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Federal Register / Vol. 86, No. 145 / Monday, August 2, 2021 / Notices
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will need to equal or exceed $20
million. The method of calculating the amount of the deduction relies on the calculations Covered Entities must make under the Basel capital standard.275 In particular, under the Basel capital standard, Covered Entities must riskweight their assets. This involves adjusting the nominal value of each asset based on the inherent risk of the asset. Less risky assets are adjusted to lower values i.e., have less weight than more risky assets. As a result, Covered Entities must hold lower levels of regulatory capital for less risky asset and higher levels of capital for riskier assets.
Similarly, under Exchange Act rule 18a 1, less risky assets incur lower haircuts than riskier assets and, therefore, require less net capital to be held in relation to them. Consequently, the process of risk-weighting assets under the Basel capital standard provides a method to account for the inherent risk in an asset held by a Covered Entity similar to how the haircuts under the Exchange Act rule 18a-1 account for the risk of assets held by SBS Entities. For these reasons, it is appropriate to use the process of risk-weighting assets under the Basel capital standard to determine the amount of the deduction haircuts under the first prong of the second additional capital condition.
Under the Basel capital standard, Covered Entities must hold regulatory capital equal to at least 8% of the amount of their risk-weighted assets.276
Therefore, the deduction haircut required for purposes of the first prong of the second additional capital condition is determined by dividing the amount of the Covered Entitys riskweighted assets by 12.5 i.e., the reciprocal of 8%.277 In sum, the Covered Entity must maintain an excess of liquid assets over total liabilities that 275 See BCBS, Risk-based capital requirements RBC20, available at: https www.bis.org/basel_
framework/chapter/RBC/
20.htm?inforce=20191215&published=20191215.
276 Id.
277 See para. c1iiiC of the Order. The Commission acknowledges that a Covered Entitys risk-weighted assets will include components in addition to market and credit risk charges e.g., operational risk charges. However, the Commission expects the combined market and credit risk charges will make up the substantial majority of the risk-weighted assets. In addition, the Commission believes that this method of calculating the deduction in the first prong of the second additional capital condition is a reasonable approach in that it addresses market and credit risk similar to the process used by security-based swap dealers authorized to use internal models to compute market and credit risk deductions under Exchange Act rule 18a1. See, e.g., Exchange Act rule 18a1e prescribing requirements to calculate market and credit risk charges, including use of an 8% multiplication factor for calculating the credit risk charges.

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equals or exceeds $100 million before the deduction derived from the firms risk-weighted assets and $20 million after the deduction. 278
The second prong of the second additional capital condition requires the Covered Entity to make and preserve for three years a quarterly record that: 1
Identifies and values the liquid assets maintained pursuant to the first prong;
2 compares the amount of the aggregate value the liquid assets maintained pursuant to the first prong to the amount of the Covered Entitys total liabilities and shows the amount of the difference between the two amounts the excess liquid assets amount; and 3 shows the amount of the deduction required under the first prong and the amount that deduction reduces the excess liquid assets amount.279 This prong has been modified from the proposed Order to conform to the modifications to the first and third prongs of the proposed capital condition discussed above i.e., combining them into a single prong that imposes a simplified net liquid assets test. Under the Order, the quarterly record will include details showing whether the Covered Entity is meeting the $100
million and $20 million requirements of the first prong.
The third prong of the second additional capital condition requires the Covered Entity to notify the Commission in writing within 24 hours in the manner specified on the Commissions website if the Covered Entity fails to meet the requirements of the first prong and include in the notice the contact information of an individual who can provide further information about the failure to meet the requirements.280 As discussed above, the first additional capital condition requires the Covered Entity to apply substituted compliance with respect to notification requirements of Exchange Act rule 18a8 relating to capital.281 A
278 For example, assume a Covered Entity has total assets of $600 million of which $595 million are liquid and $5 million are illiquid and total liabilities of $450 million. In this case, the Covered Entitys liquid assets would exceed total liabilities by $145 million $590 million minus $450 million and, therefore, the Covered Entity would have excess liquid assets greater than $100 million as required by the first prong of the second additional capital condition. Assume further that the Covered Entitys risk-weighted assets under the Basel capital standard equal $400 million. In this case, the Covered Entitys deduction would equal $32
million $400 million divided by 12.5. Subtracting $32 million from $145 million leaves $113 million, which exceeds $20 million. Therefore, the Covered Entity would meet the second requirement of the first prong of the second additional capital condition.
279 See para. c1iiiA2 of the order.
280 See para. c1iiiA3 of the Order.
281 See para. c1ii of the Order.

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Covered Entity applying substituted compliance with respect to Exchange Act rule 18a8 must simultaneously submit to the Commission any notifications relating to capital that it must submit to the French authorities.
However, French and EU notification requirements do not address a failure to adhere to the simplified net liquid assets test required by the first prong of the second additional capital condition.
Moreover, due to the differences between Exchange Act rule 18a1 and the Basel capital standard discussed above, a Covered Entity could fall out of compliance with the requirements of the first prong but still remain in compliance with the requirements of the Basel capital standard. Accordingly, the third prong requires the Covered Entity to notify the Commission if the firm fails to meet the requirements of the first prong. This will alert the Commission of potential issues with the Covered Entitys financial condition that could pose risks to the firms customers and counterparties.
The fourth prong of the additional capital condition in the proposed Order would have required the Covered Entity to include its most recently filed statement of financial condition whether audited or unaudited with its initial notice to the Commission of its intent to rely on substituted compliance.
No commenters raised specific concerns with this condition and the Order includes it as proposed, but now it is the fourth prong of the second additional capital condition.282
The commenter who opposed additional capital conditions stated that their burdens would be disruptive to market participants and could cause Covered Entities to exit the U.S.
security-based swap market.283
However, this may not be case. For example, the commenter stated that the Covered Entities expected to register with the Commission transact predominantly in securities and derivatives and do not extensively engage in unsecured lending or other activities more typical of banks.284 The commenter based this statement on a high-level review of public information about the balance sheets of six Covered Entities undertaken to create the 282 See para. c1iiiA4 of the Order. As discussed above, a commenter objected to the capital conditions generally and provided specific comments with respect to the first three conditions, but not the fourth condition. See SIFMA Letter at 920. This commenter did support the fourth condition as part of its recommended incremental approach to implementing the capital conditions.
See SIFMA Letter at 1920.
283 See SIFMA Letter at 19.
284 See SIFMA Letter at 1011.

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