OTC Derivatives Dealers

A broker-dealer may apply to the Commission for authorization to register as an OTC derivatives dealer (OTCDD) and to compute capital charges for market and credit risk contained in Appendix F to Rule 15c3-1. Under Appendix F, firms with strong internal risk management practices may utilize the mathematical modeling methods they use to manage their own business risk, including value-at-risk (VaR) models, to compute deductions from net capital for market risks and for credit risks arising from OTC derivatives transactions.

An OTCDD is subject to Commission rules that limit its activities generally to:

• Engaging in dealer activities in eligible OTC derivatives;
• Engaging in cash management securities activities; and
• Engaging in ancillary portfolio management securities activities.

Application Process

A broker-dealer that wishes to register as an OTCDD must file an application that outlines how it meets the requirements of Appendix F and Exchange Act Rule 15c3-4. Among other things, the application must describe:

• The mathematical models to be used to compute deductions for market risk, including how the models meet the requirements of Appendix F; and
• The broker-dealer’s system of internal risk management controls to assist in managing the risks associated with its business activities, including market, credit, leverage, liquidity, legal, and operational risks, and how the system satisfies the requirements of Rule 15c3-4; and
• Risk reports that are produced for the persons at the firm who are responsible for internal risk management.

SEC staff reviews the application and conducts on-site reviews prior to action by the Commission. The application may be supplemented by other information that may be requested to complete the review.

Ongoing Oversight of OTCDDs

Following approval, SEC staff conducts ongoing supervision of OTCDDs, including its internal risk management controls, financial and operational condition, and modeled net capital computation. SEC staff primarily accomplishes this through:

• Reviews of monthly, quarterly, and annual filings containing financial, operations, risk management, and statistical data;
• Regular meetings with firm personnel; and
• Examinations of the books and records, capital calculations, and internal risk management controls of the OTCDD.

SEC staff focus includes:

• Risk management of the OTCDD, including market, credit, leverage, liquidity, legal, and operational risks;
• Regulatory capital and risk model performance;
• Stress test modeling and results;
• Risk governance including setting and monitoring risk limits;
• Management of outsized risk exposures;
• Independent price verification function and results; and
• Internal audit infrastructure and coverage of broker-dealer businesses and internal controls.

Other Resources

• Appendix F Adopting Release
• Appendix F Correction

This overview of the Commission’s prudential supervision program for broker-dealers was prepared by staff of the Division of Trading and Markets. SEC staff statements represent the views of the SEC staff. They are not rules, regulations, or statements of the SEC. The SEC has neither approved nor disapproved their content. SEC staff statements, like all SEC staff guidance, have no legal force or effect: they do not alter or amend applicable law, and they create no new or additional obligations for any person.

For further information, contact Michael A. Macchiaroli, Associate Director, at (202) 551-5525 or Thomas K. McGowan, Associate Director, at (202) 551-5521.