but related actions. First, Regulation T would exclude government securities brokers and dealers who register with the SEC under section 15C of the Act from the definition of "creditor" in Regulation T. Second, general broker/dealers effecting customer transactions that could be effected by a section 15C broker/dealer could record the transactions in a new government securities account in which the other restrictions in Regulation T would not apply.

Before the enactment of the Government Securities Act of 1986, broker/dealers who limited themselves to transactions in government securities were not subject to a comprehensive regulatory scheme and were not required to be registered with the SEC. Although such brokers were within the definition of "creditor," there was no practical way to enforce Regulation T for them. The Government Securities Act of 1986 required SEC registration of all non-bank government securities brokers and dealers under a new section 15C of the Act. The Government Securities Act of 1986 also added the term "government securities" to the Act.

The advance notice invited comment on two areas involving government securities: repurchase agreements (repos) and the borrowing and lending of securities. The advance notice explained that the Board has not specified the exact treatment of repos while noting that repos of government securities do not raise credit issues under Regulation T because the good faith loan value of such securities is often close to 100 percent of their current market value. Many of the commenters suggested that the Board create a new account for exempted securities that could be used for transactions such as repos and forward transactions. Most of the commenters supported exemption of government securities from §220.16 of Regulation T. This would allow loans of government securities without the current requirement that a broker document the reason for the borrowing stems from a short sale or failure to receive securities required for delivery.

Under today's proposal, whenever a general broker/dealer effects a transaction for a customer that could be effected by a section 15C broker, the transaction could be recorded in a new government securities account. The account would allow these transactions to be effected without regard to other restrictions in Regulation T. The account would be permissive; brokers could continue to let customers who wish to use the cash or margin account for transactions involving government securities do so. It would allow institutional customers who cannot or will not use a margin account to engage in government securities transactions not specifically authorized in the cash account. For example, the government securities account could be used to effect purchases of government securities on credit or for cash as well as repos and reverse repos. Borrowing and lending of government securities could also be effected in the proposed account without being subject to the "permitted purpose" requirement in §220.16 of Regulation T that requires brokers to limit and document the reasons for their securities borrowings. The account would also permit net settlement of offsetting purchases and sales of government securities. Government securities purchased or deposited in a margin account would still be subject to the current Regulation T rules and would therefore still be available to finance the purchase of other securities in a margin account.

The Board is not proposing to include additional types of exempted securities, such as municipal securities, in the proposed government securities account. Government securities constitute an unusually deep and liquid market and are subject to a unique scheme of regulation, as evidenced by the Government Securities Act of 1986.

NASD members that wish to comment on the proposed amendments should do so by August 25, 1994. Comments should refer to Docket R-0840 and should be sent to:

William Wiles, Secretary Board of Governors of the Federal Reserve System 20th Street and Constitution Avenue, NW
Washington, DC 20551

Members are requested to send copies of their comment letters to:

Joan Conley,
Corporate Secretary National Association of Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1500

Questions concerning this Notice may be directed to Derick Black, District Coordinator, NASD Compliance Department, at (202) 728-8225.