Comments of R.B. Litterman et al. on S7-30-97: OTC Derivatives Dealers

GOLDMAN, SACHS & CO.
85 Broad Street
New York, N.Y. 10004

April 6, 1998

Mr. Jonathan G. Katz, Secretary
Securities & Exchange Commission
Mail Stop 6-9
450 Fifth Street, N.W.
Washington, D.C. 20549

RE: Release No. 34-39454
File No. S7-30-97

Dear Mr. Katz:

Goldman, Sachs & Co. (herein AGoldman Sachs@ or Awe@) is pleased to comment on proposed new rules and amendments to existing rules under the Securities Exchange Act of 1934, as amended, that would tailor capital, margin, and other broker-dealer regulatory requirements to a class of registered dealers, called OTC derivatives dealers, active in the over-the-counter (AOTC@) derivatives markets.

Goldman Sachs is registered with the Commission as a broker-dealer. Goldman Sachs is also a Futures Commission Merchant registered with the Commodity Futures Trading Commission (ACFTC@). Goldman Sachs trades derivatives (futures and options) on organized exchanges for customers as well as on a proprietary basis. Goldman Sachs also engages in transactions in OTC options on securities and securities indices. Affiliates of Goldman Sachs engage in OTC derivatives such as interest rate and currency swaps, caps, floors and swaptions.

The Goldman Sachs Group, L.P. (AGSGroup@), the principal owner of Goldman Sachs, was a member of the Derivatives Policy Group (ADPG@). Certain affiliates report information to the Commission pursuant to undertakings made by GSGroup in the DPG=s report entitled AFramework for Voluntary Oversight of Unregulated OTC Derivatives Dealers@.

Goldman Sachs enthusiastically supports the initiative taken by the Commission in proposing rules that would permit registration of an OTC derivatives dealer.

While we support the proposals, we would like to recommend modifications, and to suggest areas where the proposed rules could be clarified, to further enhance the benefits and utility of the OTC derivative company structure to a firm such as ours. We believe these modifications will not compromise the Commission=s stated objective that traditional customer business involving securities should remain in the fully-regulated broker/dealer.

Goldman Sachs endorses the comments on the proposed rules submitted by the Securities Industry Association=s Derivative Products and Risk Management Committees (the ASIA Letter@).

I. Competitive Considerations.

As a firm interested in forming an OTC derivatives dealer under the new rules, we would like first to respond to the Commission=s request for comment on the extent to which the proposed system would address any competitive inequalities that discourage securities firms from conducting an OTC derivatives business in the United States.

We believe there are several areas where regulations applicable to broker-dealers place requirements or create impediments to the conduct of an OTC derivatives business by a U.S. securities firm in a manner consistent with how such a business is conducted by banks and foreign firms. These impediments include:

First, costly and inefficient capital charges under current rule 15c3-1 require, in our view, a commitment of capital out of all proportion to the risks (both market and credit risks) involved in a dynamically hedged portfolio of OTC derivative transactions.

Second, margin regulations, particularly those imposed by our designated self-regulatory organization (ASRO@) do not permit negotiation of the bilateral credit exposures which are inherent in many of these products.

Third, as a result of the first two points, a U.S. broker-dealer is unable as a practical matter to consolidate the exposures arising from different OTC derivative transactions with counterparties who engage in a full spectrum of OTC derivative transactions. Such consolidation allows banks and foreign broker-dealers to take advantage of payment and termination netting provisions which help control credit risk and, in turn, permit booking of more business.

Fourth, rules regarding the treatment of customer securities pledged as collateral do not permit broker-dealers to negotiate agreements regarding the use of collateral by broker-dealers, adding to the broker-dealers' costs.

The proposed rules address all of these impediments. First, the OTC derivative dealer may elect to employ a capital adequacy standard based on the firm=s Avalue at risk@ for the market risks associated with a portfolio of OTC derivatives and related hedges, plus credit risk charges based on the creditworthiness of counterparties to whom an OTC derivatives dealer has unsecured credit exposure. This is a more efficient measure of the capital required to support these risks than the approach taken in the Commission=s existing net capital rule. Because a derivatives dealer should achieve significant reductions in the capital allocable to support a book of OTC derivatives business, firms will have less incentive to seek other jurisdictions to carry positions in cases where the market risks are more efficiently managed in the United States.

Second, by not being required to be subject to Regulation T and to SRO margin rules, securities firms will be better able to consolidate credit exposure to a counterparty by booking a broad range of OTC derivative products in the OTC derivatives dealer. This consolidation will benefit both the dealer and a counterparty and has the potential to reduce substantially aggregate credit exposures to the extent that derivatives contracts can be made subject to enforceable netting agreements.

Third, OTC derivatives dealers will have greater flexibility to negotiate collateral agreements which allow the dealer to reduce its costs.

Thus, by using the OTC derivatives dealer, U.S. securities firms will be able to compete more effectively with banks and foreign dealers by being able to negotiate credit terms without regard to the inflexible strictures of self-regulatory organization margin maintenance and net capital rules.

Goldman Sachs is, of course, mindful of the fact that the proposed new regulatory scheme is not a license to engage in transactions which are proscribed by other statutes such as the Commodity Exchange Act (ACEA@). Thus, to the extent that OTC derivative transactions and other activities such as the offer and sale of hybrid securities in which an OTC derivatives dealer may engage under the proposed rules are covered by exemptions from the CEA promulgated by the CFTC, we would expect that such transactions would be structured to fall within such exemptions.

Finally, Goldman Sachs does not believe that the Commission=s proposals encroach in any way on CFTC jurisdiction, as the CFTC and others have suggested in comment letters to the Commission. We would urge the Commission to address any ambiguity in this regard when promulgating its final rules along the lines suggested in the SIA Letter. We urge the Commission not to delay issuance of final rules as suggested by these other commentators.

We now address specific comments on the proposed rules.

II. Capital Standards.

A. Rule 15c3-1f(c)(C)(ii) B AConcentration Charge@

The Commission asks whether the Aconcentration charge@ in proposed rule 15c3-1f(c)(C)(ii) that requires a firm to deduct from net worth 100% of the excess by which aggregate net replacement values of all counterparties exceeds 300% of an OTC derivatives dealer=s tentative net capital is excessive. Goldman Sachs responds emphatically that the answer is Ayes@ and urges the Commission to delete this provision.

The release offers no justification for what is in effect an upper limit on exposures for which charges have already been taken B including those charges in rule 15c3-1f(c)(C)(i) which are true concentration charges based on exposures to a single counterparty. Deductions beginning at 300% of tentative net capital is an entirely arbitrary limitation which substantially impairs the effectiveness of the net capital proposal. We are not aware of any analogous requirement applicable to banks, the OTC derivatives dealers= principal competitors. The proposed charge therefore reintroduces what will inevitably be a competitive constraint. Most importantly from our point of view is that the limitation will be a material negative factor in our ultimate decision regarding whether it is preferable to organize an OTC derivative dealer or to find other alternatives to effectively compete in the current environment.

B. FOCUS Report B Part IIB

The Capital Computation portion of the FOCUS Report for dealers electing Appendix E of rule 15c3-1 requires reporting total Value at Risk (AVaR@) as well as separate computations of VaR components for fixed income, currency, commodities and equities. Goldman Sachs requests that the FOCUS Report be amended to delete the requirement to report the component numbers. Goldman Sachs will not use the component calculations in its own risk management, in part because certain derivative securities such as equity basket options, will likely include exposures to more than one component risk (e.g. equity and currency risks). Moreover, as stated, the component computations could be interpreted as meaning that OTC hedges of, for example, the interest rate or currency risk in an OTC equity derivatives portfolio must be extracted and VaR separately calculated as a fixed income component. Moreover, requiring such computations on a daily basis will be burdensome.

If the Commission believes that component VaR calculations are of any value for informational purposes, Goldman Sachs suggests that the Commission staff consult with individual registrants with a view to receiving periodic reports (on a confidential basis) on one or more component VaR calculations which reflect the business as being conducted by the firm.

III. Permissible Securities Activity

In discussing proposed Rules 3b-15 and 3b-16, the Commission correctly recognizes that the management of risks in an OTC derivative book is accomplished by a combination of transactions related to specific positions and with transactions intended to manage the risk of the entire portfolio. The Release states that OTC derivatives dealers should develop reasonable procedures for ensuring compliance with the restrictions on securities transactions set forth in the proposed rules. While this statement is consistent with the internal risk management control systems set forth in proposed rule 15c3-4, the Release goes on to imply that the only adequate procedure a firm could employ to meet this requirement is to create a record which documents that each securities transaction satisfies one of the permissible purposes under the proposed rules. This approach justifies the Commission=s proposal that a firm be allowed a basket of 150 transactions per year which cannot be substantiated as related to a permissible activity.

Goldman Sachs believes that any trade-by-trade documentation requirement is unworkable, unduly burdensome and involves a degree of micromanagement unnecessary to secure the Commission=s policy objectives. A properly implemented management control system monitored by an independent internal audit and compliance function under the authorizing guidelines mandated by rule 15c3-4 should, in our view, be adequate to assure that the securities activities are appropriate to the permissible business of the OTC derivatives dealer. It should not be difficult to spot problematic trading activity, particularly transactions between the OTC derivatives dealer and the affiliated broker-dealer or transactions booked by traders who are not delegated to manage the OTC derivatives dealer=s business.

For these reasons Goldman Sachs urges the Commission to clarify in the adopting release that as long as the risk management control systems adopted pursuant to rule 15c-4 provide for surveillance of the securities trading activities of the firm in line with the permissible securities trading activity ultimately determined by the Commission to be permissible, trade-by-trade documentation of securities transactions is not required. In this regard, Goldman Sachs supports the expansion of permissible securities trading activities proposed in the SIA Letter.

IV. Need for Flexibility

Goldman Sachs believes the degree to which the OTC derivatives dealer initiative will be used by securities firms will to some significant degree depend on whether the Commission and its staff can respond in a timely and efficient manner to requests by participating firms to engage in specific activities or transactions which are beyond the scope of the proposed rules. The Commission recognized that these situations may arise under proposed rule 15a-1, ATransactions by OTC derivatives dealers@. The proposed rule allows an OTC derivatives dealer to engage Ain other securities transactions which the Commission designates by order@. Goldman Sachs believes that application for a Commission order is an unnecessarily cumbersome process in this context and requests the Commission to consider an explicit delegation to allow senior staff of the Division of Market Regulation authority to grant relief in appropriate circumstances.

We further suggest that similar clarification be made with respect to other proscriptive rules. These include the definitions in the proposed rules which are, by their structure, limiting. See, for example, the definitions of AOTC derivatives dealer@ (Rule 3b-12), Aeligible OTC derivative instruments@ (Rule 3b-13), Apermissible derivatives counterparty@ (Rule 3b-14), and Apermissible risk management, arbitrage and trading transactions@ (Rule 3b-15). It is difficult to predict those situations where firms may need to seek approval. To the extent the Commission adopts the modifications to the proposed rules recommended in the SIA letter, we believe there will be fewer situations where staff action will be deemed necessary. Even if the Commission agrees with these changes, however, Goldman Sachs believes that the Commission should encourage staff to adopt a flexible and pragmatic approach to specific issues as they arise in these areas.

V. Conclusion.

In conclusion, Goldman Sachs expresses again its appreciation to the Commission for taking a bold initiative in proposing the package of rules which will dramatically address the competitive disadvantages which have faced U.S. securities firms in accommodating the needs of their counterparties in the OTC derivatives markets. We respectfully urge the Commission to adopt the improvements and clarifications proposed herein and in the SIA Letter. We invite the staff to contact any of the undersigned if further clarification of these comments is required.

Yours sincerely,

Robert B. Litterman
212-902-1677 Mark W. Holloway
212-902-1360 Anthony J. Leitner
212-902-5730

cc: Richard Lindsey
Catherine McGuire
Michael Macchiaroli
Jon S. Corzine
John A. Thain
Barry L. Zubrow
David A. Viniar
C. Douglas Fuge